Foreign Capital Inflows and
Economic Development:
The moderating role of financial development
Kh. Muhammad Ali, Duaa Khan & Rehmatullah
Development Economics, University of Karachi, July 2024
Contents
01. Introduction
02. Literature Review
03. Methodology
04. Data Analysis
05. Recommendations
Foreign Capital Inflows and Economic Development:
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The moderating role of financial development
Introduction
• Foreign capital inflows (FDI) are a key indicator for economic
growth, especially in developing countries with high investment
needs and low incentives, leading to low employment levels.
• Developing economies accounted for two-thirds of global FDI in
2020, according to UN Trade and Development (UNCTAD).
• Developed countries saw a 58% fall in FDI due to COVID-19 in
2020 (UNCTAD 2021).
• Developed countries recovered in 2021, with FDI more than
doubling to $746 billion (UNCTAD 2022), but fell dramatically
again in 2022.
• The difference in FDI trends between developing and developed
countries highlights the greater importance of FDI for developing
economies.
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The moderating role of financial development
Introduction
(THEORETICAL BACKGROUND & OBJECTIVE OF THE STUDY)
• Foreign direct investment (FDI) links closely with development and growth indicators ( Todaro, 2017).
• FDI helps fill the resource gap between desired investment and locally mobilized savings.
• FDI fills the gap between foreign-exchange needs and net export earnings plus foreign aid.
• FDI also bridges the gap between targeted government tax revenues and locally raised taxes.
• Borensztein, De Gregorio, & Lee (1998) found FDI positively affects economic growth, depending on the host
economy's human capital.
• Institutional factors like corruption control, political stability, and financial sector development influence FDI inflows.
• This study examines how development level and financial development affect FDI inflows and their relationship
with economic development.
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The moderating role of financial development
Literature Review
• Two types of studies were reviewed: those examining FDI as a dependent variable and those using development proxies
as dependent variables.
• Islam, Khan, and others (2020) & Louail & Zouita (2021) found per capita income positively affected FDI inflows, along
with financial development & institutional quality. Magbondé & Konté (2022) had similar results.
• Shahzad & al-Swidi (2013) found positive effects of GDP growth, political stability, imports, and exports on FDI inflows
in Pakistan.
• Vera & Jagono’o (2020) found FDI's effect on development in Kenya insignificant in the presence of inflation, while
Nguyen (2022) found positive effects in ASEAN-6 countries.
• Bahri, Nor, and others (2017) found FDI negatively affected per capita income, but the effect became positive with
financial development.
• Empirical findings support theories that FDI positively impacts development indicators, but this effect varies with
institutional quality, political stability, financial development, and other control variables.
• The effect of development indicators on FDI is ambiguous and depends on sample, interactions, and moderation effects.
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The moderating role of financial development
Methodology
• For this study, Panel Data Analysis using OLS method is applied.
• We tested for Fixed Effects Models, Random Effects Models and Linear Regression Model.
• For analysis, Microsoft Excel and EViews (Econometric Views) were used.
• For visualizations, Python was used with libraries such Matplotlib and Plotly.
• Summary statistics for both countries and complete data was generated for basic ideas of
chosen variables.
• Correlation heatmap and matrix was made to check relationships between variables and
multicollinearity.
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The moderating role of financial development
Methodology
SAMPLE
• The sample includes seven developing South Asian countries: Pakistan, India, Sri Lanka, Bangladesh, Nepal,
Indonesia, and Vietnam.
• These countries are rapidly developing economies with significant growth potential and similar socio-
economic challenges.
• The study period is from 2000 to 2021, examining FDI inflows trends.
• FDI data from 2000 to 2021 shows distinct economic development patterns across these nations.
• Vietnam experienced a sharp rise in FDI inflows from 2007 to 2009, linked to its WTO accession.
• Indonesia's FDI inflows showed greater variance, especially after 2003, due to policy changes and global
commodity prices.
• Nepal, Pakistan, Bangladesh, and Sri Lanka displayed similar low FDI inflows in recent years, with an
overall steady trend in the five countries, except Nepal.
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The moderating role of financial development
Methodology
SAMPLE
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The moderating role of financial development
Methodology
VARIABLE CHOICE
• The dependent variable for this study is foreign direct investment (FDI) inflows.
• Primary explanatory variables are real per capita income and financial development.
• The main effect examined is the impact of real per capita income on FDI inflows, with
financial development as a moderating factor.
• Control variables include trade openness, domestic investment, human capital,
macroeconomic instability, and control of corruption.
