WALIA journal 30(S3): 18-22, 2014

Available online at www.Waliaj.com

ISSN 1026-3861
© 2014 WALIA

The relationship between external debt and foreign direct investment in D8 member
countries (1995-2011)

Hossein Ostadi *, Samin Ashja

Department of Economic, Dehaghan Branch, Islamic Azad University, Isfahan, Iran

Abstract: As the structure and infrastructure of a country's economy become stronger, foreign investors are more
likely to have direct investment in that country. On the other side, when the free market does not work properly and
the market mechanism cannot use its facilities completely or develop new competitive advantages or fails to give an
appropriate signal to economic agents' decision making for investments, government intervention in the economy
increases. By reducing the burden of foreign debt, financing increase due to capital inflows into the country.
Therefore, in this study, the relationship between external debt and foreign direct investment (FDI) in D-8 member
countries over the period 2011-1995 have been analyzed using panel data. The results show that external debt have
significant negative effect on foreign direct investment, and increasing foreign debt has destroyed foreign investors
vision and created negative expectations of the future economy which together reduced investment in the country.
The results also indicate that the government size has a negative effect on attracting foreign investment and
presence of government leads to less participation of private sector. GDP has a positive effect on attracting foreign
direct investment and that means increasing in production leads to higher potential consumption and investment
which ultimately increases direct foreign investment. The results suggest that "population" as controlling
independent variable has a positive effect on attracting foreign direct investment and increasing population creates
a great potential of consumption and boosts the attraction of foreign direct investment.

Key words: Foreign debt; Foreign direct investment (FDI); D8 member countries; Panel data method

1. Introduction As a result, increasing the amount of FDI and

investigating the effective factors on FDI is of high
*Foreigndirect investment (FDI) is a kind of importance. In the present study, first the theoretical
investment in which the investor country directly foundations including the economic policy factors
invests on the assets and resources of the host affecting the flow of foreign direct investment, the
country. In this kind of investment, through physical economic structure factors affecting the flow of
presence at the investment place and taking the foreign direct investment, encouraging and
financial responsibilities, the foreign investor takes supporting factors affecting foreign direct
direct control and management of the unit in the investment, external debts, and the relationship
host country. UNCTAD's FDI consists of investments between external debt and foreign direct investment
which involve long-term relationships and reflect flow are reviewed. Then, the research model and
continuing benefit of the real or legal personality research variables and test are represented.
resident in a company outside of the home country
of investor. In Palgrave encyclopedia foreign direct 2. Theoretical background
investment is defined as ownership in a company or
entity based in a foreign country. This kind of 2.1. The economic policy factors affecting the
investment has high stability and in the event of a flow of foreign direct investment
downturn in the host country, not only cannot easily
leave the country, but also helps to pull the country The role of FDI has been long discussed in the
out of crisis mode. FDI requires high risk and its economic development. Many researches address
income is not guaranteed. Also, the long period of the effective factors on attracting foreign direct
foreign direct investment distinguishes it from investment; the most important ones include
foreign indirect investment. Buying bonds and domestic market size, growth, technical capabilities,
shares in securities trading and certificates of infrastructure, government policies, institutions, etc.
deposits in the banks are among foreign indirect FDI plays an important role in economic promotion
investments. The main characteristics of this type of of development and growth, increasing the
investment are low risk, high income, short period of technological level of country and creating
investment, and better liquidity. employment (Dinda, 2010). When the economic
policies in the host country are in line with creating
an open stable economic situation, the risk of
* Correspondin g Au thor.

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investment decreases and following that, the flow of accumulated debt in developing countries, financing
indirect foreign investment to that country the developmental needs and also boosting per
increases. The economic policies effective on FDI capita income. Excessive dependence to foreign
flow can be summarized in the following items: debts is associated with tremendous risks; it
monetary policy, fiscal policy, currency policy, trade impedes economic growth and development of the
policy, and regulatory policies. country (Khan, 2007).

