Topics in Middle Eastern and African Economies

Vol. 1, September 1999

Foreign Direct Investment and Economic Growth In Some MENA Countries:

Theory and Evidence

Abdel-Hameed M. Bashir*, Department of Economics, Grambling State University, E-mail:

[email protected]

1. Introduction

The rapid growth of foreign direct investment (FDI) and its overall magnitude had sparked numerous studies
dealing with the channels of transmission from FDI to growth. Theoretically, models of "endogenous"
growth were recently combined with studies on the diffusion of technology in an attempt to emphasize the
major role played by FDI in the economy [see Barro (1990), Lucas (1988)]. In these models, technology
plays a fundamental role in the process of economic development. Moreover, the extensions of the
neoclassical models to allow for international mobility of capital and technology have reinforced the notion
that low-income countries tend to grow at higher rates [see Barro (1991)]. The new developments have also
indicated the volatility of FDI and called for important macroeconomic and financial adjustments 1.
Meanwhile, the original contribution of these models is that, financial liberalization and stabilization must be
undertaken by host countries before any increases in FDI become feasible (see De Gregorio and Guidotti,
1995).

The purpose of this paper is to examine the empirical relationship between FDI and per capita GDP growth
in selected MENA countries for the years 1975-1990. To our knowledge, no attempts have so far been made
to investigate the relationship between FDI and economic growth in the selected countries2. In particular, the
paper aims to construct an endogenous growth model in which the rate of technological progress is the
primary determinant of GDP growth rate. The theoretical model will then be empirically tested to examine
the effects of FDI on economic growth. The rest of the paper is organized as follows. In section 2 we
construct a growth model in which production depends on an exogenous state of technology, human and
physical capital. The key to our model is that there is a fixed amount of human capital, but different types of
capital goods produced by both domestic and foreign firms. We show that the larger the number of foreign
firms (MNCs) operating in the economy, and the higher the level of human capital, the higher the growth rate
of the economy. In section 3, we substantiate the above-explained findings empirically using panel data. The
results are qualified and interpreted in the light of the recent developments in the theory of economic growth.
Finally, section 4 provides some concluding remarks.

2. The Model

Using Spence (1976) and Ethier (1982), and closely following Barro and Sala-i-Martin (1995), suppose that
the production function is given by

(1) Y = A H(1- α ) ∑ jN=1 ( kj )α

Where 0<α < 1, Y is the aggregate output, H is the stock of human capital in the economy, kj is the capital
good used by the jth firm, and A is a fixed technology parameter. There are N firms engaged in the
production process, n domestic firms, and N-n foreign firms (MNC). Technological progress takes the form
of expansion in N, the number of firms undertaking production. It can easily be shown that if the units of
capital are all employed in the same quantities across firms, i.e., kj = kj+1 = K, then equation (1) can be
written as:

(2) Y = A H(1-α ) (NK)α N1-α

 Topics in Middle Eastern and African Economies
Vol. 1, September 1999
Equation (2) indicates that production exhibits constant returns to scale in H and NK. The technological
progress is captured by the fact that, for given quantities of H and NK, the term N(1-α ) indicates that output
increases with N. Assume that the price of the capital good is P j the price of H is normalized to one, and the
producers operate in a competitive market. Since the producers take these prices as given, then profit
maximization entails equating the price Pj to marginal productivity of capital. Solving for the optimal amount
of capital employed by firm j:

(3)Kj = H (α A/Pj)1/ (1-α )

Equation (3) shows the quantity demanded of Kj depends only on the price Pj.

