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Foreign direct investment FDI in South Africa

Abstract

The purpose of this paper is to examine whether foreign direct investment, FDI, has any impact on economic growth in South Africa. In order to find a possible connection I use a multiple regression analysis with GDP per capita as dependent variable. Furthermore, I critically examine previous studies of FDI and its effect on GDP per capita in South Africa as well as other studies with several developed and developing countries. The difference between this paper and previous studies is that the data is more up-to-date here. My results, like most of the previous studies, do not indicate on any statistical significance that FDI has a positive effect on economic growth. FDI do however seem to produce positive spillover effects on the domestic economy, mainly through knowledge and technological spillovers.

1. Introduction

The foreign direct investment (FDI) flows has increased dramatically since the last decade. The annual average inward flows of FDI across the world during 1990-2000 was 492 605 million US dollars. The size of FDI has increased every year during this decade and was as large as 1 833 324 million US dollars in 2007. However, the FDI is spread unevenly across the world. The obvious action for multinational enterprises (MNEs) would be to invest more in regions with low labour costs and large supplies of natural resources. This is not the case though as the developing economies only received 499 747 million US dollars from FDI in 2007 (UNCTAD, 2008). Although a large portion of the FDI flows has been directed towards developed countries, the developing countries share has increased significantly during the last decade. The winners here are Africa and Asia while Africa only receives moderate amounts of FDI. In Africa it is South Africa that receives the largest amount of FDI (Ramirez, 2000). South Africa is no exception when it comes to the increase in FDI inward flows. The annual average inward flows of FDI was 9 368 million US dollars during 1990-2000. The increase in FDI gave an inward flow of 24 686 million US dollars in 2007 (UNCTAD, 2008). Many studies on whether or not FDI affect economic growth have been done through the years. These studies all come to varied conclusions. Some find that FDI indeed affect the economic growth while others find no such connection. The earlier studies focus on country case studies and industry level cross sectional studies. Overall, they find that there is a positive correlation between average value added per worker and the productivity of a MNE. Later studies gave up on country case studies and instead shifted the focus to firm level panel data. Typical for these studies is that the majority find no effect from FDI on economic growth. Moreover they find negative spillover effects from MNEs in developing countries while positive spillover effects only are found in developed countries. Since older studies are found inadequate, more recent studies have adopted another approach. These argue that spillovers should be thought of as exchanges between different industries which mean that focus should shift to vertical (inter-industry) externalities. This refers to the contacts established between domestic suppliers and the foreign firms (Alfaro et al, 2006). The purpose of this paper is to study possible effects on the economic growth in South Africa from FDI. In order to achieve this we shall conduct regression analyses with data on FDI and GDP per capita in South Africa during the period 1993-2007. Furthermore we shall examine earlier studies that deal with FDI and its effect on economic growth in South Africa as well as in general. My own results will be interesting in the way that the data is very recent. We will therefore be able to see if any changes have occurred during the last years, compared to earlier studies. It is a fact that the results vary much among the previous studies. Therefore recent studies have put focus on explaining why this is the case. We will examine some of these results in this paper since they are relevant to my own results. In this paper FDI will be expressed in millions of US dollars and the economic growth as GDP growth per capita. GDP per capita has endured a lot of criticism for not including effects on the environment and distribution of income. Nevertheless, it is the measure most commonly used and that is why

we shall use it as well.

The remaining part of this dissertation is structured as the following: Section 2 present's available theories on FDI and its effect on the economy. It also contains information on growth

models and the theoretical impact from FDI. Finally economic information concerning South Africa is presented. Section 3 present's my own result and compares it with earlier studies. Section 4 contains interpretations and a discussion of the results. Finally section 5 summarizes the paper.

