Article

Relationship Between FDI Global Business Review

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and Economic Growth in © 2019 IMI
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DOI: 10.1177/0972150919833484
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from OECD Countries

Syed Ali Raza1

Nida Shah1
Imtiaz Arif1

Abstract
This study analyses the relationship between foreign direct investment (FDI) and economic growth
in the presence of good governance system in the Organization for Economic Co-operation and
Development (OECD) countries. The dataset comprised of the years 1996–2013. Fixed effect model
and the Generalized method of moments (GMM) estimator are used in this study. The result of the study
unveils that all the variables have a significant positive association with economic growth. Moreover, the
study establishes the interaction terms which also depict a positive effect on economic growth. Further,
the Granger causality test shows that the bidirectional causal relationship exists between the FDI and
regulatory quality (REQ) on economic growth, whereas the unidirectional causal relationship is found
among the corruption control, political stability (POS), voice and accountability (VAC), government
effectiveness (GOE) and economic growth. Finally, it can be concluded from the above results that the
more the countries maintain their institutional quality the better will be the economic growth and the
FDI inflows. This result gives valuable policy implications, which the government should use to improve
the economic growth. Further, the result obtained from this study is beneficial for policymakers who
can draft effective government policies which will foster the economic growth rate of the country. Last
but not least, there is a need to improve the REQ which can only be improved subject to changes in
the laws of corruption.

Keywords
Econometric technique, economic growth, FDI, OECD countries

1
Department of Management Sciences, IQRA University, Karachi, Pakistan.

Corresponding author:
Nida Shah, Department of Management Sciences, IQRA University, Karachi 75300, Pakistan.
E-mail: [email protected]
2 Global Business Review

Introduction
The ultimate objective of any country is to achieve and to sustain economic growth both in the present
generation and the upcoming generation (Tahir, Khan, Israr, & Qahar, 2015). Economic growth is highly
dependent on the efficient utilization of economy’s factors of production. However, the question that
which factors affect the economic growth of the country is under investigation since the late 1950s
(Lucas, 1988; Romer, 1986; Solow, 1956; Swan, 1956). Several factors have been identified, foreign
direct investment (FDI) is one of them. FDI is a way to increase the host country’s physical and human
capital which then potentially increases the real GDP (Elkomy, Ingham, & Read, 2016; Qazi, Sharif,
& Raza, 2017). Furthermore, FDI helps in the generating technological spillovers, transferring knowledge
development of new enterprises, and also provides opportunities for the host countries to integrate into
the global economic trade (Jawaid, Raza, Mustafa, & Karim, 2016; Mahembe & Odhiambo, 2016).
Apart from FDI, the institutional quality also plays an important role in the economic growth of the
country (Jude & Levieuge, 2016; North, 1990). The weak institutional quality brings in adverse economic
problems like low investment, slow productivity and low GDP per capita which ultimately slow down
the economic growth process. On the contrary, good institutional quality ensures high investment,
efficient factor allocation, minimizes uncertainty and ease economic agents’ coordination which results
in economic growth (Jude & Levieuge, 2016). In this regard, Acemoglu and Robinson (2008) reported
that accurate institutional arrangements benefit the country because better institutions act like a public
good, and all the agents use these factors to get benefited which ultimately upsurge the economic growth
rate (North, 1990).
The determinants of institutional quality also play an important role in the FDI inflows (Acemoglu
& Johnson, 2005; IMF, 2003). The poor institutional quality impedes the FDI inflows, acts as a tax and
consider as a cost to FDI (Buchanan, Le, & Rishi, 2012; Daude & Stein, 2007). The absence of
institutional quality in any context, that is, POS, law and order, code of conduct, public policies, and
investor protection, brings a negative effect on the FDI inflows (King & Levine, 1993; La Porta et al.,
1998; North, 1990). On the contrary, a better institutional quality enhances the FDI inflows (Globerman
& Shapiro, 1999). Further, institutional quality is also valued by the foreign investors because it decreases
the implementation cost and ensures the ease of doing business (Shah, Ahmad, & Ahmed, 2016).
With an economy, FDI has both direct and indirect effects and the indirect effects are more pronounced
because they cause the technology transfer and efficiency gains (Elkomy et al., 2016). The success
of these indirect effects of FDI is highly dependent on the levels of institutional development, economic
growth, the human capital’s absorptive capacity, financial development and the quality of policy
making of the host countries (Jude & Levieuge, 2016). Thus, to generate positive effects of FDI inflows
on the economy certain preconditions need to be satisfied. To begin with there needs to be a minimum
capacity of human capital followed by good governance and the developed political system. The
existence of these conditions will help the disbursement of the FDI benefits to the larger population
(Elkomy et al., 2016).
With respect to FDI, economic growth and institutional quality association, three strands of literature
are found. The first strand focuses on FDI and economic growth nexus (Pegkas, 2015; Zhang, 2001), the
second strand focuses on the institutional quality and economic growth (Afonso, 2016; Chong
& Calderón, 2000) and the third strand takes the role of institutional quality with economic factors such
as FDI on economic growth (Agbloyor et al., 2016; Buchanan et al., 2012).
Thus, this study assesses the association among the FDI, institutional quality, and the economic
growth in OECD countries. The reason for choosing the OECD countries is that they had the major share
of the world’s total FDI inflows from the last 20 years (2005–2015). In 2017 the OCED economies
Raza et al. 3