Suppose that each time the firm engages in production, it incurs one unit of output to use Kj. Then the present
value of future cash flows for the jth firm is

(4) V(t) = ∑ jN=1 (Pj-1) Kj e- rt

Where, r is the steady state rate of return of capital. Equation (4) shows that the cost of production can be
covered only if the sales price, Pj , exceeds the marginal cost of production, 1, (i.e., Pj >1). Borensztein, De
Gregorio and Lee (1995) assumed that the process of adaptation of new technology of production requires a
set up cost ϕ (N-n, N/N*). This cost is inversely related to the number of foreign firms (MNC), and to the
ratio of the number of goods produced in the domestic (developing) economy to the number of goods
produced in foreign (developed) economy. Now the profit of the jth firm is Π j (t) = V(t) - ϕ (N-n, N/N*).
The competitive firm will choose the quantity Kj to maximize Π j (t), where Kj is given by equation (3). In
fact equation (3) indicates that the choice variable is Pj , and the expression to maximize is (Pj -1) H . (α
A/Pj)1/(1-α ).

The optimal solution to the maximization problem is

(5) Pj = P = 1/α >1

Hence, the price Pj is constant over time and is the same for all capital goods j. The cost of production is also
the same for all goods and each good enters symmetrically into the production function (see Barro and Sala-i-
Martin, 1995, Chap. 6). Substituting equation (5) into equation (3) will determine the aggregate quantity
produced of each capital good:

(6) Kj = K = H (Aα 2)1/ (1-α )

The quantity Kj is the same for all goods at all points in time (if H is constant). If we substitute for P j and Kj
into equation (4), expression for the net present value is now:

(7) V(t) = H A1/(1-α ) (1-α )/α . α 2/ (1-α ) . ∑ jN e-r(v-t)

Assuming free entry in the product market, equilibrium will indicate that

(8) ϕ = H A1/(1-α ) (1-α )/α . α 2/ (1-α ) . ∑ jN e-r(v-t)

 Topics in Middle Eastern and African Economies
Vol. 1, September 1999
As the number N gets large, the summation reduces to 1/r and hence, the zero-profit condition V(t) = n
implies

(9) r = (H/ϕ ) A1/(1-α ) (1-α )/α . α 2/ (1-α )

That is, the rate of return, r, is pegged by the underlying technology and the marginal productivity of capital.

We further assume that the households are represented by the standard, infinitely-lived, Ramsey consumer
who maximizes the utility function:

(10) U = ∑ t∞ (Cθ - 1)/(1-θ ) . e-ρ t

where C is consumption, ρ is the subjective rate of time preference, and θ is the inverse of the intertemporal
elasticity of substitution. Households earn the rate of return on asset and the wage rate w (normalized to 1) on
the fixed quantity H of human capital. The key condition characterizing the solution for utility maximization
will reveal the growth rate:

(11) γ c = (1/θ ). (r - ρ )

Equation (11) indicates that, in steady-state equilibrium, the rate of growth of consumption is positively
associated with the rate of return, and negatively related to the rate of time preference and the elasticity of
substitution. Moreover, the number of firms, N, and the level of output, Y, will grow at the same rate of
growth of consumption γ c.

Substituting equation (9) into equation (11), we get the following expression for the rate of growth of the
economy:

(12) γ = (1/θ ) {(H/ϕ ) . A1/(1-α ) (1-α )/α . α 2/ (1-α ) - ρ }

The expression in (12) is valid only if the parameters are such that γ ≥ 0.

Equation (12) then shows that the rate of growth of the economy is solely determined by the household's
preference parameters, ρ, and θ , and the level of technology, A. A reasonable interpretation of equation (12)
is that, a greater willingness to save - lower ρ and θ - and a better technology - higher A - will raise the rate
of growth of the economy. Alternatively, a decrease in the set up cost ϕ (an increase in the number of MNC)
will raise the rate of return and raise the rate of grow γ . Equation (12) also shows that, a high level of human
capital, H, raises the rate of growth, γ . Therefore both factors, more MNC and higher H, have positive
impacts on the rate of growth of the economy3.

