Financial development, foreign direct investment and

Int. J. Economic Policy in Emerging Economies, Vol. 7, No. 1, 2014

77

Financial development, foreign direct investment and economic growth in Sri Lanka Athambawa Jahfer* Department of Accountancy and Finance, Faculty of Management and Commerce, South Eastern University of Sri Lanka, P.O. Box-01, University Park, Oluvil # 32360, Sri Lanka E-mail: [email protected] *Corresponding author

Tohru Inoue Graduate School of International Social Sciences, Yokohama National University, 79-4 Tokiwadai, Hodogaya-ku, Yokohama City, Japan E-mail: [email protected] Abstract: This paper examines the relationship between the financial development, foreign direct investment and economic growth in Sri Lanka using quarterly data over the period 1996 to 2011. Johansen co-integration technique and vector error correction model are used to investigate the relationships. The results demonstrate that there is a long-run equilibrium relationship and that there is bi-directional causality between the financial development and economic growth. Further, economic growth and financial development causes foreign direct investment, but no strong evidence that FDI causes economic development. Moreover, major implication of our findings is that financial development matters for the economic growth of Sri Lanka than foreign direct investment. Keywords: financial development; foreign direct investment; FDI; economic growth; Sri Lanka. Reference to this paper should be made as follows: Jahfer, A. and Inoue, T. (2014) ‘Financial development, foreign direct investment and economic growth in Sri Lanka’, Int. J. Economic Policy in Emerging Economies, Vol. 7, No. 1, pp.77–93. Biographical notes: Athambawa Jahfer is a Senior Lecturer in the Faculty of Management and Commerce, South Eastern University of Sri Lanka, Sri Lanka. He has been teaching financial management, investment valuation, accounting, etc., since 1997. His research interest includes financial market development, capital market, investor behaviour, capital market efficiency, and monetary economics. He received his PhD in Business Administration from Yokohama National University, Japan in 2006. He was a Visiting Research Fellow in the same university (June 2012 to May 2013). He has published articles in reputed national as well as international journals and presented papers in national and international conferences.

Copyright © 2014 Inderscience Enterprises Ltd.

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A. Jahfer and T. Inoue Tohru Inoue is a Professor in the Graduate School of International Social Sciences, Yokohama National University. He has been teaching econometrics, macroeconomics, finance, etc. His research interest includes monetary economics, capital market, corporate finance, and economic growth. He received his Mater in Economics from Osaka University, Japan. He has published articles in reputed national as well as international journals and presented papers in national and international conferences.

1

Introduction

Although the relationship between financial development, foreign direct investment (FDI) and economic growth has been comprehensively in the theoretical and empirical literature, specific studies addressing the links between financial development, FDI and economic growth are very scant in Sri Lanka. The study on the relationship between financial development and economic growth goes back to the work of Schumpeter (1911). The endogenous growth literature (Lucas, 1988; Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991) stressed that financial development is an important factor for the long run economic growth. It has been argued that the financial development enhances economic growth by enabling efficient inter temporal allocation of resources, capital accumulation and technological innovation.1 Meanwhile, there are large number of empirical studies on the relationship between FDI and economic growth, have so far yielded mixed results on whether FDI contributes positively to economic growth (e.g., Balasubramanyam et al., 1996; Borensztein et al., 1998; Hansen and Rand, 2006, Ayadi, 2010; Feng, 2009). It is also widely recognised that FDI produces economic growth to the recipient countries by providing capital, foreign exchange, technology and by enhancing competition and access to foreign markets (Crespo and Fontura, 2007; Romer, 1993; Uttama and Peridy, 2010; Chung, 2009). Tsaurai and Odhiambo (2012) show that there is a distinct causal flow from economic growth to FDI in Zimbabwe. Thus countries, where investment demand is higher compared to their domestic savings rate, may be able to invest in their priority sectors and thus achieve faster economic growth by importing capital from abroad in the form of FDI. However, more recent studies have shown that the positive growth impact of FDI is dependent on the extent of financial sector development in host countries. Hermes and Lensink (2003), Alfaro et al. (2004) among others, have provided empirical evidence supporting this proposition. This paper mainly investigates the relationship between economic growth, financial developments, and FDI, while contributing to the existing literature by linking the financial development, FDI for the economic growth with reference to Sri Lanka. The rest of paper is organised as follows: Section 2 presents Sri Lanka’s financial development, FDI and economic growth. Literature review is summarised in Section 3. Section 4 describes the data and methodology. Section 5 presents empirical evidence of the study while summary and conclusions are presented in Section 6.