accounted for 54 per cent of global FDI inflows (OCED, 2018). Moreover, in 2005 economies received
23.5 per cent of FDI inflows of GDP which has increased to 40.7 per cent of FDI inflows of GDP in the
year 2017 (OECD, 2018). Whereas, by region, the FDI inflows in the OECD countries are decreased by
37 per cent in the year 2017 due to significant drop in FDI flows to the UK, USA, Belgium, Luxembourg,
Netherlands and Spain. However, the USA was still the largest recipient of FDI inflows (161 billion $)
around the globe followed by China in 2017, the major FDI recipients worldwide were the USA (US$287
billion) followed by China (US$168 billion), Brazil (US$63 billion), the Netherlands (US$58 billion),
France (US$50 billion), Australia (US$49 billion) and Switzerland (US$41 billion) (OECD, 2018).
Thus, this research work contributes to the literature in a number of ways: First, to the best of
our knowledge, this is the first study that has tested this association in the context of the OECD countries.
Second, in past studies different proxies of institutional quality have been used, that is, the rule of law,
voice and accountability (Jadhav, 2012); corruption (Javorcik & Wei, 2009); quality governance (Ferreira
& Matos, 2008); and political instability (Herrera-Echeverri, Haar, & Estévez-Bretón, 2014). This
study has used all the five proxies of institutional quality to analyse their impact on economic growth.
Third, this study uses the GMM estimator to estimate the association. The GMM estimator technique
is used because it provides reliable result in the presence of arbitrary heteroscedasticity (Tiba, Omri,
& Frikha, 2016) and also it helps to overcome the endogeneity and non-observable heterogeneity
problem (Blundell & Bond, 1998).
The rest of the article is as follows: literature reviews are explained in the second section, the data
source and methodology are explained in the third section, data analysis and its discussion are explained
in the fourth section, conclusion and recommendations are explained in the fifth section.

Review of Literature
FDI–Economic Growth
Borensztein, De Gregorio, and Lee (1998) concluded that the FDI acts as an important vehicle which
contributes to the economic growth of the 69 developing countries. However, the maximum benefit from
FDI can only be achieved by the countries when the economies have the minimum stock of human
capital. Zhang (2001) studied the FDI and economic growth connection in 11 economies of Latin
America and East Asia and reported that the FDI acts as a tool that increases the economic growth,
however, the extent to which it increases the economic growth is dependent on the country’s characteristics.
Adams (2009) uses the fixed effects estimation and OLS to study the FDI and economic growth
relationship in Sub-Saharan Africa. It is concluded that a significant positive association between the
variables is found only in the OLS estimation. Wang (2009) examined the sector-level FDI inflows and
economic growth connection in 12 Asian economies. It is reported that only the FDI inflows in the
manufacturing sectors affect the economic growth significantly. Similarly, Azman-Saini et al. (2010)
reported that the FDI affect the economic growth significantly as well as positively only when the
financial market development exceeds a threshold level. Tiwari (2011) reported that the FDI increases
the economic growth process in Asian countries. He further mentioned that the capital and labour are
also important for the economic growth. Mehic et al. (2013) reported that the positive and significant
connection exists between the FDI and economic growth in seven southeast European countries. Omri
and Kahouli (2014) reported that the bi-directional causal association exists between the FDI and
economic growth in 13 Middle East and North Africa (MENA) countries. Pegkas (2015) reported that
FDI is the significant factor that contributes to the economic growth in Eurozone countries. Durmaz
(2017) reported that FDI has a spillover effect on the Turkish economy.
4 Global Business Review

Institutional Quality and Economic Growth

Chong and Calderón (2000) studied the institutional quality and economic growth nexus and reported
that bi-directional causal association exists between the variables. This implies that institutional quality
causes the economic growth and vice versa. Butkiewicz and Yanikkaya (2006) concluded that institutional
quality (rule of law) promotes economic growth. Demetriades and Law (2006) examined the link
between institutional quality and economic growth in 72 economies. They reported that institutional
quality has a significant influence on economic growth. Moreover, for the economic growth, good
institutions are more important for middle-income economies compared to high-income economies.
Aixalá and Fabro (2008) explored the institutional variables that effect the economic growth and
concluded that in the rich countries rule of law is important for the economic growth, whereas, in poor
countries control of corruption (COC) is important for the economic growth. Sawyer (2010) reported
that institutional quality and total factor productivity (TFP) growth affects the economic growth in Latin
America. Valeriani and Peluso (2011) concluded that a positive association exists between the institutional
quality and economic growth in developed and developing economies. Abuzayed and Al-Fayoumi
(2016) mentioned that in MENA countries, the institutional quality matter for the economic growth.
Afonso et al. (2016) also reported the positive association between the institutional quality and economic
growth in 140 economies. Olayungbo and Adediran (2017) studied the institutional quality and economic
growth association in Nigeria and concluded that institutional quality improves the economic growth in
the short run and impedes the economic growth in the long run. The study further suggests that in order
to sustain economic growth the anticorruption policies should be initiated. Berhane (2018) used the data
of 40 African countries to study the link between institutional quality and economic growth. The study
showed that significant positive association exist between the variables implying the institutional quality
boost economic growth.

