Economic Modelling 37 (2014) 332–339

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Economic Modelling
journal homepage: www.elsevier.com/locate/ecmod

Growth and Foreign Direct Investment in the Pacific

Island countries☆,☆☆
Simon Feeny ⁎, Sasi Iamsiraroj, Mark McGillivray
Alfred Deakin Research Institute, Deakin University, Geelong, Australia

a r t i c l e i n f o a b s t r a c t

Article history: Achieving sustained high rates of economic growth in Pacific countries has proved incredibly challenging. Despite
Accepted 15 November 2013 many being rich in natural resources, receiving high levels of foreign aid and being open to external trade, the
economic growth rates of Pacific Island countries are the lowest and most volatile for all groups of developing
JEL classification:
countries. This paper examines the impact of Foreign Direct Investment (FDI) to the Pacific region. Results
F21
from the estimation of a number of empirical models suggest that the impact of FDI is lower in Pacific countries
O11
than it is in host countries on average. A 10% increase in the ratio of FDI to host Gross Domestic Product (GDP) is
Keywords: associated with higher growth of about 2% in all countries on average. The impact in Pacific countries falls to
Foreign Direct Investment between 0.1 and 0.4%. A number of explanations for this finding are provided including some empirical evidence
Economic growth that FDI displaces domestic investment in the region.
Pacific © 2013 Elsevier B.V. All rights reserved.

1. Introduction primary school and seven out of every 100 children die before their fifth
birthday. At least 80,000 adults have HIV and the rate of infection is
Pacific Island countries (PICs) face many tremendous challenges. growing by more than 40% per year, the fastest of any region of the
These include small domestic markets, limited resource bases, great world (AusAID, 2009).
distances from major markets, vulnerability to external shocks such Despite the immense challenges faced by the Pacific, the region
as hikes in the prices of key international commodities and natural remains startlingly under-researched. There is a small literature
disasters, often inadequate governance and political instability. Western examining the economic growth impact of foreign aid and remittances
governments seemingly recognise this to the extent that PICs receive to the region. For example, Pavlov and Sugden (2006), Feeny (2007)
some of the highest levels of foreign development aid in the world and Feeny and McGillivray (2010) provide positive assessments of
relative to the size of their economies. In 2009, Official Development foreign aid to Pacific countries, while Connell and Brown (2005),
Assistance (ODA) accounted for as much as 34% of GDP in the Browne and Mineshema (2007) and Brown (2008) examine the impact
Solomon Islands and 68% of GDP in Tuvalu. On average ODA accounted of remittances. Yet, surprisingly, the impact of Foreign Direct Invest-
for over 25% of recipient GDP in PICs. Despite these aid levels, PICs have ment (FDI) has been neglected.1 This is despite FDI accounting for a
experienced the lowest and most volatile economic growth of greater share of Gross Domestic Product (GDP) in Pacific countries
any region of developing countries, including sub-Saharan Africa than for developing countries on average. The main objective of the
(McGillivray et al., 2010). Partly due to these growth rates, poverty is paper is therefore to help fill the void in development related research
increasing in the region. Approximately 2.7 million people, one-third for the PICs by providing the first study to comprehensively examine
of the region's population, live in poverty, without the income to satisfy the growth impact of FDI to the region. It is, to the knowledge of the
their basic human needs. More than 400,000 children are not enrolled in authors, the first study to look at the impact of FDI in these countries.
A fundamental premise of this paper is that the behavioural relationship
between growth and FDI in Pacific countries cannot be assumed to be
the same as that for other countries, observed either from cross country,
☆ This paper is an output from an Australian Research Council funded linkage project panel or time series datasets. It would therefore be inappropriate to rely
with Sustineo Pty Ltd entitled Supporting Pacific Development (LP110200746).
☆☆ The authors are grateful for helpful comments and suggestions from two anonymous
referees.
1
⁎ Corresponding author at: Alfred Deakin Research Institute, Deakin University, Jayaraman and Singh (2007) provide the only exception, finding that FDI contributes
Geelong, VIC 3220, Australia. Tel.: +61 3 5227 1428; fax: +61 3 9918 9001. to employment creation and economic growth in the case of Fiji. See Read (2007) for an
E-mail address: [email protected] (S. Feeny). examination of the determinants of FDI flows to Small Island Developing States (SIDS).

0264-9993/$ – see front matter © 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.econmod.2013.11.018
 S. Feeny et al. / Economic Modelling 37 (2014) 332–339 333