Financial development, foreign direct investment and economic growth

2

79

Financial development, FDI and economic growth in Sri Lanka

2.1 Financial development After open economic policy in 1977, there were changes in the Sri Lanka’s financial sector which improved financial sector significantly. Changes to the financial system included establishment of new branches of foreign banks and off-shore banking units and an increase in the number of privately-owned domestic banks, instruments and better monitoring role by the regulators. The policy reform took place in 1977 includes trade liberalisation, a significant exchange rate realignment, financial market reform, export promotion, new incentives for foreign investors, limits on public sector participation in the economy and encouragement of the expansion of private sector activity, and the removal of price controls and government monopolies in domestic trade (Cuthbertson and Athukorala, 1990). The banking sector is the dominant player in the financial sector accounting for 55% of the total assets of the financial sector. The activities of the banking sector further accelerated through an extended banking network and credit expansion with strengthened risk management practices as depicted in the improved asset quality, healthy liquidity ratios, adequate profitability and high quality capital levels ensuring sufficient risk absorption capacity. The banking sector consists of 12 domestic licensed commercial banks, including two state-owned banks, 12 foreign banks and nine licensed specialised banks. One of the new banks was established to offer Islamic banking services in Sri Lanka and is expected to introduce new mechanisms to further increase financial inclusion. The banking network increased to 6,122 outlets (including 12 overseas outlets) and 2,240 automated teller machines (ATMs) (Annual Report of the Central Bank of Sri Lanka, 2011). The Finance Business Act, No. 42 of 2011 (FBA) was enacted on 09.11.2011 repealing and replacing the Finance Companies Act, No. 78 of 1988 (FCA) to further strengthen the regulation and supervision of Licensed Finance Companies (LFCs) and to curb unauthorised finance businesses. Due to the significant developments that have taken place in the financial sector over the past two decades, there has also been an immense need for a new legislation to address the lacunas of the FCA to ensure the safety and soundness of the financial system. Since 1997, the Central Bank of Sri Lanka, while eliminating the credit control and administratively determined bank rate was gradually abandoned. The floating of the exchange rate in 2001 added to the operational independence of monetary policy. Figure 1 shows the trends of GDP, domestic credit, credit to private sector, money supply, quasi money and money during the period 1996–2011 in Sri Lanka. Financial depth in Sri Lanka shows a significant improvement during the period 1996–2011.

2.2 Foreign direct investment After economic liberalisation in 1977, investment policies have been engineered to attract FDI inflow to Sri Lanka. FDI inflows have been significantly increased during the last three decades from US $47 million in 1979 to US $956 million in 2011. Figure 2 shows the trend of FDI inflows during the period 1978–2011 in Sri Lanka. It was less than US $200 during the period 1978 to 1996. Then the FDI inflow went up to US $400. From 2006–2010, FDI flows to Sri Lanka averaged about $500 million per year. However,

80

A. Jahfer and T. Inoue

Sri Lanka’s FDI is around US $1 billion in 2011 and Sri Lanka’s investment board had indicated with a stated target of US $1.75 billion in FDI being set for the end of 2012. The end of Sri Lanka’s long-running civil war in May 2009 has opened a new era of economic opportunities and rebounding economic growth. The Government of Sri Lanka (GSL) has set very ambitious goals for economic development, aspiring to GDP growth rates over 8%, and developing economic hubs in ports, aviation, commercial, knowledge and energy. Sri Lanka also provides very strong prospects in tourism and infrastructure. Sri Lanka’s strong prospects for economic growth have attracted the interest of foreign investors. Leading sources of FDI in Sri Lanka are Malaysia, the UK, the USA, Singapore, India, China, the UAE, and Korea. Figure 1

GDP, domestic credit, claims to private sector, M2, QM, M1 in Sri Lanka (see online version for colours) 3,500,000 3,000,000 GDP

Rupees in

2,500,000

DC

2,000,000

M2

1,500,000

M1

1,000,000

CPS

500,000

QM

1996.1 1996.4 1997.3 1998.2 1999.1 1999.4 2000.3 2001.2 2002.1 2002.4 2003.3 2004.2 2005.1 2005.4 2006.3 2007.2 2008.1 2008.4 2009.3 2010.2 2011.1 2011.4

