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FDI and Balance of Payment Relationship in Canada

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Chapter One


History of FDI

Foreign investment was very common in the late nineteenth century. It was a strategy from British to provide fund for economic development in other nation, as well as to gain ownership of financial assets. Godley 1999 mentioned in his research that the bulk of FDI that was based on British manufacturing industry before 1890 was in industrial goods sector. He also mentions that most investors failed as a result of narrow focus and their major concern his to enhance British market. Singer Manufacturing Company was an exception due to its commitment to FDI and being the first biggest and modern Multinational Corporation in the world (Moosa, 2002).

During the era of interwar in the twentieth century, FDI declined and later rose but there was an astonished development in that period, British status was lost as a world creditor, and USA became the economic and financial power and FDI was favoured by USA tax law. After the world war, FDI increased as a result of two reasons: firstly, good technology in the area of communication and transportation that eliminate distance barrier. Secondly, the need of reconstruction of war damages by European countries and rest of the rich nation around the world. (Moosa, 2002).

In the 1980s, there was a decline in FDI (outward). This was due to the fact that most host countries started resisting U.S control and ownership of domestic firms. Also, host countries recovered by initiating FDI in USA which affect US net inflow. In the 1970s, there was a big fall in the U.S FDI but British was back to FDI business as a result of North sea oil boom and the abolition of foreign exchange controls in 1979. In 1980s, changes in FDI occurred in which USA became a net debtor nation and major recipient of FDI with an unfavourable net international position. This was caused by depreciation of U.S dollar, restrictive trade policy and low saving rate in U.S economy. This disenabled the U.S in financing its own investment in its economy, giving rise to needs of FDI from other nations like Germany and Japan. Also, in the 1980s Japan became a major supplier of FDI to U.S.A, Europe and South East of Asia. Most countries embrace Japanese investors because of its provision of cheap labour. The revolution of FDI in the 80s can be attributed to globalization. (Moosa, 2002).

In the 1990s, there was reasonable improvement in the investment climate which exposed most countries to the benefits of FDI. Some of the reasons that led to the improvement FDI of are: removal of FDI obstacles, changes in attitude and increases in FDI intensive. The removal of local hindrances through deregulation and privatization was favourable to FDI. Another remarkable thing that happened in the 1990s was the fall in the importance of Japan as a front runner of FDI. This caused economic doom in Japanese economy. Finally, FDI has gone through many reforms from countries to countries, in the late 90s, the number of treaties for the avoidance of double tax reached a total of 1871. In 1998 and 1999 some measures like protection, liberalization and promotion was brought in by the host nation (policies) on FDI. (Moosa, 2002).

Globally, the economic development of deeper and more sophisticated internal and international financial market, improvements in information network and technological advancement have made contribution to sound financial and economic integration. For a nation to partake in any of the economic gains arising from these processes it need to adopt reform policies to improve efficiency.

Most countries advocate FDI to encourage economic development because of its indirect impact in the host economy due to increase in competition, technical know-how and technological spill-over via multinational corporations to domestic firms. Gorg and Greenway (2002, stated in Morris 2008, p.4) that a possible channel is "one in which domestic firms are thought to 'imitate' the technology used by the companies." This will result to better ways of local firms of making their production. Competition is another positive effect of FDI. The entry of foreign companies compels the domestic ones to be more efficient in all ramifications. The latter gains better skill will from employee training through new improved technology requirement in the production process. (Morris 2008).

FDI helps local firm to bypass government bureaucracy, legality and financial obstacles encountered in the host economy. International organisations always recommend that less developed countries rely mainly on FDI as a source of external finance. Hericourt & Poncet (2008, p.1) confirm that the development of cross border relationship with foreign countries help private domestics firms to bypass both the financial and legal obstacles that they face at home

At the same time, many may not be pleased with the policies that encourage FDI which might be unfavourable to host economy since foreigners will have share in domestic economic activity. According to Holden (2007), there was an argument that foreign-controlled investments may be bias and not act in the best interest of locals and nationals; that profit may be exported out of the country; and that foreign ownership could have national security implications in situation where industries or products are of strategic importance. These concern links to energy and natural resource sector. The concerns may lead to countries to place restriction on investment in sector that involves strategic importance.

Canadian Chamber of Commerce had an annual general meeting in 2007. A resolution was passed ''Attracting FDI to Canada'', among the issues discussed in the meeting was an advise for Canadian government to adopt policies that encourage foreign investor to Canada, even though some call for tighter restrictions for FDI due to its demerits (Morris, 2008).

Canada was among the countries that provided a shield for his economy with the provision of 1985 Investment Canada Act. This Act states that any proposed foreign direct investment above a certain amount is subject to review and approval from the industry Minister. For the proposed investment to be approved, it must demonstrate that its proposed investment provide a ''net benefit'' to Canada, some of the things the industry Minister will consider are; employment, investment in Canada to compete in the world market, the compatibility of the investment with national industrial, economic and cultural policies and many others (Holden, 2007).

Using Canada (a country that has benefited from FDI in all ramifications from the perspective of macro economics level down to the micro level, from one sector to another sector) as a case study. It is obvious that Canada has gained so much in FDI both in forward linkages and backward linkages. According to the Daily (May 6, 2008), the stock of FDI in Canada sky rocketed in the last eight years, and the sector that had the biggest share were the resource based industries.

The Canadian Chamber of Commerce Annual General Meeting (2007) passed a resolution titled ''Attracting Foreign Direct Investment to Canada''. The meeting called for the Canadian government to ''send a clear and positive message to foreign investors that Canada wants inbound investment through a proactive investment strategy and promotion champagne" (Morris, 2008).