FDI, Institutional Quality and Economic Growth

Wei (2000) examined the corruption and FDI association and reported that the increase in the corruption
level minimizes the FDI inflows. Aizenman and Spiegel (2006) reported that the institutional quality has
a direct correlation with the FDI inflows. Daude and Stein (2007) studied the FDI and institutional
quality nexus and reported that the significant positive association exists between the two. They reported
that the government instability, the unpredictability of laws, excessive regulations and policies and the
lack of commitment deteriorate the FDI inflows. They also concluded some determinants has a more
profound effect than the other. Gani (2007) also reported that the determinants of institutional quality,
that is, POS, rule of law, GOE, COC and REQ have a positive impact on the FDI inflows in Asian and
Latin American countries. Kandil (2009) also explored the institutional quality, FDI and economic
growth nexus in MENA countries and reported the POS, COC, VAC, rule of law and GOE increases
the economic growth. Whereas institutional quality has a negative influence of economic growth
and FDI. The study concluded that improvement in institutional quality does not attract FDI in the
examined countries. Masron and Abdullah (2010) uses the data of ASEAN countries and reported
that institutional quality plays a significant role in attracting FDI.
Buchanan et al. (2012) based on the data of 164 countries concluded that institutional quality has a
significant effect on the FDI. They further suggested that a 1 standard deviation change in institutional
quality improves the FDI by 1.69. Ahmed and Ahmed (2014) also reported that institutional quality helps
in attracting the FDI inflows in short and long run in the context of Pakistan. Economou, Hassapis,
Raza et al. 5

Philippas, and Tsionas (2016) reported that the institutional variables play an important role in the
attraction of FDI in OECD and developing countries. Jude and Levieuge (2016) stated that the FDI
significantly affect the economic growth only when the countries have the institutional quality above a
certain threshold. They also concluded that the institutional reforms should be given more consideration.
Yerrabati and Hawkes (2016) performed a meta-analysis on the governance and FDI inflows relationship
and reported that countries that have a low corruption level and good quality regulation get more FDI
than other countries. Nguyen et al. (2018) studied the institutional quality and economic growth nexus in
29 emerging economies and reported that positive association exist between the variables. They further
concluded that institutional quality impedes the positive effects of FDI on economic growth. The
improvement in institutional quality helps in mitigating the competition brought by FDI. Peres et al.
(2018) stated that institutional quality has significant and positive association with FDI in developed
economies. Thus, a 1 standard deviation change in institutional quality improves the FDI by 0.225.

Methodology
To study the relationship between the FDI, institutional quality and economic growth Cobb–Douglas
production function is used. The Cobb–Douglas production function is widely used in the literature to
analyse the economic growth in different countries. The function shows the technological association
between the two or more inputs (labour and physical capital) and the output produced by using inputs
(Cobb & Douglas, 1928). In other words, the Cobb–Douglas function claims that the production capacity
of an economy is dependent on the labour force (L) and physical capital (K) and some additional variables
(technology) presented through A in the below equation. Thus, the model used to examine the association
between the FDI and economic growth is derived using production function. The generalized form of the
production function is mentioned as follows:

GDP = f (LAB, A, CAP) (1)

In Equation 1, GDP represents the economic growth, CAP represents the capital stock, LAB represents
the labour force, A denotes total factor productivity. It has been presumed that FDI and institutional
quality create an impact on economic growth through A (see Jawaid & Raza, 2014; Kohpaiboon, 2003).
Several previous studies have used the Cobb–Douglas production function to examine the FDI and
economic growth nexus (Alfaro et al., 2010; Jawaid & Raza, 2012). Similarly, Ketterer and Rodríguez-
Pose (2018) uses the Cobb–Douglas function to study the institutional quality and economic growth
nexus. Therefore, the estimation model based on the Cobb–Douglas function is as follows:

GDP = FDI a1 + C a2 + La3 + COC a4 + REQ a5

(2)
+ GOE a6 + POS a7 + VAC a8 + e n

Equation is written in the time series specification as follows:

GDPt = a 0 + b 1 FDI t + b 2 CAPt + b 3 LAB t + b 4 COC t

(3)
+ b 5 REQ t + b 6 GOE t + b 7 POS t + b 8 VAC t + f t

The data we have taken in this study is comprised of panel data, so we change Equation (3) in the
panel form as follows:
6 Global Business Review