on the findings of previous studies to draw inferences about the impact small size, remoteness, insecure land rights, high cost and low availabil-
of FDI in PICs. The main reason for expecting that the incremental im- ity of skilled labour and unfavourable business environments (Nathan
pact of FDI will be different in the Pacific is the widely acknowledged Associates Inc., 2007). Yet to varying extents, Pacific countries have
difficulty of doing business in these countries. As noted in AusAID overcome these obstacles. Outside of the extractive industries, FDI in
(2008) and World Bank (2011), doing business in these countries is be- the Pacific has flowed to agriculture (the palm oil, copra, sugar and live-
coming increasingly difficult. This is likely to retard the productivity of stock industries), forestry, fishing, banking and finance, real estate and
FDI in the region. It is also recognised that FDI might displace domestic tourism. There has been less FDI to the manufacturing sector. A notable
investment in PICs, thereby limiting its effectiveness with respect to exception is the Yazaki automobile wiring harness plant in Samoa.
growth. FDI is particularly likely to displace domestic investment if While flows of FDI to the Pacific are small in absolute terms, levels
foreign firms have superior managerial and technical expertise than of FDI (relative to the size of host country GDP) are actually higher
their domestic counterparts. (on average) in PICs than they are in other low and middle income
FDI can play a crucial role in contributing to growth and poverty countries. This is demonstrated by Table 1 which provides net FDI
reduction in host countries, particularly in small countries located a inflows relative to GDP for selected Pacific countries and country groups
long way from major markets. These countries often lack the resources during the last three decades.
to develop their own technology and suffer from technical and institu- Fiji and Vanuatu have received far higher levels of FDI (relative to
tional constraints to the accumulation of physical and human capital. low and middle income countries on average) in each of the last three
Domestic financing for investment projects can be limited and unpro- decades. The same is true for Kiribati and the Solomon Islands in the
tected property rights, corruption, and civil and political instability 1990s and 2000s. Levels of FDI to Samoa and Tonga have been lower
may either hinder capital accumulation, or become obstacles for using and fluctuated widely. While PNG has received a lower level of FDI
already existing resources. FDI should, therefore, be an attractive source in the 2000s, the level is starting to increase dramatically with the
of development financing for these countries. A number of positive ex- construction of a large Liquid Nitrogen Gas (LNG) plant.
ternalities are associated with FDI inflows, such as advanced technology,
managerial expertise, R&D, employment, productivity and efficiency 3. Data and methods
gains in the domestic economy.2
Support for FDI is not universal despite its potential benefits. Critics Empirical studies examining economic growth have specified
argue that the policies to attract FDI can distort domestic incentives and models to include measures of human capital, institutional factors, pol-
as noted above, can displace domestic investment, crowding out icy related factors, and conditional convergence in addition to domestic
employment and domestic firms. The impact of FDI on the host country and foreign investment (recent examples include Azman-Saini et al.,
is therefore an empirical issue and one that has been examined by a 2010; Basu and Guariglia, 2007; Li and Liu, 2005). The current study
voluminous (cross-country) empirical literature. The consensus of this follows this approach in examining the relationship between FDI
literature is that the impact of FDI has been favourable, by contributing flows and economic growth in 209 countries covering the period 1971
to the economic growth rates of host countries. It is also clear from a re- to 2010.3 Cross country data are averaged over five-year periods, as is
view of this literature that the impact of FDI varies across host countries. standard practice. To examine whether the FDI–growth relationship is
Little is known of the impact of FDI on Pacific Island countries. There different in Pacific countries, the paper includes a FDI–Pacific interaction
is anecdotal evidence to suggest that FDI has provided little benefit to term. The Pacific variable is a dummy variable taking the value of 1 if
some of these countries. FDI to Papua New Guinea (PNG) and the the country is located in the Pacific and zero otherwise.4 The model is
Solomon Islands, for example, has been characterised by large capital specified as follows:
intensive projects in the extractive industries (mining and logging) of
0
these economies. These industries have been plagued by corruption, g it ¼ α 0 þ β1 P i þ β2 FDI it þ β3 FDI it  P it þ β4 Z it þ μ it i ¼ 1; …; n ð1Þ
widespread concerns over environmental damage and the exploitation
of domestic landowners. FDI has focused on agriculture and tourism in
where gi is a real growth in GDP per capita, Pi is the Pacific dummy
other Pacific countries, sectors which (directly and indirectly) provide
variable, FDIi is the percentage of FDI relative to GDP, FDIi ∗ Pi is the
employment to a substantial proportion of their populations.
FDI–Pacific multiplicative interaction term and Zi is a vector of control
The paper finds that FDI is associated with higher rates of economic
variables. Subscript i represents recipient country and t represents
growth in the Pacific. Yet it also finds that the impact of FDI is lower in
time. The vector of additional variables (Zi) contains the initial level of
the region than it is for countries on average. Further evidence is pre-
GDP per capita (to capture convergence), the secondary school enrol-
sented which indicates that FDI has displaced domestic investment in
ment rate (as a measure of human capital), the ratios of imports and
the Pacific which sets this region apart. One of the recommendations
exports relative to GDP, the rate of inflation (logged), domestic
emanating from this finding is for donor governments to shift the nature
investment, a measure of economic freedom and the coefficient of
of their assistance to the region. There are limits to what aid can achieve
variation for the FDI variable. It also includes interactions of FDI with
to the region and instead of providing additional assistance, a change in
other region dummy variables. The data include 42 observations for
the focus of aid is appropriate. More specifically, donors should examine
the seven Pacific countries provided in Table 1. Data are sourced from
ways of improving the growth (and other) impacts of FDI in the Pacific.
the World Bank's World Development Indicators (WDI) online database.
This is likely to require a greater focus on improvements in human
The exception is the economic freedom variable which is obtained from
capital and private sector development.
the Freedom House database.
The choice of the explanatory variables included in the model war-
2. An overview of FDI to the Pacific rants some discussion. This is especially the case with the FDI variable

Pacific countries suffer from a number of factors which might limit 3

The specific choice of the empirical model is motivated by maximising the number of
the desire of international firms to invest in them. These include their observations for PICs to be included in the analysis.
4
An alternative approach is to estimate models for Pacific countries only. This option is
2
In the context of the neoclassical growth framework, FDI affects only the level of in- not pursued by the current paper on the grounds of data availability and sample size. If an-
come. Long-run economic growth will be unchanged unless FDI influences technological nual data are employed, there are just 95 FDI observations for Pacific countries over the
progress (see de Mello, 1997; Solow, 1957). In endogenous growth models, however, eco- period 1971 to 2010. Moreover, there is a greater chance of estimating spurious regres-
nomic growth will be generated if FDI increases productivity via externalities and spillover sions using annual data for just Pacific countries and therefore a greater need to address
effects such as know-how and improvements in human capital (Lucas, 1988; Rebelo, the time-series properties of the data. Time-series properties are less of a concern with da-
1991; Romer, 1986). ta averaged within countries over five-year periods.
334 S. Feeny et al. / Economic Modelling 37 (2014) 332–339