3. The Data and The Empirical Evidence

The degree of association between FDI and economic growth will be tested using data from a sample of six
MENA countries during the period 1975-90. The countries in the sample are chosen on data availability
basis. The econometric technique employed can be discussed briefly by writing the equation (12) above in
the linear form:

(13) γ it = α i + β 1 FDIit + β 2 Hit + β 3 (FDI*H)it + β 4 Xit + uit

 Topics in Middle Eastern and African Economies
Vol. 1, September 1999
Where, i denote a country and t a time-period. α i is a country-specific parameter. γ it represents the rate of
growth of per capita GDP adjusted for the terms of trade, while Xit is a matrix of other growth determinants.
A key issue in the use of panel data is how the country-specific effect is treated and consequently how the
parameters should be estimated. There are two ways of estimating equation (13) using panel data: the "fixed
effects" method which includes a dummy variable and uses OLS, and the "random effects" method which
considers the α i as a random variable, and therefore, uses generalized least squares (GLS). Both procedures
provide consistent estimates. The main results are provided in table (1), for the fixed effects method, and
table (2), for the random-effects method. Regression (1) in table 1 indicates that the correlation between
growth and FDI is positive. Although the result confirms the theoretical findings established in section II
above, the coefficient is not statistically significant. This certainly contradicts previous studies, which
showed a strong and positive correlation between growth and foreign investment [see De Gregorio (1992)].
The variable representing human capital (H), is negatively correlated with growth, contradicting theoretical
findings. While the interaction variable (FDI*H) is positive, it is not statistically significant. In regression 2,
FDI has a positive impact on growth while H has a negative and statistically significant effect. Population
growth (POPGR) also seems to impact growth negatively. Regressions, 3, 4, and 5 in table (1), add relevant
variables such as openness to international trade (OPN), and inflation (INF), and drop some of those in
regressions 1 and 2. Openness (OPN) is positively correlated with GDP growth, and statistically significant at
the 10% level.

Table (2) contains the 'random effects' method estimates. In all the regressions, the coefficient of FDI is
positive but not significantly different from zero. This result should not be surprising since all countries in
the sample had received insignificant amount of foreign direct investment during the 1970s and 1980s. In fact
they experienced hardship in getting foreign loans. The proxy of human capital is still negative but
statistically significant in all versions of the growth regressions. Again this result is expected since all
countries in the sample were experiencing lower secondary school enrollment ratios during the study period.
Previous studies (Barro, 1991) found a positive and significant effect of the secondary school enrollment rate,
when used as a proxy for human capital. When the primary school enrollment rate was used as a proxy for
investment in human capital, the coefficient is significant. Moreover, the positive and statistically significant
effect of government spending (GOV) contradicts the crowding-out effect predicted by the neoclassical
growth model. This is an indication that the governments in these countries still play a leading role in the
development process. Indeed, part of the government spending in these countries was used to build
infrastructure and institutions to attract foreign investment. Finally, the regression equations in table (1)
performed slightly better than those in table (2).

4. Concluding Remarks

This paper has examined the relationship between foreign direct investment and economic growth
theoretically and empirically. The review of the literature and our findings suggest that, by and large, foreign
direct investment leads to economic growth. The effect, however, varies across regions and over time. Our
results also indicate that domestic investment and openness to international trade are complementary to
economic growth. More comprehensive studies are very much needed in this area.

*Prepared for the MEEA Annual Meeting in Conjunction with the ASSA, January 3-5, 1999, New York, N.Y. An earlier version
of the paper was presented at The ERF Third Conference, Tunisia, August 31st-September 2, 1998. I would like to thank the
participants at both meetings and two reviewers and for their valuable comments.

End Notes

1While capital inflows can provide a strongly expansionary impulse to the domestic economy, a reduction in capital inflows will
typically generate an increase in domestic interest rates and consequently, a decline in asset values.

2The countries in the sample are Algeria, Egypt, Jordan, Morocco, Tunisia, and Turkey. These countries were chosen on the basis
 Topics in Middle Eastern and African Economies
Vol. 1, September 1999
of data availability only.

3Note that the number of foreign firms (N-n) affects ϕ , the cost of adaptation of technology negatively.

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Topics in Middle Eastern and African Economies
Vol. 1, September 1999