Foreign direct investment, financial development and economic performance: a comparative study of Malaysia and Sri Lanka

2017-05-19T03:19:30Z (GMT) by Subasinghe, Sanjeevan Chalaka
Malaysia has emerged as a leading destination for foreign direct investment in South East Asia while Sri Lanka has been less successful in utilising foreign direct investment in her development process. Both countries have a rich history of financial sector reforms. Even though the two countries share similar initial conditions, there are vast differences in their subsequent performance in terms of foreign direct investment experience, the pace of financial development and economic performance. These two countries are, therefore, ideally suited for a comparative investigation. Foreign direct investment directly affects capital accumulation and generates many indirect benefits through spillover effects. One prominent factor that contributes to the effectiveness of the accumulated stock of foreign direct investment is the level of financial development in the host country. This interface between foreign capital and financial development is the domain of the present study. Specifically, the aim of this study is to examine the role of financial development in the relationship between foreign capital and domestic output, in particular to explore the effect of the interaction between foreign capital and financial development in promoting economic development in the host country. While a few cross-country studies have explored the trivariate relationship between foreign direct investment, financial development and growth, there is a dearth of time series studies in this area. The present study seeks to fill this gap. One of its substantive innovations is its comparative nature. This study makes a contribution to the literature by examining the long-run cointegration relationships for Malaysia and Sri Lanka between the stock of foreign capital, financial development and output based on four alternative measures of financial development – bank-based, money stock-based and stock market-based. Employing a variety of financial development indicators makes it possible to explore different aspects of the complementary relationship between the stock of foreign capital and financial development and their effects on output. Further, in contrast with previous work, the present study also examines the causal relationship between the stock of foreign capital and financial development. The empirical specification is based on the AK growth model with its focus on the level of domestic output as the dependent variable. This strategy contrasts with previous studies of the trivariate relationship between foreign direct investment, financial development and economic performance which mostly employ the growth rate of per capita output as the dependent variable without providing a sound theoretical basis for their empirical specifications. A particular novelty of the present specification is that all variables are consistently specified in stock terms. A Vector Error Correction Model (VECM) is employed to test the cointegration relationships using annual data over the period 1961-2007. The VECM assumes all underlying variables are endogenous. This methodology is thus superior to the growth regressions employed in previous studies in this area which typically fail to explicitly recognise the endogenous effects of these variables. The findings indicate that the interaction between the stock of foreign capital and financial development exerts a significant and positive long-run impact on output in both sample countries. This result is robust with respect to the alternative measures of financial development. Secondly, VECM-based causality tests suggest that a significant causal relationship exists between the stock of foreign capital and financial development. Lastly, comparison of the results for the two sample countries reveals salient differences such as the ways in which the stock of foreign capital interacts with different components of the financial system. These differences are consistent with their respective foreign direct investment experiences, levels of financial development, institutional environments and policy regimes.