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European Journal of Social Sciences ISSN 1450-2267 Vol. 41 No 1 December, 2013, pp.148-154 http://www.europeanjournalofsocialsciences.com

Investigating Effective Factor Impacts on FDI Inflow in Iran using ARDL Model Ali Fegheh Majidi Assistant Professor of Economic, University of Kurdistan Abstract According to the role of Foreign Direct Investment (FDI) in economic growth and development Investigating of its effective factor is particularly important. This paper surveys the factors affecting FDI over the period 1979-2012 using Auto Regressive Distributed Lag (ARDL) Method. The result shows that GDP, Economic Openness and have significant and positive effect on FDI inflow, while government size and inflation rate have significant and negative effect. The speed of adjustment implied by the error correction term coefficient is 23 per cent.

Keywords: FDI Inflow, ARDL, Cointegration.

1. Introduction Economic growth and development is an objective focused upon by all government bodies and economic policy-making agencies worldwide. In all growth models, capital is posited as the strong deriving force of economic growth and development. Attraction of foreign financial resources as complementary to domestic resources is crucial to attainment of economic growth objectives. Foreign capital transfer facilitates the trade for countries hosting the capital in addition to providing compensations for lack of foreign resources. Multinational companies bring forth considerable development benefits through investing on host countries. Giant leap in economic growth, improved exports, and technical adjustments in southeast Asian countries, Indo-China, and other newly industrialized countries are partly indebted to attraction of FDI (Institute for Trade Studies & Research (ITSR)). In the lack of domestic financial resources, FDI could help boost economic growth and development, bridging the gap between capital resources and domestic investments. Generally, foreign investment positively contributes to development of multinational firms in order to attain improved competitiveness, higher profits, more access to lower-wage labour force and wider consuming markets, technological advancement, rapid capital transfer, and development of foreign trade (IMF).. The present study investigates the effective factors on FDI attraction in the context of Iranian economy. In doing so, we investigate the impact of variables such as, GDP, inflation, exchange rate, human capital, and economic fluctuations. Furthermore, we investigate the theoretical underpinnings and model structures, and drawing upon data available for the period 1981-2011, provide an estimation of the model. In the final section, an analysis of the estimation results and a conclusion is presented.

2. Literature Review In classical theory, capital is the major force of economic growth derived from savings. In neo-classical theory however, investment and its consequent economic growth are not solely the outcomes of domestic investment. As some countries lack the necessity capital inside, they attract foreign 148

European Journal of Social Sciences – Volume 41, Number 1 (2013) investments; the FDI impact on improvement of exports and interactions with outer world is obvious. The most important contribution of FDI is changing the economic phase of the host country from that of an exporter of raw material to that of an exporter of value-added industrial products, and in some cases, as exporter of high technology products as a result. Furthermore, the impact of FDI on host country is not restricted to exports growth and structural adjustment of exports; rather, cutting-edge technology worldwide transfer to the country and plugging of the host country to international production network are among other FDI effects (Kazeroni and Taheri, 2010). FDI indeed functions as a channel for technology and capital transfer to host countries. FDI had been deemed as a good stimulant of technology transfer and improvement in management practices (Koko et al., 1996). It also boosts efficiency in production level, which itself contributes to improved efficiency in higher levels (Markusen and Venables, 1999). FDI inflows inward developing countries improve their economic performance through technological advancement and encouragement of national investment (George and Catono, 2009). The impact of attracting foreign investment and fierce competition to attract investment especially for mother and major industries such as oil industry has revolutionized these sectors. A major question to be answered is that what the effective factors on foreign investment are. Understanding of these variables and factors offers some approaches to improve inward FDI inflow in any country. Generally, effective factors on FDI inward inflow are as the following: 2.1. Market Size Market size plays an important role in a specific category of foreign investments made with the objective of finding customers in domestic markets rather than exporting products, especially, when the host country grants the economies of scale to investors. To the extent that the markets of any country are wider or still needs to be saturated, the inward inflow of investments will be improved. Based on a theoretical model suggested by Chakrabarti (2003), any increase in the market size leads to an increase in FDI via increasing the demand. In the present study, GDP in fixed prices has been taken as an index of domestic market size. public sector resources. 2.2. Exchange Rate Aliber (1970) investigated the impact of exchange rate fluctuations on FDI inward inflow for the first time. He argued that countries with depreciated domestic currency would probably attract FDI with the objective of increasing power purchase. Exchange rate wields its effect on foreign investment through its fluctuations. Traditional views assumed that exchange rate level had no effect on FDI, since decisions about sectors on which to invest find no relevancy to exchange rate level. The view, however, garnered much criticism and opposition. Froot and Stein (1991) believed that if the capital market flawed, exchange rate level would be effective on FDI. Kiews (1996) investigated the FDI inflow behaviour in the US, showing a negative association between nominal exchange rate level and FDI. Blonigen (1997) believed that exchange rate had a direct effect on benefits accruing to the FDI, since it wielded impact on the purchase of firm’s assets using foreign currency, which could be yielding other benefits if transferred to domestic production process. Depreciation of the host country currency could lead to increased benefits coming from domestic assets for foreign firms and consequently, improved FDI. Campa (1993) suggested a different theory of the relationship between exchange rate and FDI. According to his model, decisions made by the firms to invest or not to invest in foreign countries depends on firms expectations about future benefits, and the higher the exchange rate becomes, the higher the expectation about the benefits from foreign markets will be. Thus, his model predicts that improving the value of host country’s currency results in increased FDI, a prediction well in contrast to theories put forth by previous models. Boyor (2003) maintains that exchange rate had an ambivalent effect on FDI, much dependent on the motivations of the investors. In fact, the effect depends on the export of produced goods by foreign investors. In this analysis, FDI and 149