2. Theoretical framework

2.1 FDI

There are two forms of foreign investment. The first is when foreign investors purchase stakes in a domestic enterprise, an indirect investment or foreign portfolio investment as it is known. The other is FDI and it is when a foreign owner finance the enterprise but is also directly involved in the management of the enterprise. The International Monetary Fund (IMF) defines the share to be 10 percent or more of the equity of the enterprise by the owner. This includes eventual loans from the foreign owner to the local company (IFC and FIAS, 1997). In most papers FDI is only mentioned as a certain level of inward or outward flow to or from a country. FDI can however be narrowed down to vertical and horizontal FDI. Vertical FDI (VFDI) aims at efficiency seeking while horizontal FDI (HFDI) aims at market seeking. HFDI emerges when MNEs seeks to cut costs that arises with exporting their goods. By establishing the production closer to the customer, costs associated with transportation and trade barriers are avoided. HFDI is believed to have a greater impact on spillover effects due to its intense use of knowledge while VFDI is believed to affect the local labour demand to a greater extent. To this date, there are mostly theoretical papers available about HFDI and VFDI and hardly any empirical studies. This is the case due to difficulties associated with distinguishing HFDI and VFDI in FDI data (Beugelsidjk et al, 2008). The FDI can also be divided into greenfield and brownfield FDI. The difference between the two is that MNEs construct new factories, invest in distribution or research in the host country with greenfield FDI whereas brownfield FDI acquires factories that already exists in the host country. Therefore, greenfield FDI stand for the largest inflow of physical capital between the two types (Johnson, 2005). Like IMF the Organization for Economic Cooperation and Development (OECD) proclaim that 10 percent ownership give the foreign owner an “effective voice” in the company. However, if 10 percent is not enough to ensure an effective voice, it should not count as FDI according to OECD. Conversely, if the owner's share is less than 10 percent and the owner still has management control in the company, it will count as FDI. Since there are different opinions of how to calculate FDI, OECD has formulated four components that should be included when calculating the flows. These are retained earnings, equity capital, intra-company loans and intra-company borrowing (Jones and Wren, 2006). These definitions make it possible to compare FDI flows between countries. There are several difficulties when calculating FDI though. The reason for this is due to different regulations and laws between countries when measuring components of FDI (Jones and Wren, 2006). The most important factor for FDI is MNEs. The formal definition of MNEs by OECD is “companies or other entities established in more than one country, and so linked that they may co-ordinate their operations in various ways”. Some argue that MNE activity is the same as FDI. Those who are against this assumption point out that this is not a perfect measure of MNE activity. A firm will only invest in a foreign country if the investment fulfills three conditions. First of all, the firm must have an advantage over the domestic firms, an ownerspecific asset. Then an advantage must exist in the setting-up production instead of relying on exports. The third condition is that the firm must internalize its assets (Jones and Wren, 2006). FDI is a source for financing a domestic firm. It is not in itself the firm nor its assets. A common misinterpretation is that many benefits generated by the domestic firm are attributed to FDI. The firm can borrow money from domestic banks or apply new technologies from their foreign owners, but this is not FDI. Should the foreign owner buy out the equity position of the domestic owner however, this would be considered FDI (de Macedo and Iglesias, 2001). Something that is not discussed much in the literature on FDI is the exploitation of the domestic cultural environment. It is somewhat frowned upon by authors of the subject but nonetheless an important factor for MNEs. Those MNEs that do take advantage of these differences and exploit it to their gain get a competitive advantage compared to those that refrain from it (Hosseini, 2005). The impact of FDI on economic growth in a country depends on the degree of development. The investment development path (IDP) suggests five stages that a country goes through and which affect the level of investment. During the first stage a country is considered to be almost unable to attract inward direct investment. This is the case due to low per capita income, underdeveloped economic systems and governmental policies, poor infrastructure and communication, and above all, a labour force with low human capital. The few direct investments made are mainly in the labour-intensive manufacturing and primary sector like agriculture. In the second stage, inward direct investment starts to rise. The investments are still mostly located in natural resources and primary commodities. In this stage, the host government is beginning to change policies in order to stimulate FDI. The domestic firms begin to move their production towards semi-skilled and knowledge-intensive consumer goods. The third stage is characterized by rising domestic income which causes an increase in demand for high quality goods, partly enhanced by an increased level of competition among firms. The rising incomes cause a decrease in growth of inward direct investment and an increase in the growth of outward direct investment towards countries with lower levels of IDP. The competition between domestic and foreign firms increases as well when the domestic firms acquire competitive advantages. The enlarged market and increased innovation will enable economies of scale and encourage technology-intensive manufacturing. When the stock of outward direct investment exceeds the stock of inward direct investment, the country has reached the fourth level. The domestic firms can only compete with foreign firms in sectors where they have a competitive advantage. Instead they invest abroad in markets where the labour is cheaper. In the domestic market the capital-intensive production increases in turn. The fifth stage characterizes by a continuous increase in outward and inward direct investment. This is the stage where advanced industrial nations find themselves. The importance of MNEs is clear here. The domestic supply of natural resources is of less importance and instead the ability to exploit markets in other countries is significant (Dunning and Narula, 1996).