GDPi, t = a 0 + b 1 FDI i, t + b 2 CAPi, t + b 3 LAB i, t + b 4 COC i, t

(4)
+ b 5 REQ i, t + b 6 GOE i, t + b 7 POS i, t + b 8 VAC i, t + f i, t

where i represents the number of countries (in our case 35); t represents the time frame (in our case 18);
economic growth is represented by GDP; FDI is the foreign direct investment; CAP is the capital, LAB
is the labour, COC is the corruption control, REQ is the regulatory quality; GOE is the government
effectiveness; POS is the political stability; VAC is the voice and accountability; Ɛ is the error term and
β1–β8 represent the coefficients.
We run six different models, at first, we test the FDI, capital and labour relationship with economic
growth. And then we tested the individual effect of each institutional quality on this association, so six
different models were run simultaneously, the simultaneous equations were:

GDPi, t = a 0 + b 1 FDI i, t + b 2 CAPi, t + b 3 LAB i, t + f i, t(5)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + b 3 COC i, t + f i, t(6)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + b 3 GOE i, t + f i, t(7)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + b 3 POS i, t + f i, t(8)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 REQ i, t + f i, t(9)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 VAC i, t + f i, t(10)

Moreover, the association between the FDI and economic growth in the presence of institutional quality
is estimated by using the following framework:

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 FDI * COC i, t + f i, t(11)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 FDI * GOE i, t + f i, t(12)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 FDI * POS i, t + f i, t(13)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 FDI * REQ i, t + f i, t(14)

GDPi, t = a 0 + b 1 CAPi, t + b 2 LAB i, t + + b 3 FDI * VAQ i, t + f i, t(15)

Raza et al. 7

The data related to FDI and economic growth is derived from the World Development Indicators
(WDI) database managed by the World Bank, the determinants of institutional quality data are derived
from the Worldwide Governance Indicators (WGI) and capital and labour data is derived from Penn
World Tables v9.0. These indicators include GOE, VAC, REQ, POS and COC. The scale of these
indicators ranges from −2.5 to 2.5, the positive sign shows the high institutional quality and the negative
sign shows the weak institutional quality. In this study, we used the five indicators of institutional quality.
The detail related to these indicators and the other variables used are explained in Table 1.
To sum up, the purpose of this study is to examine the connection between the FDI, labour,
capital, REQ, government effectiveness, corruption control, POS, VAC and economic growth in the
OECD countries by using the GMM technique. The GMM technique is the most commonly used
method in panel data and in the complex models (i.e., multiple linkages between certain variables). This
technique is preferred over other OLS approaches due to its multiple advantages: (a) this technique
provides reliable result in the presence of arbitrary heteroscedasticity and (b) this technique overcomes
the potential endogeneity and non-observable heterogeneity problem that may emerge from explanatory
variables (Jalilian et al., 2007; Tiba et al., 2016). The list related to the countries is mentioned in Table 2.

Table 1.  Variable Description

Variable Full Form Definitions

COC Corruption It indicates the perception on magnitude in which the public power
control is exerted to obtain private gains; it includes great and small forms of
corruption, as well as the use of the state to satisfy private interests.
Upper values indicate greater corruption control.
REQ Regulatory It indicates the perception ability of a government to formulate and to
quality implement political regulations that allow promoting development of
the private sector.
GOE Government It indicates the perception of quality of public and civilian services
effectiveness and its independence degree of political pressure. It measures the quality
in formulation and implementation and the commitment of the government
with related policies.
POS Political It captures the perception of probability that the government is destabilized
stability or overthrown by nonviolent or non-constitutional means.
VAC Voice and It captures the perception level in which the citizens of a country
accountability can also participate in the government selection. It reflects expression
and association freedom.
FDI Foreign direct Foreign direct investment refers to direct investment equity flows in
investment the reporting economy. It is the sum of equity capital, reinvestment of
earnings, and other capital. Direct investment is a category of cross-border
investment associated with a resident in one economy having control or a
significant degree of influence on the management of an enterprise that is
resident in another economy. Ownership of 10%or
more of the ordinary shares of voting stock is the criterion for determining
the existence of a direct investment relationship.
GDP Economic growth It is the monetary value of all the finished goods and services produced
within a country’s borders in a specific time period.
Source: The definitions related to institutional quality determinants are taken from World Wide Governance Indicators
whereas, the definition related to FDI and economic growth are taken from world bank database.
8 Global Business Review

Table 2.  List of Countries

Australia Greece Netherlands

Austria Hungary New Zealand
Belgium Iceland Norway
Canada Ireland Poland
Chile Israel Portugal
Czech Republic Italy Slovak Republic
Denmark Japan Slovenia
Estonia Korea Spain
Finland Latvia Sweden
France Luxembourg Switzerland
Germany Mexico Turkey
UK USA
Source: The authors.

Analysis
Descriptive Statistics
The statistical information related to the variables used in this study is mentioned in Table 3. The result
shows that the FDI has the highest value of 340 billion and the lowest value of 25.30 billion with a
standard deviation of 46.90 billion and a mean value of 23.10 billion. Similarly, the economic growth
(GDP) has the highest value of 14,500 billion and the lowest value of 7.60 billion with a standard
deviation of 2,290 billion and a mean value of 1,110 billion. Likewise, the POS has the highest value of
3.295 and the lowest value of –2.578 with a standard deviation of 0.895 and a mean value of 0.870. On
the other hand, the REQ shows the highest value of 4.029 and the lowest value of 0.031 with a standard
deviation of 0.697 and a mean value 1.447. Further, the VAC has the highest value of 3.390 and the
lowest value of –1.267 with a standard deviation of 0.688 and a mean value of 1.341; whereas, the GOE
has the highest value of 4.303 and the lowest of –0.288 with a standard deviation of 0.885 and a mean
value of 1.557. Finally, the COC has the highest value of 5.044 and the lowest value of –1.044 with a
standard deviation of 1.135 and a mean value of 1.519.

