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Determinants of foreign direct investment in South Asia

ABSTRACT

Foreign direct investment (FDI) creates employment opportunities, helps transfer managerial skills and technology, and provides the much-needed capital for domestic investment in developing countries, all of which contribute to their economic development. Recognizing the manifold benefits of FDI, developing countries around the world have significantly eased restrictions on foreign capital transfer since the early 1980s. This paper studies 5 countries in South Asia - Bangladesh, India, Nepal, Pakistan, and Sri Lanka, and investigates which factors, both economic and non-economic, drive the flow of FDI into these countries. Employing 1995-2000 panel data, this study finds that economic freedom, economic openness, economic prosperity, human capital, and incremental lagged changes in FDI significantly increase FDI inflow in South Asia, while political instability significantly depresses it. These results further our knowledge of the determinants of FDI, which is crucial for devising strategies to promote economic development --a course that holds much at stake not only for South Asia, but also for developing countries in general.

Economics Introduction

There is a general consensus in development economics literature that the inflow of foreign direct investment (FDI) can play a critical role in the growth dynamics of recipient countries. The literature holds that FDI can fill at least three “development gaps” in developing countries. FDI can fill, first, the “investment gap” by providing the much needed capital for domestic investment; secondly, the “foreign exchange gap” by providing foreign currency through initial investments and subsequent export earnings; and finally, the “tax revenue gap” by generating tax revenues through creation of additional economic activities (Smith 1997). FDI can also help generate domestic investment in matching funds(Bosworth and Colllins (1999) found that FDI inflow helps generate almost equal amounts of domestic investment in matching funds in recipient LDCs), facilitate transfer of managerial skills and technological knowledge, increase local market competition, create modern job opportunities, increase global market access for locally produced export commodities, etc. all of which should ultimately contribute to economic growth in recipient countries.

Recognizing the benefits of FDI, many developing countries have significantly eased restrictions on the inflow of foreign capital since the early 1980s. Furthermore, the end of the Cold War in the early 1990s resulted in a new political dynamics that not only ended the foreign aid programs sponsored by the erstwhile Soviet Union in left-leaning LDCs, but also diminished the strategic alliances between the US and the pro-US developing nations resulting in a sizable reduction in the US-sponsored foreign aid programs. The new political reality has forced LDCs, hitherto heavily dependent on foreign public aid regardless of their political ideological leanings, to seek out alternative sources of foreign private capital. As a result, the annual FDI inflow to developing countries has increased manifold from $24 billion in 1990 to almost $178 billion in 2000 (from 24% of total foreign investment in 1990 to 61% in 2000) (World Bank 2001). According to other World Bank estimates, FDI inflow in all developing countries has grown since the 1980s by almost 672%, while the regional breakdown of the increased FDI inflow during the same period is as follows: Europe and Central Asia - 5,200%, East Asia and Pacific - 942%, South Asia - 740%, Latin America and Caribbean - 455%, and Sub-Saharan Africa - 59% (World Bank 2000).

The increasingly significant role of FDI in the growth dynamics of developing countries has created much research interest among development economists. Consequently, a sizeable empirical literature has evolved on the determinants of FDI. These studies have identified a number of variables, such as market size, wages, inflation, financial liberalization, quality of infrastructure, trade liberalization, return on investment, political instability, etc. as key determinants of FDI. However, due to non-availability of reliable and consistent set of quantitative data on investment climate, the literature has generally excluded the domestic investment climate in recipient countries as a determinant of FDI. This study seeks to fill that void by using a reliable proxy for domestic investment climate -- the index of economic freedom, an annual publication by The Heritage Foundation and The Wall Street Journal. This series is continuously available since 1995 for most countries in the world. The primary focus of this study is to investigate whether, in addition to the other variables routinely used in the literature, economic freedom is also a significant determinant of FDI in South Asia.

This paper studies five countries in South Asia - Bangladesh, India, Nepal, Pakistan, and Sri Lanka, and quantifies the effects of factors that drive the flow of FDI into these countries. Employing 1995-2000 panel data, this study finds that economic freedom, economic openness, economic prosperity, human capital and incremental lagged changes in FDI significantly increase FDI inflow in the sample countries, while political instability significantly depresses it. These results further our knowledge of the determinants of FDI, which is crucial for devising strategies to promote economic development --a course that holds much at stake not only for South Asia, but also for developing countries in general.

