Economic Impact of Foreign Direct Investment in Sri Lanka

89 Central Bank of Sri lanka
Economic Impact of Foreign Direct Investment

in Sri Lanka

B. H. P. K. Thilakaweera*

Abstract
This paper investigates the long-run relationship and causality between
real per capita GDP, foreign direct investment (FDI) and the level of
the infrastructure in Sri Lanka over the period 1980 to 2011. Level of
the infrastructure has been measured by using a summary measure
based on principal component analysis. Analysis shows that there is a
long-run relationship between real per capita GDP, foreign direct
investment (FDI) and the level of the infrastructure. The empirical
results further confirm the unidirectional causality from level of the
infrastructure to FDI.

I. Introduction
Foreign Direct Investment (FDI) as a growth stimulus tool has received great attention
from developing countries in recent decades. In a closed economy without access to
foreign saving, investment is financed from domestic savings. However, in an open
economy, investment may be financed through both domestic savings and foreign capital
flows, including FDI. Therefore FDI enables host countries to achieve investment levels
beyond their capacity to save. Over the last couple of decades, FDI flows have increased
significantly and remain the largest form of capital flows into developing countries, far

* The author would like to thank Dr. D.S Wijesinghe and Dr. M.Z.M. Aazim for their
guidance and comments.
Staff Studies Volume 41 numbers 1 & 2
Central Bank of Sri lanka 90
Staff Studies Volume 41 Numbers 1 & 2

CENTRAL BANK OF SRI LANKA
90
surpassing portfolio investment, foreign loans and other forms of financial assistance
1
.
FDI now accounts for more than half of the private capital flows between countries in the
world. Therefore the contribution of FDI to economic growth has been studied quite
extensively in the recent literature of studies focused on FDI. A preponderance of studies
shows that FDI encourages the economic development of a country through both direct
and indirect channels (Borensztein et al. 1998, Asafu-Adjaye, 2000, Fan and Dickie
2000).

The positive role of infrastructure in the economic development of a country
also has been emphasized in both the theoretical literature and empirical studies (Rioja
2004, Ramiraz and Nazmi 2003, Wang 2002, Kessides 1993, Ford and Poret 1991).
Infrastructure facilities contribute to economic development by improving productivity
and by providing amenities that enhance the living standards of the society. Therefore,
infrastructure is generally believed to be one of the essential factors for economic
development, especially roads, telecommunications services, electricity, water supply etc.

More recently, a number of studies have suggested a potential role for advanced
infrastructure, in particular, in attracting FDI (Reynolds et al. 2004, Yol and Teng 2009).
A countrys capacity for absorbing FDI depends highly on the infrastructure facilities in
terms of physical and regulatory framework available in the economy for foreign
investments. Therefore, countries with advanced infrastructure absorb more FDIs than do
countries with a relatively low-level infrastructure facilities. According to the World
Investment Report 2011, despite the slow recovery from the economic downturn of
2008-09 and uncertainties in developed economies particularly in euro zone, developed
countries accounted for 52 per cent of FDI flows in 2011.Although the World Investment
Report 2011 highlights the increased participation of MNCs(Multi National Companies)
in the infrastructure sector of developing countries, development in regulatory
infrastructure and reforms are not inline with those FDI inflows.

Within this global investment environment, the relationships between FDI,
infrastructure and economic growth are a subject of debate in this era. Sri Lanka
introduced an open market economy with trade and FDI liberalisation in 1977 and
became the most open economy in South Asia. Most of the other South Asian countries
introduced FDI liberalisation policies after the mid-1980s; therefore, South Asia was not

1
www.unedforum.org/policy/economic/fdi.pdf
www.undp.org/content/dam/undp/library/Poverty Reduction/Inclusive
development/Towards Human Resilience/Towards_SustainingMDGProgress_Ch3.pdf
91
economic impact of foreign Direct investment in Sri lanka
Central Bank of Sri lanka
Economic Impact of Foreign Direct Investment in Sri Lanka

91
generally a large recipient of FDI. In the 1980s with early liberalisation, Sri Lanka
attracted an annual average of US$ 40 million in FDI flows, while large South Asian
economies recorded lower FDI flows with respect to the size of their GDP. During this
period, the average annual flow of FDI was around US$ 2 million per annum for
Bangladesh, US$ 100 million for India and around US$ 90 million for Pakistan
(UNCTADstat 2012). The past three decades have witnessed a dramatic increase in
foreign capital flows into Sri Lanka. The inflows of FDI increased from US$ 47 million
in 1979 to US$ 752 million in 2008
2
. Sri Lanka is trying to offer relatively better
infrastructure facilities to foreign investors compared with most of the other South Asian
nations, with high public investment in infrastructure sector. Thus, the empirical
investigation of the dynamic interactions between FDI, infrastructure and economic
growth is important for researchers and policy makers both in Sri Lanka and in other
developing countries in order to examine the effectiveness of liberalisation policies on
FDI and infrastructure development in enhancing economic prosperity.