2.1.1 Positive effects from FDI

We have previously mentioned that MNEs stand for the largest share of FDI. In comparison to a domestic firm it is presumed to have more skilled labour and better access to advanced technology which in turn gives a greater output than the smaller firms. The obvious positive effects from FDI are a decrease in unemployment and an increase in investment and output. There are also other positive effects on the domestic economy from positive externalities, known as spillovers. Jones and Wren (2006) present four transmission mechanisms that identify a spillover: “the movement of labour between MNEs and indigenous plants; purchase and supply linkages between MNEs and domestic firms; imitation of MNE-specific technology by domestic firms; and competition effects that force domestic firms to become more efficient”. The first type is productivity spillover which increases the productivity of domestic firms. The second one is market-access spillover which makes it possible for domestic firms to use export markets and distribution networks for their own gain. When a MNE establishes in a foreign market it is possible for domestic firms to learn directly from them through linkages. A forward linkage enables the domestic firm to use another firm's output for its input and the other way around for a backward linkage. The domestic firm can also profit from movement of labour. The worker has often acquired knowledge and specific competence from the MNE which benefits the domestic firm. Both of these mechanisms make it possible for productivity and market-access spillovers. Besides these effects MNEs also improve the degree of technology and competition in the domestic market. Domestic firms often imitate MNEs use of technology to increase their productivity, something which is known as “demonstration effect”. This is an indirect technological transfer. A direct transfer of technology occurs when a MNE passes information to its local suppliers or when it licenses the technology to a domestic firm. The increase in competition forces the domestic firms to improve the efficiency of their production techniques. Those that do not adapt are forced out of the market. FDI also improves the connection between firms and institutions and improve the market diversity in many cases. There is nonetheless a danger involved with large gaps in productivity between MNEs and domestic firms according to Glass and Saggi (1998). A large gap in technological knowledge might indicate that there is a large potential catch-up effect. If the gap is too large though, the case may instead be that the domestic economy does not have the capacity to absorb the technology. To low levels of human capital and infrastructure makes it impossible to learn and use higher levels of technology. A fifth mechanism is proposed by Crespo and Fontoura (2006) and that is exports. MNEs usually have a positive effect on distribution networks, infrastructure etc which in turn increase the export capacity of domestic firms. The effect of the positive spillover depends on how well the host country can absorb it, the absorptive capacity hypothesis. If the country has a low level of technology and human capital, it will not be able to acquire and use the knowledge that MNEs produce. This is commonly accepted as a fact and explains why developed countries receive more positive spillovers from FDI than developing countries. A large technological gap should then be negative for absorbing the positive spillovers. However, in recent empirical studies, evidence has been found that this may not be the case. Here, economies with a large gap in the technological level between domestic firms and foreign firms are the ones that get the most effect from positive spillovers. The most plausible explanation here is that the domestic economy increase structural and policy changes in order to attract FDI and to be able to absorb the positive spillovers that come along with it (Jordaan, 2005). Furthermore, spillovers can be voluntary or involuntary. They are voluntary when a MNE interacts with a domestic firm and a positive spillover is taking place. The domestic firm may then increase its quality of labour etc which is beneficial for the MNE as well. With an involuntary spillover on the other hand the domestic firm applies the technology that the MNE is using, often by imitation or hiring experienced workers from the MNE. Thereby the competition gap decreases to the advantage of the domestic firm (Johnson, 2005). Obviously the size of the benefits from FDI on a country's economy depends on several factors. One of these is the export-rate of domestic firms. Firms that are more exportoriented have adapted to foreign competition and are therefore better prepared to absorb the positive spillovers generated by MNEs. The smaller the firm is, the harder it is to imitate the production pattern of the MNE due to its large production scale. Another important factor that has recently gained in importance is the regional effect. This implies that the further away the source for the FDI is, the lesser effect it has on the domestic economy. The reason for this is rising transport costs and limited labour turnover among other things. One of the most discussed factors is the absorptive capacity of domestic firms previously mentioned. The domestic firm must possess basic technological and knowledge skill in order to absorb new skills generated from FDI. This idea can also be applied at the macroeconomic level. MNEs tend to invest more in advanced technology in countries with a certain level of knowledge and human capital. These are all factor that has been examined and discussed thoroughly. The following factors are somewhat less discussed though. One is the notion that FDI generates different spillover effects depending on the source country. Here culture, language, laws, transfer distance and structures of FDI is of importance. The more alike the countries are, the better the chance for a larger effect from the spillovers (Crespo and Fontoura, 2006).

2.1.2 Negative effects of FDI

As mentioned before, FDI might have positive effects on the level of employment on the domestic market. The level of employment does not have to rise though. If the MNE is capital intensive and forces domestic firms out of the market due to competition, the rate of unemployment might actually rise instead. When MNEs invests in a new region they tend to set the wages above the domestic firms in order to attract the most competent workers of the labour force. This in turn forces the domestic firms to raise their wages in order to keep their workers. A high increase of the wages might have negative effects on the economy though. Some fear that MNEs only invest in sectors with low-skill production and low-wage jobs. These investments tend to focus on producing at a low cost and do not generate an investment in research and development. The notion on whether or not this is the case goes apart. Another implication of FDI on the level of employment is that MNE firms are “footloose”. It means that if the production turns out to be less costly in another country, it is easier for a MNE to move the production to that country than for a domestic firm to relocate their production. This may cause instability to the regional economy in the country. During a recession, it is particularly harmful for the region if the foreign firms shut down, which are just what they might to do on these occasions. Empirical evidence indicates that foreign firms exit the market one-and-a-half times more often than domestic firms. Moreover, FDI may decrease the diversification of firms in a market. Agglomeration in a region tends to increase the average risk for the economy and population in case of a shutdown (Jones and Wren, 2006). Other negative effects arise from a market stealing effect. It means that foreign firms enter the domestic market and take over part of the market which causes domestic firms to exit the market as a result (Jordaan, 2005). There are those who believe that domestic investments are better for the local economy since domestic firms are supposed to have better knowledge and access to domestic markets. The evidence from the positive spillovers by MNEs and their FDI goes against this presumption though (Borensztein et al, 1998). A problem with FDI in developing countries is that it is argued only to be a transfer of assets. When foreign firms conduct mergers and acquisitions of domestic firms it does not automatically lead to an increase in the capital stock. Since developing countries tend to be capital-scarce, an increase in the capital stock is of great importance for future economic growth. If capital accumulation takes place as a positive effect from FDI, it is required that the FDI does not crowd out investment from domestic sources in order for economic growth to increase (Herzer et al, 2008). A problem with the use of spillovers arises when the MNEs export their products. The domestic firm is usually a producer for the domestic market, which implies that the production process is not the same between the two. This in turn makes it difficult for the domestic firm to imitate the MNE and its production process and thereby gaining positive spillovers (Crespo and Fontoura, 2006).