Most previous studies focused on the role of FDI on economic growth but their findings shows that FDI is not significant to economics growth. Carkovic and Levine (2002), prove that FDI does not independently influence on economic growth. However, economic growth and balance of payment (BOP) as a macro-economic objectives of any rational nation, in which there is sort of trade-off in both objectives.(this will be explain in the literature review section ).(pass et al. 1995). Countries calls for FDI coming between the two objectives as result nation rationale of protectionism ( quotas ,high import duties and embargo) to resolve balance of payment problem, and to achieve import substitution and export promotion agenda. Keynesian economic growth model, which is measured with Gross Domestic Product (GDP), have many component such as government expenditure, consumption level, investment, and export minus import (BOP current account). Changes in any of these components will have multiplier effect on the economic growth. (Moosa, 2002). FDI will have direct effect on host nation's balance of payment which will indirectly impact the host country growth. The question being asked in this research is there any relationship between FDI and BOP? The aim of this dissertation is to determine the relationship between FDI and Balance of Payment in Canada over the period of 1990 to 2008. This aim will be achieve by building a model to explain the casual relationship between dependent variable and independent variables to figure out the relationship between FDI and BOP. Also, hypothesis will be formulated to test some of the objectives of the study. Robin says in Saunders (2007) that with deductive research it's necessary to deduct a hypothesis. The study explores six possible issues:


  • To determine the proportion of Canadian Capital account explained by growth in FDI in Canada over the period of 1990 to 2008.
  • To determine the proportion of Canadian Current account explained by growth in FDI in Canada over the period of 1990 to 2008.
  • To determine the proportion of Canadian Import explained by growth in FDI in Canada over the period of 1990 to 2008.
  • To determine the proportion of Canadian Export explained by growth in FDI in Canada over the period of 1990 to 2008.
  • To ascertain the relationship between Canadian FDI and Canadian BOP over the period of 1990 to 2008.
  • To examine the major (countries) contributor to Canadian FDI over the period of 1990 to 2008.

Significant of the study

The significant of this study is to know the role of FDI in achieving one of the macro economic objective. This to ascertain if FDI will affect BOP in Canada positively or negatively. If the effect is positive, there will be needs of improving scope or magnitude for FDI in Canada for the future .However; if it is negative there may needs for government policies to restrict the inflow of FDI to Canada so as to achieve a favourable bop.

The consecutive chapters will structure in the following ways: chapter two discusses the theoretical background information related to FDI, chapter three examines the academic literature relevant to the topic and also describes the methodology while chapter four presents the empirical analysis and discusses the econometrics result. The concluding chapter provides a conclusion of the research work.

Chapter two

Literature Review

Theoretical Background

(Moosa,2002) defines Foreign Direct Investment (FDI) as ''the process whereby residence of a country (the source country) acquire ownership of asset for the purpose of controlling the production, distribution and other activities of a firm in another country (the host country). It involves the transfer of financial capital, technology and other skills such as managerial, marketing, accountancy, and so on''. International Monetary Fund's Balance of Payment Manual defines FDI as an investment that is made to get a long lasting interest in a organisation operating in an economy difference the investor.

(Canada Statistics, 2008) defines FDI as "a component of a nation's international investment position which explains a country's investment position: the difference between aggregate financial assets and aggregate financial liabilities.'' Direct investment, portfolio investment and other investment are the component of financial asset and financial liabilities. (Frankel and Romer, 1999) describe FDI as one of the crucial catalysts for economic growth in a nation especially in less developed countries. This statement describes the significance of FDI to a nation.

FDI can also be described as a company from one country making physical investment into building a factory in another country. It is the establishment of an enterprise by a foreigner. (UNCTAD, 2002) defines FDI as ''investment made to acquire lasting interest in enterprise operating outside the investor's economy''. In short, a business or firm that undertake FDI become a multinational national company (MNCs) because of it ability to own many subsidiaries in many foreign countries. Foreign Direct investment (FDI) plays a crucial role in any host economy in the aspect of economic prosperity and building wealth. It also leads to increase in capital flow and, highly skilled human power, and reduction in unemployment and importation of advanced equipment and technology to enhance output level. This has a direct impact on the nation's gross domestic product by promoting economic development. Mutenyo (2008), said most less developed countries now adopt policies that encourage FDI. Among these policies are privatization, trade and exchange rate liberalization, and, tax rebate and incentives for foreign investors to enjoy the business environment.

FDI is different from other components (such as international financial assets, portfolios and so on) of international investment. International Monetary Fund (IMF 2003, p.6) define FDI as ''a category of international investment that reflects the objective of a resident in one economy (the direct investor) obtaining a lasting interest in an enterprise resident in another country'' (p.6). IMF further explained that a direct investment is established when a foreign investor has more than 10% ordinary share or voting right of a host country enterprise (IMF 2003, p6-7). In Canada, direct investment is measured as the total value of equity, net long-term claims and net short-term claims held by the enterprises border (Canada Statistics, 2008). FDI has been increasing globally over the last two decades. Especially in the 90s, FDI increased more than the world economic growth. According to United Nations Conference on Trade and Development (UNCTAD) data collection pertaining to FDI regulations in 1991, it shows that between January 1991 and December 2002, total of over 1600 measures were introduced by 165 countries; more that 90% of them was in favour of FDI in terms of changes; the nature of the introduced measures ranging from security for investors, to liberalization of rules governing the inflow of foreign investors, to measures that are promotional in nature(UNCTAD, 2003). The measures were extended to the international level through double taxation treaties (DTT) and bilateral investment treaties (BIT).

Over the last four decades, FDI have gone through series of transformation in Canada. Gellaty 2006 (in Morris, 2008, p6) explained the reason for the emergence of the Foreign Investment Review Agency (FIRA). Due to growing concern of FDI in the late 1960s and early 1970s, the Foreign Investment Review Agency (FIRA) was established to regulate and monitor FDI. The regulation governing FDI and FIRA was replaced with Investment Canada in 1985. The regulation was aimed at protecting and promoting FDI in Canada. There was also an implementation of Canada-U.S Free Agreement (CUFTA) and North American Free Trade Agreement (NAFTA) to promote FDI further in Canada.

