FDI Driven Growth in Emerging Economies: Impact of Levels of Central Bank Independence

Abstract

This paper investigates the impact of levels of central bank independence (cbi) on the relationship between foreign direct investment (fdi) and economic growth. Economic theory confirms that a higher level of central bank independence is associated with a relatively lower and stable rate of inflation. To the extent that inflation moderation contributes to macroeconomic stability, and the latter provides a favorable environment for fdi to impact growth significantly, we considered it important to examine the possible effect of cbi on the fdi-economic growth relationship. Our attempt in this direction fills an important gap in the literature by adding a new dimension to the fdi-growth nexus. We proceed by subjecting data on fdi flows and gross domestic product (gdp) to Granger causality tests within a panel cointegration framework. Our panel consists of 22 emerging countries subdivided into groups of high and low cbi countries. The empirical investigation in our framework proceeds in three different steps. We begin by testing for non-stationarity in the two variables of fdi flows and gdp in our panel of 22 countries. Prompted by the existence of unit roots in the time series of the referred variables, we use the panel cointegration technique to test for a long-run cointegrated relationship between the two variables of interest in the second step of our estimation. With evidence of cointegration in the long-run fdi-growth relationship for the full and the subdivided panels, we finally use an error correction model to uncover Granger causality in the long run relationship along with its short-run dynamics. The results of our tests indicate a strong cointegration between fdi and economic growth for both the subdivided country groups referred above; causal links between the two variables, however, vary substantially between the two groups. While the high cbi countries show a significant long run bidirectional causality between fdi and economic growth, the low cbi countries demonstrate only a unidirectional link running from economic growth to fdi; there is no evidence of a link running from fdi to economic growth for the low cbi countries. Additionally, we find that for both the country groups, fdi induced growth is a long run phenomenon only. These results seem to suggest that with associated price stability, high cbi countries serve not only as an attraction for fdi flows but, through productivity spillovers, triggers economic growth that induces additional fdi flows.