‐

Notes: GDP – nominal GDP; DC – domestic credit; M2 – money supply; M1 – money; CPS – credit to private sector; QM – quasi money Source: International Financial Statistics (IFS-2012) published by the International Monetary Fund and the annual and quarterly reports of Central Bank of Sri Lanka Figure 2

FDI in Sri Lanka (see online version for colours)

1,000 800 600

FDI US$

400 200

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

0

1978

US $ in Million

1,200

Source: International Financial Statistics (IFS-2012) published by the International Monetary Fund


81

2.3 Economic growth In spite of years of civil war, the country has recorded strong growth rates in recent years. Sri Lanka is poised for economic growth. Despite the 1983–2009 civil war, GDP growth averaged around 5% from 1996–2008. Due to the civil war and global recession and escalation of fighting during the final stages of the war, GDP growth was negative 1.55% in 2001 and slowed to 3.5% in 2009. Economic activity rebounded strongly with the end of the war and an IMF agreement resulting in two straight years of 8% growth in 2010 and 2011. The gross domestic product (GDP) in Sri Lanka was worth Rs. 6,542,663 million in 2011, it was Rs. 42,665 million in 1978. According to a report published by the World Bank in 2012, the GDP value of Sri Lanka is roughly equivalent to 0.10% of the world economy. Sri Lanka is now a lower-middle income developing nation with a GDP of about $59 billion. This translates into a per capita income of about $2,800, among the highest in the region. The main sectors of the Sri Lanka’s economy are tourism, tea export, apparel and textile, and rice production. Remittances also constitute an important part of country’s revenue. Figure 3 shows the trends of GDP in million rupees during the period 1978–2011. Figure 3

Trend of GDP in Sri Lanka (see online version for colours) 7,000,000

Rupees in Million

6,000,000 5,000,000 4,000,000 3,000,000

GDP (current LCU)

2,000,000 1,000,000

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

0

3

Literature review

The contribution of the financial markets to growth has received considerable attention with the emergence of the endogenous growth theory. Hermes and Lensink (2003) studied the foreign capital inflow and financial development as a channel for the economic growth and found that both have positive spillover efficiency and significant impact on economic growth, if the domestic financial sector has achieved certain level of development. According to Edison et al. (2002), more developed financial system is better able to effectively absorb capital inflows, especially if these flows are fungible. Bhanumurthy and Singh (2013) studied the trend and determinants in the Indian states and found that there is a long run relationship between financial variables and the growth. Thus, financial development might help explain possible divergent outcomes across

82


countries with different incomes. Cross-country studies (Roubin and Salia-i-Martin, 1992; Easterly and Rebelo, 1993; De Gregorio and Guidotti, 1995; Khan and Senhadji, 2003; Andersen and Tarp, 2003) lend credence to financial development having a positive effect on long-run economic growth. Sheera and Bishnoi (2012) studied the financial deepening in newly industrialised economies in Asian region and found that market-based system is boosting the overall financial system of Singapore whereas the financial systems of China, Hong Kong and Korea are equally attended by both types of environment. Further, Levine and Zervos (1998), Beck et al. (2000) and Rajan and Zingales (2001) gave empirical evidence supporting the hypothesis that financial development enhances economic growth. Empirical studies (Hermes and Lensink, 2003; Omran and Bolbol, 2003; Choong and Lim, 2009) on the tri-variate relationship between financial development, FDI and economic growth, focused on the role of financial development in enhancing the positive relationship between FDI and economic growth, but failed to examine the extent of causality between these variables. Ahmed and Ansari (1998) investigated the relationship between financial sector development and economic growth for three South-Asian economics, namely, India, Pakistan, and Sri Lanka using standard Granger causality tests and Cobb-Douglas production function framework and concluded that financial development causes economic growth. Demetriades and Hussein (1996) show that Sri Lanka’s economic growth causes financial development and to a lesser extent, financial development leads to its economic growth. Macri and Sinha (2001), using multivariate causality tests on first differenced variables which are stationary, suggest that there is hardly any evidence of causality between financial development and economic growth in any direction for Sri Lanka. Abma and Fase (2003) have investigated how the financial intermediation matters for growth for nine selected Asian countries using Granger causality test and regression analysis. They have found non-significant relationship between finance and growth for Sri Lanka. Hemachandra (2005) concludes that banking sector financial deepening has had positive implications on the growth of the Sri Lankan economy. In Sri Lanka, FDI has increased significantly after liberalisation. Previous studies found a positive link between FDI and economic growth. Athukorala and Karunaratne (2004) examined the impact of FDI on the economic development of Sri Lanka using co-integration and ECM models over the period 1959–2002. The study was based on the FDI-led growth hypothesis. They found that the direction of causality was not towards FDI to GDP growth. Further, the impact of domestic investment and trade liberalisation was found to have a positive effect on GDP growth. The literature on FDI suggests that inflows of FDI can exert a positive influence on economic growth through the transfer of new technology and spillover efficiency. However, such a positive impact does not occur automatically, but rather, it depends on the absorptive capacity of the recipient country.

