Determinants of foreign direct investment in Sri Lanka

Sri Lanka is moving towards achieving a per capita income of US$ 4,000 by 2016 and it has to maintain a growth rate around 8 per cent per year to realise the expected target. However, internal investment capability of the country is limited due to low domestic savings. Therefore, Sri Lanka has to rely on external finance such as foreign Direct Investment to achieve expected prosperity. This paper investigates the determinants of Foreign Direct Investment in Sri Lanka and evaluates the attractiveness of India, Sri Lanka, Bangladesh and Pakistan for foreign direct investment during the period of 1975-2012. Fully modified least squares (FM-OLS) regression model was fitted to estimate the determinants of foreign direct investment. Attractiveness of the selected countries for foreign direct investment was evaluated using an index. Empirical results revealed that GDP growth rate, inflation, infrastructure quality, lending interest rate, labour force, exchange rate, and corporate income tax were significant determinants of FDI in Sri Lanka during the period of 1975 -2012. Main feature of the variables which are determinants of FDI is that they are directly associated with the cost of production of the investors. Therefore, it can be interpreted that the main motive of the foreign investors in Sri Lanka is to reduce the cost of production by improving the efficiency of operations. FDI index suggests that India and Bangladesh were more attractive for FDI inflows over Sri Lanka and Pakistan. Market seeking investors are keen on the potential large market size of India and Bangladesh over Sri Lanka. Therefore, the motive of the investors is important in evaluating determinants of foreign direct investments in a country.


Introduction
Global volume of Foreign Direct Investment (FDI) has increased dramatically over the second half of the 20 th century because of changing global economic and political environment. The aggregate net inflows of FDI of Sri Lanka have followed the global trend by increasing net inflows nearly by five times (US$ 43 million in 1988; US$ 201 million in 1999 (WDI, 2010)).Further, the growth rate of FDI flows has been accelerated with the beginning of the 21 st century. In 2012, Sri Lanka has recorded its highest FDI inflow of US$ 1,338 million (Central Bank, 2012). The ending of prevailed civil war in the north and east of 30 years in 2009 has given a great opportunity for Sri Lanka to move forward as a fast growing country. However, internal investment capability of the country is limited as result of low rate of domestic savings and high cost of accessing global capital markets. Investment and savings positions of the country during the last eight years are shown in the Maintaining at least 30% of investment to Gross Domestic Product (GDP) ratio is required to sustain an economic growth at around 8%. Sri Lanka has reached around 30 per cent by 2011(inclusive of the government investment). However, still Sri Lanka has to motivate FDI since the inflow of FDI is expected to improve efficiency and productivity in a developing country as a result of new technology, export expansion, employment opportunities and development of human capital. Further, FDI is very important and sensitive to a developing country as FDI flows contribute in building strong economic links between developed and developing countries. Having identified the importance of FDI, the governments offer various tax concessions and incentives to attract more FDI. Therefore, Sri Lanka has to motivate FDI inflows to achieve economic development goals. Empirical studies on the area of FDI are very broad. FDI inflows are determined by various political, social, economic and cultural factors. Sri Lanka shows a substantial increase in FDI inflows in recent years, however, it is relatively low compared to other Asian countries (ADB, 2011). Therefore, Sri Lanka needs to identify principal factors that determine FDI inflows or the factors, which are attractive for FDI inflows. Considering above facts, the main objective of this study was to investigate the determinants of foreign direct investment in Sri Lanka. In addition to the main objective, attractiveness of some selected countries in south Asian region for FDI was evaluated by using an FDI index.
Previous studies have viewed FDI in different perspectives such as FDI in respect of Multinational Corporations (MNCs), home countries, and host countries. Analysis of the literature of FDI reveals that there isn't a single theory which explains the determinants of FDI, but a variety of theoretical models attempting to explain FDI and the location decisions. Subsequent to the Second World War, there have been some attempts to explain FDI in terms of the motives for international production. Macdougal (1960) used the concept of capital arbitrage in a perfectly competitive environment to explain the transfer of capital across borders. This Neoclassical trade theory, which explained international capital trade due to differences in returns on capital, was heavily criticized (Hymer, 1976) because of its assumption of perfect competition. Then, Hymer (1976) suggested that MNCs are oligopolistic firms that need to locate their production in various countries to compete against rivals. This became a landmark in the study of FDI and it explained ownership of specific assets using variables derived from the market failures to explain FDI. Theories of FDI developed extensively based on the foundation of Hymer's work. Since then, two groups of theories were developed based on the classification of Hymer's two variables. One group framed within location decisions of MNCs and the other group focused on internalisation process. Buckley and Casson (1976) and Rugman (1981) extended the Coasian theory of the firm to explain why and how the production decisions are made among MNCs.
Buckley and Casson (1991) explained that market failure was more prevalent in an international framework and so MNCs organised an internal market to avoid excessive transaction costs (Williams, 1997). Investment as a percentage of GDP Domestic savings as a percentage of GDP Vernon (1966 and1979) explained movement of production operations from one country to another in search of markets and lower cost production bases using product life cycle concept. However, Dunning's (1977Dunning's ( , 1981 and 1993) eclectic paradigm framework was proved to be a better approach of explaining FDI. This is also known as the OLI framework. OLI framework combined ownership, location and internalisation advantages as determinants of FDI, which were previously discussed in separate theories. In brief, ownership advantage explains who will undertake FDI; location advantage explains where FDI flows to; and the internalisation advantage explains how the FDI flows or the mode in which international production will take place. Previous studies have identified four main reasons for MNCs to undertake international production activities -market seeking, resource seeking, efficiency seeking, and strategic asset seeking (UNCTAD, 1998; Mallampally and Sauvant, 1999;Dunning, 2000). The aim of this study is to identify the distinctive determinants in respect of a host country. Sri Lanka has shown a substantial increase in FDI inflows in recent years. However, it is relatively low compared to other Asian countries (ADB, 2011). Therefore, Sri Lanka needs to identify the principal factors that determine FDI inflows or the factors, which are attractive for FDI inflows. The following propositions are made based on previous studies for the purpose of identifying the determinants of FDI in Sri Lanka.