2.2. The economic structure factors affecting the 3. Research methodology and variables
flow of foreign direct investment
The model used in this research is as follows:
As the structures and infrastructures of a Yij = α + β 1 x1ij + β 2 x 2 ij + U i
country's economy be stronger, foreign investors are
Research variables include FDI (dependent
more likely to have direct investment in that country
(Selian, 2010). The main factors of economic variable), foreign debts (main independent variable),
government size, GDP and population (control
structure which affect directly on attracting foreign
direct investments include: stable trade balance, independent variables) of D-8 member countries.
In this study panel data method are used and the
market size and expansion, foreign debt, structure of
financing, infrastructure installations, skilled information related to during 1995-2011 are used in
Eviews software for constructing the model. For data
workforce and development of human resources,
information technology widely available. processing and summarizing Eviews software is
used. The statistics and information are extracted
from World Bank website.
2.3. Encouraging and supporting factors affecting
foreign direct investment
3.1. Data referential analysis
Some countries offer incentives for attracting
foreign investors. It is certain that as the amounts of 3.1.1. Research variables' stationary test
incentives increase, the investors are more likely to
invest. In this regard, the following instances can be Before estimating the model it is necessary to test
mentioned: Tax exemption for foreign investor the stationarity of all the variables used in the
production companies, granting insurance covers to research calculations. To this aim, the following tests
investors, granting customs exemptions on imported can be useful: Levin, Lin and Chu test (LLC), IM,
factors needed for foreign investment companies, Pesaran and Shin (ISP), Breitung test, Fisher-tests
subsidies for training local workforce, creating free using ADF.
The results of tests indicate the stationary of all
trade areas for investment, granting infrastructure
facilities and cheaper public services such as water of the variables. In this test H0 refers to non-
stationary of variables and H1 refers to stationary of
and electricity, guaranteed return of principal capital
and its interest, and prevent their confiscation and the variables, and all the variables have stationary at
the zero level.
nationalization.
Table 1: the results of variables' stationary
2.4. Foreign debts Levin, Lin
Variable & Chu t- probability result
The issue of "borrowing" has attracted more Statistic
attentions of economic and political issues' pundits I(0) -
from different countries, and due to its economic, Population -1.83783 0.0330
stationary
political and even managerial dimensions is of high I(0) -
FDI -3.80836 0.0001
significance. The discussions concerned with this stationary
subject are mainly around foreign debt and its I(0) -
Govt. size -5.44624 0.0001
positive and negative effects. stationary
Foreign I(0) -
-2.01600 0.0219
debt stationary
2.5. The relationship between FDI direct flow and
I(0) -
foreign debts GDP -2.56456 0.0052
stationary

FDI is very important for economic development In order to test research hypotheses, first it must
especially in the developing countries; since it brings be discussed whether the data are panel data or
about not only financial help, but also other pooled data. For this, F-Limer statistics was used
investments, technology, new jobs, skills, where if the calculated F is larger than F in the table,
management and expertise. It is obvious that H0 is rejected and using panel data method is
increasing the investments on the projects leads to recommended, otherwise it is better to use pooled
creation of more job opportunities. FDI is a main data.
source of financing and investment for less In F-Limer test, H0 hypothesis represents equal
developed countries all over the world. The FDI intercept (pooled data) versus the opposite
inflow helps to solve the problem of foreign

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hypothesis, the intercept anisotropy (panel data). test is 12.79 at zero probability which confirms fixed
Thus it can be: effects method.
The generalized least squares (GLS) method is
used in panel data. Weighting is done based on
H1: at least one of the intercepts is different with
companies. Cross-section (weights) and Wald chi-
the others.
square statistics are also considered and regarding
This model is tested using Eviews software. To
its value with the zero probability, the regression is
choose between panel data or pooled data method,
significant. LR test is an estimator for
F-Limer statistics is used. In this test, H0 is based on
heteroscedasticity of variance and has chi-square
pooled data method and H1 is based on panel data
distribution. H0 is based on homoscedasticity.of
method. F-Limer showed 26.36, with the zero
variance and the opposite hypothesis is based on
probability which confirms using panel data; and
heteroscedasticity of variance. The estimated model
regarding the value of this statistics and testing the
in this research is as follows (Table 2, Table 3 and
panel data method it is accepted. For deciding on the
Table 4):
application of fixed effects or random effects method,
Hausman test is used. In fact this tests that individual
Table 2: F-Limer statistics
effects are uncorrelated with explanatory variables Degree of
under which the estimation of generalized least Result F-Limer Probability
freedom
squares is consistent under H0, and inconsistent Panel
under H1. In other words, using random effects 26.363176 4 0.0001
data
method in which generalized least squares
estimators are used; H0 shows consistency of the Table 3: Hausman test results
coefficients while H1 rejects this consistency. If H0 is Hausman- Degree of
Result Probability
not rejected by doing Hausman test, the used method statistics freedom
for estimation will be random effects method Panel
12.791765 4 0.0123
(Baltagi, 2005). The value calculated by Hausman data

Table 4: results of combined regression estimations over 1995-2011

variable coefficient Standard deviation t-statistics Sig.
C -59.26237 8.553721 -6.928256 0.0001
GDP 0.596822 0.063915 9.337712 0.0001
DEP -0.012602 0.004039 -3.120237 0.0024
POP 0.139708 0.043062 3.244329 0.0016
GO -0.090190 0.036683 -2.458617 0.0158
R 2: coefficient of
1.84 Durbin-Watson statistics
determination 0.90
84.16 F-statistics
Adjusted R 2 0.89
0.01 F-statistics sig.
0.01 Prob (F) F-Limer 26.36