The development of a number of theories to explain FDI was led by the growing
interest in FDI as a stimulus tool for rapid economic development. These theories explain
the reasons for an investors preferences for some locations, selection of different entry
modes or reasons for inward FDI or outward FDI, etc. Although most of the FDI theories
are focused on determinants of the FDI, impact of FDI on the host economy or
infrastructure has been highlighted in some of them. In neoclassical theory, Heckscher
Ohlin (HO) model introduced by the Samualson in 1941 explains the mobility of
investment from countries with low marginal productivity of capital to the countries with
high marginal productivity of capital (Leamer 1995). Since the underlying assumptions of
HO model are based on perfect competition, balanced trade, constant return to scale and
full employment, it is inadequate to explain real world phenomena such as FDI flows in
imperfect market competition along with the risk and uncertainties. Therefore HO model
failed to explain the FDI flows among developed countries and to make distinction
between FDI and other investment. Eclectic theory of FDI developed by Dunning (1977)
poses two questions: (i) Why the local demand is not met by local firms? (ii) When a firm
wants to expand production, why does it choose FDI? He argued that for investing in a
foreign country, three conditions should be satisfied by the firm that invite FDI; first, the
firm should have a comparative advantage such as brand named technology, etc., second,
it should be beneficial to invest rather than sell the rights and third, it should be profitable
to use these advantages. Kojimas hypothesis presented in 1973 explains FDI as
transferring modes of technology, managerial skills and technology. It classifies FDI into

2
http://www.fdi.net/index.cfm?infocntry=179 viewed 02 October 2009

92
two types, as trade oriented and anti-trade oriented. The trade-oriented FDI is based on
comparative advantages. These FDIs encourage trade in both host and home country
while improving welfare, but the second type does not improve trade.

Many researchers have attempted to quantify the impact of FDI inflows on the
economic growth of the host country. Most of these highlight the positive impact of FDI
on economic growth while more recent studies also prove the same positive impact of
FDI on economic growth while emphasising the necessity of the threshold level of other
factors, such as infrastructure and institutional frameworks (Borensztein et al. 1998,
Jyun-Yi and Chih-Chiang 2008, Alfaro et al. 2001).

Early theoretical works on FDI also include the influence of infrastructure on
FDI. Hymer (1970) developed a model highlighting the importance of infrastructure for
attracting FDI and ultimately, for the level of economic development. Meanwhile, the
impact of infrastructure on economic growth has been investigated by many researchers.
Interest in the impact of infrastructure on economic growth was first triggered by a series
of papers published by Aschauer (1989). Later, Ford and Poret (1991), Wang (2002) and
Kessides (1993) also tested the interaction between infrastructure and economic growth.

Despite the fact that FDI flows have focused on the infrastructure development
and the economic development of emerging economies, most empirical studies examine
the impact of FDI on the economic growth rather than investigating the interaction
between FDI, infrastructure and per capita GDP. Comprehensive analysis should analyse,
how FDI impacts on GDP, the impact of the infrastructure on economic growth and the
type of relationship that exists between FDI and infrastructure. Therefore this paper is an
attempt to combine these three branches of research to fill the lacuna in empirical
literature and test the relationship among these 3 variables within a multidimensional
framework.

Economists and policy makers have analysed the contribution of FDI and
infrastructure separately in accelerating the process of economic growth in developing
countries. However, most studies make implicit assumptions that causality runs from FDI
and infrastructure to economic growth. Such an assumption precludes the possibilities of
reverse causation or a simultaneous relationship between the variables. Therefore, the
foremost objective of this study is to investigate the possible links between FDI inflow,
economic growth and infrastructure based on a systematic approach such as vector
autoregression (VAR), rather than merely operating with a production function equation
which explains that growth is driven by the factors such a labour, capital, FDI
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93
etc.(Unidirectional causality). The study seeks to examine whether a stationary long-run
relationship exists among FDI inflow, economic growth and infrastructure and causality
between those three variables along with the direction of the dynamic interaction between
them.

Trends in FDI
During the British Colonial Period from 18151948, the UK was the major source of FDI
in Sri Lanka. British FDIs focused on the development of infrastructure facilities that
were required for their investment in the plantation sector of the country. After achieving
independence in 1948, Sri Lanka followed different strategies with changes in
government until 1977. FDI flows were negligible as a percentage of GDCF (Gross
Domestic Capital Formation) until the late 1970s. The annual average inflow of FDI
during the 19701977 was only US$ 0.5 million and it was around only 0.2% of GDCF.
With the economic policy reforms introduced in 1977, the FDI flows rapidly increased
continuously until 1983. The annual average FDI inflows, as a percentage of GDCF,
increased to 4.2% in the period 19781982.

However, the impressive upward trend in FDI flow was disrupted by the
escalation of ethnic problems into a civil war in 1983. Sri Lanka lost its investment
potential due to the uncertainty created by the civil war. As an example, two electronic
manufacturing giants, namely Motorola and the Harris Corporation which obtained BOI
approval to establish plants inside the Katunayaka free trade zone in 1982; withdrew their
investment projects from Sri Lanka with the uncertainty created by the war(Kelegama
2006).

In addition, the Japanese yen appreciated in value in the mid-1980s and Sri
Lanka may have had an opportunity to attract Japanese investment, as had other East
Asian economies, if there had been a peaceful environment in the country. Even with the
civil war, Sri Lanka was able to maintain the average FDI flow of 3.2% as a percentage
of GDCF until the Marxist-armed insurrection started in the southern part of the country
in 1988. Due to the conflict in both the northern and southern parts of the country, FDI
flows significantly dropped in 1988 and 1989. However, in late 1989 the government
managed to crush the rebels in the southern part of the country and armed struggle was
again limited to the Northern and Eastern Provinces.