FDI appear to be a topic that covers both narrow and broader area. Feenstra (1999,quoted in Liebscher 2007, p.3) expresses FDI as the combination of both international trade in goods and international financial flows, and as a phenomenon more complex than either international trade or international financial flow. From micro-economics perspective, FDI raises the issues of location consideration and ownership. From the macro-economics angle, FDI considers the fear of unemployment and the loss of freedom. For Policy makers, FDI is an issue to balance the benefits of spillovers with growing concern of the public. The concern authorities will be rational in policies that will favour FDI and all concern parties. FDI is one of the key features of the modern globalized world. According to (Peter 2008), most industrialists believed that there is international links in the late medieval and early modern era. They were also of the opinion that multinational firms became crucial in numerous industries in the late nineteenth century but the period since World War II and in particular, since 1985 have seen an explosion in FDI both in relative and absolute terms to the levels of trade and gross domestic product.

However, economic theory provides an extensive economics literature which was developed to investigate the causes, nature and consequences of FDI. One of the reasons for the creation of FDI is as a result of cheap cost of production in the host economy. FDI occurs when the benefits of producing in a foreign market out weighs the cost of economic of scale from producing exclusively in the firm's home plant (Neary 2008, p.13). This benefit can be explained by the concept of proximity –concentration trade-off. That is foreign firms take advantage of trade off in production in home countries which will expose them to high exportation cost and international trade barriers relative to proximity to customer and low transportation cost. There are some conflicting predictions about the effect of FDI on economic growth. Blomstrom and Kokako (1998, quoted in Mutenuyo 2008, p.3) explain that spillover occurs if the entrance of multinational enterprises (MNE) result to efficiency and productivity benefit to the domestic firms in the host country and MNE is not able to internalize the full value of these benefits. On the other hand, negative externalities exist if the activities of FDI result to loss in efficiency, productivity and profitability among the local firms and the alien investors do not compensate them for their loss. In a nutshell, FDI can be detrimental to an economy.

MNE are assumed to compete favourably with the more advanced local firms since the local firms will have an edge over the foreign investors in local market share, skills, export contracts, cordial relationship with suppliers and the customer and so on. On the other hand, the foreign firms may be more advance in technological know-how, research and development, and the financial resources for their home economy.(Hericourt and Poncet ,2009) confirms that the development of cross-border relationships with foreign companies helps private firms to bypass both the financial and legal hindrance that they face at home.

Types of FDI

The types of FDI can be considered from dual angle: from the perspective of foreign investor country and from the perspective of host country. Since the study is focused on Canada, FDI will be examined in both ways. There are three types of FDI- vertical, horizontal and conglomerate- from the perspective of the source nation (investors).

Vertical FDI: (Hill,1998) provides a clear illustration of vertical FDI by dividing into two: Forward vertical FDI and Backward vertical FDI. The former is applicable in a situation where a local firm invest into another industry abroad that sells the output product of the local firm's production process, while the latter is used when the foreign sales of a firm provide inputs for the downstream operation of the local firms.

Horizontal FDI: is applicable when the goods produced in the host country are the same as in the home country for horizontal expansion (Caves, 1971). (Hill,1998) defines it as "firms invest in the same industry as the same operational activity in their homeland."

Conglomerate FDI is the combination of horizontal and vertical FDI. That is, firm operating in separate business, (Luladhar 2008).


Export-increasing FDI: is caused as a result of items produced in host country as an input for home country; such as raw material or intermediate goods. This type of FDI will enhance the exportation of the host nation if there is high demand for the raw material or intermediate goods from the home country.

Import- substituting FDI: This type of FDI is applicable when the goods previously imported from the home country are now been produced from the host economy which will generate more employment .This is caused as a result of host government policy on trade barriers, market size, labour cost and so on.

Government initiated FDI: This is when the policy makers provide some incentive that attracts foreign investors into the host economy. This incentive could be tax holiday, tax discount and so on.

The Determinant of FDI (Motives)

There are four motives that determine FDI. These determinants provide reason why firms should use FDI to tap in business globalization. These motives are acquired inputs (raw material orientation), market orientation, cost orientation, and strategic asset seeking motives orientation.

Raw Material Orientation: According to Dunning (1993), availability of raw material is the bed rock of any firm, especially the manufacturing firms. Usually the cost of importing raw material from the source to where is needed is outrageous, even the duration cost of getting the raw material to host firm is another visible problem that affects the overall performance of production. Therefore, it is more economical for firms to produce in an environment that has easy access to raw material.s (Atik et al., 2008).

Market Orientation: This is when firms produce goods in a host country instead of shipping it directly from the home country. This occurs when foreign market is protected by the government restriction goods importation or high importation duties. It will cost less to produce in the host economy market to avoid international restriction and unnecessary cost. Market orientation draws foreign supplier closer to the buyers in the host economy. (Atik et al., 2008).

Cost- Orientation Motive: Cost minimization is one the firm's strategy to optimize profit. Porter (1998, stated in Atik et al.2008, p 29) explains that among the generic strategies of a firm, cost leadership is the best strategy. In cost leadership strategy, a firm will prefer to become the lower cost producer in its industry. So firm prefer to site their location where they will enjoy the lower cost of factors of production. Good examples of this firm from developed nation prefer to locate their firms in less developed nation because of cheap labour and other cost of production.

Asset Seeking FDI: Foreign firm's prefer to have access to gain industrial asset in host country which will more profitable to have in there home country. The foreign firm will sustains or advance its international competitiveness, technological advancement, and opening up the new market though its asset accusation from the host nation (Atik et al., 2008). There fore, a firm that owes foreign asset is better positioned in global market competition compare to its counterpart.

Theories of FDI

Most literature reveals why investors prefer to produce abroad instead of staying in the home country. Dunning 2003 p.278) assert that ''the growth of existing foreign value activities in service might require a different set of explanations than to follow initial decision to invest abroad''. There are some theories that explain FDI and MNEs in global business especially in goods sector.

(Helldin ,2007) is of the opinion that FDI theory is fragmented and consists of various economic theories. There are no complete theories that explain FDI; it was just the bits by bits from numerous authors. Hymer was one of the first authors to explain the theory of FDI in 1960(mention in Na, Lv & Ligthfoot, 2006). Hymer believes that the multinational national companies (MNCs) have the potential to expand the business due their oligopolistic nature. He said MNCs have firm specific advantages that create market power on global market due to their technical know-how, product differentiation, R&D and so on.