4

Data and methodology

4.1 Data source In this study, we use quarterly data for the Sri Lanka economy for the period 1996 to 2011 and collected mainly from International Financial Statistics (IFS-2012) published by the International Monetary Fund and the reports of Central Bank of Sri Lanka. Due to


83

unavailability of data on GDP, our analyses are restricted from 1996. Data on GDP were collected from the reports of Central Bank of Sri Lanka. Data on money supply (M2), quasi money (QM), credit to private sector (CPS), domestic credit (DC), foreign direct investment (FDI), and openness (OPEN) were collected from International Financial Statistics published by International Monetary Fund. Following common practice in the literature, the FDI is measured as inflow of FDI. We employ four commonly used measures of financial development in order to see the association of financial development with economic growth and, further, to examine the sensitivity of the results.2 First one is the credit to the private sector to nominal GDP (CPSGDP). This measure has been used extensively in numerous works (Beck et al., 2000; Demetriades and Hussein, 1996; King and Levine, 1993, among others). Calderon and Liu (2003) suggest that this indicator has an advantage as it takes into account the credits to private sector only and isolates the credits channelled to public sector and credits from central bank. We feel that this measure is much relevant proxy for financial market development of Sri Lanka, since it is one of the developing countries. Second measure we use the quasi money to GDP (QMGDP) which is an alternative measure for M2. Because, in developing countries, a large part of M2 stock consists of currency held outside banks. As such, an increase in the M2/GDP ratio may reflect an extensive use of currency rather than an increase in bank deposits, and for this reason this measure is less indicative of the degree of financial intermediation by banking institutions. An increase in M2/GDP may also indicate a capital flight out of a country, therefore negatively affecting economic growth. This measure had been used by King and Levine (1993), Demetriades and Hussein (1996) and Abu-Bader and Abu-Qarn (2008). Third measure is the M2GDP, represents ratio of money supply (M2) to nominal GDP. M2GDP has been used as a standard measure of financial development in numerous studies (for example: Calderon and Liu, 2003; King and Levine, 1993). Total credit to nominal GDP (DCGDP) is used as a fourth measure. King and Levine (1993) measure financial development by using the ratio of gross claims on the private sector to GDP, which includes credits issued by the monetary authority and government agencies. Even though we use four variables as proxies for the financial development, our main proxy for the financial development is CPSGDP. Economic growth is measured by the change in real GDP. All the data were transferred to natural logarithms for conventional statistical reasons. Figures 4 and 5 show the patterns of key variables on financial development and FDI used for study over the period 1996–2011. We also incorporated the openness measure, calculated as the sum of exports and imports as a ratio of nominal GDP (OPENGDP). Goswami (2013) examined the dynamic impact of financial development and trade openness on economic growth among five major South Asia countries and found that the existence of long-run relationship between economic growth, trade openness and financial development. Dash and Sharma (2010) investigated the interrelationship between export and FDI and the causal linkage with import and FDI among four major South Asian countries, namely India, Bangladesh, Sri Lanka and Pakistan. And show that there is a bi-directional causality between FDI and trade. Historically, Sri Lanka reported a trade deficit. We can observe from the Figure 6, which shows very clearly about the trade deficit. The level of openness changed significantly after the late 1970s. The first phase of trade policy was characterised by inward-looking economic strategies, which then gave way to free market economic strategies. This structural change had a significant influence on economic performance; hence, this policy change is considered for the empirical model. Sri Lanka exports mostly textiles and garments (40% of total exports) and tea (17%). Others

84


include: spices, gems, coconut products, rubber and fish. Main export partners are USA, UK, Germany, Belgium and Italy. Sri Lanka imports petroleum, textile fabrics, foodstuffs and machinery and transportation equipment. Main import partners are India, China, Iran and Singapore. Figure 4