With the second wave of trade and FDI liberalisation in the early 1990s,
Sri Lanka attracted significant FDI flows. Privatisation of state-owned enterprises also
contributed to attracting significant amounts of FDI between 1990 and 2001. More than

94
two-thirds of the state-owned enterprises were acquired by foreign investors in 1990s
(CBSL 2002). In the 1990s, the largest 20 foreign investors went into telecommuni-
cations, power generation, port and other infrastructure development and industrial
sectors. More than one-third of the FDI flows in the 1990s came through the privatisation
of state-owned enterprises (Athukorala and Jayasuriya 2004).

However in the second half of the 1990s, FDI inflows recorded somewhat of a
deceleration due to the external shocks and the political environment in Sri Lanka.
The sector was affected by the escalation of violence in the Northern and Eastern
Provinces of the country and the consequences of the East Asian currency crisis. Before
the recovery from the set-back in the late 1990s, the adverse impact of the 9/11 attack in
2001 was felt in FDI flows. In addition, the LTTE attacked Sri Lankas only international
airport in the same year, and this also badly affected to the FDI flows. Again, a somewhat
conducive economic environment was visible in the country after 2002, with the signing
of a peace agreement with the LTTE Tamil rebel group. Although the LTTE withdrew
0
2
4
6
8
10
12
1980 1985 1990 1995 2000 2005 2010
FDI as a Percentage of GDCF
(%)
Figure 1
Year
95

95
from negotiations and the government decided to crush the rebels in 2005, FDI flows into
the sector have shown a steady growth over 2003-2010. In year 2011 country attracted
significant inflow of FDI consequent to achieving sustainable peace after the government
forces crushed the LTTE rebels in May 2009.

Following this introduction, section II provides Literature Review on Economic
Growth and FDI. Further, section III focuses on the model specification, data and
methodology used to assess these relationships and the statistical tests applied in this
methodological framework. The empirical analysis is presented in section IV and
section V concludes the research with the conclusion, policy recommendations and
limitations of the study.

II. Literature Review on Economic Growth and FDI
Empirical research in this area falls roughly into two groups. First, there is a plethora of
empirical studies that examine the impact of FDI flows on economic growth based on
cross-sectional or panel data from groups of countries. Some of the studies have
examined other factors, such as domestic investment, trade, financial sector development,
etc., while assessing the impact of FDI on economic growth. Only the studies focused on
finding the determinant of FDI in this category have addressed the relationship between
infrastructure and economic growth. Those have incorporated proxy variables, such as
telecommunications and road developments to represent infrastructure developments.
Second, the relationship between FDI and economic growth has been investigated by
many researches focused on one country using time series data. Most of those studies are
focused on GDP-FDI nexus, and the role played by the some other variables such as
financial sector development and infrastructure development have been taken into
consideration.

When considering the econometric methodologies used, previous studies in this
area made use of regression models and causality analysis. The neo-classical growth
theory defines aggregate growth as a sum of the total factor productivity growth and the
weighted sum of the growth rate of factor inputs while incorporating the Hicks-neutral
technological change. Therefore, some studies investigate the impact of FDI and
infrastructure on economic growth using these aggregate production function models
based on both cross-sectional data and time series data. This method implicitly assumes
that the selected economic variables (explanatory) cause the growth without formal
testing of the direction.


96
The issue of causality between FDI and some other macro economic variables
has been empirically examined in a number of more recent studies. Two approaches
based upon bivarite and multivariate models have been used. The general tests for
causality within the bivariate models are the Granger test, Sims test and Geweke test.
On the other hand, multivariate models of correlation are characterised by examining the
variance decompositions functions and impulse response functions.