Dunning's Eclectic Paradigm (Professor John H. Dunning's 1977 OLI-framework also called Dunning's eclectic paradigm)

Dunning 1977,Helldin 2007, p8), explains that the three factors that constitute to MNEs location in host country. These factors are Ownership Specific Advantage (O), Location-Specific Advantage (L) and Internalization Advantage (I). Ownership specific are business advantages such as capital, advance technology, well known brand names and product with dominant standard (p8). It further explained that the higher the level of business competitive advantage are compare to foreign competitors on a specific location the more the business will be involved in foreign production. Location will also be based on the countries' competitive advantage, originated in the partner's home countries (Helldin, 2007). Ekstrom (1998 stated in Helldin 2007) is of the opinion that the combination of O with L is why a specific location is chosen to make FDI. The third (internalization) advantage is meeting demands on global market by trading. (Dunning 1977, Helldin 2007, p8).

Ownership Specific Advantage (O): MNEs enjoys business advantage in some area such as size, established position, and monopoly power. MNEs also have some specific advantage in some business area such as capital, advance technology, research and development, highly skilled human capital, trade marks, receipt of government grant and property right over intellectual property (Bennett, 1999).

Location Hypothesis (L):

This hypothesis explains the existence of FDI which is a result of international immobility of factors of production: labour, natural resources and weather. The immobility factors result to location-related differences in the cost of production. Horst (1972b, quote in Moosa, 2002, p.33) used this hypothesis to explain US FDI in Canada. Most MNEs prefer to locate their production facilities in an area where there is cheap labour. Lucas (1993) proves that there is inverse relationship between FDI and wages. He explained that a rise in wages in the host economy will increase the cost of production and have adverse effect on production and FDI. This will shift the host economy from labour incentive to capital incentive and will also encourage FDI Lucas (1993).

The advantages of location specific (L) include low transport cost, low purchase input, economics of large scale, good communication, low labour cost, near to market advantage, availability of local business support ( market research firm) and the avoidance of trade restriction (artificial barriers) impose by host nation to reduced import (Bennett, 1999).

Internalization Hypothesis

Internalization hypothesis explains that FDI arises due to the impact of MNEs. MNEs is established to replace market (external) transaction with internal transaction. Coase (1973, says in Moosa, 2002) is of the opinion that ''market cost can be saved by forming a firm'' (p, 32). He gave an example of bottleneck encountered in purchasing oil product while compelling a firm to buy a refinery. These problems are caused by market failure and imperfection in intermediate goods, including technical know how, marketing and management enterprises (Moosa, 2002). MNEs invest in host countries in order to boycott expensive suppliers and distributors. Foreign government import restrictions will be avoided through local subsidy rather than exporting direct. Also the marketing aspect will be managed and controlled by the producing firm; there will be no intermediate sales or Value Added tax (Bennett, 1999). According to Dunning (2003), internalization incentive advantages are to protect or exploit market failure (p.99).

The Product Cycle Theory

The theory was invented by Vernon in 1966. This theory explains the competitive advantage possessed by MNEs or potential MNEs originated in a country instead of another. The competitive advantage move from a stage of local production in home market, to exportation, and then to FDI (Dunning 2003). His theory was a based on U.S. directs investment in import substitution producing activities standards and economics structure. Also the ownership advantages of firms that produces or supplies a product had a little say about the advantages of common governance (Dunning, 2003). The theory is more useful in analysis of MNEs in FDI activities such as capital exportation, services activities, inward & outward investment and so on.

Core –Asset Theory

Core Asset Theory was propounded by Hymer in 1976. Dunning said the theory ''explains the territorial expansion of a firm in terms of its exclusive or privileged possession of intangible assets, which it perceived could be utilized in a foreign country Dunning (2003, p.279). '' Several writers have to identify which O specific right were the most significant in determining the ability of MNEs to compete in foreign market. The theory examines the role of Foreign Service firms in market seeking sector, which is different from Product Cycle Theory focus on resources based industries or manufacturing sector. Also the theory was less concerned with where firms or MNES are located. According to Dunning (2003), the theory underestimates the important of the organizational mechanism by which the competitive advantage (Product Cycle Theory) is exploited (Dunning, 2003). The theory is limited to FDI or MNEs in technological advancement ,R&D, position, product quality and so on, but it just examines the growth in foreign firms in global oriented and integrated service industries (Dunning ,2003).

Strategy Related the Theories

Knickerbocker, in 1973, was the first person to examine the strategy of MNEs. His analysis was that MNEs activities will be a function of high seller concentration. Dunning (2003) stated that ''Knickerbocker hypothesized that MNE activity would tend to be concentrated in industries characterized by high seller concentration, and that firms in those industries will engage in ''follow my leader'' tactics in the timing of their foreign investments, to protect or advanced their global competitive position (Dunning, 2003, p.280).'' Most studies on MNEs, the area of extraction, manufacturing and the likes was in support of this theory but the theory was less relevant in foreign firms' activities in service industries because of its less oligopolistic nature (Dunning, 2003). However, these theory was fragile in MNEs with high level of diversification since one of the main aims of MNEs is expansion and diversify in area like service sector which may be outside their main activities which will create problem for the theory.

The Risk Diversification Hypothesis

The theoretical background of this hypothesis can be traced back to the theory of portfolio selection by Markowitz (1959) and Tobin (1958). The risk diversification hypothesis was propounded by Grubelin in 1968, but the idea was revisited and made known by Rugman in 1979. The hypothesis was that MNEs reduces the portfolio risk by diversification, which is investment in foreign assets that usually consist of service industries like banking, insurance, communication and so on. Most construction firm may want to make their working capital active by buying financial assets (Dunning, 2003). This kind of investment is not capital intensive.