Behaviour of key variables on financial development (see online version for colours) 7

Percent

6 5

M2/GDP

4

MM M1/GDP

3

DC/GDP 2

CPS/GDP

1

QM/GDP

1996.1 1996.4 1997.3 1998.2 1999.1 1999.4 2000.3 2001.2 2002.1 2002.4 2003.3 2004.2 2005.1 2005.4 2006.3 2007.2 2008.1 2008.4 2009.3 2010.2 2011.1 2011.4

0

Source: Computed from International Financial Statistics (IFS-2012) published by the International Monetary Fund and the annual and quarterly reports of Central Bank of Sri Lanka Figure 5

Behaviour of FDI (see online version for colours)

FDI/GDPN 12%

8% 6% 4%

FDI/GDPN

2% 0%

1996.1 1996.4 1997.3 1998.2 1999.1 1999.4 2000.3 2001.2 2002.1 2002.4 2003.3 2004.2 2005.1 2005.4 2006.3 2007.2 2008.1 2008.4 2009.3 2010.2 2011.1 2011.4

Percent

10%

Source: Computed from International Financial Statistics (IFS-2012) published by the International Monetary Fund and the Annual and quarterly reports of Central Bank of Sri Lanka

Financial development, foreign direct investment and economic growth Figure 6

85

Trend of exports and imports (see online version for colours) 60%

Percent

50% 40% 30% EXGDP 20%

IMGDP

10%

1996 Q1 1996 Q4 1997 Q3 1998 Q2 1999 Q1 1999 Q4 2000 Q3 2001 Q2 2002 Q1 2002 Q4 2003 Q3 2004 Q2 2005 Q1 2005 Q4 2006 Q3 2007 Q2 2008 Q1 2008 Q4 2009 Q3 2010 Q2 2011 Q1 2011 Q4

0%

Source: Computed from International Financial Statistics (IFS-2012) published by the International Monetary Fund and the Annual and quarterly reports of Central Bank of Sri Lanka

4.2 Empirical model specification In order to investigate the effect of financial development (FD) and FDI on economic growth (GDP), co-integration test and vector error correction model (VECM) are applied. Since macroeconomic time series data contain unit root, variables used in the study are tested for stationary before running causality tests. For this purpose, unit roots are tested using augmented Dickey-Fuller (ADF) (Dickey and Fuller, 1979) test. After confirming that the variables are integrated of order one, then it is tested the existence of co-integration relationship between the variables. The co-integration tests were done among the variables using the Johansen (1998) co-integration tests. Since Johansen co-integration is sensitive to the lag length, we used Schwarz information criterion to determine the appropriate number of lag. If co-integration detected between variables, then it is known that there exists a long term equilibrium relationship between them. So, we can estimate VECM with variables. The equation forms for VECM are as follows. Trade openness has been included as an additional variable in this study. To test whether financial development and FDI Granger-causes economic growth, the following VECM is estimated. n

ΔGDPt = λ10 +

∑

n

∑λ

λ11i ΔGDPt −i +

12 i ΔFDI t − i

i =1

i =1

n

+

∑λ

13i ΔFDt − i

i =1

(1)

n

+

∑λ

14 i ΔOPEN t − i

+ λ15 ECTt −1 + μt

i =1

In order to investigate opposite hypothesis that economic growth and FDI granger-causes the financial development following equations is estimated

86

A. Jahfer and T. Inoue n

ΔFDt = λ20 +

∑

n

λ21i ΔFDt −i +

i =1

22i ΔFDI t − i

i =1

n

+

∑λ

(2)

n

∑λ

23i ΔGDPt − i

+

i =1

∑λ

24i ΔOPEN t − i

+ λ25 ECTt −1 + μt

i =1

In the same way to investigate the hypothesis that economic growth and the financial development granger-causes FDI following equations is estimated n

ΔFDI t = λ30 +

n

∑

λ31i ΔFDI t −i +

i =1

32i ΔFDt − i

i =1

n

+

∑λ

(3)

n

∑λ

33i ΔGDPt − i

+

i =1

∑λ

34i ΔOPEN t − i

+ λ35 ECTt −1 + μt

i =1

where ECTt–1 is the lagged value of the error correction term (ECT), μt is white noise error terms, Δ is the first-difference of the variable, GDP is the change in real GDP, FDI is the FDI, FD is the financial development, OPEN is the trade openness.