Proposition 1:
High growth rate of potential market encourages FDI Size of the host country market is a very important factor for potential investors. Previous studies have used GDP as a proxy to measure the market size of an economy (Janicki et al., 2004;Mohamed et al., 2010;Tsikata, 2000). Accordingly, GDP growth rate can be considered as the growth of market potential. A growing market would increase the prospects of market potential and a large market size would generate economies of scale (Bhattacharya et al., 1996). Further, having studied the contribution of inward FDI to China's recent rapid economic growth, Whalley and Xin (2009) suggested that the sustainability of both China's export and overall economic growth might be questionable if inward FDI plateaus in the future. Therefore, the economies that maintain a higher GDP growth rate are very attractive for foreign investors. GDP growth rate of Sri Lanka during last couple of years were around 7% to 8%. This is a good indicator of the market potential for investors and, in return, it is very sensitive for FDI inflows since many previous studies have confirmed that FDI has a positive relationship with the GDP and GDP growth rate (Frenkel,

Proposition 3:
High government consumption expenditure discourages FDI Government capital expenditure is a good motivator for investors since it enhances the quality of the infrastructure of a country. However, high proportion of government expenditure in many developing countries comprises of consumption expenditure and in many instances, total government income is not sufficient to meet at least current expenditure. Therefore, high government consumption expenditure is assumed as an indicator of macroeconomic instability. Negative fiscal impacts crowd out foreign investments and hamper the prospects of socio-economic development (Vadlamannati, 2008). Some studies have found that FDI has a negative relationship with government consumption expenditure (Mohamed et al., 2010;Yang et al., 2000).

Proposition 4:
High interest rates discourage FDI Today, many investors seek third party funds in addition to their own funds to invest in projects. Developed capital markets and sound financial systems encourage investors to leverage their risk exposures as a result of easy access to third party funds. Therefore, lending interest rates are very sensitive for foreign investors, high lending rates may increase the cost of capital of projects, and it discourages FDI inflows. A negative relationship of FDI with lending interest rates has been revealed in previous studies (Yang et al., 2000;Tsikata et al., 2000). However, Wei (2005), having studied the differences of FDI in India and China, found a positive relationship for India and a negative relationship for China.

Proposition 6:
High rates of taxes on international trade discourage FDI Taxes on international trade affects potential FDI flows due to the decrease of profitability of projects as a result of high tax rates on imports and exports. Therefore, FDI has a negative relationship with tax on international trade (Wei, 2005; Gastanga et al., 1998).

Proposition 7:
Exchange rate stability encourages FDI The stability of currency of a country is also an important factor for FDI. Continuous fluctuations of exchange rate denote instability of the currency of a country. Drake and Caves (1992) found the real exchange rate that influenced the Japanese share of foreign investment transactions in US manufacturing industry. Wihlborg (1978) suggested that, for a riskaverse firm, higher volatility lowered the certainty equivalent value of the investing firm. Hence, FDI decreased as exchange rate volatility increased. By contrast, Goldberg and Kolstad (1995) illustrated the importance of considering the post-FDI changes in the exposure of a firm's profits to exchange rate risk. If the investing firm could choose to serve foreign markets via exports or FDI, then an increase in exchange rate volatility might lead the firm to substitute FDI for exports, since FDI activity reduces the exposure of its profits to exchange rate risk. Lin et al. (2010) examined how exchange rate uncertainty influences the timing of FDI using firm-level data on Taiwanese firms' outward FDI into China over the period between 1987 and 2002 .They concluded that exchange rate uncertainty tends to delay the FDI activity of a market-seeking firm and, it may accelerate the FDI activity of an export-substituting firm if the degree of risk aversion of the firm is high enough. Therefore, the results reveal that the relationship between exchange rate uncertainty and FDI crucially depends on the motives of the investing firms. Lower exchange rate in the host country means higher purchasing power of investing country's currency in the host country.