Table 1 The level of freedom is an institutional variable included in the

Flows of FDI to selected Pacific countries. model. Indices are constructed by Freedom House to measure freedom
Pacific country/country group Net inflows of FDI to GDP (%) in terms of two dimensions: political rights and civil liberties. The sur-
vey reports a numerical rating on a scale of 1 to 7 for each index, with
1980–1989 1990–1999 2000–2009
1 representing the highest and 7 the lowest level of freedom. In this
Fiji 2.13 3.24 5.42
study, the variable Free is a dummy variable taking the value of 1 if
Kiribati 0.14 9.42 11.41
Papua New Guinea 3.98 3.65 1.71 the country has an average rating of between 1.0 and 2.5 and zero
Samoa 0.14 3.09 0.87 otherwise.
Solomon Islands 1.33 2.92 5.72 Pacific countries experience volatile levels of FDI in addition to vola-
Tonga 0.13 0.55 2.77 tile growth rates, potentially hampering FDI's impact on economic
Vanuatu 5.33 11.34 6.09
Pacific average 1.88 4.89 4.86
growth. To capture this volatility, the coefficient of variation (CV) of
Low and middle income countries 0.58 1.94 2.79 FDI is employed as an explanatory variable. The CV is a statistical mea-
World 0.67 1.49 2.86 sure of the dispersion in a series around the mean. It is calculated as
Notes: Data are from the World Bank (2011). the ratio of the standard deviation to the arithmetic mean of the vari-
able. Finally, while the initial level of per capita income is included as
an explanatory variable to capture convergence, a lagged dependent
variable (lagged growth) is included in some specifications to capture
any persistence and mean-reverting dynamics in economic growth
as it can be specified in a number of different ways. Firstly, FDI can be rates.
measured either as a ‘flow’ or a ‘stock’. While the flow of FDI is based Data are averaged within countries over five-year periods. The esti-
on current account inflows of foreign capital for a year, stock measures mation sample includes all countries (developed and developing) for
estimate the total cumulated value of foreign-owned capital in a coun- which requisite data are available. This maximises sample size and min-
try (Bornschier et al., 1978). Secondly, a choice must be made between imises the chances of sample selection bias as well as allowing for an ex-
using FDI inflows or net FDI inflows (with FDI outflows subtracted). amination of whether the FDI–growth relationship differs for the Pacific
The analysis in this paper focuses on net FDI inflows, as a percentage (as well as other regions). Full details of data sources and definitions are
of host country GDP. This approach is preferred over one examining the reported in Table A1 of Appendix A. Summary statistics for the variables
stock of FDI on the grounds that the paper is concerned with the current are provided in Table A2, disaggregated into Pacific countries and other
impacts of annual FDI inflows to the host country.5 Net FDI inflows countries. They reveal that average growth is lower in Pacific countries
provide a measure of the additional capital available to the production relative to other countries although the level of FDI in these countries is
process of the host economy in a particular year (Alfaro et al., 2004; higher.7 The statistics also reveal the greater openness to trade of Pacific
Bornschier et al., 1978). Net FDI inflows include new investment from countries but lower levels of human capital relative to other countries.
foreign investors less disinvestment. Net FDI flows can therefore be neg- Eq. (1) is initially estimated using Ordinary Least Squares (OLS). Re-
ative if disinvestment exceeds new foreign investment in a country. sults from these estimations can be validly questioned due to concerns
However, the regression sample includes just 41 observations that are over the endogeneity of the FDI (and other) variables. For example,
negative. The initial level of GDP per capita is included in the model to FDI will be endogenous if the economic growth rate of a host country
capture convergence effects. This is standard practice in an empirical is an important factor for international firms when deciding where to
growth model given the predictions of the Solow model that poorer invest. In other words, FDI can determine and be determined by host
countries will tend to grow faster than richer ones (Barro, 1991; country growth rates. Studies, in response to these concerns, have
Mankiw et al., 1992). Initial GDP per capita is measured in constant US adopted different instrumentation strategies.
dollars and the variable is logged. If convergence holds, the coefficient Some studies have sought to find valid external instruments for
on the initial GDP per capita variable will be negative. the FDI variable. Unfortunately suitable instruments have been difficult
The importance of human capital to economic growth is highlighted to identify.8 The favoured approach of the recent FDI literature
by Barro and Sala-i-Martin (1995) and Mankiw et al. (1992). In addition has therefore been to control for the potential endogeneity of the
to a direct impact on economic growth, human capital can be critical for FDI (and other) variables using internal instruments (see for example,
absorbing foreign knowledge and is an important determinant of Basu and Guariglia, 2007; Bengoa and Sanchez-Robles, 2003;
whether positive FDI spillovers will be realised. Human capital has Berthélemy and Démurger, 2000; De Vita and Kyaw, 2009). Dynamic
been measured in various ways by the literature. Average years of panel estimators such as ‘Difference’ and ‘System’ General Method of
schooling and school completion rates from Barro and Lee (2001) are Moments (GMM) have become popular estimation methods for panel
often favoured. The current study uses the secondary school enrolment data with small T and large N. They are able to handle lagged dependent
rate to capture human capital since these data are widely available for variables; unobserved fixed effects; endogenous independent regres-
the Pacific countries under consideration. sors as well as heteroskedasticity and autocorrelation across and within
Trade variables are also included in the empirical model. Both individuals or countries (Roodman, 2009).9
the ratio of imports and exports to GDP are included in the model.6 In System GMM is preferred over difference GMM due to gains in
addition, the inflation rate is included as an indicator of macroeconomic efficiency. In difference GMM all regressors are transformed through
policy and stability. The variable is logged to capture the non-linearity in differencing. Lagged levels of the regressors are used as instruments
the inflation–growth relationship. for the first differenced regressors. However, for variables that closely