Among the recent cross sectional studies, Borensztein et al. (1998) examined the
effect of FDI on economic growth using seemingly unrelated regressions technique
(SUR) in production function framework for 69 developing countries over the period
19701989. The results suggested that FDI contribute more to economic growth than
domestic investment in the developing countries studied. Further, the transfer of
technology is the vehicle for developing the economy through FDI inflows. However,
Borensztein et al. mentioned that the contribution of the FDI to the host countrys
economic growth is highly dependent on the absorptive capability available in the
economy to attract new technology into the country. This absorptive capacity is highly
correlated with human capital, which was estimated using average educational attainment
of the labour force in each country. Although the theoretical models imply that FDI
promotes economic growth in the host country, Alfaro et al..(2001) revealed that the
efficiency and development of the local financial market in the host country is crucial for
a positive impact of FDI on growth. Alfaro et al used OLS and instrumental variable
regression to analyse three samples of cross-country data (39-41 countries). The study
emphasised that the spillover effects of the FDI are increased with financial
infrastructure. The findings of the research teams calibration exercise are: (i) the impact
of FDI with developed financial infrastructure is twice the impact of FDI when there is
poor financial infrastructure, (ii) productivity of foreign firms further increases with
sound financial infrastructure and (iii) other host country conditions such as market
structure and human capital levels are also important and have a positive impact on FDI.
The causal relationship between foreign direct investments (FDI) and economic growth
in developing countries was examined by Zhang (2001a) using data from 11 economies
in East Asia and Latin America from 1970 to 1995. A stationarity test and co-integration
techniques were used to assess the relationship between FDI and growth. The study found
that FDI improved growth in five of the eleven countries. Of these eleven countries, four
were Asian. The study indicated that the impact of FDI on growth varied with the
economic environment of the host country. When the host country encouraged export-
oriented FDI with pro-free trade and pro-education policies, the impact tended to be
positive on growth. Besides the study by Borensztein et al. (1998), Jyun-Yi and Chih-
Chiang (2008) examined whether the impact of FDI on GDP growth is dependent on
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97
other factors, namely initial GDP, human capital and volume of trade, by using a sample
based on 62 countries covering the years 1975 through to 2000. The technique used for
the study is the threshold regression technique developed by Caner and Hansen (2004).
Initial GDP, human capital and volume of trade are assigned as threshold variables. They
found that the impact of FDI on economic growth is positive and significant when the
host country has improved human capital and high level of initial GDP. These results are
consistent with those of Borensztein et al. (1998). Some researchers have found that the
state of infrastructure plays a significant role in attracting FDIs into a country. Some
highlight infrastructure facilities such as telecommunications as a determinant of the FDI.
For example, Reynolds et al. (2004) examined the empirical relationship between FDI
flows and the level of telecommunications infrastructure using data from 212 countries
for 19601998. While proving the positive relationship between FDI and telecommuni-
cations infrastructure, the study revealed that privatisation increases the number of
phones per 100 by 1.2, the amount of FDI by 0.52 cents per dollar of GDP. Carkovic and
Levine (2005) assessed the relationship between FDI flows and economic development in
72 countries from 19601995 using a dynamic panel approach of OLS estimating method
into panel data. The results show that the FDI flow is positively related to economic
growth, and from the sensitivity analysis it was found that the relationship between FDI
and TFP (total factor productivity) is not significant. Further study revealed there is no
positive impact on economic growth from portfolio investment.

While Borensztein et al. (1998) highlighted human development levels and
Alfaro et al. (2001) emphasised the importance of financial markets, Busse and Groizard
(2008) argued that good government regulation is required for FDI to have a positive
impact on economic growth of the country. Busse and Groizard studied 89 countries,
using the standard growth regression model and instrumental variable regression models.
The data were for 19942003. The study showed that the tax holidays offered by the host
countries are not effective if there is a poor regulatory system in the country. Some recent
studies have also suggested that the institutional framework and fewer labour and
business regulations are essential to stimulate growth through international trade of host
countries (Bolaky and Freund 2004).

Atiken and Harrison (1999) examined the effect of FDI on domestic firms in
Venezuela by using a weighted least-square regression model. The study focused on
spillover effects of FDI based on data from 4,000 Venezuelan manufacturing plants
between 1976 and 1989. The study revealed that foreign participation increased the
productivity of firms with less than 50 employees. Although previous research generally
revealed the positive impact of FDI on productivity, this study found that the impact on

98
productivity of the domestic firms was negative. Therefore the net positive impact of the
FDI is quite small for the country. However, the results of the study may be biased since
foreign firms acquired most of the productive plants and invested in the more productive
sectors of the Venezuelan economy. Asafu-Adjaye (2000) investigated the effect of
foreign direct investment on Indonesian economic growth by using time-series data for
19701996. He used the error-correction regression model along with the Johansen
co-integration test. The results suggested that the FDI, gross domestic savings, other
private capital flows and human capital jointly influenced economic growth and the
impact of FDI is significant. In addition, the education level of the labour force, which
was used as a proxy for human capital, and gross domestic saving also contributed to the
rate of Indonesian economic growth separately. Fan and Dickie Ruane (2000) studied the
contribution of FDI to the growth and stability of Indonesia, Singapore, Thailand,
Malaysia and the Philippines during 19871997. They used the Cobb-Douglas growth
accounting regression models to evaluate the effect of FDI on economic growth. The
results of the study showed that FDI has made significant contributions to the economic
growth of these five ASEAN economies. The contribution of FDI was estimated at
between 420% of GDP growth. Further study highlighted that FDI played an important
role in averting external shock during the period of financial crisis. Besides the FDI
impact of growth on East Asian and Latin American countries, Zhang (2001b) assessed
the direct and indirect affect of FDI on the Chinese economy using provincial data for
19922004. A panel data set was used to evaluate the impact of FDI. The study indicated
that FDI contributed to Chinese economic development directly by promoting exports
and improving productivity, and indirectly with spillovers. An important conclusion was
that the estimated marginal product of the foreign capital is higher than local capital with
higher levels of productivity in foreign firms in China. The dynamics of the relationship
between FDI, economic growth and domestic investment were examined by Kim and Seo
(2003) by applying VAR models to South Korea. The results revealed that FDI has some
positive effect on economic growth; however, its effect seems to be not significant. On
the other hand, the economic growth of South Korea was found to have had a statistically
significant effect on the FDI flows in to the country. Athukorala and Karunaratne (2004)
examined the impact of FDI on the economic development of Sri Lanka using
co-integration and a ECM models over the period 19592002. The study was based on
the FDI-led growth hypothesis. He found that the direction of causality was not towards
FDI to GDP growth. Further, the impact of domestic investment and trade liberalisation
was found to have a positive effect on GDP growth. Wijeweera and Mounter (2008)
examined the causality relationship among five macroeconomic variables, namely wage
rate, exchange rate, GDP per capita, external trade, FDI and interest rate for Sri Lanka.
The study used VAR techniques. The findings indicate wage rate as the variables
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99
studied is the most important determinant of FDI. Despite this, the study emphasised
that the other four variables should also be considered for policy formulation.