2.2 Economic growth

Economic growth within a country can be derived from several growth models. The best known growth model is the Solow-Swan model which was formulated in 1956. In this model, production is generated through capital and labour under the assumption of constant returns to scale. This is a neoclassical growth model and it explains growth partially by exogenous improvements in technology (Gylfason, 1999). The effect from FDI on growth in this model in the medium and long run depends on increases in the volume of investment or its efficiency level (Nair-Reichert and Weinhold, 2001). Domestic investment (DI) plays an important role in neo-classical growth models where it enhances production growth and technological progress. FDI is also an investment but differs from DI. First of all FDI increases the technological inventions and especially general purpose technologies. These innovations are breakthroughs which all countries can adopt, but at different pace. The second difference is that FDI include more advanced technological aspects. These advantages transfer to domestic firms in due time, increasing the level of output (Yao and Wei, 2007). A model that explains growth endogenously was developed during the 1980s and 1990s. It was the endogenous growth model or as it is also known as, the new growth model (Gylfason, 1999). When considering the different models and the effect from FDI, the result differs. FDI increases the volume of investment in an economy and may increase its efficiency in a neoclassical growth model. In the endogenous growth model FDI can increase the economic growth mainly through technology transfer and the previously mentioned spillover effects (Nair-Reichert and Weinhold, 2001). Since the technological progress in the neoclassical growth model is determined exogenously, the model fails to explain growth or the technological change itself satisfactory. Therefore we shall focus on the endogenous growth model. In neoclassical growth models, FDI only has a short-run growth effect. In endogenous growth models on the other hand, FDI is believed to have a greater impact on economic growth than domestic investments. The production function in the receiving country incorporates the technological advances from FDI and thereby increases growth. These technological spillovers make it possible for a long-turn growth to take place by counteracting the effects of diminishing returns to capital. Beside capital accumulation, knowledge spillovers from FDI can also enhance the economic growth. This takes place when alternative management practices and organizational changes occur alongside an increase in knowledge stock through skill attainment and labour training. The accumulation of capital through FDI generates positive spillover which enhances economic growth. Due to this, we can not only study flow variables in order to understand the connection between FDI and economic

growth (Herzer et al, 2008). One of the first endogenous growth models was constructed by Marvin Frankel (Carlin and Soskice, 2006). By starting with a Cobb-Douglas production function his aim was to retain desirable properties of the neoclassical production functions, but not the limitations:

……………..2.1

where Yi is output for each firm, Kiα is the aggregate capital, A is the outcome of aggregate capital accumulation in the economy and Li is labour. The difference from the Solow-Swan model is that A is not an exogenous productivity factor. Labour enables knowledge in the production function which increases labour productivity, also known as “learning by doing”. This phenomenon occurs due to the accumulation of capital. It is assumed that each firm's knowledge is a public good which gives an expression for knowledge in the whole market:

……….2.2

Where ή is a positive constant. The production function for all the firms on the market when

taking A as given is:

…………………2.3

Since A is constant for the firm, there are diminishing returns to capital and constant returns to scale. There are increasing returns to scale for the economy

If the knowledge spillover from capital accumulation, ή, is 1, then returns to aggregate capital accumulation are constant:

……………………………….2.4

What is interesting with this production function is that the economy grows at a rate independent of the savings/investment rate if ή < 1, but unlike the Solow-Swan model, its output per capita does grow. This is obvious if we take the production function :

and then apply logs and differentiate with respect to time:

…………….2.5

Along a balanced growth path gy = gk. This in turn gives us:

………………………2.6

Since the growth rate of output per capita is in steady state, then

Which gives us:

……………..2.7

Since technological progress is endogenous it is the only cause for growth of per capita output. Beside technological progress and its impact on economic growth, we encountered other spillover effects from FDI. One of these is the accumulation of human capital. The growth rate for human capital in an economy is:

………………………2.8

where gh is the growth of human capital, h' is the change of human capital, h is the amount of human capital per person, c is a scaling parameter and (1-u) is the fraction of labour hours spent in education in order to learn new skills that can be used in production. Human capital is also present in the equation for the growth rate for capital per worker:

……………………2.9

If steady state exists when capital per worker grows at a constant rate, then the ratio (k/h) has to be constant. The assumption of constant returns to human capital accumulation needs to be held in order for the endogenous growth to emerge. The spillovers from human capital accumulation are important for the productivity and are sometimes referred to as “social capital”. This is not only the notion of sharing information and innovations but also of reciprocity and behaviour (Carlin and Soskice, 2006). Some of the models consider domestic investments to be of little importance for economic growth. Direct investments from other countries are somewhat different though. Due to the spillovers from FDI, they may have a positive effect on economic growth (Gylfason, 1999). It is commonly believed that developing countries can have a high growth rate due to the catch-up effect. Since their technological level is much lower than developed countries they can implement already available technology and thereby increasing the growth rate. In order for the country to absorb the new technology, a certain level of human capital is necessary. Since MNEs are the largest contributor of new technology, their presence in a country may be important for the economic growth. A large amount of FDI may cause positive spillovers which in turn enables for the country to raise the growth rate (Borensztein et al, 1998).