The Aliber Thesis

Aliber's (1970 & 1971, quoted in Dunning, 2003, p.280) seek to determine why firms pay their foreign assets in local currencies when they produce abroad. The theory explains that foreign firms take advantage of the home stronger currency to acquire ownership of assets in host economy due to their weak currency. Albert also argues that fluctuation in foreign exchange market that result to undervaluation or overvaluation make MNEs to gain in the sales or purchase of foreign assets (Dunning, 2003). The thesis was more favourable to FDI investment in capital-intensive industries but was bias towards service based sector. Also, research was put to test during the ten years era of strong British pound against the U.S dollar and it was discovered that MNEs in U.K. acquire high number of U.S service companies due to U.S bear market (Dunning, 2003).

The Kojima Thesis

The thesis argues that countries should take foreign investment in industries they have comparative disadvantage and should adopt policy that encourage inward direct investment in industries they have Comparative advantage (Dunning, 2003). It later claims that Kojima thesis was just a norm of international trade than a positive one. Countries like Japan and China that have limited amount of service investment that it will be difficult to validate the thesis.

Economic Growth

Economic growth can be defined as an increase in a nation's economy output of goods and service over a period of time. Gale Encyclopaedia of U.S Economic History (1999), state that ''Economic growth refer to a much broader period of prosperity than the narrow expansion phase of the traditional business cycle since an economy can still be in a period of long term economic growth while undergoing recession.'' Economic growth can be measured in real terms, which is adjusted for inflation or nominal term, which included in inflation. Economic growths also have to do with technological changes of a nation to increase production capacity of a nation couple with an improvement in the quality of life of the residents of the nation. (Gale Encyclopaedia of U.S Economic History 1999).

Theories of Economic Growth

Classical View

Adam Smith (1766), Joseph Schumpeter (1942), and David Ricardo (1817) are among the classical economists that provide views on modern theories of economic growth. Economic growth was first analyzed by a classical Scottish economist named Adam Smith (1766) in a book titled ''The Wealth of a Nation''. He describes economic growth as a nation's ability to engage in large scale production in manufacturing sector and highly specialized craftsmen. He also stresses the benefit of agriculture in an economic. (Gale Encyclopedia of U.S Economic History, 1999).

Joseph Schumpeter (1942)

Joseph Schumpeter is another twentieth century economist that describes economic growth as "technological innovation of an entrepreneur". He clearly explains this in his theory of ''creative destruction''. He believes ''successful entrepreneur creates an economy of copycats who strive to duplicate the entrepreneurs' but end up causing a depression in overinvesting. (Gale Encyclopedia of U.S Economic History, 1999).

David Ricardo (1817)

David Ricardo view economic growth as gain from trade. The theory argued that a country's reward to free trade is economic growth. That is, free trade is essential factor for economic growth. His theory was based on comparative advantage which was more superior to Adam Smith theory of absolute advantage (Luladhar, 2008). Measurement of Economic Growth

Since economic growth has been defined as a growth real output of a country over a period of time, the growth can be measured in terms of an increase in real gross domestic product of a nation over a period of time or increase in per capita income. The measurement of economic growth can be called growth rate but the measure does not adjust for inflation. (Pass et. al, 1995).

Per capital Income

Per capital income is the fraction of the amount each citizen of a country receives if national income is shared equally. This is used to measure the wealth of the population of a nation. Therefore, the growth rate in per capital income is another measure for economic growth. There are many variables related to increase in per capital GDP. In some research, growth have a positive relationship with human investment (education ), ratio of gross investment to GDP, technological changes and so on. Similarly, political instability, BOP difficulty, and distortion in international trade may have a negative impact on growth due to previous findings. But timing evidence suggests that attractiveness of investment is one of the key to economy growth (Luladhar, 2008).

Balance of Payment.

Balance of payment is the economic transaction that covers between a host country resident and non resident in twin accounts named current and capital account, and financial account (Canada Statistics 2008). Since all nations depend on international via exportation of its local output of goods and service to other nations in exchange for imports of goods and services from them, many countries invest in another country, and the same token, receive inward investment into their own economies. In so far nations operate with different money systems, trade and capital flows between countries needs to be financed by changing of currencies via foreign exchange market. The collection of these activities is called the Balance of Payment (BOP) (Pass et.al, 1995.)

BOP of a nation is a statement of all transaction which gives rise to the exchange of a nation currency to other currency on foreign exchange market. BOP is an account that follows the principle of double- entry book keeping, that is, each transaction payment and receipt will debited and credited respectively. BOP accounts establish the transaction for value of payment between the foreign resident and domestic one. Such transaction includes purchase of import, receipt from export, use of service, and FDI. (Greenaway & Shaw, 1998). FDI is very strong factor in BOP, since it involves foreign investors or MNEs setting up firms in host nations to boost their exportation and to reduce importation (import substitution).

Balance of Trade: is another aspect in BOP. Balance of trade is the difference between a country's export of goods with the import of its goods, excluded all financial transfers and investments. It can be in surplus or in deficit. The surplus is when the export of goods and services exceeds the import of goods, while deficit is when the import of goods and service exceeds the export of goods. But nations are worried when they are faced with deficit rather than surplus.

BOP Accounts

BOP is made up of three different accounts: current account and capital account (financial account). These accounts will discuss as follows:

Current account: it comprises transactions in investment income, current transfer and good and services. (Canada Statistics, 2008). Also, it is one of the main components of BOP, which is the addition of balance of trade (difference in export and import of goods and service), net factor income (profit & dividend) and net transfer (foreign). It is called current because it is consumed in current period. The current account can be surplus or deficits. The surplus enhances the net foreign assets while the deficit enhances the country liabilities.

Capital and Financial account: These are transactions in financial instrument. That is the record of all activities between a local and foreign resident that requires changing ownership of asset. This includes FDI, portfolio investment and so on. When the foreign investor acquires ownership of assets in a host nation, it is referred to capital inflow or FDI. The capital account can also be called financial account.

Balance of Payment in Canada

BOP in Canada is the economic activity between Canadian non-resident and resident in current and capital account. The Canadian current account transaction with the rest of the world has been in upward and downward position in last four year. There was a deficit in 1999, but after then, there have been surplus until the fourth quarter of 2007 when there was a deficit of 1.8 billion. It became surplus in the first and second quarters in 2008 with 5.6 billion and 6.8 respectively. The account slips back to deficit in the last two quarter 2008 (-5.6 billion and -7.5 billion) and the first quarter of 2009 (-9.1 billion) (Canada Statistics 2009).