Unit Root Test

Unit root test is the preliminary analysis that needs to be performed to undertake the data analysis
further. This test ensures the stationary properties of the variable used in the study. The Im, Pesaran and

Table 3.  Descriptive Statistics

FDI GDP PS RQ VA GE COC

 Mean 23.10 1110.00 0.870 1.447 1.341 1.557 1.519
 Median 7.93 319.00 0.950 1.394 1.320 1.562 1.444
 Maximum 340.00 14500.00 3.295 4.029 3.390 4.303 5.044
 Minimum –25.30 7.60 –2.578 0.031 –1.267 –0.288 –1.044
 Std Dev. 46.90 2290.00 0.895 0.697 0.688 0.885 1.135
 No. of 630 630 630 630 630 630 630
Observations
Source: The authors.
Raza et al. 9

Table 4.  Stationary Test Results

Im, Pesaran and Shin Levin, Lin and Chu

I(0) I(1) I(0) I(1)
Variables C C&T C C&T C C&T C C&T
GDP –0.246 2.329 –5.550* –6.044* 0.819 0.111 –3.419* –3.740*
LAB 4.108 2.172 –5.766* –4.304* –0.614 1.263 –2.357** –3.279*
CAP –1.205 –0.386 –10.122* –10.203* –0.782 1.241 –8.358* –7.359*
FDI –0.635 –0.378 –3.644* –1.426*** 2.330 0.907 –5.622* –7.256*
COC –0.488 1.985 –9.188* –5.554* 0.413 2.052 –6.852* –7.245*
GOE –1.198 0.137 –12.308* –2.104** 1.768 –0.305 –5.304* –9.179*
POS –0.895 2.632 –6.278* –6.882* 0.475 0.291 –5.122** –4.613*
REQ –0.102 –0.950 –6.828* –7.149* 3.312 0.707 –8.516* –8.153*
VAC –0.178 2.138 –8.294* –8.750* 2.699 –0.358 –9.973* –9.028*
Source: The authors.
Note: *, **, *** indicates significance at 1%, 5% and 10% levels, respectively.

Shin (IPS) and Levin–Lin–Chu (LLC) unit root test are applied to the dataset (Raza & Jawaid, 2014) and
the results are mentioned in Table 4. The result shows that all the variables are non-stationary at the level
and becomes stationary at first difference I(1) which means that the series does not exhibit the unit root
problem and can be used for the further analysis.

Cointegration Test
After the confirmation that the variable series are free from the unit root problem, the next step is to
assess the long run association among the FDI, capital, labour, corruption control, REQ, GOE, VAC,
POS and economic growth. For this purpose, the Pedroni technique has been employed (Raza & Shah,
2017) and the results are reported in Table 5. All in all, the six models, the panel v-statistic, panel rho-
statistic and group rho-statistics show the acceptance of the null hypothesis, whereas the rest four models
(panel PP statistic, panel ADF statistic, group PP statistic and group ADF statistic) show the rejection of
the null hypothesis and accepts the alternative hypothesis which implies that the under-examined
variables are co-integrated in the long run.
The long run association among the variables is also analysed by using the Kao cointegration test, and
the results are mentioned in Table 6. The result also shows the existence of cointegration among all the
variables used in this study.

Long Run Estimation

All the six models developed earlier are analysed by using the fixed effects regression model
(Azam & Raza, 2018). The result of the Hausman test confirms that the fixed effect is preferred over the
random effect model. The result related to all the models is reported in Table 7. In model 1, the nexus
between the FDI, labour, capital and economic growth is tested. The result shows that significant positive
association exists between the examined variables and economic growth. In models 2–6, along with the
labour, capital and the individual determinants of the institutional quality impact are analysed on
economic growth. The corruption control, REQ, POS, GOE, VAC (determinants of institutional quality),
labour and capital have a significant positive effect on the economic growth.
10 Global Business Review

Table 5.  Pedroni (Engle–Granger based) Panel Cointegration

Estimates Stats. Prob.