7
While there are many values of net FDI flows (relative to GDP) that are close to zero,
there are no observations which are actually zero implying that censoring/truncation is
5
Moreover, poor data availability for Pacific countries prevents the calculation of appro- not a pertinent issue for the analysis.
8
priate FDI ‘stock’ variables. Previous studies have used the distance that host countries are from major investing
6
The adoption of the Sachs–Warner trade openness variable often used in the literature countries (Egger, 2008; Guerin, 2006).
9
is not possible due to the limited observations for Pacific countries. See also Harris et al. (2008) for an overview of different dynamic panel models.
 S. Feeny et al. / Economic Modelling 37 (2014) 332–339 335

follow a random walk (such as economic growth), lagged levels can be with GMM estimation as a preferred method to account for the
poor instruments for first differences. In response, Arellano and Bover endogeneity of the variables. System GMM purges country specific
(1995) and Blundell and Bond (1998) develop system GMM by includ- effects and results are largely driven by the time-series variation of
ing an equation in levels in addition to the differenced one. The equa- the data within countries. However, system GMM includes equations
tion specified in differences uses lagged levels of the regressors as specified in levels as well as first differences and in this way a cross-
instruments and the equation in levels uses lagged differences of the country dimension of the data is preserved.
regressors as instruments. Efficiency is gained through the use of the Results from system GMM estimation of Eq. (1) are provided in
additional instruments. System GMM makes the assumption that columns (4) to (7) of Table 2. In these specifications FDI, human capital,
the differenced variables used as instruments are uncorrelated imports, exports, inflation, domestic inflation and the FDI–Pacific
with country fixed effects. Two-step robust estimation is employed interaction variable are all treated as endogenous. Instrument lags
ensuring that standard errors are adjusted for autocorrelation and begin at t-2 and end at t-4. Further lags are unable to be employed
heteroskedasticity.10 since the number of instruments should be less than the number of
country groups (Roodman, 2006). All GMM specifications pass
the Hansen J test for the validity of instruments (overidentifying restric-
4. Results and interpretation tions) and the Arellano–Bond AR(2) test for autocorrelation.12 The
Arrellano–Bond test for autocorrelation is based on the difference resid-
Results from OLS estimation are provided in columns (1) to (3) of uals. First order autocorrelation is therefore expected since differenced
Table 2. The second column presents results when the model is error terms will share a common error term.13
augmented with period (time) dummy variables. These period fixed- In GMM estimation, coefficient estimates will be unbiased and
effects capture time specific factors that determine growth, which are greater emphasis should be provided to these results. The results
not captured by the other explanatory variables. Results from column provided in column (4) are broadly consistent with those from OLS.
(1) indicate that FDI has a positive association with host country Important differences, however, are the size of the coefficients attached
growth. The coefficient attached to the FDI variable suggests that a to the key variables. The coefficient attached to the FDI variable remains
10% increase in FDI is associated with (on average) about a 1% increase positive but becomes larger and the coefficient attached to the FDI–
in per capita income growth. In contrast, the coefficient attached to the Pacific interaction variable remains negative but becomes smaller.
FDI–Pacific interaction variable is negative, large and statistically signif- Given the size of the coefficients on these variables, these results
icant. Since the coefficient on the FDI–Pacific interaction is in absolute suggest that the impact of FDI in the Pacific is actually positive — but
terms larger than the coefficient on the FDI variable, the results imply is much smaller than for countries on average.
that FDI has a negative association with growth in the Pacific. Since the coefficient attached to the freedom variable is not found to
Other results from column (1) indicate that, as expected, the level of be statistically significant in any of the models it is dropped in order to
exports and domestic investment have positive associations with obtain more observations. Similar results are reported in column (5).
growth while imports, inflation and the volatility of FDI have negative The impact of FDI to the Pacific remains small and statistically signifi-
associations. The coefficients attached to these variables are all statisti- cant. Column (6) reports results from a model which examines whether
cally significant (at the 10% level or greater). The coefficient attached the impact of domestic investment on growth is lower in Pacific
to the initial GDP per capita variable provides evidence of growth countries. The coefficient attached to the domestic investment–Pacific
convergence.11 interaction variable is not statistically significant suggesting that it is
Similar results are provided from OLS estimation of the model with only the FDI–growth relationship which is different in this group of
period effects in column (2). The period effects are (jointly) statistically countries. Finally a dynamic specification of the model is estimated
significant but the coefficients attached to the FDI and FDI–Pacific and results are presented in column (7). Unfortunately, the inclusion
interaction variables are very similar to those presented in column of a lagged dependent variable reduces the number of observations
(1). The coefficient attached to the human capital variable is also posi- (including observations for Pacific countries). While results are broadly
tive and statistically significant in this specification. consistent with those presented earlier, they suggest that the impact of
As discussed in Section 3 above, there are valid concerns over these FDI on growth in the Pacific is negative but small.
results due to the endogeneity of the FDI and other variables. Coefficient In summary, results indicate that higher levels of FDI are associated
estimates will be biased and inaccurate due to simultaneity bias. One with higher growth rates. However, the impact of FDI is much lower in
way to try and overcome this problem is to lag the potentially endoge- the case of PICs.14
nous variables. Results from this exercise are presented in column (3). While the primary focus of this paper is the Pacific, it is also useful
Interestingly, results remain largely unchanged. The coefficients to examine whether the FDI–growth relationship is different for
attached to the imports, exports and inflation variables are no longer other regions of the world. Countries are categorised into the following
statistically significant. Results regarding FDI and its impact in the regions: Africa; Asia; Central and Eastern Europe; Latin America and the
Pacific are comparable to those reported earlier. Caribbean; and North America and Europe. Results from system GMM
The results from OLS estimation capture relationships using both the
cross-country and time-series variation in the data. This paper proceeds