The effect of balance of payment on FDI

FDI effect on BOP is more crucial in less developed countries than the developed countries, since foreign exchange is regarded as a limited resource affecting growth though the foreign exchange gap. (Moosa 2002, p.82) states that ''any effect of FDI may mitigate or worsen the constraints imposed by the balance of payment on the attainment of macroeconomic objectives pertaining to growth and employment''. In a nutshell FDI can be blame for BOP problem in any nation due to fact that the investing country still experience leakage or outflow of funds which will have an adverse effect on BOP while the host nation will face a small perpetual deficit as a result of profit repatriation. Although in a case were profitable FDI project which lead to profit repatriated in foreign currency will result to greater BOP outflow compare to a similar project financed locally. (Julius ,1990). The impact of FDI on BOP can be examine from many angles ranging from the proportions of output sales both in local and foreign market, the level of usage of the host nation's factor input in the production process and the distribution of value output within the host government (tax revenue),host nation's factor inputs and retained share. FDI can affect BOP in two difference ways: direct and indirect effect.

Direct effect

The direct effect of FDI on BOP will reflect immediately in the foreign exchange gap, result from the flows is related with the investment. This can be examining in both in inflow and outflow. Inflows include outflow and inflows of equity capital and foreign loans net of capital and loans repatriated, while the outflow examine the amount of inflow of capital goods, raw materials and intermediate goods, foreign payment after tax on royalties and technical fees and net profits after tax and interest accruing abroad. There are flows in the direct effect which make it narrow, firstly it fail to show the what would have happen if FDI didn't exist, secondly, it also fail to give an idea of the impact of FDI on BOP via local sales and the use of local resources. (Moosa, 2002).

Indirect effect

Indirect effect feature of FDI on BOP as to do with improvement in the BOP capital account of the host nation by the value of the investment less the value of imported machinery. Also the FDI will impact on BOP of the host country as a result of (i) import substitution effect; (ii) export effect, (export promotion), (iii) the import effect and (iv) the remittances effect. Import substitution and export promotion will improve the position of BOP while import effect and remittance effect will have a negative impact on BOP. (Moosa, 2002). The Indirect effects of FDI on BOP have been the aim of this research, to know how Canadian FDI will impact on Canadian BOP.

Empirical Literature

There exist an unlimited number of previous studies of the relationship between FDI and economics growth examining both developed and under developed countries by employing rigorous econometrical framework. These studies have examined the roles of FDI on the host nation or the effect of FDI on the economic growth in the host country. Some of these findings prove that there is no significant relationship between FDI and economic growth while other findings show that there was a relationship but it might be a weak one. Most of their studies have been reviewed as follows:

Ross Levine and Maria Carkovic (2002) made an assertion that FDI inflows don't have a direct independent influence on Economic Growth. In their research, they employed Ordinary Least Square (OLS) to regress the relationship between FDI and economic growth using GDP as a proxy. Other control variable was included using cross- sectional data between rich and poor countries over the period of 1960 and 1995. Also, their study adopts dynamic panel estimator, hence, using the General Method of Moment (GMM) with the data for five years period.

Carkovic and Levine (2002) found out that FDI does not have impact on economic growth in their regression on cross-sectional analysis, but the second result using General Method of Moment (GMM) dynamic panel estimator shows that three out of the seven regression prove FDI have a direct relationship with growth but there on robust. (Carkovic and Levine, 2002).

Blomstrom et. al. (1994, stated in Mutenyo 2008, p.5) that FDI have a positive impact on growth in GDP per capita in more sophisticated developing nations than lower income nation. Mutenyo (2008) used cross- sectional and standard panel regressions to analyse this. The study also adopt General Method of Moment (GMM) dynamic panel estimator to obtain the efficiency and consistency estimate of the impact of FDI on economic growth in 32 sub Saharan African countries. His findings was that FDI have a positive impact in economics growth but the efficiency level is low than private investment (Mutenyo, 2008).

Choe (2003) used Granger causality test to investigate the relationship between FDI and economic growth in his research. He sampled 80 countries both less developed and developed within a time period of 1971 to 1995. He concludes that ''Causality seems to run in either direction, but the effects are more apparent from growth to FDI than FDI to growth.'' (Choe, 2003, p 52). Firstly, an entire sample was used, followed by the second sample which has the outliers removed. Choe tested if FDI Granger encourages economic growth or economic growth Granger encourages FDI, using variable representing FDI as a ration of FDI inflows to GDP. His test for first sample shows that FDI Granger encourages economic growth, and vice versa. But the second sample shows that FDI Granger does not encourage economic growth but economic growth encourages FDI. Zhang (2001) also use a similar test (causality) to examine the relationship between FDI and economic growth. He collected data from 11 less developed countries in Latin America and East Asia using co- integration and Granger causality test. His study shows that economic growth encourages FDI in direction with macroeconomic stability and trade regime in the host nation.

Batten and Vinh Vo (2008) used panel data modelling technique to determine the link between FDI and economic growth, and to determine if the relationship changes under educational, institution and economic condition. The outcome of their research was in favour of FDI. Their findings analyse that FDI has a stronger positive role in economic growth in nations with better education achievement, exposure to international trade, sound stock market, low population growth and low level of risk Batten and Vinh Vo (2008).

Tang and Rao (2001, quoted in liang 2008) found that MNEs spend significant money on research and development and are more active in adopting advance technology than domestic firm in Canada. Harcourt and Poncet (2009) examine the role of FDI in funding Chinese corporate sector. In the study, they used firm-level data on 1300 local companies between 2000- 2002. Euler equation model was used for the data and their finding shows that FDI was able to provide funding for private domestic firm in China.