European Journal of Social Sciences – Volume 41, Number 1 (2013) trade complement each other. Thus, improvement of domestic currency value could decrease the FDI inflow due to poor competition, or contribute to domestic market. Doing so, it boosts FDI due to higher power purchase. Blonigen (1997) suggests that exchange rate fluctuations could possibly affect the FDI inflow to the host country. If FDI is triggered by a firm drawing upon assets inside the same firm among different markets without money exchange (for example, assets specific to firms, such as technology, management skills, etc.), then increase in exchange rate will cut the price of assets calculated in foreign currency; but will not necessarily decrease the nominal output. 2.3. Inflation Rate Rise in prices for any given reason would decrease the value of domestic assets; as a result, investors would prefer to change the optimum composition of their assets, with more weight assigned to foreign assets (capital flight). On the other hand, sinking prices would result in decreasing interest, net investment, and asset value, and capital inflow to the country. Inflation leads to increased investment risk, reduced average maturity of commercial loans and impairment of information conveyed by the price. Also, high inflation is an indication of economic instability and the lack of control over macroeconomic policies. 2.4. Political and Economic Instability A stable political and economic atmosphere would foster FDI inflow to any given country. In a turbulent political environment, the investor would fear the unexpected and sudden changes of economic and political atmosphere and its consequences. Thus, they would prefer to effectively avoid official long-term trade arrangements with several parties to it, and would do the trade in local and smaller scales. Put it differently, with the rise in political and economic risks, firms enter a period of dormancy, and postpone their expected investments for the time being so that they could find better insights about the economic situation when the smoke is cleared. In general, political risk is an important contributing factor in making decisions about foreign investments. Political change inside the host country is significantly related to the foreign investment decisions. In his examination of political risks effective on FDI, Hartman (1985) concluded that when the host country is a developing country, multinational firms react to two inter- and intra-national variables. Reduced uncertainty and risk bring about optimum allocation of resources and boosts attraction of foreign investments. 2.5. Human Capital The interaction between FDI and human capital is highly important. FDI is not solely a source of capital and employment, but it can also function as a means for developing countries to acquire skills, technology, organizing and management skills, and accessing international markets. The hypothesis that human capital in host countries is an effective factor of attraction of foreign investments, has gained popularity during 1990s. Lucas (1993) states that the lack of skilled human capital in lessdeveloped countries discouraged foreign investment. Markusen and Zhang’s (1996) model emphasized upon the skilled human capital as a real boon for multinational firms, which is effective on FDI inflow. In addition, Dunning (1998) believes that educational attainment and skilled human capital are effective on FDI inflow and multinational firms’ activities in host countries. 2.6. Economic Openness The degree of economic openness is an effective factor to be considered by multinational firms in their decisions on participating in investments in developing countries. Countries with higher share of attraction of FDI have often economic policies dominantly to liberalize trade. The degree of openness of economy of a given country is usually measured by the index of ratio of net exports to GDP. A major factor of success of Southeast Asian countries in attracting FDI is their recent decade open-door 150

European Journal of Social Sciences – Volume 41, Number 1 (2013) economic policy. Countries such as Hong Kong, Singapore, Thailand, and Argentine have highly open economies (Rahmani, 2000).