12
The Hansen J statistic for over identifying restrictions is used and reported rather than
the Sargan statistic. The latter is not robust to heteroskedasticity or autocorrelation. The
Hansen J statistic indicates whether the instruments (as a group) are exogenous
10
Note that country fixed effects are not explicitly included in system GMM estimation. (Roodman, 2009).
13
The system includes equations in levels and differences. They are purged in the differenced For example, D.ei,t = ei,t − ei,t−1 which will correlate with D.ei,t−1 = ei,t−1 − ei,t−2
equations and are not introduced in the level equations since they would introduce bias since they share the common error term ei,t−1. Therefore to check for autocorrelation in
(Roodman, 2009). levels we test for second order autocorrelation in differences. The detection of autocorre-
11
A model was estimated with a Pacific region dummy included and the FDI–Pacific re- lation would indicate that the variables used as instruments are bad instruments since
gion interaction term omitted. However the coefficient attached to the region dummy var- they are endogenous (Roodman, 2009).
14
iable was not statistically significant, implying that growth rates have not been different in The empirical models were re-estimated using data averaged within countries over
the Pacific than they have elsewhere. There is a high level of collinearity between the re- three and four-year periods. While some results changed, the core finding of the paper:
gion dummy and the interaction term and including them in the model simultaneously that FDI has a lower impact on growth in the Pacific relative to other countries prevailed.
makes interpreting results very difficult. Results are available from the authors upon request.
336 S. Feeny et al. / Economic Modelling 37 (2014) 332–339

Table 2
Econometric results.

Dependent variable: Growth in real GDP per capita (1) (2) (3) (4) (5) (6) (7)

OLS GMM

Constant 7.090⁎⁎⁎ 6.229⁎⁎⁎ 2.456⁎⁎ 11.984⁎⁎⁎ 12.062⁎⁎⁎ 11.922⁎⁎⁎ 11.461⁎⁎⁎

(1.133) (1.199) (1.212) (2.911) (2.985) (2.864) (3.238)
FDI 0.099⁎⁎ 0.094⁎⁎ 0.189⁎ 0.194⁎ 0.177⁎⁎ 0.155⁎⁎⁎
(0.043) (0.042) (0.102) (0.102) (0.088) (0.089)
Initial −0.576⁎⁎⁎ −0.569⁎⁎⁎ −0.439⁎⁎⁎ −1.324⁎⁎⁎ −1.419⁎⁎⁎ −1.450⁎⁎⁎ −1.352⁎⁎⁎
(0.135) (0.144) (0.147) (0.354) (0.361) (0.327) (0.363)
Human capital 0.010 0.013⁎ 0.037⁎ 0.041⁎⁎ 0.046⁎⁎ 0.039⁎
(0.007) (0.008) (0.021) (0.019) (0.018) (0.021)
Imports −0.052⁎⁎⁎ −0.046⁎⁎⁎ −0.069⁎⁎ −0.075⁎⁎ −0.075⁎⁎ −0.054⁎⁎
(0.013) (0.012) (0.033) (0.034) (0.030) (0.025)
Exports 0.047⁎⁎⁎ 0.044⁎⁎⁎ 0.098⁎⁎ 0.105⁎⁎⁎ 0.088⁎⁎ 0.081⁎⁎
(0.013) (0.013) (0.041) (0.040) (0.039) (0.033)
Inflation −1.419⁎⁎⁎ −1.284⁎⁎⁎ −1.868⁎⁎⁎ −1.903⁎⁎⁎ −1.918⁎⁎⁎ −1.613⁎⁎⁎
(0.220) (0.201) (0.430) (0.459) (0.434) (0.520)
Investment 0.155⁎⁎⁎ 0.151⁎⁎⁎ 0.104⁎ 0.116⁎⁎ 0.144⁎⁎⁎ 0.089⁎
(0.027) (0.028) (0.058) (0.059) (0.046) (0.053)
Freedom 0.183 0.139 0.203 0.128 0.063 0.270
(0.252) (0.248) (0.283) (0.331) (0.303) (0.339)
CV −0.005⁎⁎ −0.004⁎⁎ −0.006⁎⁎⁎ −0.010 −0.008 −0.007 −0.010
(0.002) (0.002) (0.002) (0.008) (0.008) (0.008) (0.008)
FDI ∗ Pacific −0.182⁎⁎ −0.174⁎⁎ −0.179⁎⁎ −0.157⁎ −0.182⁎⁎
(0.078) (0.081) (0.089) (0.089) (0.075)
Investment ∗ Pacific −0.043
(0.033)
Lagged growth 0.108⁎⁎
(0.052)
Lagged schooling 0.019⁎⁎⁎
(0.007)
Lagged imports −0.012
(0.010)
Lagged exports 0.010
(0.011)
Lagged inflation 0.216
(0.156)
Lagged investment 0.083⁎⁎⁎
(0.024)
Lagged FDI 0.171⁎⁎
(0.067)
Lagged FDI ∗ Pacific −0.380⁎⁎⁎
(0.083)
Period dummies No Yes Yes Yes Yes Yes Yes
R-squared 0.25 0.29 0.20
AR (1) (p-value) 0.00 0.00 0.00 0.00
AR (2) (p-value) 0.39 0.43 0.46 0.77
Hansen test (p-value) 0.37 0.31 0.50 0.61
N 967 967 831 967 980 957 881

Notes: Numbers in parentheses are robust standard errors.