GDP = f (LAB + CAP + FDI)
Panel v-statistic 2.474 0.993
Panel rho-statistic 5.287 1.000
Panel PP statistic –1.715 0.043
Panel ADF statistic –2.355 0.009
Alternative hypothesis: individual AR coefficient
Group rho-statistic 7.621 1.000
Group PP statistic –2.249 0.012
Group ADF statistic –6.237 0.000
GDP = f (LAB + CAP + COC)
Panel v-statistic –0.895 0.815
Panel rho-statistic 1.282 0.900
Panel PP statistic –2.956 0.002
Panel ADF statistic 0.263 0.604
Alternative hypothesis: individual AR coefficient
Group rho-statistic 3.742 1.000
Group PP statistic –2.462 0.007
Group ADF statistic 1.175 0.880
GDP = f (LAB + CAP + GOE)
Panel v-statistic –3.094 0.999
Panel rho-statistic 2.293 0.989
Panel PP statistic –2.155 0.016
Panel ADF statistic –1.324 0.093
Alternative hypothesis: individual AR coefficient
Group rho-statistic 6.550 1.000
Group PP statistic –2.164 0.015
Group ADF statistic –2.573 0.005
GDP = f (LAB + CAP + POS)
Panel v-statistic –1.301 0.903
Panel rho-statistic 2.040 0.979
Panel PP statistic –1.932 0.027
Panel ADF statistic –1.974 0.024
Alternative hypothesis: individual AR coefficient
Group rho-statistic 4.368 1.000
Group PP statistic –1.251 0.100
Group ADF statistic –2.333 0.010
GDP = f (LAB + CAP + REQ)
Panel v-statistic –1.447 0.926
Panel rho-statistic 2.163 0.985
Panel PP statistic –1.516 0.065
Panel ADF statistic –2.820 0.002
Alternative hypothesis: individual AR coefficient
Group rho-statistic 4.541 1.000
Group PP statistic –2.820 0.002
Group ADF statistic –3.250 0.001

(continued)
Raza et al. 11

Table 5. (continued)

Estimates Stats. Prob.

GDP = f (LAB + CAP + VAC)
Panel v-statistic –3.314 1.000
Panel rho-statistic 2.536 0.994
Panel PP statistic –3.183 0.001
Panel ADF statistic –1.517 0.065
Alternative hypothesis: individual AR coefficient
Group rho-statistic 4.635 1.000
Group PP statistic –0.584 0.280
Group ADF statistic –1.489 0.068
Source: The authors.
Note: The null hypothesis of Pedroni’s (1999) panel cointegration procedure is no cointegration.

Table 6.  Kao Residual (Engle–Granger Based) Panel Cointegration

Estimates Stats. Prob.

GDP = f (LAB + CAP + FDI)
Panel ADF statistic –2.120 0.017
Residual variance 0.001
HAC variance 0.002
GDP = f (LAB + CAP + COC)
Panel ADF statistic –3.127 0.001
Residual variance 0.001
HAC variance 0.001
GDP = f (LAB + CAP + GOE)
Panel ADF statistic –3.383 0.000
Residual variance 0.001
HAC variance 0.002
GDP = f (LAB + CAP + POS)
Panel ADF statistic –3.643 0.000
Residual variance 0.001
HAC variance 0.001
GDP = f (LAB + CAP + REQ)
Panel ADF statistic –2.970 0.002
Residual variance 0.001
HAC variance 0.002
GDP = f (LAB + CAP + VAC)
Panel ADF statistic –3.690 0.000
Residual variance 0.001
HAC variance 0.002
Source: The authors.
Note: The null hypothesis of Kao residual cointegration panel cointegration procedure is no cointegration.

The FDI has a significant positive effect on economic growth, a 1 per cent increase in FDI increases
the economic growth by 0.015 per cent. The result is supported by the studies of Elkomy et al. (2016),
Iamsiraroj (2016) and Raza and Karim (2018). The FDI brings in new technology, innovative ideas and
enhances the knowledge of human capital which improve the economic growth.
Table 7.  Results of Fixed Effect Models of Economic Growth

I II III IV V VI
Variables Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob.
C 18.431 19.961 0.000 17.608 19.566 0.000 16.732 19.245 0.000 18.691 20.615 0.000 17.441 18.696 0.000 18.205 19.895 0.000
LAB 0.463 7.971 0.000 0.540 9.284 0.000 0.590 10.515 0.000 0.471 8.031 0.000 0.551 9.135 0.000 0.498 8.410 0.000
CAP 0.164 5.757 0.000 0.124 4.956 0.000 0.135 5.703 0.000 0.137 5.498 0.000 0.123 4.728 0.000 0.142 5.635 0.000
FDI 0.015 3.819 0.000                              
COC       0.048 7.467 0.000                        
GOE             0.079 10.378 0.000                  
POS                   0.053 7.136 0.000            
REQ                         0.049 4.784 0.000      
VAC                               0.066 5.927 0.000
Adj. R2 0.998 0.998 0.998 0.998 0.998 0.998
F-stats 7118.194 8146.546 8877.344 8078.563 7684.110 7856.281
(prob.) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

Source: The authors.