The rest of the paper is organized as follows. Section II presents a review of the empirical literature, section III describes the model, section IV discusses data, methodology and estimation, section V discusses the results and their policy implications, and section VI concludes the paper.

LITERATURE REVIEW

A sizable empirical literature exists on the determinants of FDI in developing countries. Most of these studies have identified a number of variables, such as market size, quality of infrastructure, labor cost, economic openness, return on capital, political stability, etc. as key factors that drive the flow of FDI. The literature has by and large excluded the domestic investment climate in recipient countries as a determinant of FDI, as reliable data on investment climate has been generally lacking. There are many instances of conflicting results regarding the direction of influence of the determinants of FDI (Chakrabarti 2001). For example, Wheeler and Mody (1992) found that labor cost has positive effects on FDI, but Schneider and Frey (1985) found the opposite, and Schneider and Frey (1985) found that political instability significantly depresses FDI, while Loree and Guisinger (1995) found the effects to be insignificant. Notwithstanding these differences, the FDI literature has continued to grow and capture the fascination of applied development economists.

Most empirical studies in the FDI literature have found domestic market size to be a significant and robust determinant of FDI. Scaperlanda and Mauer (1969) advanced the hypothesis that FDI responds positively to the market size once it reaches a threshold level that is large enough to allow economies of scale and efficient utilization of resources. Many studies have empirically confirmed this hypothesis for developing host countries. Several of these studies have used large samples of LDCs and found different proxy variables for market size, e.g. per capita GDP/GNP, total GDP/GNP, etc., to be significant determinants of FDI. For example, Root and Ahmed (1979) used a sample of 58 developing countries over 1966-1970; Schneider and Frey (1985) used a sample of 54 countries in 1976 and 1979-80; Wheeler and Mody (1992) used a sample of 42 countries over 1982-88; and Tsai (1994) used 62 countries over 1975-78 and 51 countries over 1983-86.

Barro (1991) and Corbo and Schmidt-Hebbel (1991) argued that political instability creates an uncertain economic environment detrimental to long-term planning, which reduces economic growth and investment opportunities. Political instability thereby seriously erodes the foreign investors' confidence in the local investment climate, which repels foreign investors away. Leavell et al. (2004) addressed the importance of political structure, level of political corruption, efficient markets, enforceable contracts and property rights in attracting FDI. They emphasized the need for social, political and economic reforms in many African countries as a precondition to attracting more FDI, and argued that national pride may lead, however inappropriately, to an opposition to receiving foreign capital. Asiedu (2002) and Haque et al. (1997) contended that countries located in Sub-Saharan Africa are perceived as inherently risky, which likely keeps foreign investors away.

Some studies have suggested that, even after the economic fundamentals are accounted for, there may still exist a regional bias in the FDI inflow. For example, Schneider and Frey (1985), Edwards (1990), Gastanaga et al. (1998), Jaspersen et al. (2000), and Asiedu (2002), have found results that suggest that there exists a regional bias in the FDI inflow against countries located in Sub-Saharan Africa vis-à-vis other developing regions. These studies, however, could not provide a consistent set of explanations for the apparent inability of Sub-Saharan Africa in attracting FDI. Quazi and Rashid (2005) found that when economic freedom is incorporated as a determinant of FDI, there remains no inherent bias against Sub Saharan Africa, but there may be a regional bias in favor of countries located in Latin America & Caribbean vis-à-vis other developing regions, which is perhaps due to the geographical proximity of this region to the US and Japan – the two most significant source countries of FDI.

Hanson (1996), Root and Ahmed (1979), and Schneider and Frey (1985) found that the level of human capital, which is a good indicator of the availability of a skilled work force, is a significant determinant of the locational advantage of a host country and plays a key role in attracting FDI. Noorbakhsh et al. (2001) also found that human capital, which can also be a proxy for investment attractiveness, is a key determinant of FDI.

In the backdrop of this empirical literature, this study makes two significant contributions to the empirical FDI literature. First, it adds South Asia to the empirical regional studies of FDI. Second, and more importantly, it explicitly treats domestic investment climate, as captured by the economic freedom index, as a determinant of FDI.

THE MODEL

Most empirical models in the FDI literature have included various subsets of the following variables as exogenous variables: lagged changes in FDI, economic openness, economic prosperity, political instability, human capital, quality of infrastructure, rate of return, financial liberalization, etc. In the absence of a consistent theoretical framework in the FDI literature that incorporates economic freedom to guide our empirical work, this study formulates a general-to-specific model comprising all these exogenous variables in the initial version and upon statistical testing retain only the significant variables in the final version. Accordingly, the following initial version is specified. Since the model is estimated with panel data, subscript i refers to countries and t refers to time.