⁎ Denotes significantly different from zero at the 90% confidence level.
⁎⁎ Denotes significantly different from zero at the 95% confidence level.
⁎⁎⁎ Denotes significantly different from zero at the 99% confidence level.

estimation, our preferred technique, are presented in Table A3 of extractive industries with such investments being plagued with allega-
Appendix A. The approach necessitates the employment of interaction tions of corruption, disputes with local landowners and environmental
variables in the model on an individual basis to avoid problems of collin- damage. Profits from these investments may also have been repatriated
earity between the key variables and the proliferation of instruments in overseas rather than re-invested in the Pacific. Another explanation is
system GMM estimation. FDI is positively associated with growth in all that the returns to FDI in the Pacific are lower due to factors that reduce
specifications expect when a FDI–Central and Eastern Europe region the productivity and profitability of foreign investments in Pacific coun-
interaction term is introduced. In this case the coefficients attached to tries. These factors include a high cost and low availability of skilled la-
the FDI variables are no longer statistically significant. Other results sug- bour, a great distance to major markets as well as unfavourable business
gest that FDI has a larger impact on growth in Africa, relative to other environments.
countries and a lower than average impact in North America and The World Bank's ‘Doing Business’ project lends some support to this
Europe (although still positive). latter assertion. The project provides objective measures of business
There are number of explanations as to why the impact of FDI to the regulations and their enforcement in 183 economies. Each economy is
Pacific is lower (on average) than in other parts of the world. Some of ranked according to their ease of doing business. A high ranking
these explanations might also apply to North America and Europe. means the regulatory environment is more conducive to the starting
One explanation is that a lot of FDI has been concentrated in the and operation of a local firm. The best performing Pacific countries in
 S. Feeny et al. / Economic Modelling 37 (2014) 332–339 337

Table 3 indicate that FDI crowds-out domestic investment in the Pacific.

Econometric results of FDI effect on domestic investment. This helps explain the lower impact of FDI on growth in this region.
(1) (2) (3) Results from system GMM for other regions are reported in
Table A4 of Appendix A. They suggest that FDI ‘crowds in’ domestic
OLS FE GMM
investment (more than average) in Asia and in Latin America and
Constant 14.866⁎⁎⁎ 16.556⁎⁎⁎ 8.754⁎⁎⁎
the Caribbean but there is evidence of a crowding out effect in
(1.433) (2.411) (2.072)
FDI 0.389⁎⁎⁎ 0.494⁎⁎⁎ 0.309⁎⁎ North America and Europe. Taken together, these results suggest
(0.111) (0.114) (0.151) that it is important to account for heterogeneity across regions and
Exports 0.016 −0.017 −0.023 countries when exploring the impacts of FDI.
(0.011) (0.033) (0.026)
Government Expenditure 0.189⁎⁎⁎ 0.083 0.125
(0.039) (0.054) (0.083)
Inflation 0.604⁎ 0.502 0.115 5. Conclusion
(0.321) (0.359) (0.493)
Growth rate of GDP/cap 0.778⁎⁎⁎ 0.443⁎⁎⁎ 0.463⁎⁎⁎ The economic growth record of the Pacific region has been very
(0.087) (0.092) (0.108)
disappointing and partially as a result of this, poverty in the region is
Financial market 0.017⁎⁎⁎ 0.017 0.002
(0.005) (0.012) (0.005) increasing and progress towards the MDGs has been slow and in some
FDI ∗ Pacific −0.669⁎⁎⁎ −0.637⁎⁎ −0.328⁎ cases non-existent. With their limited resource bases, small domestic
(0.209) (0.281) (0.193) markets and lack of economies of scale, Pacific countries are heavily
Lagged investment 0.485⁎⁎⁎ reliant on assistance from other countries in the forms of foreign aid,
(0.100)
AR (1) (p-value) 0.003
trade, access to labour markets and FDI. This paper finds that the growth
AR (2) (p-value) 0.475 return from FDI to the region has (on average) been very small
Hansen test (p-value) 0.655 (although positive). A 10% increase in the ratio of FDI to host GDP is
R-squared 0.29 0.26 associated with higher growth of about 2% in host countries on average
Period dummies Yes Yes Yes
but just 0.1 to 0.4% in the case of the Pacific.
N 1036 1036 935
Given the (often) more positive assessments of aid and remittances
Notes: Numbers in parentheses are robust standard errors. to the region it might be tempting to conclude that donors should focus
⁎ Denotes significantly different from zero at the 90% confidence level.
⁎⁎ Denotes significantly different from zero at the 95% confidence level. their assistance to PICs through higher levels of Official Development
⁎⁎⁎ Denotes significantly different from zero at the 99% confidence level. Assistance (ODA) and greater access to their labour markets. While
the latter policy is certainly likely to provide high development returns,
calls for additional aid should be met with a great amount of caution.
There is a substantial literature which demonstrates that there are
diminishing returns to foreign aid owing mainly to limited absorptive
capacities within recipient countries. Past a certain level or threshold
2011 include Vanuatu, Samoa and Fiji with country ranks of 60, 61 and of aid, its growth impact starts to diminish. A number of Pacific coun-
62 respectively. Other Pacific countries perform less well including tries already receive some of the highest levels of aid in the world rela-
Kiribati, the Solomon Islands and Papua New Guinea, ranked 93, 96 tive to the size of their economies, and levels at which diminishing
and 103 respectively (World Bank, 2011). Unfortunately, a paucity of returns will have set in (Feeny and McGillivray, 2008). A key implication
this data for countries over time prevents an empirical analysis into is NOT for higher levels of aid to be provided to PICs to compensate for
this explanation. the relatively small impact of FDI on growth, unless absorptive capaci-
Another explanation is that FDI might have crowded out domestic in- ties can be quickly increased.
vestment and employment in the Pacific region. Data availability allows The international community must find other ways to assist PICs.
for such an investigation and is undertaken in the current paper. A With regard to FDI, two policy recommendations emerge from the find-
model of domestic investment is estimated with FDI being included as ings of this paper, based on the principle of attacking the development
an explanator together with a number of other variables including ex- problems of the region: (i) for developed (source) country govern-
ports, government spending, the rate of inflation, economic growth and ments to encourage firms to invest more in Pacific Island countries
financial market depth. The model is kept relatively parsimonious in without introducing market distortions; and (ii) for both host and
order to maximise the number of observations for Pacific countries. source country governments to find ways of increasing the impact of
Again, the FDI variable is interacted with a Pacific dummy variable to FDI on economic growth. Concerning the first recommendation,
examine whether any crowding in or crowding out effect is different Moran (2010) points to three areas in which developed country policies
for this region than it is in others. Results are presented in Table 3. are important for facilitating the flow of FDI to developing countries: the
Table 3 presents results from OLS (column 1), fixed effects provision of national or multilateral political risk insurance; the avoid-
(column 2) and system GMM estimation (column 3) which allows ance of double taxation of profits earned abroad; and finally, regulation
for the inclusion of a lagged dependent variable.15 Results are consis- to combat bribery and to prevent diversion of public revenues to private
tent across these estimation techniques.16 FDI is found to crowd-in pockets.
domestic investment in host countries (on average) but the sign Concerning the second recommendation, some general lessons
and size of the coefficient attached to the interaction variable from the FDI–growth literature are likely to be particularly applica-
ble for PICs. Limited absorptive capabilities and poor business envi-
ronments hamper the positive impacts of FDI on growth. They also
imply that domestic firms are less able to compete with foreign
ones and that FDI is more likely to displace domestic investment. A
greater donor focus on improving human capital and private sector
development in Pacific Island countries should therefore improve
15
The finding of FDI displacing domestic investment in the Pacific remains without the the productivity of investment and lead to FDI having a greater im-
inclusion of a lagged dependent variable. However, results from the Arellano–Bond test
provide evidence of second order autocorrelation in this specification.
pact on economic growth. The research community could also assist
16
In the system GMM estimations, all explanatory variables are treated as endogenous in this regard, by investigating ways of increasing the growth impact
with the exception of the financial market variable. Lags start at t-2 and end at t-4. of FDI in the Pacific.
338 S. Feeny et al. / Economic Modelling 37 (2014) 332–339