5

Empirical results

5.1 Unit root test As a first step, to check the stationarity of the variables, the ADF test was employed. The test is conducted with intercept only and intercept and trend respectively on the level and first differences of the variables. The results of ADF test are given in Table 1. FDI is stationary in both its level and first difference at 1% significant level. Also, the variables GDP and money multiplier are weakly significant at its level under intercept and trend and intercept respectively. However, all variables are stationary on first differencing. Thus, variables are stationary and integrated of same order I (1). Table 1

ADF unit root test results Level

First difference

Variables

Test with intercept

Test with trend and intercept

Test with intercept


CGDPR

-2.826*

–2.974

–20.434***

–20.237***

(3)

(3)

(2)

(2)

–5.897***

–7.747***

–8.973***

–8.905***

(0)

(0)

(1)

(1)

–1.849

–2.444

–8.649***

–8.575***

(4)

(4)

(2)

(2)

FDI/GDP CPS/GDP

Number of observations (after adjustments)

Notes: ***, **, * indicates significance at the 1%, 5% and 10% level respectively. Critical values with intercept and trend and intercept are for all tests are –3.546, –2.912, –2.594 and –4.121, –3.488, –3.172 at the 1%, 5% and 10% levels of significance in that order. The numbers within bracket indicates number of lags which are selected based Schwarz information criterion.

59 61 61

Financial development, foreign direct investment and economic growth Table 1

ADF unit root test results (continued) Level

First difference

Test with intercept


Test with intercept


QM/GDP

–1.808

–2.130

–3.960***

–4.094***

(4)

(4)

(4)

(4)

OPEN/GDP

–0.5387

–2.587

–9.909***

–7.039***

(0)

(0)

(0)

(2)

–1.978

–2.027

–3.544**

–3.528**

(4)

(4)

(3)

(3)

–1.342

–2.122

–3.405**

–3.509**

(4)

(4)

(3)

(3)

Variables

87

DCGDP M2GDP

Number of observations (after adjustments) 58 60 62 59

Notes: ***, **, * indicates significance at the 1%, 5% and 10% level respectively. Critical values with intercept and trend and intercept are for all tests are –3.546, –2.912, –2.594 and –4.121, –3.488, –3.172 at the 1%, 5% and 10% levels of significance in that order. The numbers within bracket indicates number of lags which are selected based Schwarz information criterion.

5.2 Co-integration tests Having confirmed that all variable are integrated of order (1), the co-integration tests were done among the variables using the Johansen’s co-integration tests to investigate long-term equilibrium relationship among the variables. Number of lags is selected using an optimal lag structure in the unrestricted VAR. Johansen’s approach derives two likelihood estimators for the co-integration rank: a trace test and a maximum Eigen value test. Table 2 presents summarised co-integration results between the variables. Co-integration results indicate the existence of long-run association between financial development, FDI and economic growth in Sri Lanka.4 Therefore, VECM can be used to investigate the relationships among the selected variables. Table 2

Johansen co-integration test results – FDI, economic growth and financial development

Hypothesised no. of CE(s)

Trace test Test statistic

Critical value 5%

Maximum eigenvalue test Prob.**

Test statistic

Critical value 5%

Prob.**

i. GDPR, FDI, CPS and OPEN None*

84.04789

47.85613

0.0000

47.83636

27.58434

0.0000

At most 1*

36.21153

29.79707

0.0079

23.91991

21.13162

0.0197

At most 2

12.29162

15.49471

0.1435

7.110816

14.26460

0.4761

At most 3*

5.180805

3.841466

0.0228

5.180805

3.841466

0.0228

Notes: * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis p-values

88


Table 2

Johansen co-integration test results – FDI, economic growth and financial development (continued)

Hypothesised no. of CE(s)