FDIi,t = a + b1 DFDI i,t–1 + b2 Economic Freedom i,t + b3 Economic Openness i,t

+ b4 Per Capita Income i,t + b5 Political Instability i,t + b6 Human Capital i,t

+ b7 Quality of Infrastructure i,t + b8 Rate of Return i,t + b9 Inflation i,t

+ b10 Financial Liberalization i,t + e

Selection of the explanatory variables listed above has been guided by the empirical literature. The lagged change in dependent variable (DFDI i,t–1) has been added following Noorbakhsh et al (2001); economic openness has been added following Edwards (1990), Gastanaga et al (1998) and Ryckeghem (1998); per capita income has been added following Edwards (1990), Jaspersen et al (2000), Lipsey (1999), Loree & Guisinger (1995), Schneider & Frey (1985), Tsai (1994), and Wei (2000); infrastructure quality has been added following Loree & Guisinger (1995), and Wheeler & Mody (1992); political instability has been added following Edwards (1990), Hanson (1996), Jaspersen et al (2000), Loree & Guisinger (1995), and Schneider & Frey (1985); human capital has been added following Hanson (1996), Noorbakhsh et al (2001), Root & Ahmed (1979), and Schneider & Frey (1985); and financial liberalization has been added following Arguelles (1986) and Root & Ahmed (1979).

Rationale of the Model

This section explains the justification for including the explanatory variables.

Lagged changes in FDI (DFDIt-1): Foreign investors are typically risk averse, who tend to favor familiar territories and avoid unfamiliar ones. It is therefore very important for developing countries to establish a track record of FDI inflow, which can help dispel the foreign investors’ fear of investing in an unknown location. Also, there is evidence that many MNCs test their new markets by staggering their investments, which gradually reach the desired levels after some time adjustments (Noorbakhsh et al. 2001). Incremental lagged changes in FDI should therefore contribute positively toward the current level of FDI.

Economic Freedom: The general quality of investment climate in host countries plays a critical role in either attracting or deterring FDI. The investment climate is, however, determined by a host of economic and non-economic factors, which makes it difficult to construct an accurate indicator of the investment climate. The annual index of economic freedom, jointly published by The Heritage Foundation and The Wall Street Journal, can be viewed as a reliable proxy for domestic investment climate. The publication defines economic freedom as “the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself” (p. 50). This index can therefore broadly reflect the extent to which an economy is pursuing free market principles.

The economic freedom index is constructed by incorporating 50 independent variables that fall into 10 broad categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and black market activity. These factors are weighted equally in determining a country’s overall index score, which broadly reflects the institutional setting for economic activities in a country. This index is constructed on a scale of 1 to 5, where a score of 1 signifies a consistent set of policies most conducive to economic freedom, while a score of 5 signifies a set of policies least conducive to economic freedom. Therefore, countries with lower scores on the economic freedom index are likely to attract more FDI inflow vis-à-vis countries with higher scores on the index, and vice versa.

Economic Openness: Since economically open countries generally pursue economic policies that are conducive to foreign trade and investment, foreign investors typically have favorable impressions of such countries. Therefore, there should be a positive relationship between economic openness and FDI inflow. Following the literature, economic openness is measured by a proxy variable - the share of total volume of trade (exports plus imports) in GDP.

Per Capita Income: Domestic demand in the host country can play a crucial role in attracting “market seeking” FDI, where the primary objective of MNCs is to serve the domestic market. It is possible that some FDI flowing to the sample countries is “market seeking” in nature, which should respond to the domestic market potential. The huge market potential in India is a good example in case. Following the literature, this study uses per capita real GDP as a proxy for the domestic market size.

Political Instability: A significant factor in the location decision of MNCs is political stability in the recipient countries. Political instability and the generally concurrent occurrences of disorder usually create an unfavorable business climate, which seriously erodes the risk-averse foreign investors' confidence in the local investment climate and thereby repels FDI away (Schneider and Frey 1985). Since measuring political uncertainty is difficult, several studies, such as Edwards (1990) and Asiedu (2002), have either used the occurrences of such events as strikes, political assassinations, and coups d’état, as proxy variables for political instability or have used them to construct indices of political instability. A number of studies, such as Alam and Quazi (2003) and Lensink et al. (2000), have used dummy variables as proxies for political risk variables, such as the extent of political rights and civil liberties and occurrences of war.