2.3 South Africa

South Africa has received FDI for several decades. Up until the mid-1940s the country could hardly attract any FDI and was therefore considered a stage-one-country in the IDP. From the 1950s to the 1970s the direct investment increased continuously. The metal-mechanical and the diamond industries were where most of the investments ended up. The basic infrastructure and the human capital were upgraded and the domestic market increased in size. This made it attractive for MNEs to invest in the country. Although South Africa has large domestic firms and increasing outward direct investment, the country has not reached the third stage. Today, South Africa relies more on FDI than on the domestic producers in order to modernize the industry. South African exports grow constantly and it is especially positive that the exports are rather diversified. South Africa's forward development has resulted in one of the most open economies in the world. The average tariff in modern time is only about 10 percent (Dunning and Narula, 1996). All these measures together with an attractive investment policy increase the FDI into the country. According to Ramirez (2000) FDI inflows account for more than 15 percent of the gross fixed capital formation. Since South Africa has received FDI for a very long time, the country has learned to handle these flows in a good way. The government has changed its policies during these years in order to be able to direct the FDI. The government is now able to direct these investments to priority sectors that exhibit high production capacity, improve the infrastructure and use new technologies (Ramirez, 2000). However, the inflows of FDI are not evenly spread across the South African states. The vast majority of FDI to South Africa originates from developed countries especially in diamond trade, with over 95 percent from the OECD. The developing countries are hardly considered due to the low investments from them. The main part of the FDI in South Africa goes into the manufacturing and services sectors. When turning to agriculture and mining, these sectors receive negligible shares of the investment from other countries (Jensen and Rosas, 2007). South Africa is the country in Africa that receives most of the private foreign capital inflow, almost 50 percent. The main reason why the country receives such a large share because that they have a huge diamond industry. South Africa is also rather open and is improving the possibilities for foreign investment (Dunning and Narula, 1996). There is empirical evidence that for South Africa and other developing countries the rates of return to capital are high. It is also the case that the level of FDI is not higher in developing countries than in industrialized countries. So even though FDI has increased dramatically in South Africa during the last two decades( mainly because of end of aperthied), the level of FDI is still higher in more developed countries (Banerjee and Duflo, 2005). The next section presents my own results as well as previous studies and their results.

3. Data and statistical analysis

Several studies have been made on FDI and its impact on economic growth. Some of these studies concern South Africa alone but most include several countries. One difference between these studies and my own is that mine includes data up to year 2007, which makes it more up-to-date than the previous studies. Many of the previous studies do not find that FDI have any significant effect on economic growth.

3.1 Results

The measurement of inward FDI flows in South Africa gives slightly different results from different sources. Therefore we use two sources for the data on FDI. This data has been calculated by the OECD and the UNCTAD. The data differs somewhat which indicate on different methods of measurement. When comparing the data to the domestic measurement (Secretariat for Economics, South Africa) the data from UNCTAD differ the least. Nevertheless we shall perform two regression analyses, one with data on FDI from OECD and one with data on FDI from UNCTAD. This way we will find possible differences between the two data sets. The first variable, the dependent variable, is Ln(GDP) per capita. As independent variables we use Ln(FDI) and the lagged variables Ln(GDP) per capita the previous year and Ln(FDI) the previous year. In order to achieve this we shall use a dynamic adjustment model by Verbeek (2004):

……..3.1

where t-1 is the previous year. The reason why we compare with the previous year is because FDI might affect GDP per capita, not only the present year, but also in the longer run. No dummy variables are used in the model in order to observe the difference from before and after SADC. The reason for this is that the data is mainly from after South Africa joined SADC in 1994. Suppose that b=1 and d= - c, then we have:

…..…..3.2

which is a difference-in-difference model. In this case, c= Δ% in GDP by a % increase in FDI.

The long-run expression of (3.1) is:

………………………..3.3

By using the model (3.1), we obtain the results as shown in Tables 1 and 2(Appendix).

95 percent confidence intervals are used in the tests. The P-value of Ln(FDIt) in the first test is 0,398 and 0,282 in the second test. The corresponding P-value for Ln(FDIt-1) is 0,965 and 0,982. Evidently the result is not significant at any conventional level (95 % - 99 %) and we cannot reject coefficient c or coefficient d in neither test. According to the tests, there is a difference between the two sources. However, both values are very high and therefore we conclude that FDI does not have any significant effect on economic growth in South Africa here. We have also tested other model variants, for example, without the lagged FDI term, and find that the insignificant result remains. Fig.3 and 4 show the correlation between Ln(GDP) per capita and Ln(FDI). Both figures, with data from UNCTAD and OECD, display a positive correlation. When looking at these regression plots, we could draw the conclusion that GDP per capita and FDI are correlated. Even though a positive correlation might exist, this does not mean that there is causality in the test. The earlier opinion was that an increase in FDI leads to an increase in economic growth. This is not the general belief today and there are those that claim that instead it is an increase in economic growth that causes an increase in FDI flows. There are a lot of arguments on which is true and the opinion differ. One explanation is spurious regression. This is when the t-value suggests a significant relationship between two variables when there in fact is no significant relationship to be found (Verbeek, 2004). More about the causality between economic growth and FDI is presented in section 3.2, comparison with previous studies.