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The moderating role of financial development
Methodology
VARIABLE INFORMATION
• 𝐹𝐷𝐼𝐺𝐷𝑃 = 𝛼 + 𝛽1 𝑃𝐶𝐼 + 𝛽2 𝐹𝐷 + 𝛽3 𝐹𝐷 ∗ 𝑃𝐶𝐼 + 𝛽4 𝑇𝑂 + 𝛽5 𝐷𝐼 + 𝛽6 𝐻𝐶𝑙 + 𝛽7 𝐼𝑁𝐹 + 𝛽8 𝐶𝐶 + 𝜇
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The moderating role of financial development
Summary Statistics
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The moderating role of financial development
Correlation Heatmap
• No serious multicollinearity issues, as all correlation
coefficients are below 0.8.
• Better governance (CC) positively correlates with per
capita income, human capital, trade openness, domestic
investment, FDI inflows, and financial development.
• Inflation negatively correlates with real per capita
income, financial development, and control of
corruption.
• Trade openness positively correlates with domestic
investment and financial development.
• Expected relationships with FDI inflows are observed,
except for a contradictory relationship with inflation, to
be further analyzed in regression.
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The moderating role of financial development
Analysis and Results
• FDI as % of GDP (FDIGDP) was regressed with all
explanatory variables using a fixed effects model in
EViews 10.
• Logarithm of per capita income (logPCI) was used to
avoid high coefficient values and variation; life
expectancy (LIFE) was used as a proxy for human capital.
• Other variables include trade openness (TO), domestic
investment (DO), and control of corruption (CC).
• (FD*PCI) shows the interaction term.
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Analysis and Results
• Negative effect of per capita income on FDI inflows observed, aligning with Magbondé & Konte (2022).
• Higher FDI levels in developing economies & lesser in developed ones support the introduction's idea.
• Positive effect of financial development on FDI inflows, consistent with expectations and theory.
• Results align with findings of Islam (2020), Mohamed & Zouita (2019), and Magbondé & Konte (2022).
• Financial development moderates the effect of per capita income, making it positive for FDI inflows.
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The moderating role of financial development
Analysis and Results
• Human capital variable shows an insignificant effect on FDI inflows.
• Macroeconomic instability positively affects FDI inflows, contradicting expectations but aligning with
Islam (2020), & Magbondé & Konte (2022).
• Trade openness positively affects FDI inflows, consistent with findings from Vietnam and others.
• Domestic investment positively and significantly affects FDI inflows.
• Control of corruption positively affects FDI inflows, meeting expectations.
• Real per capita income likely negatively affects FDI inflows without financial development.
• With financial development, per capita income positively affects FDI inflows.
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The moderating role of financial development
Analysis and Results
• Adjusted R-Squared value indicates our model explains around 81% of the total variation in FDIGDP.
• The remaining 19% of the variation is due to other explanatory variables not included in our model.
• The fixed effects Panel model provides better interpretation and policy recommendations than separate
time series analysis for each country.
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The moderating role of financial development
Recommendations
• Reform financial sector to enhance institutions and markets, & develop the sector.
• Modernize financial levels for a better investment environment.
• Couple financial and economic development with education and health investments.
• Increase government spending on education, currently at, on average 2.8% of GDP.
• Boost health expenditure, now at 3.7% of GDP, for better workforce efficiency.
• Improved health outcomes attract more foreign investments.
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The moderating role of financial development
Recommendations
• Increase government spending to boost per capita income and human capital.
• Prioritize expenditures on human capital to attract more foreign direct investments.
• Enhance trade openness by reducing tariffs and simplifying trade processes.
• Follow Vietnam's strategy to make trade processes more effective.
• Increase domestic investments in infrastructure for a better business environment.
• Implement anti-corruption reforms to boost investor confidence.
• Improve governance efficiency and accountability to attract foreign investment.
• Adopt a comprehensive policy approach targeting key development indicators.
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The moderating role of financial development
Limitations
• The limited sample size of seven countries may restrict the applicability of our results.
• Variable choice may have affected the model's explanatory power and overall fit.
• The fixed effects model may introduce bias, assuming constant relationships over time.
• Missing data and gaps, such as those in Sri Lanka and control of corruption data, complicate analysis.
• Addressing these limitations may be essential for improving the applicability of the findings.
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The moderating role of financial development
Summary
• This study examines how financial development moderates the impact of economic
development on foreign capital inflows in seven South Asian countries from 2000 to 2021.
• Results indicate a negative overall effect of economic development on foreign direct
investment inflows, which turns positive when financial development is present.
• Positive relationships were found with inflation, trade openness, better governance, and
domestic investment; human capital (life expectancy) was insignificant.
• The findings highlight the need for both economic and financial sector development to enhance
foreign direct investment inflows.
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The moderating role of financial development
Thank you
‘He who is presented with a flower
should not reject it, for it is light
to carry and pleasant in odour.’
(Sahih Muslim, Hadith: 2253)
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