Table 8.  Results of GMM Models of Economic Growth

I II III IV V VI
Variables Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob.
C 20.265 14.481 0.000 17.124 15.737 0.000 15.472 13.630 0.000 17.538 14.061 0.000 17.099 14.942 0.000 19.128 18.603 0.000
LAB 0.266 2.405 0.017 0.573 8.125 0.000 0.655 8.899 0.000 0.548 6.740 0.000 0.571 7.657 0.000 0.420 6.247 0.000
CAP 0.134 2.936 0.004 0.092 2.495 0.013 0.167 4.707 0.000 0.090 2.389 0.017 0.096 2.539 0.011 0.195 5.785 0.000
FDI 0.036 2.726 0.007                              
COC       0.107 4.209 0.000                        
GOE             0.180 9.993 0.000                  
POS                   0.143 5.805 0.000            
REQ                         0.139 5.897 0.000      
VAC                               0.183 5.666 0.000
Hansen 2.662 0.421 0.139 0.258 2.104 2.662
J-stats. (0.103) (0.516) (0.709) (0.611) (0.147) (0.103)
(prob.)
Adj. R2 0.998 0.998 0.999 0.998 0.998 0.998
Source: The authors.
Raza et al. 13

In all, the six models, the significant positive association exists between the labour, capital and
economic growth. The results are supported by the studies of Tiwari et al. (2011) and Kizilkaya, Ay, and
Akar (2016). This implies that if there is an abundance of competent people in the country, and if they
are used efficiently, then the country’s economic position would be improved. Additionally, with the
presence of human capital there will be an increase in the productivity which will foster the economic
position of the country.
All the determinants of institutional quality show the significant positive association with economic
growth, which is in accordance with the study of Afonso and Jalles (2016) who also reported the same
result. This result implies that the more organized the institutional quality is the greater will be the
economic growth. The economies which are less corrupt, have strong accountability and are politically
stable and more prone to economic growth.

Robustness Check
The result of the fixed effect model is analysed by using the sensitivity GMM estimator. The result
related to GMM is reported in Table 8. The result is consistent in terms of significance and sign, but
different in terms of the coefficient values. The result shows that all the examined variables have a
significant positive association with economic growth. An increase in any variable (FDI, capital, labour,
corruption control, REQ, POS, GOE, VAC) upsurges the economic growth.

Results of Interaction Terms

The result related to the interaction terms of FDI and institutional quality and its impact on economic
growth using a fixed effect model is presented in Table 9. The reason behind this estimation is to explore
the impact of institutional quality on the FDI and economic growth association. The result shows that the
interaction terms of institutional quality factors (REQ, corruption control, POS, GOE, VAC) with FDI
have a significant positive effect on economic growth. The results are supported by the work of Buchanan
et al. (2012) and Jude and Levieuge (2016). Thus, it can be concluded that strong institutional quality,
strengthen the FDI and economic growth association.
The robustness of the above result is analysed by using the GMM estimator. The result is reported in
Table 10 and the result shows the consistent result as shown by the fixed effect model in terms of
significance, and sign but different in terms of the coefficient values.

Granger Causality Test

The result related to the Granger causality test is reported in Table 11. The result shows that the
bi-directional causality exists among the FDI and economic growth, REQ and economic growth. This
implies that FDI and REQ cause the economic growth and the vice versa. Moreover, the unidirectional
causal relationship exists among the COC, POS, VAC, GOE and economic growth. This implies that
these variables cause the economic growth and not vice versa.
Table 12 shows the Granger causality result related to the interaction terms of FDI and institutional
quality on economic growth. The result shows the existence of bidirectional causality between the
interaction terms of FDI with COC, REQ, VAC on economic growth. It implies that the countries which
Table 9.  Results of Fixed Effect Models of Interaction Terms and Economic Growth

I II III IV V VI
Variables Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob.
C 18.431 19.961 0.000 18.137 19.559 0.000 17.417 19.534 0.000 18.939 20.415 0.000 17.896 18.822 0.000 18.617 19.940 0.000
LAB 0.463 7.971 0.000 0.505 8.424 0.000 0.545 9.468 0.000 0.453 7.557 0.000 0.520 8.459 0.000 0.469 7.773 0.000
CAP 0.164 5.757 0.000 0.137 5.258 0.000 0.151 6.085 0.000 0.151 5.860 0.000 0.137 5.093 0.000 0.156 5.978 0.000
FDI 0.015 3.819 0.000                              
FDI*COC       0.021 7.072 0.000                        
FDI*GOE             0.032 10.015 0.000                  
FDI*POS                   0.024 7.272 0.000            
FDI*REQ                         0.023 5.244 0.000      
FDI*VAC                               0.032 6.555 0.000
Adj. R2 0.998 0.998 0.998 0.998 0.998 0.998
F-stats 7118.194 7592.208 8297.497 8078.563 7276.352 7493.369
(prob.) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Source: The authors.

Table 10.  Results of GMM Models of Interaction Terms and Economic Growth

I II III IV V VI
Variables Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob. Coeff. T-stats Prob.
C 20.265 14.481 0.000 18.095 16.847 0.000 16.052 13.043 0.000 18.211 14.498 0.000 17.819 15.340 0.000 19.707 18.911 0.000
LAB 0.266 2.405 0.017 0.514 7.361 0.000 0.624 8.156 0.000 0.508 6.202 0.000 0.526 6.952 0.000 0.383 5.617 0.000
CAP 0.134 2.936 0.004 0.080 2.087 0.038 0.156 4.541 0.000 0.086 2.316 0.021 0.092 2.383 0.018 0.192 5.731 0.000
FDI 0.036 2.726 0.007                              
FDI*COC       0.046 4.010 0.000                        
FDI*GOE             0.063 4.048 0.000                  
FDI*POS                   0.053 5.404 0.000            
FDI*REQ                         0.062 5.939 0.000      
FDI*VAC                               0.084 6.069 0.000
Hansen 2.662 0.109 0.009 1.990 0.698 1.553
J-stats. (0.103) (0.741) (0.924) (0.158) (0.403) (0.213)
(prob.)
Adj. R2 0.998 0.998 0.999 0.999 0.998 0.998
Source: The authors.
Raza et al. 15

Table 11.  Results of Panel Granger Causality Test

Variables F-stats Prob.