Materials and methods
This study is primarily based on the country level secondary data for the period from 1975 to 2012. Fully modified least squares (FM-OLS) regression, which was originally designed in work by Phillips and Hansen (1990), is used for empirical analysis since it provides optimal estimates of cointegrating regressions. The method modifies least squares to account for serial correlation effects and for the endogeneity in the regressors those results from the existence of a cointegrating relationship. This method employs a semi-parametric correction to eliminate the problems caused by the long run correlation between the cointegrating equation and stochastic regressors innovations. Therefore, FM-OLS estimator is asymptotically unbiased and has fully efficient mixture of normal asymptotics allowing for standard Wald tests using asymptotic Chi-square statistical inference. The FM-OLS estimator employs preliminary estimates of the symmetric and one-sided long run covariance matrices of the residuals. Considering the above, equation (1) is fitted using FM-OLS model.  FDI Index √ --- (2) In addition, FDI index given in equation (2) is used to compare the attractiveness of selected south Asian countries for FDI. Proposed index is not similar to the two indices compiled by the UNCTAD for avoiding the comparison of the absolute values of FDI inflows into host countries. Even though the purpose of the proposed index and the two indices of UNCTAD is the same, the proposed index considers the macroeconomic stability view of a country, whereas the Inward Foreign direct investment Performance Index considers the market size of the host country and potential index considers the unweighted average of the normalized values of eight variables. According to the UNCTAD (2002), the two indices are intended neither to provide a comprehensive model explaining the locational decisions of MNCs nor to measure the impact of FDI on host economies. Therefore, the proposed index will be very useful to measure the attractiveness of countries for FDI in terms of the stability aspects of a country. Attractiveness of foreign direct investment to Sri Lanka, India, Pakistan and Bangladesh was measured based on the proposed FDI index and the countries were ranked based on its value. It was concluded that a country was more attractive over the others when it had a lower value of the index. FDI index was calculated using equation (2). Description of data is given in Table 1.

Results and Discussion
Summary of the sample statistics of the study is given in Table 2. Empirical results generated by equation (1) show a reasonable fit of the equation as given by R 2 . Accordingly, 91.06% of FDI inflows of Sri Lanka is explained by the selected independent variables. The Durbin -Watson statistic indicates that there is no first-order serial correlation. The results confirm six propositions out of twelve which were established for the study. The empirical results of the equation (1) are given in the Table 3. GDP growth rate shows a positive significant relationship as hypothesised. Therefore, GDP growth rate is a good indicator of growing market potential as well as economic prosperity of a country. This hypothesis has been confirmed by some other studies in developing countries (Frenkel, 2004;Janicki et al., 2004;Mohamed et al., 2010;Tsikata, 2000). FDI does not hold the expected relationship with inflation. However, it reveals a significant positive relationship. High rate of inflation is an indicator of macro-economic instability of a country. Proposition 2 may be rejected due to the fact that many foreign investors are concentrated in export processing zones and they are not exposed to the local market . Hence, inflation is a motivator for FDI in Sri Lanka since it provides a competitive advantage to foreign investors over the domestic investors due to the disparity of cost structures. However, many previous studies have found significant negative relationship of FDI with the inflation (Frenkel, 2004

Conclusion
The primary objective of the study was to investigate the determinants of foreign direct investment in Sri Lanka and the secondary objective was to evaluate attractiveness of some selected countries in south Asian region for FDI. Fully modified least squares regression model was used to achieve the main objective of the study and the proposed FDI index was used to evaluate the attractiveness of countries for FDI. The results suggest that GDP growth rate, government expenditure, lending interest rate, trade balance, and corporate income tax were significant determinants of FDI in Sri Lanka during the period of 1975 -2012. Empirical results revealed statistically significant positive relationship of FDI with GDP growth rate, inflation, infrastructure quality income tax, labour force, lending interest rate, official exchange rate, and population growth rate, GDP growth rate was used as a proxy to measure market potential. Therefore, FDI in Sri Lanka is focussed on the domestic market in addition to highly exportoriented investments. Availability of domestic fund at an affordable interest rate is a motivator to attract more FDI to the country. Tax concessions and benefits had motivated FDI flows in Sri Lanka during the period of study. Foreign investors do not expect tax neutrality in a host country and they expect more benefits over the domestic investors.
FDI showed a statistically significant negative relationship with lending interest rates and official exchange rate. This shows the interest of foreign investors on the local capital market and currency stability of the economy. Further, currency stability is a major concern since it affects the value of investments and return on investments According to the findings, it can be concluded that the main motive of foreign investors in Sri Lanka is to improve the efficiency.