Balasubramanyam et al (1996) examines the impact of FDI on economic growth in developing economies. They applied cross- sectional data and ordinary least square regression method. The result shows that FDI has a positive impact on economic growth in host nation that adopt export promotion policy but not in nation that use import substitution policy. Another research by Olofsdotter (1998) investigated role of FDI on economic growth using cross- sectional data. It was discovered that the more the stock of FDI is positively related to economic growth in countries that have high level of institutional capability, the more it is measured by the bureaucratic efficiency and degree of property rights protection in the host nation. Borensztein et al (1998) provides similar studies to examine the role of FDI in economic growth and technological diffusion. The outcome of the studies concludes that FDI have a good impact in economic growth but it depend on the of human capital development in the host nation.

Lensink and Morrissey (2006) investigated the relationship between FDI and economic growth. The volatility of FDI was also included in the analysis. In their research, 87 developed and less developed countries were sampled using cross–sectional panel da ta and instrumental variable technique. Their findings shows that the volatility of FDI is significant and negatively related to economic growth while FDI has a positive impact on economics growth but its impact is not a robust one. Firm-level studies (Aitken and Harrsion's 1990) examine whether foreign investment encourage technological spillover to the local firms, they use panel data on Venezuela plants with two decades (between 1979 and 1989). The employed the OLS regression estimation technique, they found that FDI have a negative impact on the productivity of the local firms, which means FDI does not accelerate economic growth.

Most previous studies was able to provide mixed view concerning the impact of FDI on the growth of the host economy, some of said FDI have positive effect to the host even though it might not be significant while other saw it as doom to the host country. None of the past studies was able to look at the role of the FdI on BOP which is a good indicator of economic growth. A nation with a good favourable BOP over sustainable period of time may experience economic growth. Since FDI have an indirect impact on BOP (Moosa, 2002).This study will complement the previous researcher work to know the contribution of FDI to Canadian economic growth via Canada BOP.

Chapter three

Research Methodology


Research methodology is a systematic process of planning and executing a research work (McNeill and Chapman, 2005). There are some research designs in planning and conducting a study. The term paradigm is a way or method of conducting research. Saunders et al. (2007, p.112) defines paradigm as ''a way of examining social phenomena from which particular understanding of these phenomena can be gained and explanations attempted.'' Most researchers operate within the categories of social science paradigms; which can be used in management and business research to bring new and fresh insight into real-life issues and problem (Burrell and Morgan ,1979). There four paradigms that can be used to analyze social theory: they are functionalist, interpretive, humanist and radical structuralists.

Paradigm #1: Functionalist

Since the study is about the impact of Foreign Direct Investment on Canadian economic growth, the finding(s) will further examine the role of FDI on BOP and ascertain whether this paradigm will solve the problem of BOP. It can be proved that this study operate with the functionalist paradigm that is located on the objectivist and regulatory dimensions. Saunders et al. (2007) is of the opinion that if the researcher is operating inside this paradigm, it is likely to adopt objectivism as an ontological position. He states that the research will probably be more concerned with a rational explanation of why a particular organizational problem is occurring, and develop a set of recommendations.

Research Philosophy

Research philosophy explains a researcher's thinking about development of knowledge in a field of study. It is rather profound than the thought of the researcher. There are three forms of research philosophy that dominate a research literature; they are interpretivism, realism and positivism (Saunders et al. (2003).


Remenyi et al. (1998, quoted in Saunders et al. (2007, p.103) that ''those who like positivism prefer working with an observable social reality and the end product of such research can be law-like generalizations similar to those produced by the physical and natural scientists''. Since the study is to investigate the impact of Foreign Direct Investment on Balance of payment, in which some micro economic social variables like exchange rate, inflation and interest rate will also be a determinant factor, it shows that this research epistemological view is positivism. Saunders et al. (2003) explain that a positivism philosophy assume the role of an objective analyst, solemnly making separated interpretation about data that have been collected in an apparently value-free manner and it will create an emphasis on a highly structured methodology to facilitate duplication and a quantifiable observation that result to statistical analysis. However, since the research epistemological concept is positivism, it is expected that the existing theory be used to develop hypotheses. In this case this will establish a hypothesis.

Ontology- Objectivism

Ontology has to do with the nature of reality which is greater than epistemological considerations. This research has to do with an aspect of ontology known as Objectivism. Objectivism as an ontological position implies that social phenomena confront us as external facts that are beyond our reach of influence (Bryman & Bell 2007). Smircich (1983 quoted in Saunders et al. (2007, p.109) noted that objectivists would tend to view the culture of an organization as something that organization 'has'. (Jankowicz ,2000), states that the truth exists separately from those who seek it. The truth is objective fact i.e. collection of data to find fact. The study has an objectivist approach, which means that documentary quantitative data will be collected as an evidence of 'truth'.

Research Approach: (Deductive or Inductive)

Research approach must be first known in any research design. If a researcher chooses an inductive approach, the study will collect data and develop theory as a result of the data collection. Also, if a researcher chooses a deductive approach, it will develop theory and hypothesis, and design a research strategy to test the hypothesis. Deduction owes more to positivism while induction owes more to interpretivism (Saunders et al. 2007).

This study will use deductive approach in this research because it will develop theory and hypothesis, and will accommodate research design to test the hypothesis. (Gill and Johnson ,1997, p178) defines theory as 'a formulation regarding the cause and effect of relationships between two or more variables, which may or may not have been tested.'( Moosa,2002) says FDI will have an indirect effect on BOP of host country's capital account and also reflects on the nation import substitution effect and export promotion. This study have already developed a theory in line with the research objectives that FDI will have a relationship with some component of host country's BOP (current account, capital account, export, import). The study will build a model to explain the casual relationship between dependent variable and independent variables to figure out the relationship between FDI and BOP. Robin says in Saunders (2007) that with deductive research it is necessary to deduce a hypothesis.

Hypothesis Testing

Hypothesis is a testable proposition about two or more events or concept. That is, in effect the researcher is comparing the data collected with what is theoretical expected to happen. It also called significant test: which is thought of as helping to rule out the possibility that one's result could be due to random variation in the sample (Saunders et al. 2007). Blumberg et.al (2005, mention in Saunders et al. 2007) the two main groups of statistical significance test:

Non parameter statistics: these are designs used when data are not normally distributed. It is usually used with categorical data, and Parameter statistics: these designes are more powerful because they are quantifiable data.