Regarding the coefficient of determination, the

model has a good fitness and the variables used in 3.1.3. Collinearity Test
this model indicate the explanatory strength of the
model 90%, which is a good value in panel data For Collinearity Diagnostics two methods of
method. Durbin-Watson demonstrates absence of condition index and Eigen value by SPSS software
autocorrelation by 1.84. F statistics in this fitness are used. As the condition index gets closer to zero
rejects coefficients' equality to zero. i.e. lower than 30, it represents lack of serious
Collinearity in the intended estimation. Also, as the
3.1.2. Analyzing model's coefficient of Eigen values are different than zero, it represents
determination lack of serious Collinearity in the intended
estimation. Hence, regarding the values of the two
Coefficient of determination examines the tests, collinearity in the research results is rejected.
suitability of fitted regression line based on a series
of dat. As the value of this coefficient increases, 3.1.4. Residuals' variance heteroscedasticity test
independent variables are more capable of
explaining the behavior of dependent variable. The One of the classic assumptions of regression
value of coefficient of determination in the estimated models is Residuals' variance heteroscedasticity
results of regression model is calculated as R2 =0.90. which is regarded a basic assumption in any
The estimated value of coefficient of determination relationship. For testing variance heteroscedasticity
indicates that about 90% of dependent variable in this research, ARCH-LM test is used. The test
behavior is explained by independent variable; this results are presented in the attachment but
represents the rather high relationship between following table represents a summary of this test for
independent variables and the dependent variable. the relationships of research. As it was explained

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before, the null hypothesis and its opposite

hypothesis is defined as follows:
H0: the variance of errors is homogenous.
H1: the variance of errors is not homogenous.

Table 5: Collinearity Test

Collinearity Diagnostics a
Variance Proportions
Model Dimension Eigenvalue Condition Index
(Constant) FDI GDP go de pop
1 2.993 1.000 .00 .00 .00 .00 .00 .00
2 2.363 1.125 .05 .00 .03 .00 .00 .02
3 2.000 1.223 .00 .07 .00 .00 .00 .00
1
4 .356 2.899 .74 .04 .05 .00 .00 .10
5 .211 3.764 .04 .66 .21 .00 .00 .05

Table 6: Residuals' variance heteroscedasticity test

Obs*R-squared Null hypothesis and
Test-result P-value F-statistics
statistics opposite hypothesis
Homoscedasticity of
Null hypothesis H0 Variance
0.14 18.62 1.74
accepted (variance) Hetrooscedasticity of
H1 variance
In this test null hypothesis indicates H1: the residuals of model do not follow a normal
homoscedasticity of variance and the p-value distribution.
calculated by ARCH-LM test for the relationship is Regarding the value of probability or p-value
estimated 0.14 i.e. bigger than 0.05, the significance estimated for Jacque-bera test, it is observed that the
level (p-value≥0.05); as a result the null hypothesis null hypothesis is not rejected; hence, the residuals
is accepted indicating that variance of model use normal distribution.
heteroscedasticity does not exist.
3.1.6. Residuals autocorrelation test
3.1.5. Examining the normality of residuals of
multiple regression model In order to test the autocorrelation between the
error values B-G test is used. The null and opposite
For investigating the normality of residuals of hypotheses are as follows:
multiple regression model Q-Q plot, Jarque-Bera H0: there is no correlation between error values.
Normality Test and Histogram of error values are H1: there is autocorrelation between error
used. The null hypothesis and the opposite values.
hypothesis in Jarque-Bera Test are as follows:
H0: the residuals of model follow a normal
distribution.
Table 7: testing the residuals autocorrelation
Obs*R-squared Null hypothesis and
Test-result P-value F-statistics
statistics opposite hypothesis
H0: lack of
Null hypothesis
0.82 8.6 0.5 autocorrelation
accepted
H1: autocorrelation
Regarding the output table of this test and investment. This is in line with crowding out effects
observing the value of probability or p-value, it is and shows that the presence of government reduces
found that the value of probability is above 5% level the presence of private sector.
so the null hypothesis is confirmed and the existence Findings also show that GDP has a positive effect
of autocorrelation between error values is rejected. on attracting FDI as the dependent variable. This
means that increase in the production implies higher
4. Conclusion potential for consumption and investment which
ultimately increases FDI.
The research findings show that foreign debts has Moreover, the results indicate that population as
a negative significant effect on FDI and that a controlling independent variable has positive effect
increasing foreign debts destroys foreign investors on attracting FDI as the dependent variable which
attitude and creates negative expectations from the means that population growth has created a high
economic future and thus, reduces the degree of potential for consumption and increases foreign
investments in that country. direct investment.
Also, the results indicated that the government
size has negative effect on attracting foreign

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