Impact of Foreign Direct Investment and Domestic Investment in South Asia: Time Series and Panel Evidence

Abstract

Investment is a crucial intermediate variable for economic growth; therefore, the relationship between FDI and domestic investment is widely debated in economic literature. Chapter 8 therefore analyses the dynamic relationship between FDI and DI empirically for five South Asian countries by using both time series and panel data analysis and for China for comparative purpose. The empirical test shows that all the explanatory variables except RER have expected signs for India. The variable of interest is FDI as a share of GDP; it shows that FDI crowds in DI in both the short and long run. This suggests complementarities between FDI and DI. China is a special case, where FDI crowds out DI in the short run and stimulates it in the long run. From the panel estimation, it is observed that for South Asian countries, one unit increase in FDI results in more than one unit increase in DI in the long run. The causality test indicates one-way causality from FDI to DI in all South Asian nations except Pakistan, where there is a two-way mutual feedback between FDI and DI. Based on the current study, the policy to enhance FDI should be implemented to stimulate DI. More FDI should be encouraged in less-developed regions, as the positive impact of FDI on DI is more pronounced there. But sectors should be selected so that backward and forward linkages through spillovers increase rather than displacing domestic firms. Overall, FDI has played a significant complementary role to DI in developing South Asian countries. Therefore, these countries must make every effort to get FDI and, thereby, improve DI—which is crucial for sustaining high economic growth.