Following the literature, this study uses a dummy variable to capture occurrences of political instability in the sample countries. More complex methodologies may be used to construct more sophisticated proxy variables for political instability, and it is likely that the estimated coefficients of such variables would vary in absolute magnitude with the specific choice of these variable. Since this study seeks to estimate the direction of effects of the determinants of FDI, and not the absolute magnitude of these effects, the use of a dummy variable should suffice for this study.

Human Capital: MNCs often undertake investment in developing nations to cut labor costs. The cost advantages generated by lower wages in developing nations can however be negated by lowly skilled workers. Higher level of human capital is a good indicator of the availability of skilled workers, which can significantly boost the locational advantage of a country. Following Hanson (1996) this study uses the adult literacy rate as a proxy for the level of human capital.

Quality of Infrastructure: The quality of infrastructure in recipient countries can be a critical determinant of FDI. Availability of crucial infrastructure, such as roads, highways, ports, communication networks, electricity, etc. should increase productivity and thereby attract higher levels of FDI. Following the literature, such as Loree and Guisinger (1995) and Asiedu (2002), this study uses the natural log of the number of telephones available per 1,000 people as a proxy for the quality of infrastructure. However, it should be noted that, in addition to availability, reliability of infrastructure (such as the frequency of telephone or power outage) is also a crucial indicator of the overall quality of infrastructure, for which quantitative data is not very readily available for most developing countries.

Rate of Return: Higher rates of return on investment in recipient economies should naturally attract higher levels of foreign capital. Measuring the rate of return on investment, however, is difficult as developing countries generally lack well-developed capital markets. To get around this problem, the inverse of per capita income in its natural logarithmic form has been used in several studies, such as Edwards (1990), Jaspersen et al. (2000), and Asiedu (2002), as a proxy for the return on investment. The rationale is that return on investment should be positively related to the marginal product of capital, which should be high in capital-scarce poor countries where per capita income is low (or the inverse of per capita income is high). Therefore, the inverse of per capita income should be positively related to FDI inflow. Following the literature, this study uses the natural log of inverse of per capita real GDP as a proxy for the rate of return on FDI.

Inflation: Higher domestic price level relative to foreign price level causes the real value of domestically held assets to erode faster than foreign assets. Therefore, domestic capital owners may choose to avoid the “inflation tax” by sending their capital abroad to countries with lower inflation rates. By the same token, high rates of domestic inflation can erode the real monetary value of foreign investors’ profits and assets, which would discourage FDI. Therefore, there should be an inverse relationship between domestic inflation rate and FDI inflow.

Financial Liberalization: Countries that pursue financial liberalization policies, such as relaxation of interest rate and exchange rate controls, etc., can instill greater confidence among foreign investors about their economic environment. International financial institutions, such as the World Bank, have long advocated financial liberalization policies in poor countries on grounds that these polices would encourage higher level of investment – both domestic and foreign. Following the literature, this study uses the ratio of broad money (M2) to GDP as a proxy for financial liberalization.

DATA, METHODOLOGY AND ESTIMATION

This study uses panel data over 1995-2000 from a sample of five South Asian countries -- Bangladesh, India, Nepal, Pakistan, and Sri Lanka. Data on the dependent variable (FDI) and several of the explanatory variables -- quality of physical infrastructure, per capita income, literacy rate, GDP growth rate, inflation rate, and money supply, are collected from the World Tables (World Bank 2003). FDI is measured by the net foreign direct investment inflow as a percentage of GDP; the natural log of the number of telephones per 1,000 people is used as a proxy for the quality of physical infrastructure; per capita income is measured by the natural log of per capita GDP; human capital is measured by the literacy rate; financial depth is measured by the share of broad money (M2) in GDP; and the inverse of the real GDP per capita is used a proxy for return on capital (Edwards (1990), Jaspersen et al (2000), and Asiedu (2002) also use the same proxy for return on capital). Data on economic freedom are collected from the 2003 Index of Economic Freedom (Heritage Foundation/Wall Street Journal 2003).