III. Model Specification and Data Sources
Following framework model is employed to investigate the relationship between real per
capita GDP, FDI and the level of the infrastructure.

Y (GDP) = f (INFR, FDI)
In this analysis, three variables were considered to investigate the relationships among
them. The system consists of real per capita GDP of Sri Lanka (GDP), real FDI, and level
of infrastructure (INFR). FDI in rupee terms is deflated by GDP deflator to derive real
FDI. In some of the time series studies, only one variable is used to measure the financial
or physical infrastructure due to limitations in accommodating more variables into the
analysis of a small data set. However, this study has used logarithms of total number of
fixed telephone lines, no. of Bank Branches, electricity generation and total length of
A&B class roads in the country to develop a summary measure by using principal
component analysis
3
to quantify the level of infrastructure. This summary measure avoids
the problems of multi-collinearity and over-parameterisation as an index of infrastructure
level of the country. The sample period uses annual time series data over the period from
1980 to 2011. These annual data were obtained from the UNCTAD database, various
issues of Economic and Social Statistics of Sri Lanka and Annual reports published by
the Central Bank of Sri Lanka .

Cointegration Relationship
Investigation of the stationarity properties of variables allows researchers to avoid
spurious regressions. Therefore it is essential to test the stationary properties of the
selected variables. Unit root tests are conducted to test the stationarity properties of the
selected variables. The first step in applying the unit root test is to determine the
stationary properties of the levels of the time series. If the variable is non-stationary, then
it is preferable to carry out the same test including a trend and/or a constant term.
However, most of the financial and economic data series are non-stationary at levels and
differenced series should be checked as the second step. If the variable achieves the
stationary properties when it is differenced once, the variable is termed as integrated of

3
Pls.see the Appendix A for calculation of principal components

100
order one or I(1). Most financial and economic data series are I(1) and this would imply
the presence of stochastic trend in those series. But the higher order differencing is not
recommended for empirical analysis due to the loss of information and difficulties in
interpretation. The typical unit root tests employed in econometric studies are the Dickey
and Fuller test (DF), the Augmented Dickey-Fuller Test (ADF) and the Phillips-Perron
(PP) test. The ADF test can be considered as an improved version of the DF test. The
ADF test is used to check the stationary properties of the variables considered in this
study.

Granger (1981) first introduced the concept of cointegration, referring to the
long-run equilibrium relationships in economics. Later this concept was supported by
Nelson and Plosser (1982) who argued that taking differences of the series until
stationarity is achieved, as remedial measure to spurious regression may lead to a loss of
information regarding long-run properties. The precise definition of cointegration can be
derived from its statistical concepts. The long-run equilibrium relationship between two
variables could be presented as follows in the case of a bivariate model:

t t t
x y
2 1
----------------- (1)

If y
t
and x
t
are at equilibrium, then the disequilibrium term
t t t
x y
2 1

is
equal to zero. However, there are many instances when Y is not in its equilibrium relative
to X such that the disequilibrium terms will be non-zero. To have real meaning for the
equilibrium relationship, the disequilibrium errors observed over time should tend to
fluctuate at about zero (Eagle and Granger, 1987). If the equilibrium relationship such as
model (1) exists, it would imply that the disequilibrium
t
is I(0) - i.e. and the linear
combination of two variables must also be I(0). Therefore, conditions for the existence of
a long-run relationship is that the error term or linear combination of two variables is I(0).

Error correction models
One way of solving the spurious problem is to get the difference series of I(1) variables
and run a regression model as follows:

t t t
x y
2 1

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101
This model gives us correct estimates of
1
and
2
parameters and solves the

problem of spurious regression. However, the model does not hold true in the long run.
In order to solve this problem, error correction models (ECM) are useful:

t t t t
u x b a y
1 1 0

This ECM model includes both short-run and long-run information. The b
1
is the
impact of the changes in x
t
on y
t
in the short-run. On the other hand, is the adjustment
affect, which shows how much of the disequilibrium has been corrected (Asteriou and
Hall 2007).

Johansens Full information Maximum Likelihood (FIML) approach
Although there are three approaches for testing cointegration, this study uses one
approach, namely Johansens Full Information Maximum Likelihood (FIML) approach.
When more than two variables are to be considered, there is a possibility of having more
than one cointegration vector. In this situation, the variables in the model might form
several equilibrium relationships governing the joint evaluation of all the variables.
Therefore Johansens FIML approach is the best approach relative to other two
approaches.The FIML approach provides a good framework for estimating the
cointegration relationships in the context of Vector Auto Regressive (VAR) error
correction models (Johansen 1988, Johansen and Juselius 1990). There are two methods
for determining the number of cointegration vectors and both involve estimation of the
matrix . The tests are based on the rank of the matrix as r and eigenvalues. Johansen
and Juselius (1990) provided the critical values for both test statistics.