Trace test

Maximum eigenvalue test

Test statistic

Critical value 5%

Critical value 5%

Prob.**

None*

55.27051

47.85613

0.0086

28.08352

27.58434

0.0432

At most 1

27.18698

29.79707

At most 2

8.293420

15.49471

0.0971

18.89356

21.13162

0.1000

0.4346

5.064485

14.26460

0.7337

At most 3

3.228935

3.841466

0.0723

3.228935

3.841466

0.0723

None*

66.76705

47.85613

0.0003

37.82735

27.58434

0.0017

At most 1

28.93970

29.79707

0.0625

21.91429*

21.13162

0.0388

At most 2

7.025408

15.49471

0.5747

4.208773

14.26460

0.8367

At most 3

2.816634

3.841466

0.0933

2.816634

3.841466

0.0933

27.58434

0.0000

Prob.**

Test statistic

ii. GDPR, FDI, QM and OPEN

iii. GDPR, FDI, M2 and OPEN

iv. CGDPR, FDI, DC and OPEN None*

83.41950

47.85613

0.0000

53.71110

At most 1

29.70840

29.79707

0.0512

21.64667*

21.13162

0.0423

At most 2

8.061730

15.49471

0.4588

7.000307

14.26460

0.4891

At most 3

1.061424

3.841466

0.3029

1.061424

3.841466

0.3029

Notes: * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis p-values

5.3 Vector error correction model Since the variables are co-integrated, there are long term relationships among the variables under consideration. Table 3 presents summary results of VECM with respect to GDP, FDI, indicators of financial development and openness under the three models. The estimated ECTs are negative and highly significant in model 1 and 2. These results are supporting the co-integration among the variables represented by model. However, in model 3, the estimated ECT is negative and significant when we use quasi money as a proxy for financial development only.5 According to the VECM results, coefficients of financial development proxies are major interest. In model 1, coefficient of credit to private sector is 1.23 and significant at the 1% level. This magnitude implies that 1% increase in credit to private sector will increase GDP by 123% in the long run. Coefficient of quasi money is 0.67, which is significant at the 5% level. This magnitude implies that 1% increase in quasi money will increase GDP by 67% in the long run. Coefficient of money supply is 0.96, which is also significant at the 1% level. This magnitude implies that 1% increase in money supply will increase GDP by 96% in the long run. When we use total domestic credit as a measure of financial development, the co-integration coefficients are not significant, even though ECT is negative and significant. In the case of FDI, the coefficient of FDI is 0.14, which is significant at the 5% level when we use the quasi money as a measure of financial development. This magnitude implies that 1% increase in FDI will increase GDP by 14%


89

in the long run. Compared to quasi money, contribution of FDI for economic growth is very less. In other cases the coefficients of FDI are insignificant. It is also observed that openness affects GDP negatively at 1% level significantly in the model 1. The reason for the negative effect on GDP shall be trade deficit during the period in Sri Lanka. Figure 6 shows very clearly about the trade deficit. According to the model 2, it is observed significant results that economic growth causes the financial development in all equations. And when QM and M2 were used as measure for financial development, FDI is also causes financial development. In the model 3, ECT is significant and negative only with quasi money as financial development measure. And it reveals that economic growth and financial market development causes the FDI. Table 3

Results of VECM a. Model 1: dependent variable – GDP

GDP, CPS, FDI, OPEN

GDP, QM, FDI, OPEN

GDP, M2, FDI, OPEN

GDP, DC, FDI, OPEN

CGDPR (–1) 1.000 CGDPR (–1) 1.000 CGDPR (–1) 1.000 CGDPR (–1) 1.000

CPSGDPN (–1) FDIGDPN (–1) OPENGDP (–1)

ECT

–1.229

0.098

0.0827

–1.902

(–4.134)***

(1.977)

(4.465)***

(–7.704)***

QMGDPN (–1) FDIGDPN (–1) OPENGDP(–1)

ECT

–0.676

–0.1355

0.0249

–1.1358

(–2.170)**

(–2.202)**

(1.665)

(–3.935)***

M2GDPN (–1) FDIGDPN (–1) OPENGDP(–1)

ECT

–0.961

–0.0376

0.055

–1.947

(–3.994)***

(–0.942)

(4.089)***

(–5.492)***

CPSGDPN (–1) FDIGDPN (–1) OPENGDP(–1)

ECT

–0.259

–0.051

0.021

–1.757

(–1.038)

(–0.991)

(1.495)

(–5.611)***

b. Model 2: dependent variable – financial development CPS, GDP, FDI,OPEN

QM, GDP, FDI, OPEN

M2, GDP, FDI, OPEN

DC, GDP, FDI, OPEN

CPSGDPN (–1) 1.000

CGDPR (–1)

FDIGDPN (–1) OPENGDP (–1)

ECT

–0.813

–0.080

–0.067

–0.325

(–7.064)***

(–2.139) **

(–8.673)***

(–5.560)***

QMGDPN (–1)