3.2 Comparison with previous studies

The results on whether or not FDI is positive for economic growth differ between different studies. One conclusion can be made when comparing these studies and that is that it depends on if it is a microeconomic study or a macroeconomic study. The microeconomic studies at the firm-level often end up with the result that FDI does not increase economic growth and does not produce positive spillover effects. No technological transfer from MNEs to domestic firms is taking place according to this. When we look at the studies with aggregate FDI flows for a broad cross section of countries that is at the macroeconomic level the result is another. Here, FDI should have a positive effect on economic growth. Even though the macroeconomic studies show a positive effect from FDI, we must look at these studies a bit skeptically. One reason is that they do not control for different country-specific effects. Another is the use of lagged dependent variables such as regressors. This can cause inaccurate coefficient standard errors (Carkovic and Levine, 2002). In Carkovic and Levine's (2002) study they use a macroeconomic method that excludes many of the earlier macroeconomic problems. Here they find that FDI is not independent in changing the economic growth. Even though FDI may cause an increase in economic growth, other growth determinants and a developed financial market are necessary for the effect to be effective. Waldkirch (2008) has studied the effects from FDI on the economic growth in South Africa after SADC was implemented in 1993. The result show that the level of FDI has increased substantially since South Africa joined SADC. However, the investments are often placed in sectors with unskilled workers. One of the reasons with the paper was to see if FDI from more distant countries had a larger effect on various economic indicators in South Africa. The conclusion is that there is not enough evidence for this presumption. Ramirez (2000) has also studied data on the impact of FDI flows on economic growth specifically for South Africa. Generally the FDI in the country can be said to give large positive spillover effects and yield strong international trade links. Moreover, the econometric evidence indicates that the variables in the production function in the study do not fluctuate much in relation to each other in the long run. When using Error Correction Models (ECMs) the author find a positive and statistically significant effect on the labour productivity from the growth rate of private and foreign capital stock. One important aspect with FDI is the question if the gain is larger than the negative side-effects. Even though positive spillovers will occur, there are also costs for South Africa such as subsidies and tax concessions. Another study of FDI and the effect of its spillover in South Africa have been made by Jordaan (2005). He concludes that FDI do result in positive externalities which are positive for the economic growth. Furthermore, the FDI tend to focus on labour-intensive and low productivity industries in the manufacturing sector. He also finds proof, contradictory to the theory, that the economy is positively affected by agglomeration. These geographical concentrations of domestic and foreign firms increase positive externalities through imitation, labour turnover and inter-firm linkages. Industries that are less agglomerated thus receive less positive externalities. In highly agglomerated sectors Jordaan (2005) discovers, unlike previous studies, that firms with a large technological gap compared to foreign firms, are the ones that gain the most on positive externalities. He is of the opinion that the absorptive possibilities of a firm might not be as large an issue as believed earlier. The empirical evidence clearly indicates this. Tuan and Fung-Yee (2007) also find positive effects from FDI and agglomeration, but in China. The FDI is mainly focused in the southern and eastern regions and is believed to contribute to the sustained growth in the regions. A larger and more recent study has been made by Alfaro et al (2004). They use more explanatory variables than the previous study, such as population growth, inflation rate, government consumption etc. They find that FDI affect the economic growth positively. For the positive effects to take place though the local financial market has to be developed in the receiving country. A poorly developed financial market cannot make use of neither short-term capital flows nor long-term stable flows. With this, they claim to have proven that the link is causal between FDI and economic growth. Furthermore they found that most countries, including industrialized ones, have special policies with fiscal and financial incentives in order to attract FDI. In a later study by the same authors (Alfaro et al, 2006) they use both microeconomic and macroeconomic empirical literature in order to acquire satisfying results. They find that the growth rates appear to be almost twice from FDI in a country with developed financial markets compared to countries with poorly developed markets. They also find larger growth effects when the domestic firms and MNEs produce substitutes. Balasubramanyam et al (1996) find a statistically significant result at the 1 percent level in their study of 46 countries, which are classified as developing. Since the study focus on trade, their result indicates that FDI accelerate economic growth faster in an economy that promotes export. Borensztein et al (1998) use a large number of explanatory variables in a cross-country regression framework like the study by Alfaro et al (2004). Their study includes data from 69 developing countries that receive FDI. Although their result is not statistically significant, they believe that FDI do have positive effects on the economic growth of a receiving country. This positive effect mainly takes place through improvements of the technological knowledge. Like many other studies they use human capital as an explanatory variable. Just like the rate of technological progress, the rate of human capital is crucial for a country's economic growth. A country with a low level of human capital cannot utilize the FDI that flow into its economy. The authors conclude that a minimum threshold of human capital stock is required and that a higher level of human capital enables a country to put the FDI to better use, and thereby facilitates for economic growth. As we observed in the theory, FDI can be divided into horizontal FDI (HFDI) and vertical FDI (VFDI). Previous studies have not made this important distinction though according to Beugelsidjk et al (2008). They test respectively effects from HFDI and VFDI on economic growth by using gross fixed investment stock, level of schooling, black market premium and population growth as explanatory variables. When the sample includes both developed and developing countries, the results indicate that neither HFDI nor VFDI affect the economic growth. When using the traditional FDI variable though, the result is significant. Still, this result changes when separating the countries into a sample of developed countries and another sample of developing countries. The sample with developed countries now shows a positive and significant result for both HDFI and VFDI. The sample with developing countries on the other hand does not show a significant impact on economic growth from neither HDFI nor VFDI. There is still a positive effect from traditional FDI on economic growth here as well as before. The result from the empirical research in the study shows that HFDI has a 50 percent larger impact on growth in developed countries than VFDI. Even though HFDI and