3. Model Estimation Now, with the review of empirical studies, a model of foreign investment in Iranian economy is estimated and presented.

Where t is in years and U is error term. denotes the market attractiveness. is an index of macroeconomic instability. is the index of economic openness, measured as the export and import to GDP ratio. In this model, the ratio of government expenditure to GDP, , which is an index of the government size. Exchange rate, , an index of concerns over the risk, political instability, economic situation, and hostile relations of host countries with other countries, could decrease the attractiveness of investment, with negative impact on FDI inflow. is fixed capital formation that includes expenditure of business enterprises, durable machinary, facilities and structure such as factories. According to the research by Wheeler and Mody (1992) and Hisarciklilar (2006), who investigated factors effective on FDI, the positive impact of FDI feedback has been confirmed, which itself contributes to the FDI attraction in the future. On the similar grounds, a two-year lag of FDI is added to the variables of the model. Before estimation of the model, it is necessary to examine the stationarity of variables. Granger and Newbold (1974) indicated that using ordinary leas squares (OLS) with non-stationary variables has had misleading results, since t and F tests lack the necessary validity. Dickey–Fuller, augmented Dickey–Fuller, and Phillips–Perron tests are extensively used to examine the stationarity of the variables. Table 1 shows the stationary test of variables using Dickey-Fuller test (1981). According to our results, time-series used in the model is characterized by I (0) andI (1). We suggest Auto Regressive Distributed Lag (ARDL) and Least Squares with first-order difference. Table 1:

Stationary test results of variables using Dickey-Fuller test. level

Variable Log GDP Log FDI Log OPEN Log IMF Log Log GFCF Log G/GDP

No trend -1/34 -1/89 -1/70 -1/99 -0/88 -1/16 -4/92

trend -2/25 -2/45 -1/90 -2/37 -1/75 -2/90 -5/29

First difference No trend -5/45 -6/04 -5/025 -4/89 -4/75 -6/16

trend -5/42 -6/53 -5/16 -4/88 -4/70 -6/17

According to our results, all variables except for goernment expenditure are reliable in level I(1). In fact, variables in the model are characterized by I (0) and I(1). Therefore, it is possible to use ARDL; since the advangate of the method is that variables with aggregate value of 0 and 1 enter the model with raising no glitch. In addition, using the model makes simultaneous examination of the short- and long-term dynamic behavior possible. Since investment is a long-term process, we emphasize on long-term relations in the present study.

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European Journal of Social Sciences – Volume 41, Number 1 (2013) Table 2:

ARDL model dynamics results

Regressor Log GDP Log OPEN Log IMF Log G/GDP Log FIX capital formation Constant

Coeff. 0/5660 ٠٣١٨ -٠٢٧١٩ -٠٧٠٣ ٧١ ٠٠٢٨٢٨ ٠١٢

٠٠٧ ٠٩ ٠٨٨٨٨

Log Log FDI-1 2

R F

S.e. 0/039 0٣٠٢٣١ ٠٠٨ ١٧ ٠0 ١١ ٠٨٢٩٠٨ ٢ ٠٢٣ ٠٠٢٩٢٨

p-value 0/٠٢٧ ٠٠٠١٢ ٠٠٠١ ٠0١٣٩

٠0٧٢٨ ٠٨

٢ ٠١ ٠٧

٠٢٢٢

0/000

0/96 23/43

Lagrange Multiplier diagnostics (LM) indicated that there was no autocorrelation problem between error terms in both models with error margin of 5 per cent. Functional form of the model has been well specified. Error terms have a normal distribution. There was no problem of Heteroskedasticity. In addition, the hypothesis of correct functional form of the second model is accepted in error margin of 10 per cent. To estimate the long-term relationship between FDI and other macroeconomic variables, the cointegration test is carried out. The necessary number of lags in the model is one lag according to Akaike information criterion (AIC). The F-test results are given in Table 2. Table 3:

Cointegration test results

variables F(Lfdi, Lgdp,Lg/GDP, Lfix , open, Lexc, ifm,) F(Lfdi|Lm2,Lg/gdp, Lfix, open infm) F(Lfdi,Lg/gdp, Lfix, open, infm) F(Lfdi, Lg/gdp, Lfix, infm,) F(Lfdi, Lg/gdp, Lfix) F(Lfdi, Lfix) F(Lfdi,Lg/gdp)

lag 1 1 1 1 1 1 1

F-statistic 1/15 1/55 1/32 2/27 4/32 3/87 4/82**

No trend 2.163 2.365 2.476 2.649 2.850 3.219 3.793

trend 3.349 3.553 3.646 3.805 4.049 4.378 4.855

results No cointegration No cointegration No cointegration No cointegration No cointegration No cointegration cointegration

F-test results show that null hypothesis of no cointegration in F (Lfdi, g/gdp) is rejected, and there is a long-term relationship between these variables. Estimation of long-term relationship gives the following results. Table 4:

Long-run model Variable

constant Lg/gdp

coefficient -2/74 0/184

t-Statistic -2/07 2/67

P value 0/000 0/046

Our results indicate that the ratio of government expenditure to GDP is an important factor of FDI attraction in long run. The error correction model results are given in the table below. The error correction term is significant and has the predicted sign, and the adjustment rate is 23 per cent; that is, 23 per cent of FDI fluctuations from balanced amount have been faded away by nearly a year.

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European Journal of Social Sciences – Volume 41, Number 1 (2013) Table 5:

Error correction model variable

constant Dg/gdp Ect(-1)

coefficient -0/96** 0/032** -0/23***

-statistic t -1/95 2/67 -3/06

P value 0/064 0/014 0/004

According to our results, significance of the coefficients of GDP, the ratio of government expenditure, FDI in previous financial period, and inflation rate have been as predicted, indicating that models used has a certain level of validity. GDP has positive and significant impact on FDI, in that with expansion of market size, FDI tends to soar. In fact, with 1 per cent rise in GDP, FDI rises 56 per cent. Given the favourable economic conditions, necessary markets for consumption goods and a profitable production are created in a considerable scale. In other words, favourable markets, either in terms of demand or supply, play a crucial role in FDI attraction. The FDI coefficient is significant and positive in period t-1, consistent with Wheeler and Mody (1992) and Chan and Kwang (2000), who maintained thatcointegrated FDI has a significant and positive effect on FDI. According to our results the coefficient of government expenditure G/GDP is negative and significant. It can be safely assumed that when government interventions in economy exceed the optimal level, it would lead to foreign investment flight due to the substitution effect. When the scope of government activities, or to put it other way, government size, expands in proportion, its inefficiency becomes evident in economics: the negative impact of interventions by public sector outruns its positive effects and due to the ineffective allocation of resources across society, government expenditure replaces private sector expenditure including investment costs (forced substitution effect), consumption expenditure, and other costs accruing to the private sector. On the other hand, in our present study, government expenditure has been taken as a general index of government intervention in economic activities, and its negative impact is not necessarily denoted negative impact of all economic activities of the government. Thus, overall, given the results from model estimation, it can be inferred that the effect of government expenditure on FDI is significant and negative. The coefficient of inflation rate is negative and significant, indicating that higher inflation rate denoted instability and ineffectiveness of economic policies. In fact, with a 1 per cent rise in inflation rate, FDI declined about 0.2 per cent. Given the fact that a lion’s share of oil income is deposited in National Development Fund, and its negative impact on inflation rate in Iran, one can safely assume that the Fund absorbs the inflationary effect of the oil incomes through fixing these incomes as investment. The coefficient of economic openness is positive and significant; that is, the more open an economy, or the less the tariff-related barriers in any given country, the more FDI inflow will be. In fact, with a 1 per cent rise in economic openness, FDI rose about 0.1 per cent. The coefficient of exchange rate is not statistically positive and significant, being not according to predictions that depreciation of the currency leads to attracting more FDI. However, if improvement of the domestic currency is assumed as an indication of future improvements (perhaps, due to improved management of the economy or more political and economic stability), it will boost FDI inflow. Since agglomeration effect is possible (in other words, previous FDI inflow would have positive effect on current inflow), this interpretation gains credibility.

4. Conclusion In the present study, we investigated the factors effective on the absorption of FDI in Iranian context for the period of 1979-2012 drawing upon ARDL approach. The results of our estimation indicate that GDP, economic openness, and previous FDI have a positive and significant effect on FDI. In addition, 153

European Journal of Social Sciences – Volume 41, Number 1 (2013) inflation rate and the ratio of government expenditure to GDP has a negative impact on FDI attraction. Exchange rate and fixed capital formation are not statistically significant.

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