CGDPR (–1)


1.000

–1.479

0.201

–0.0368

–0.092

(–3.609)***

( 2.084)**

(–1.933)*

(–2.587)***


ECT

M2GDPN (–1)

CGDPR (–1)

1.000

–1.040

0.039

–0.057

–0.218

(–6.017)**

( 0.890)

(–6.575)***

(–3.444)***


ECT

DCGDPN (–1)

CGDPR (–1)

1.000

–3.864

0.196

–0.081

–0.0567

ECT

(–5. 962)***

(0.988)

(–1.944)

(–3.225)***

90


Table 3

Results of VECM (continued) c. Model-3: dependent variable – FDI

FDI, GDP, FDIGDPN (–1) CPS, OPEN 1.000

CGDPR (–1) 10.132

–12.457

0.839

0.046

(–4.456)

(5.304)

( 0.827)

FDIGDPN (–1)

CGDPR (–1)

1.000

–7.381

FDI, GDP, M2, OPEN

FDIGDPN (–1)

CGDPR (–1)

(–3.772)***

FDI, GDP, DC, OPEN

ECT

( 7.039) FDI, GDP, QM, OPEN

1.000

CPSGDPN (–1) OPENGDP (–1)

QMGDPN (–1) OPENGDP (–1)

ECT

4.991

–0.1837

–0.192

(2.147)**

( –1.800)

(–2.457)**

M2GDPN (–1) OPENGDP (–1)

ECT

–26.603

25.571

–1.465

–0.042

(–5.999)

(3.764)

(–3.832)

(–1.449)

FDIGDPN (–1)

CGDPR (–1)

1.000

–19.729

CPSGDPN (–1) OPENGDP (–1) 5.106

–0.411

–0.053

ECT

(–5.901)

(1.026)

–1.590

(–1.822)

In sum, the results demonstrate strong evidence that there is bi-directional causality between financial development and economic growth, but no strong evidence that FDI causes economic growth even though results reveal bi-directional causality between FDI and economic growth in the model 1 and 3 when QM is used as proxy for financial development. Further, we could not find any significant results that FDI causes the economic growth, except when we used the quasi money (QM) as a proxy for financial development, where financial development and FDI causes economic growth. Hence, the results reveal that financial development is matter for economic growth of Sri Lanka than FDI. Significant negative coefficient of the openness may be related Imports than exports which effects the economic growth in Sri Lanka. Earlier studies have shown that growth of exports is conducive to economic growth. The results also showed the importance of FDI and domestic investment to economic growth.

6

Summary and conclusions

This study investigates the impact of the financial development and FDI on economic growth in Sri Lanka using quarterly data over the period 1996 to 2011. The stationary of the data are tested using ADF test. Johansen co-integration technique and the VECM are used to estimate the effect of financial development, FDI on economic growth. Four different measures of financial development (QM/GDP, M2/GDP, CPS/GDP and DC/GDP) are used in this study. Openness is used as an additional variable. Johansen co-integration test finds that financial development, FDI and economic growth are co-integrated. VECM results demonstrate that there is a long-run equilibrium relationship and that bi-directional causality between the financial development and economic growth. Further, economic growth and financial development causes FDI, but no strong evidence that FDI causes economic growth of Sri Lanka. Because we could not find any significant positive relationship that FDI causes the economic growth, except when we used the quasi money (QM) as a proxy for financial development, where financial development and FDI causes economic growth.


91

In summary, we conclude that financial development and economic growth are bidirectional causality. Further, there no strong evidence that FDI causes the economic growth of Sri Lanka. Moreover, major implication of our findings is that financial development is matter for the economic growth of Sri Lanka than FDI.

Acknowledgements The authors acknowledge financial support from the Japan Foundation under Japan Foundation Japanese Studies Fellowship 2012. The authors are also thankful to two anonymous referees and the editor of this journal for their constructive comments.

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Notes 1 2 3 4 5

See McKinnon (1973), Shaw (1973), Goldsmith (1969), Levine et al. (2000), Beck et al. (2000), Christopoulos and Tsionas (2004) and King and Levine (1993). The majority of the previous studies use a single measure of financial development. Also see Kersan-Skabic (2011) and Naghshpour (2012). We check the co-integration between GDP, FDI, money multiplier and openness and found co-integrated at 5% significant level which is not presented here. Due to space, detailed results are not presented here. Upon request, it will be provided.