Empirical relationship between foreign direct investment and economic growth

Abstract

PurposeThe purpose of this paper is to find out empirically the relationship between foreign direct investment (FDI) and economic growth and it will also highlight the relationship status between the variables included in the model, either long‐ or short‐run in case of China.Design/methodology/approachThis study uses secondary data obtained from World Development Indicators over the period 1985‐2009, whose viability has also been checked through the World Bank and IFS. An Augmented Dickey‐Fuller (ADF) unit root test is used to estimate an autoregressive distributive lag (ARDL) approach to co‐integration as the variables in the model are in I(1) and I(0) form and the Schwarz Bayesian Criterion (SBC) is used in this study to find out the estimated lags of the model, which are ultimately used to find out the short‐ and long‐run relationship of the variables included in the model. The error correction model (ECM) was also applied which basically provides information about the causal factors that may affect the variables included in the model.FindingsThe results provide evidence that there is an empirical relationship among FDI and economic growth. The computed value of F‐statistics is greater than the upper bond value described by Pesaran, M.H. et al., which depicts evidence against the null hypothesis of no effect and hence long‐run relationship among the variables is concluded at bottom line. Empirical evidence reveals that FDI has a positive effect on economic growth. An error correction model (ECM) is applied and the error correction term was negative and significant. This indicates that there exists a relationship between the variables. Diagnostic tests showed a lack of heteroscedisticity, confirming the validity of the model; CUSUM and CUSUMSQ tests were used to reveal the model's stability.Practical implicationsThe Government of China should keep keen emphasis on the ingredients of this study so that China could reap maximum share of FDI through the achievement of positive spillovers of foreign investment, which ultimately results in its economic growth. However, the ingredients of this study depict the expenditures on security status, growth options as well as on infrastructure. This study also gives better impending in decision making about FDI in case of China.Originality/valueThis study bridges the gap between theory and practice and proves empirically the relationship between FDI and economic growth through auto regressive distributive lag approach (ARDL) to co‐integration in case of China. This research includes most dominating factors in the model which differentiate it from all previous empirical researches related to FDI's relationship with economic growth. However, this study not only pin points the new dominating factors related to this kind of relationship, but also set up a new horizon in the field of research to get groundbreaking results – in case of other countries – by following the footings set by this research.