VFDI are important for different types of development, it is clear that HFDI is more important for economic growth. Herzer et al (2008) study 28 developing countries and do not find any evidence that FDI has a positive effect on GDP for most of the countries. Noticeably they cannot find a single country with a positive long-term effect from FDI on GDP. One argument from earlier studies is that a positive effect on the economy in the domestic country comes from an increase in the demand for raw materials. Foreign firms that establish factories will need raw material in order to produce their products. Yet in this study the authors find evidence that this might not be the case. MNEs that use a lot of raw material in their production do not purchase

these from the local suppliers. Instead they tend to acquire them within the enterprise and thereby from foreign suppliers. The political situation and governmental actions also have a great impact and might explain the deviations in some countries according to Fung-Yee and Tuan (2006) in their single country study of China. Moreover they conclude that FDI in areas with high agglomeration of specific sectors does not increase GDP as much as in more diversified areas. Instead local firms, especially in the manufacturing sector, seem to affect

GDP directly to a greater extent than foreign firms. One important probable effect from FDI on economic growth is the knowledge spillover as mentioned before. Görg and Greenaway (2004) however find evidence that this might be a false assumption. From a 25 firm-level studies from both developed and developing countries, only 6 show positive effects from spillovers to the domestic firms. Some of these actually show negative effects on the domestic firms as a result from FDI spillovers. One explanation for this is that foreign firms have lower marginal costs from firm-specific advantages. This competition forces domestic firms out of the market since they cannot compete. Crespo and Fontoura (2006) present empirical evidence of the extent that the domestic firms are able to absorb them and find that the effect from positive spillovers

appear to be greater in developed regions. An important aspect we have to consider is the causality between FDI and GDP. Hardly any older studies test for the causality. One causality test that has been made is by Herzer et al (2008). They test for weak exogeneity and thus for long-run Granger non-causality which was presented earlier. In order to get accurate results they do this “(i) by using several alternative methods for estimating the cointegrating parameters; (ii) by using other methods to test for causality; and (iii) by including several control variables, such as labour, domestic investment, and export” (Herzer et al, 2008). The result indicates that only four countries show a long-run positive impact of FDI on GDP. However, the long-run causality is bidirectional which signify that FDI causes growth as well as it is a cause of it. Furthermore in the long run only one country is found to have unidirectional influence from FDI on GDP. This unidirectional influence is negative though. The authors also study the short run and here they find that in five of the countries FDI affect GDP positively while it affects GDP negatively in four countries. Hence they come to the conclusion that FDI cannot be proven to have a positive impact on GDP in developing countries since they are not able to find any statistical significant long-turn impact. Liu et al (2002) also find proof of bi-directional causality in the long run from FDI on GDP in China. Beside FDI and economic growth they also include exports and imports in their study. Yet another study on causality between economic growth and FDI has been made by Chakraborty and Nunnenkamp (2007). They put data from India to Granger causality tests but conclude that there is no causal relationship between the two. An interesting observation made however is that cross-section spillovers take place from the service sector to the manufacturing sector. FDI in the service sector thus causes growth in the manufacturing sector. One reason why these studies differ so much in the result could be that some assume heterogeneity across countries in the panel studies while others assume homogeneity according to Nair-Reichert and Weinhold (2001). Their study of 25 developing countries differs substantially from traditional panel data causality results. They allow the strength of causality to vary from country to country and permit for heterogeneity. They find that the relationship between FDI and economic growth is highly heterogeneous and that the effect from FDI on economic growth is more efficient in open economies. In Johnson's (2005) study of 90 developed and developing countries the direction of causality is from FDI to the economic growth. From cross-section and panel data analyses the study show that FDI do have a positive effect on the economic growth in the receiving country. What really differ between this and the majority of previous studies is that FDI seem to improve the economic growth in developing but not in developed countries. The result should be viewed critically though due to the small sample of developed countries. In the fourth section we will discuss my result and the results from previous studies.

4. Discussion

The results presented in this paper indicate on different results from different studies. How should we be able to acquire the correct answer of the possible connection between FDI and economic growth? In order to come to a conclusion there are several factors to be considered.