Causality test for ECM
One good feature of the VAR model is that it allows us to test for directional causality.
The causality tests give an indicator about the ability of one variable to predict the other
variable. If there are two variables, x
t
and y
t
, each affect the other with distributed lag, the
relationship between these two variables can be captured by using the VAR model. Four
possible relationships can be identified in this model; (a) x
t
causes y
t
(b) y
t
causes x
t

(c) there is a bidirectional causality, and (d) two variables are independent. Granger
(1969), as cited in (Asteriou and Hall 2007), developed a test to examine the causality.
The test defines causality as follows: a variable y
t
is said to be granger cause x
t
, if x
t
can
be predicted with greater accuracy by using past values of the y
t
variable rather than by
not using such past values, all other terms remain unchanged:


102

Granger causality test
xt j t
m
j
j i t
n
i
i t
y x a y c | + + + =

=
=

1 1
1
------------------------(2)
yt j t
m
j
j i t
n
i
i t
y x a x c o u + + + =

=
=

1 1
2

------------------------(3)
where it is assumed that both
yt
c and
xt
c are uncorrelated white-noise error terms.

The steps in the Granger causality test are as follows:

Step 1

Regress y
t
on lagged y terms as in equation (4):
xt j t
m
j
j t
y a y c + + =

=
1
1
---------------- (4)

Find the regression sum of square (RSS) and label it as RSS
R
.

Step 2

Regress y
t
on lagged y terms plus lagged x terms as in equation (5):

xt j t
m
j
j i t
n
i
i t
y x a y c | + + + =

=
=

1 1
1
-------------------- (5)

Find the regression sum of square (RSS) and label it as RSS
u
.

Step 3

Define the null and alternative hypothesis as follows:
0 :
1
0
=
=
n
i
i
H | or x
t
does not cause y
t

0 :
1
1
=
=
n
i
i
H | or x
t
does cause y
t

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103
Step 4

Calculate the test statistics F for coefficient restrictions using the standard Wald test as
follows:

) /(
/ ) (
k n RSS
m RSS RSS
F
U
U R

Test statistics F follows the
m
k n
F

distribution and k = m + n + 1

If the test statistics (F) exceeds the F-critical value corresponding to
F-Distribution, reject the null hypothesis and conclude that x
t
does cause y
t
.

To check the causality in cointegrated variables, the following ECM form of
equation can be used:

t t k t
n
k
k i t
m
i
i t
v y x a y
1 3 2 1 1

where
1 2 1 1 1

t t t t
z x y v
is the residual of cointegration equation.
The null hypothesis for x does not Granger-cause y, given z, is
0 :
3 1

o
H
. This
shows that there are two sources of causation for y, either through lag terms x or
through lagged cointegration vector. The hypothesis is tested using the standard F test.
As cited in Asteriou and Hall (2007), Granger and Lin (1995) argue that the conventional
causality test is not valid for cointegrated variables. Therefore this study used VECM to
measure the causality in empirical analysis.

IV. Empirical analysis and findings
The aim of this section is to provide statistical validation of the existence of long-run
relationships and causality among the following selected variables, namely FDI, Real
GDP per capita and level of infrastructure in Sri Lanka.

The first step involves investigating the stationarity properties of the three
variables, FDI, real GDP per capita and level of infrastructure, so as to ensure the
variables are I(1) series, which enables the use of cointegration techniques to assess the
long-run relationship. Plotting the variable against the year can be considered to be a

104
preliminary indicator used in analysis of trends in time series data. The plot of logarithms
of the three variables in Figure 1 shows that all data series demonstrate an upward trend.

Univariate analysis of each variable was carried out to investigate the stationary
properties of the data series. It is required to have I(1) data series for the cointegration
test, which can be used to find existence of a cointegration relationship. In order to find
the presence of the unit root in each series, this study uses ADF test and the results of the
ADF test are given in Table 2 and Table 3.

Table 1: ADF test for unit root on the level series
Variables No Constant
& No Trend
Constant
& No Trend
Constant & Trend
LGDP 12.25429 3.080602 -0.111291
LINFRA 7.647764 -1.223449 -3.481143
LFDI 0.978890 -1.404797
-4.248370*

2
4
6
8
10
12
14
16
18
1980 1985 1990 1995 2000 2005 2010
GDP FDI INFRA
LN

Year
Figure 2

LGDP LFDI LINFRA
105

105
Table 2: ADF test for unit root on the first differenced series
Variables No Constant
& No Trend
Constant
& No Trend
Constant & Trend
LGDP -0.206335 -3.775239** -4.925005**
LINFRA -2.436660* -5.238118** -2.836852
LFDI -6.113743** -6.202526** -6.170224**
*Significant at 5% level ** Significant at 1% level

Unit root tests for stationarity are performed on both levels and the first
difference of the selected variables. The typical three types of models with varying
deterministic components have been considered while performing the ADF tests. The
results indicate that all three series are stationary in differences. Therefore, we can
conclude that the three time series are all integrated of order 1, I(1). Therefore the
cointegration test can be performed on this three data series to check the long-run
relationship among the variables.