This research statistical significance test is categorized as Parameter statistics.


Null hypothesis

H0 is called null hypothesis. The writer needs to be aware that there could be possibility that there could be relationship (null hypothesis) between two variables but the relationship cannot make any conclusion with any certainty when conducting statistical test If the probability of obtaining the test statistic or one more extreme by chance alone is higher than 0.05 (at five significant level). This means the relationship is not statistically significant. Under this circumstance the null hypothesis is acceptable (Saunders et al. 2007).

Alternate hypothesis

H1 is known as alternate hypothesis. This is the opposite of null hypothesis. This hypothesis is applicable if there is a relationship between two variable and the probability of obtaining the test statistic or one more extreme by chance alone is lower than 0.05 (at five significant level).This means the relationship is statistically significant. Hence, the relationship is statistically significant.


The role of Positivistic research is to determine what the possible outcome(s) of the research is (are). This has to be in line with the research question. In relation to the first four research questions the following four hypotheses have to be identified. H0- FDI will not have a significant relationship on Canadian Capital Account.

H1- FDI will have a significant relationship on Canadian Capital Account.

H0- FDI will not have a significant relationship on Canadian Current Account.

H1- FDI will have a significant relationship on Canadian Current Account

H0- FDI will not have a significant relationship on Canadian Import Account.

H1- FDI will have a significant relationship on Canadian Import Account.

H0- FDI will not have a significant relationship on Canadian Export Account.

H1- FDI will have a significant relationship on Canadian Import Account.


(Collis & Hussey, 2003), mention that in research ''we are interested in collecting data about variable.'' They stated that variable is something that can take one or more value and it is classified as independent or dependent variable. The independent variable is the variables whose value cannot be explained within a model while the dependent variable is variable whose value can be explained within the model or by the independent variables (Awe, 2002). Using the above hypotheses, the dependent variable will be the Canadian FDI between the period of 1990 and 2008, while the independent variables will be the component of Canadian BOP ( Current, Capital, Export and Import) and other macro economic variables like inflation and exchange rate within the same scope.


Research strategy is a plan that explains how the research question will be answered via the study objectives and the mode of data collection and analysis. There are various kinds of research strategies: experiment; survey; case study; grounded theory; ethnography; action research, time horizon (cross-sectional and longitudinal studies); exploratory, descriptive and explanatory studies. The strategy that fit in for this study is time horizon. Saunders et al. (2007).

Time Horizon (Saunders et al. 2007): The time frame for research is an important aspect of planning a research. Usually this depends on the research objective. The time horizon of a research is two types: the cross-sectional and longitudinal.

Cross-sectional studies are particular phenomenon at a particular time. That is to carry out an event that happens at a particular time. It also called the snapshot. While longitudinal has to do with study change and development. That is, a study of an event over a particular time. This research is longitudinal because it requires massive amount of published data collection (Canada statistics) over time.


For a research to give good account for reliability and validity, data collection and mode by which the study data is collected is important for the overall credibility of the research. Data collection method include interview, experiments, survey, documentary data (Secondary data) and so on (Yang, Wang and Su, 2006). As the research purpose is to examine the contribution of FDI to Balance of payment in Canada, secondary data (documentary data) will be used in the course of the study to provide comparative and contextual data which will give good credibility and validity for the research.

Qualitative Vs Quantitative

The term qualitative and quantitative technique is normally used in business and management research to differentiate between data collection techniques and data analysis procedures. The differences between these two techniques are words and numbers. The former (qualitative) deals with words, while the latter (quantitative) deals with numbers.

Qualitative Technique.

Saunders et al. (2007, p.145) says ''qualitative is used predominantly as a synonym for any data collection technique (such as interview) or data analysis procedure (such as categorising data) that generate or to use non-numeric data.'' It could refer to data other than words, such as pictures and video clips. Qualitative technique uses inductive research approach (the study will collect data and develop theory as a result of the data collection) (Saunders et al., 2007).

Quantitative Technique

Saunders et al. (2007, p.145) states that quantitative technique ''is used predominantly as a synonym for any data collection technique (such as questionnaire) or data analysis procedure (such as graph or statistics) that generates or uses numeric data.'' Qualitative technique uses deductive research approach (it will develop theory and hypothesis, and design a research strategy fits the hypothesis). This research will adopt quantitative technique of data collection and analysis procedures to answer the research question. The data collection will source from secondary data which will later be discussed. Pie chart, graph, and econometrical statistics will be used to analyze the data collected.


Secondary data are information gathered for a specific reason. Sharp et al (2002, p.159) defines secondary data ''as a data collected by others and published in some form readily accessible.'' Information gotten from an existing source which is not originally sourced from the researcher; such data include government information, published information, and on-line information and so on (Sekaran, 2003). It can be either qualitative or quantitative, but study will be used the quantitative aspect.

Secondary data are grouped into three categories: ad-hoc, time series, and cross sectional series. Ad-hoc is referred to as solo study for a specific purpose; cross sectional series are data such as interest rate, inflation, money supply provided by individual member state. And time series are data from period of time collected by statistics agencies such as Canada statistics, OECD, World Bank and other statistics offices (Hair, Money, Samuel and Pake, 2007). This research will require time series and the duration of this study is 18 years (1990- 2008). The reason why this research examines this period is because it falls under the period that Canada experiences a growth in FDI.


Saving resources (time and money in particular) is one of the main advantages of secondary data. Nevertheless, there are some advantages such as: can provide comparative and contextual data, unobtrusive, result can lead to new discoveries and permanence of data. Most secondary data are use in management and business research (Saunders et al, 2003).


Secondary data can be internal or external source. If data is provided from the main source (i.e. organization), it is known as internal data. But if it is from third party or outside the real source, it becomes external. Sometimes, data collected might be used directly (i.e. previous studies, statistics and other data base) after collection while some might need to undergo some processes

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