Appendix A

Table A1
Data description and sources.

Variable Description Source

Growth Growth in real GDP per capita (%) World Bank (2011)
FDI Net FDI inflows as a percentage of host country GDP World Bank (2011)
Initial GDP per capita Log level of GDP per capita (constant US$) World Bank (2011)
Human capital Secondary school enrolment rate (net) (%) World Bank (2011)
Imports Imports of goods and services as a percentage of GDP World Bank (2011)
Exports Exports of goods and services as a percentage of GDP World Bank (2011)
Inflation Annual growth rate of the GDP deflator World Bank (2011)
Investment Gross domestic investment as a percentage of GDP World Bank (2011)
Free Variable taking the value of 1 for countries with an average index score of between 1 and 2.5 for political rights and civil liberties Freedom House (2011)
CV The coefficient of variation for FDI defined as its standard deviation divided by its mean Authors' calculations
Financial market Domestic credit to the private sector as a percentage to GDP. Domestic credit to private sector refers to financial resources provided to World Bank (2011)
the private sector, such as through loans, purchases of no equity securities, and trade credits and other accounts receivable, which
establish a claim for repayment. For some countries these claims include credit to public enterprises.
Government expenditure General government final consumption expenditure as a percentage to GDP. It includes all government current expenditures for World Bank (2011)
purchases of goods and services (including compensation of employees) as well as most expenditure on national defense and security,
but excludes government military expenditures that are part of government capital formation.

Table A2
Summary statistics.

Variable Pacific countries Other countries

Mean SD Max Min Mean SD Max Min

Growth 1.135 2.540 6.032 −5.221 1.899 3.580 31.236 −18.645

FDI 4.174 4.948 24.798 −1.016 3.050 5.304 61.976 −20.921
Initial GDP capita 7.333 0.469 8.216 6.575 7.580 1.567 10.626 4.390
Imports 60.889 15.342 92.971 31.450 41.076 21.367 135.657 5.081
Exports 37.007 13.677 59.514 12.555 35.416 20.467 111.698 4.241
Human capital 56.115 33.675 105.18 9.022 61.238 33.300 155.579 0.374
Inflation 2.763 0.193 3.338 2.464 3.059 0.787 8.860 1.184
Investment 25.629 15.576 78.833 9.200 22.012 7.462 83.043 3.184
Free 0.595 0.497 1.000 0.000 0.427 0.495 1.000 0.000
CV 94.793 44.837 167.579 46.788 101.282 57.492 391.223 −139.618
Financial market 27.981 10.995 50.438 11.743 41.772 38.510 290.352 0.997
Government expenditure 23.242 7.857 39.906 11.087 16.413 6.469 50.862 2.727

Table A3
Econometric results of FDI on growth by region.