GDP does not Granger cause FDI 9.204 0.000
FDI does not Granger cause GDP 2.784 0.041
GDP does not Granger cause COC 1.748 0.187
COC does not Granger cause GDP 15.195 0.000
GDP does not Granger cause GOE 1.412 0.235
GOE does not Granger cause GDP 37.393 0.000
GDP does not Granger cause POS 0.987 0.374
POS does not Granger cause GDP 8.657 0.000
GDP does not Granger cause REQ 55.115 0.000
REQ does not Granger cause GDP 16.095 0.000
GDP does not Granger cause VAC 0.054 0.816
VAC does not Granger cause GDP 17.379 0.000
Source: The authors.
Note: The lag length of all focus variables is 1.

Table 12.  Results of Panel Granger Causality Test (interaction terms)

Variables F-stats Prob.

GDP does not Granger cause FDI × COC 1.951 0.051
FDI ´ COC does not Granger cause GDP 34.018 0.000
GDP does not Granger cause FDI × GOE 0.420 0.675
FDI ´ GOE does not Granger cause GDP 2.315 0.021
GDP does not Granger cause FDI × POS 0.684 0.494
FDI ´ POS does not Granger cause GDP 26.289 0.000
GDP does not Granger cause FDI × REQ 2.016 0.044
FDI ´ REQ does not Granger Cause GDP 21.776 0.000
GDP does not Granger cause FDI × VAC 2.391 0.017
FDI ´ VAC does not Granger cause GDP 40.459 0.000
Source: The authors.
Note: The lag length of all focus variables is 1.

have strong corruption and regulatory control with a defined VAC will more likely to have greater FDI
and economic growth. Further, the economic growth is more in the countries that are less corrupt and
have high accountability. Whereas, a unidirectional causal relationship exists between the interaction
terms of FDI with GOE, POS and economic growth. This implies that these variables cause the economic
growth, however, economic growth does not lead GOE and POS.

Conclusion and Managerial Implications

The main purpose of this research is to analyse the association among the FDI, capital, labour and five
determinants of institutional quality on the economic growth in the OECD countries. The data taken for
the study is comprised of the years 1996–2013. For the purpose of this study, the fixed effect model and
the GMM estimator were used. The result concluded that all the variables have a significant positive
association with economic growth. Moreover, the interaction terms were also developed which also
16 Global Business Review

show the same positive effect on economic growth. It can be concluded from the above results that the
more the countries maintain their institutional quality the better will be the economic growth and the FDI
inflows.
This result gives valuable policy implications which the government should use to improve their
economic growth. The government of the OECD countries should focus on maintaining as well as
improving the institutional quality in order to improve the FDI inflows and economic growth. Further,
the policymakers should draft effective government policies that can improve the institutional quality
measures. The radical changes should also be made in the laws related to the corruption so as to improve
the regulatory control.
The corruption can be controlled by making the government spending behaviour transparent. Anybody
who is found in the process of corruption should be penalized. Moreover, a regulatory committee should
be formed to monitor the regulation quality and to bring the changes as and when required. Further, the
government should also improve its VAC by giving rights to its citizens to express their views effectively.
When the citizens are free to share their views, they can demand accountability, transparency and they
can influence the government priorities and processes. If the citizens of the nation have the power to
make their government accountable for their actions, then the government will be more prone to fulfil
the demands and needs of their people which will eventually improve the economic performance.
In order to bring the positive effect of FDI inflows, the government should work with the foreign
firms and provide them safe and secure business environment. As FDI brings in innovation, the
government should also focus on the efficient allocation of the resources because it will help the firms to
innovate and ultimately result in economic growth.

Limitations and Future Directions

This research work has some limitations which give direction to the future researchers. First, this research
only focuses the OECD countries, so the results are not generalizable. Hence, the future research can be
done by using a single country like Pakistan, USA, etc. Moreover, a comparative study can also be
carried out. Second, this study takes the data from 1996–2013, so future research can be done by
increasing the sample size. Third, this study takes capital and labour as a control variable so future
research can be conducted by adding more variables.

Acknowledgement
The authors are grateful to the anonymous referees of the journal for their extremely useful suggestions to improve
the quality of the article.

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of
this article.

Funding
The authors received no financial support for the research, authorship and/or publication of this article.

Weblinks
https://www.oecd-ilibrary.org/finance-and-investment/fdi-stocks/indicator/english_80eca1f9-en
http://www.oecd.org/industry/inv/investment-policy/FDI-in-Figures-April-2018.pdf
Raza et al. 17

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