We have to remember to critically analyze the methods these results are based on. All different studies suffer from some sort of problems which makes it possible to question the result. A common method is cross-country studies which often show that FDI has a positive impact on the economic growth. The greatest problem here is the assumption of identical production functions from the different countries included in the study. This may give a false result since the policies and production technologies differ to a large extent between the countries. For a correct study to take place, we would have to take all these differences into account. Furthermore, if the coefficient of FDI in the growth equation is statistically significant, this does not automatically indicate a connection between FDI and economic growth. In fact, “cross-country studies may suffer from serious endogeneity biases” and “unobserved heterogeneity due to omitted variables may lead to biased parameter estimates” (Herzer et al, 2008). Since FDI is supposedly more effective when the economic growth is high, a positive correlation can be compatible with causality running from growth to FDI. Theoretically, the FDI should have a positive effect on economic growth according to the endogenous growth model, at least greater than domestic investment (Herzer et al, 2008). Another common method is panel studies which eliminates the previous problem by using unobserved country-specific effects. This method makes it possible to control for endogeneity bias due to the use of lagged explanatory variables (Herzer et al, 2008). By using time-series and cross-section panel data estimation the researcher can control for “countryspecific, time-invariant fixed effects and include dynamic, lagged dependent variables” (Nair- Reichert and Weinhold, 2001). Of course, this method also suffers from various problems. One problem is when the coefficients of the lagged dependent variables are homogeneity imposed, even though the dynamics are heterogeneous (Herzer et al, 2008). This can lead to biases which later on cannot be corrected with instrumental variable estimation (Nair- Reichert and Weinhold, 2001). Another problem is that the relationship between FDI and GDP is restricted to growth rates or first differences which also can bias the result. A level relationship would be required in order to get correct results (Herzer et al, 2008). Finally, many of the available studies should be critically examined since only system-based cointegration procedure is used to test for cointegration between FDI and economic growth. This may lead to a rejection of the result where the cointegration and the causality between FDI and GDP are presented (Herzer et al, 2008). As concluded before, the result depends on if it is a microeconomic or macroeconomic study. Furthermore, most studies also fail to consider country-specific effects from FDI. However econometrically FDI should have a positive effect on economic growth. This cannot be statistically proven according to my study and several of the previous studies. Still, FDI do produce several positive spillovers. One of the most important is technological spillovers which domestic firms can adapt. More studies are required on this subject though since there are different opinions whether a large technological gap between MNEs and domestic firms is positive or negative. Of course, the technological spillover effect is positive on the economic growth both with a small and a large technological gap. If FDI is to affect the economic growth positively, the effects from the positive spillovers must be larger than the negative spillovers. The governments yearning for FDI might actually harm the economic growth through large subsidies and tax concessions. We must also deal with the causality issue. Only one of these studies (Johnson, 2005) shows a positive causality, that FDI do effect economic growth and not the other way around. The other studies that do test for causality in the long run only find proof for this for some of the countries in the samples. The main part of the countries show no or bi-directional causality between FDI and economic growth. An interesting thought is that FDI has no effect on economic growth and that this is only a belief among the countries that try to attract it. Instead, in their efforts to attract FDI, they enable for economic growth themselves through reforms and policies. Despite the fact that most studies cannot find any statistic evidence that FDI do effect economic growth positively in the long run the authors are overall still positive towards FDI. They believe that FDI have a positive effect on GDP per capita but that it is only one factor among many others. The spillover effect is an abstract concept and not directly measurable. The empirical literature use econometric analysis to see the effect from spillover effects on economic growth. It is therefore not easy to get accurate answers on this subject (Crespo and Fontoura, 2007). An interesting point to consider is if it is at all realistic to consider FDI to affect the economic growth in a country. If we look at South Africa, the amount of FDI has risen greatly since the 1980s. Still, this is only a marginal of the GDP. Can we thus expect FDI to have any sort of impact on the economic growth in South Africa? Since FDI only is a fraction of a countries total investment, it is hard to find the evidence of to which extent FDI affect economic growth. Interestingly FDI may in fact be harmful for the regional economy but positive for the national economy (Jones and Wren, 2006). The effect from FDI on economic growth in South Africa cannot apparently, like for the other countries, be statistically proven. The studies do however show an increase in labour productivity and other positive spillovers. The inflow of FDI is relatively high in the country and a rising level of human capital and level of knowledge encourages the flow to continue and increase. Since FDI inflows have existed for a long time in South Africa the government has learned to handle it effectively through policies and institutions. Their financial market has also been developed, something that is fundamental in order for FDI to affect GDP per capita effectively. Furthermore it is a known fact that FDI inflows in South Africa tend to increase the agglomeration of firms. Whether this is positive or negative for the economic growth disputed though. Finally, we must consider the fact that even though we cannot find any statistical significance in our study, it is only the result for the data in our study. Although the null hypodisertation is rejected, this might not reflect the reality. Our regression analysis did not find any statistical significance when we used the variables in (3.1) and neither when we performed the test without the lagged variables. It is important to remember that other important variables can be used and possibly give another result. An interesting variable here is domestic investment. Further research should be made concerning domestic investment and the possible connection to FDI. The final section summarizes the paper and presents my conclusion on whether or not FDI affect economic growth in South Africa.

5. Conclusion

Whether or not FDI has any effect on economic growth is widely argued in both previous and

present studies. Some come to the conclusion that FDI does have a positive effect on GDP growth per capita. Others cannot find any evidence that this is the case. These different results depend on whether the authors have used microeconomic methods or macroeconomic methods but also on different data and different explanatory variables. Herzer et al (2008) take causality into account and test for long-run Granger non-causality. Their result indicates that there are hardly any countries that show a long-run positive effect from FDI on GDP per capita. Those countries where FDI does have a positive effect on GDP growth per capita show a bi-directional causality, which means that FDI might as well cause economic growth as well as it is a cause of it. Other studies on causality from Liu et al (2002) and Chakraborty and Nunnenkamp (2007) only find proof of either bi-directional causality or no causal relationship at all. In this paper, we use a dynamic adjustment model to study the dependence of Ln(GDP) per capita on Ln(FDI). Furthermore we use more recent data than previous studies, from 1993 to 2007 and from two different sources in order to see if the result differs. The multiple regression analysis indicates that the coefficient for Ln(FDI) and its lagged variable are not statistically significant at the 5 percent level in neither of the tests. We also perform an analysis without the lagged FDI term, but find that the insignificant result remains. Even if my results and several other studies show that FDI does not have a positive effect on economic growth, most authors argue that FDI may have a positive effect on GDP per capita at least in certain sectors. We cannot only study flow variables in order to understand the connection between FDI and economic growth. Positive spillover effects from FDI are important but the importance of country specific absorptive opportunities are disagreed upon. Available studies fail to observe important factors that might affect the economic growth, such as political and cultural differences. Future studies should focus more on specific countries in order to get more reliable results.

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