Testing for Cointegration of variables
Selection of appropriate lag length is very important in examining cointegration using
Johansens FIML approach. After inspecting the values of Akaike Information Criteria
(AIC) and Schwarzs Bayesian criteria (SBC), as well, as diagnostics concerning
autocorrelation, heteroskedasticity, possible ARCH effects and normality in residuals,
4 lags were selected as the optimal lag length for the existence of the cointegration
relationship.

Table 3 presents the results of the Johansens FIML test for the model.
According to both the Trace test and Eigenvalue test there is one cointegration
relationship existing among the three variables. Both tests do not reject the null
hypothesis of number of cointegration relationships (r) = 0 at 5% significant level.


106
Table 3: Results of Johansens test for multiple cointegrating vectors
Hypothesised
cointegrating
H
0

No. of
relationships
H
1

Test statistics Critical values (95%)
Max.
eigenvalue
Trace Max.
eigenvalue
Trace
r=0 r>0 32.95222* 41.02500* 21.13162 29.79707
r=1 r>1 7.588251 8.072776 14.26460 15.49471
r=2 r>2 0.484525 0.484525 3.841466 3.841466
Note: r indicates the number of cointegrating relationships. The optimal lag structure
of the VAR was selected by minimising the AIC criterion. Critical values are
taken from Johansen and Juselius (1990).
* indicates rejection at the 95% critical values.

Error correction model (ECM) of the following VAR system is used to examine the
relationship between variables.
1
1
13
1
12
1
11 1 1
u LINFRA LFDI GDP L LGDP
i t
m
i
m
i
i t i t
m
i
t gdp t

2
1
23
1
22
1
21 1 2
u LINFRA LFDI LGDP LFDI
i t
m
i
m
i
i t i t
m
i
t fdi t

3
1
33
1
32
1
31 1 3
u LINFRA LFDI LGDP LINFRA
i t
m
i
m
i
i t i t
m
i
t Infra t

i = Number of lags
1 t
= Error Correction terms

u
1
, u
2
, u
3
= White noise disturbance terms

Since the Trace test and Eignvalue test confirm the existence of a cointegration
relationship among variables, the cointegration equation is written in the following form
using values of cointegration matrix generated by the E-views.

107

107
Cointegration Equation

LGDP = 0.392944 - 0.013480 LFDI + 0.264194 LINFRA

T-Stat : [0.80774 -24.7217]

According to this cointegration equation, there is a long-run relationship
between GDP per capita, FDI inflows and level of infrastructure. Level of infrastructure
positively impact on GDP in log-run and impact is significant at 1% level. However the
impact of the FDI on GDP per capita is negative but not significant. The diagnostic tests
also show the relevancy of normality assumption and absence of significant
autocorrelation in the residual.

In the context of development strategy, there is intense interest in the causal
connections among the selected variables. According to Engle and Granger (1987),
if non-stationary variables are cointegrated then a vector autoregression (VAR) in the
first difference is specified incorrectly. Since a cointegration relationships are found
between GDP per capita, FDI and infrastructure, an error correction model (ECM) is used
to test for causality among these variables. The results in Table 4 provide evidence of a
causal relationship between some variables.

Table 4: Causality results based on vector error correction model
(VECM)

Dependent
variable
Exogeneity Wald Tests X
2
-statistics
LGDP
LFDI LINFRA
LGDP 6.043380 0.726763
LFDI 4.030914 10.79784*
LINFRA 6.980598 3.230782
*Significant at 5% level
Note: Causality running from columns to rows.

The results revealed a significant impact of level of infrastructure on FDI.
Impact of FDI on GDP is also to be expected according to economic theories, but
findings do not support the existence of that type of causality. However the analysis
shows that the increased in FDI with the improvement in infrastructure. Therefore study

108
proved the validity of argument that infrastructure impact on the attraction of FDI into
host country. Further, causality test results revealed the absence of other causality among
three variables selected for this study.

V. Conclusion and Policy Recommendations
The objective of this study was to identify possible long-run relationships and direction
of causalities among per capita GDP, FDI inflows and level of infrastructure in
Sri Lanka. The study has used inferential analysis based on ECM models to evaluate the
relationship between the variables in multidimensional space while considering all the
possible dynamic interactions between them.

When the long-run relationship is considered, level of infrastructure has a
stronger relationship with GDP per capita since the coefficient of level of infrastructure is
statistically significant. According to growth theory, investment plays a key role in the
production process of a country and infrastructure which is a part of investment is also an
important factor that stimulates economic growth through various channels. Many
empirical studies have investigated the long-run relationship between level of
infrastructure and GDP and proved the existence of a positive long-run relationship
between two variables. On the other hand, study does not show the existence of positive
long-run relationship between GDP and FDI based on the data for the same reference
period over 19802011 as the estimated coefficient is not significant with a negative sign.
Sri Lanka liberalised the economy in 1977 and subsequently FDI inflows increased
significantly up to 1982. However, the impressive upward trend in FDI flow was
disrupted by the escalation of civil unrest in 1983. Sri Lanka lost its investment potential
due to the uncertainty created by the civil war. Therefore the lack of a relationship
between GDP per capita and FDI may be due to the substantial fluctuation in FDI after
year 1982.