Dependent variable: Growth in real GDP per capita (1) (2) (3) (4) (5)

GMM

Africa Asia Central and Eastern Europe Latin America and the Caribbean North America and Europe

Constant 12.183⁎⁎⁎ 11.749⁎⁎⁎ 11.980⁎⁎ 12.113⁎⁎⁎ 10.993⁎⁎⁎

(2.433) (2.877) (3.370) (3.039) (2.725)
FDI 0.103⁎⁎ 0.170⁎ 0.118 0.172⁎⁎ 0.353⁎⁎⁎
(0.049) (0.092) (0.083) (0.086) (0.107)
Initial −1.339⁎⁎⁎ −1.352⁎⁎⁎ −1.243⁎⁎⁎ −1.436⁎⁎⁎ −1.100⁎⁎⁎
(0.330) (0.361) (0.432) (0.333) (0.345)
Human capital 0.051⁎⁎⁎ 0.039⁎ 0.029 0.041⁎⁎ 0.032⁎
(0.018) (0.022) (0.024) (0.020) (0.017)
Imports −0.069⁎⁎ −0.075⁎⁎ −0.072⁎⁎ −0.087⁎⁎ −0.072⁎⁎
(0.029) (0.033) (0.032) (0.034) (0.035)
Exports 0.077⁎⁎ 0.097⁎⁎ 0.104⁎⁎ 0.098⁎⁎ 0.101⁎⁎⁎
(0.030) (0.042) (0.042) (0.038) (0.038)
Inflation −1.931⁎⁎⁎ −1.818⁎⁎⁎ −1.959⁎⁎⁎ −1.814⁎⁎⁎ −1.987⁎⁎⁎
(0.416) (0.420) (0.473) (0.459) (0.421)
Investment 0.107⁎⁎ 0.127⁎⁎ 0.132⁎⁎ 0.154⁎⁎ 0.076⁎
(0.053) (0.060) (0.057) (0.063) (0.043)
Freedom 0.113 0.090 0.110 0.192 −0.097
(0.327) (0.326) (0.351) (0.346) (0.346)
CV −0.011 −0.010 −0.013 −0.009 −0.011
(0.009) (0.010) (0.011) (0.008) (0.009)
FDI ∗ regional variable 0.327⁎⁎⁎ 0.672 0.067 −0.142 −0.321⁎⁎⁎
(0.094) (0.707) (0.106) (0.089) (0.107)
Period dummies Yes Yes Yes Yes Yes
AR (1) (p-value) 0.00 0.00 0.00 0.00 0.00
AR (2) (p-value) 0.22 0.42 0.48 0.39 0.62
Hansen test (p-value) 0.25 0.41 0.20 0.28 0.22
N 967 967 967 967 967

Notes: Numbers in parentheses are robust standard errors.

⁎ Denotes significantly different from zero at the 90% confidence level.
⁎⁎ Denotes significantly different from zero at the 95% confidence level.
⁎⁎⁎ Denotes significantly different from zero at the 99% confidence level.
 S. Feeny et al. / Economic Modelling 37 (2014) 332–339 339

Table A4
Econometric results of FDI on domestic investment by region.

Dependent variable: Investment to GDP (1) (2) (3) (4) (5)

GMM

Africa Asia Central and Eastern Europe Latin America and the Caribbean North America and Europe

Constant 9.124⁎⁎⁎ 7.755⁎⁎⁎ 8.981⁎⁎⁎ 4.738⁎ 9.128⁎⁎⁎

(2.331) (2.222) (2.198) (2.452) (1.931)
FDI 0.269⁎ 0.309⁎ 0.313⁎ 0.188 0.628⁎⁎⁎
(0.160) (0.172) (0.171) (0.153) (0.144)
Exports −0.039 −0.016 −0.023 −0.022 −0.014
(0.027) (0.027) (0.028) (0.025) (0.026)
Government expenditure 0.161⁎⁎ 0.193⁎⁎ 0.175⁎⁎ 0.227⁎⁎ 0.181⁎⁎
(0.080) (0.082) (0.089) (0.089) (0.075)
Inflation 0.066 0.161 −0.108 0.662 −0.277
(0.475) (0.499) (0.472) (0.527) (0.404)
Growth rate of GDP/cap 0.521⁎⁎⁎ 0.511⁎⁎⁎ 0.444⁎⁎⁎ 0.628⁎⁎⁎ 0.352⁎⁎⁎
(0.117) (0.113) (0.124) (0.131) (0.119)
Financial market 0.007 0.001 0.0001 0.0001 0.013⁎
(0.007) (0.006) (0.006) (0.006) (0.008)
FDI ∗ regional variable 0.186 2.070⁎⁎ 0.033 0.353⁎⁎ −0.636⁎⁎⁎
(0.180) (0.937) (0.149) (0.147) (0.150)
Lagged investment 0.461⁎⁎⁎ 0.451⁎⁎⁎ 0.471⁎⁎⁎ 0.523⁎⁎⁎ 0.372⁎⁎⁎
(0.109) (0.104) (0.108) (0.092) (0.090)
AR (1) (p-value) 0.002 0.005 0.000 0.001 0.003
AR (2) (p-value) 0.402 0.415 0.264 0.473 0.429
Hansen test (p-value) 0.436 0.587 0.264 0.271 0.340
Time dummies Yes Yes Yes Yes Yes
N 935 935 935 935 935

Notes: Numbers in parentheses are robust standard errors.

⁎ Denotes significantly different from zero at the 90% confidence level.
⁎⁎ Denotes significantly different from zero at the 95% confidence level.
⁎⁎⁎ Denotes significantly different from zero at the 99% confidence level.

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