In line with the standard practice in the economic literature, this study measures economic openness by the ratio of trade (exports plus imports) to GDP. In addition, this study uses two alternative measures of trade openness, which are developed by Frankel and Romer (1996) based on the literature on the gravity model of trade, originally developed by Linneman (1966). The first one of these alternative measures, coined as the “pure geography” approach, considers only the geographical components of trade: countries’ sizes, distances from each other, whether they share common borders, and whether they are land locked. The second measure, coined as the “factor accumulation” approach, considers geographical variables as well as countries’ capital accumulation and population growth rates as additional factors. Both these measures are constructed by first estimating bilateral trade equations and then aggregating the fitted values to compute overall openness indices. This study uses the alternative openness indices as computed and reported by Frankel and Romer (1996). The FDI regression equation is therefore estimated in three different versions, each one incorporating an alternative measure of economic openness.

It is well accepted in the FDI literature that by creating an uncertain economic environment detrimental to long-term planning, political instability reduces domestic investment opportunities and thus repels foreign investors away. The brutal civil war in Sri Lanka, which during the sample period had practically rendered the economic environment there anything but congenial to foreign investment, provides a test-case for probing this hypothesis. Although the political landscape in other countries in the sample is far from placid, for example, Bangladesh, Pakistan and Nepal are often jolted by bouts of political turmoil, the severity of the decade long brutal civil war in Sri Lanka has, however, exacted a far heavier toll on the FDI inflow. Consequently, the other countries in the sample are considered, notwithstanding their occasional episodes of turmoil and uncertainty, politically stable compared to Sri Lanka. The model uses a dummy variable as a proxy for political instability, i.e. the dummy takes on the value of “1” for Sri Lanka and “0” for other countries in the sample. It should be noted here that the severity of this civil war in Sri Lanka has apparently ebbed recently. Although the current political landscape is far form normal, it is however expected to return to normalcy, albeit very gradually.

Three panel regression equations, incorporating three alternative measures of economic openness, are estimated with the GLS method with corrections for heteroscedasticity and autocorrelation. The estimated coefficients and t stats from the three regression equations are presented in the following table. Equation 1 incorporates the standard measure of economic openness (trade/GDP), while equations 2 and 3 incorporate openness as computed by the “pure geography” and “factor accumulations” approaches, respectively. All estimated coefficients turn out individually highly significant with correct signs, while the overall equations turn out highly significant as well. These equations find that lagged changes in FDI, economic freedom, economic openness, per capita income, human capital and political instability are statistically significant determinants of FDI.

Table 1: Determinants of FDI in South Asia (1995-2000): GLS Estimators

POLICY IMPLICATIONS

The estimated results are noteworthy for several reasons. First, in addition to the usual determinants of FDI found in the literature, such as economic openness, human capital, etc., this study finds that economic freedom, which is used as a proxy for domestic investment climate, is also a significant determinant of FDI in South Asia. The statistical significance of economic freedom as an explanatory variable to FDI is found to be very robust to different model specifications, which suggests that excluding domestic investment climate, or its proxy, from the FDI equation may very well render the equation mis-specified, which may in turn render policy recommendations based on the mis-specified function misleading.

These results generally suggest that in order to attract more FDI, South Asian countries, and more importantly developing countries across the third world, need to improve their domestic investment climate. Improving domestic investment climate is however an arduous process, which cannot be achieved overnight. A closer look at how the Economic Freedom Index is computed suggests that host country governments can improve their domestic investment climate by lowering average tariff rate and non-tariff barriers, reducing tax rates and government expenditures, reducing government ownership of businesses and industries, curbing the inflation rate, lifting restrictions on foreign ownership of resources, liberalizing the banking and financial sectors, allowing market wages and prices, securing private property rights and an independent judicial system, reducing excessive regulatory burden and reining in black market activities. Adopting these policies maybe politically difficult in the short run, but the economic performances of countries that have already achieved “economic freedom” in these policy yardsticks, demonstrate convincingly that these policies yield long-run economic benefits that far outweigh any short-run political costs.

Economic openness, in all three alternative measures, is also found to be a significant determinant of FDI. The point estimates however suggest that, compared with the two alternative measures of openness developed by Frankel and Romer (1996), the traditional measure of economic openness (trade/GDP) yields smaller impact on the FDI inflow. These findings have significant policy implications, as they suggest that using only the traditional measure of openness in economic modeling would possibly result in an underestimation of the true impact of economic openness on FDI. These results generally suggest that more open economies by and large host economic regimes that instill greater confidence in foreign investors and hence are able to attract more FDI. It is noteworthy that increased economic integration among South Asian nations, caused by SAFTA (South Asian Free Trade Agreement), has possibly contributed to economic openness in the region in recent years, which likely has helped attract more FDI inflow.