The findings with respect to causality indicate that the level of infrastructure of
the country plays a key role in attracting FDI into Sri Lanka. Level of infrastructure is a
determinant of FDI for MNCs to invest in developing countries. Therefore, causality
running from level of infrastructure to FDI is justifiable, particularly in developing
countries like Sri Lanka. Since level of infrastructure causes FDI, more attention should
be paid to infrastructure development as poor infrastructure would be an impediment to
future growth in FDI inflows.

109

109
According to the findings, strategies to enhance level of infrastructure of the
country should be developed by the policy makers to enhance the economic growth of
Sri Lanka. MNCs seeking to invest in infrastructure development also consider the
income level of the host country and structure of the income distribution in order to
assess the expected return on their investments. The income elasticity of services changes
with the improvements in income level. Therefore, improvement in income level of the
country in recent years would positively affect to attract the FDI, particularly for
infrastructure developments.

In addition, institutional reforms and legislative changes are also included in
broad definition of the infrastructure of the country to pave the way for sustainable
economic growth. Therefore, it is essential that policies are focused on creating a holistic
enabling environment to achieve overall economic growth.

Limitations of the Study
This study uses a composite index derived from four (4) variables of infrastructure
namely total length of A&B class roads (ROAD), No. of Bank Branches (BANKB), total
number of fixed telephone lines (TELECOM) and installed electricity generation capacity
(ELECT) of the country as proxies to measure the level of infrastructure facilities of the
country. However some other infrastructure such as water supply, payment systems,
government services, mobile phone lines, internet lines, port expansion etc., were not
taken into consideration due to the unavailability of time series data. Therefore composite
index derived from four (4) variables may not be a good proxy for level of infrastructure
of Sri Lanka.

Although the variables used to measure the level of infrastructure indicate the
availability of facility, the decisions of investors may also be based on quality factors and
the available technology, which is not reflected in variables relating to infrastructure.
This may account for the fact that India is attracting high-tech IT related foreign
investment with lower teledensity than Sri Lanka. Therefore, the lack of a representation
of quality factor in the proxy variables for the infrastructure is a limitation of this study.

FDI and infrastructure developments have been dampened by the unfavorable
economic environment within the country due to the civil war, which originated from
poverty and the loss of confidence and understanding among communities and political
parties. The civil war has had different phases from 1976 to 2009, ranging from guerrilla
tactics to intensified conventional fighting between the two forces. The confidence of

110
investors and other development activities may depend on the intensity of the war.
A proxy variable that reflects the impact of civil war which may have varied with its
intensity was not included in the study due to the unavailability of such an indicator.

Sri Lanka introduced reforms on trade, FDI and the services relating to
infrastructure during reference period of this study from 1980 to 2011, and different
regimes can be identified with respect to the liberalisation of each sector. To capture
these changes, econometricians have adapted dummy variables for analysis. However,
the application of those types of structural brakes to this study was prevented by the small
sample size.

In evaluating the interactions between per capita GDP, FDI and level of
infrastructure, the study was handicapped by the lack of empirical studies. Few studies
have focused on evaluating the direct impact of FDI on the industrial sector and economy
as a whole. The spillover effect of FDI was hardly captured by those studies. Research
papers based on comprehensive studies of the economic impact of the infrastructure are
not available for Sri Lanka. Therefore, historical descriptive data or studies based on
other countries have been used as references for the study.

111

111
Appendix A
Logarithms of total length of A&B class roads (ROAD), No. of Bank Branches
(BANKB), total number of fixed telephone lines and installed electricity generation
capacity (ELECT) of the country were used to develop a summary measure by using
principal component analysis to quantify the level of infrastructure. The results derived
from principle component analysis are presented in Table A.

Table A: Principle component analysis summary Results
Principal
Component PC 1 PC 2

PC 3 PC 4
Eigenvalues 3.694892 0.143066 0.122715 0.039327
% of variance 0.9237 0.0358 0.0307 0.0098
Cumulative % 0.92370 0.95950 0.99020 1.00000

Loading Eigen Vector
Variable PC 1 PC 2 PC 3 PC 4
ROAD 0.493736 0.762045 0.333855 0.253087
BANKB 0.502146 -0.227456 -0.634312 0.541997
TELECOM 0.493492 -0.602323 0.626982 0.023792
ELECT 0.510430 0.068979 -0.305094 -0.801012

According to the principle component analysis 92% of the standard variance of the
selected four (4) variables are explained by the first principle component. Therefore the
first principle components which explain 92% of the variation of the data is the best
combination of variables. The first principle component was calculated using the weights
of the respective loading vector for this analysis.


112
Appendix B

VEC Granger Causality/Block Exogeneity Wald Tests

Sample: 1980 2011
Included observations: 27

Dependent variable: D(GDP)

Excluded Chi-sq df Prob.

D(FDI) 6.043380 4 0.1959
D(INFRA) 0.726763 4 0.9480

All 6.447600 8 0.5972

Dependent variable: D(FDI)


D(GDP) 4.030914 4 0.4018
D(INFRA) 10.79784 4 0.0289

All 11.99809 8 0.1513

Dependent variable: D(INFRA)


D(GDP) 6.980598 4 0.1369
D(FDI) 3.230782 4 0.5200

All 8.309980 8 0.4038

113

113
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= Error Correction terms

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