Higher level of per capita income, which is a proxy for domestic market potential, is found to attract more FDI inflow in South Asia. Since per capita income is generally affected by economic growth, government strategies to promote higher FDI should comprise pro-growth economic policies. Although higher economic growth per se is a desirable outcome, under certain circumstances, such as during IMF prescribed austerity programs, the government may be forced to temporarily embrace policies that slow down economic growth and consequently lower per capita income, which will adversely affect FDI inflow. Policymakers should remain wary of the linkages between reduced economic growth and a lower FDI inflow, which in turn reduces future economic growth potential and thus sets a vicious cycle in motion.

Political instability is found to significantly depress FDI inflow in South Asia. The point estimates suggest that the occurrence of civil war is in fact the most damaging hurdle to attracting FDI inflow in Sri Lanka vis-à-vis other nations in the region. Although this study does not explicitly investigate the effects of other politically destabilizing events, such as military coups, high profile political assassinations, recurring strikes and shutdowns, etc., it is quite conceivable that these events also severely erode the foreign investors’ confidence in the host country economy and consequently reduce FDI inflow. Developing nations should therefore try their utmost to prevent a politically destabilizing climate and instead promote a stable economic environment that is conducive to long-term planning and investment opportunities, which in turn will attract more FDI inflow.

Literacy rate, which is a proxy for available human capital, is found to be a significant determinant of FDI inflow in South Asia. Evidently, the presence of a skilled work force capable of functioning effectively with modern production techniques improves the locational advantages of a host country, which induces more FDI inflow. Developing countries aspiring to attract more FDI inflow should therefore pursue educational policies that can raise both quantity and quality of educated labor force to assure the foreign investors of availability of adequate local human capital.

Finally, incremental lagged changes in FDI, which is a proxy variable for foreign investors’ incremental knowledge about investment opportunities in a host country, is found to significantly increase current level of FDI. This result suggests that if a host country is able to successfully attract incremental FDI, that will boost foreign investors’ confidence in an already familiar host country, which in turn will open the door to additional FDI inflow, thus setting a favorable cycle in motion. Since the level of FDI is not a policy instrument for host country governments, they should utilize the available pro-FDI policy instruments, which are discussed in the preceding paragraphs, to dispel the generally risk-averse foreign investors’ fear of investing in an unknown territory, which will help attract additional FDI inflow.

CONCLUSIONS

It is well accepted in development economics literature that FDI plays an important role in the growth dynamics of developing countries. Available data however suggest that there is wide divergence in FDI inflow among the third world host countries. This study seeks to investigate the factors that drive the inflow of FDI to a sample of developing countries in South Asia. This study makes two significant contributions to the FDI literature. First, it adds South Asia to the regional studies of FDI and second, it explicitly treats domestic investment climate, which has been hitherto excluded from the FDI literature due to non-availability of reliable data, as a determinant of FDI.

The estimated results, obtained from a GLS regression model based on 1995-2000 panel data, suggest that greater economic freedom, which is a proxy for better domestic investment climate, higher economic openness, greater economic prosperity, higher literacy rate and incremental lagged changes in FDI significantly boost the FDI inflow, while political instability causes the contrary. While these results are generally consistent with the current FDI literature, however the result that domestic investment climate is a statistically significant and robust determinant of FDI is a noteworthy improvement over the current literature, which by and large focuses on the other commonly used determinants.

This study finds that a domestic investment climate that is not conducive to economic freedom will likely negate the stimulating effects of other positive determinants of FDI, such as greater human capital, political stability, etc. Therefore, strategies should be formulated to promote long-term economic freedom in the developing countries, which will likely foster a healthy economic environment that is not only ready to attract more FDI inflow, but also prepared to nurture the economic ingredients necessary for economic development. Adopting policies that lead to greater economic freedom maybe politically difficult in the short run, but the economic performances of countries that have already achieved economic freedom sufficiently demonstrate that these policies yield long-run economic benefits that outweigh any short-run political costs.

The research focus of this study is worthwhile as it seeks to further our knowledge of the factors that affect FDI inflows to South Asia. Needless to say that a better knowledge of the determinants of FDI is crucial for devising strategies to promote long-term economic development -- a course that holds much at stake not only for South Asia, but also for developing countries in general.

ACKNOWLEDGMENTS

This study received research support from the College of Business, Prairie View A&M University, Texas. The authors also wish to thank the IABPAD Spring 2005 conference participants who provided many useful comments and suggestions.

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