Kashmir Economic Review, Volume 29, Issue 1, June 2020

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Kashmir Economic Review

ISSN(P): 1011-081X, ISSN(E): 2706-9516
http://www.ker.org.pk
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Do Corruption and Trade Openness Impede FDI?

ABSTRACT AUTHORS
Foreign direct investment (FDI) has been given much attention Waqar Ali Ather Bukhari
in the recent past just because of its contribution to economic Lecturer, Deparment of Economics, Bacha
development. However, there are several socio-economic Khan University, Pakistan
waqar.bukhari3@gmail.com
factors that impede FDI. Therefore, the objective of current Author’s Contributions: 2, 3, 4, 6
study is to probe whether corruption and trade openness affect
FDI. The study uses data from 1990-2015 for SAARC countries
and employs panel ARDL model to retrieve short- and long-run
Azaz Ali Ather Bukhari
Lecturer, University of Punjab, Gujranwala
results. The findings reveal that corruption plunges the FDI in Campus, Pakistan
long-run, while trade openness increases FDI. On the contrary, azaz.bukhari@pugc.edu.pk
we report heterogeneous results in short-run. Additionally, we Author’s Contributions: 1, 5, 7
deduce a few policy implications based on the findings of this
study. Noreen Khalid
MPhil Economics, Quaid-i-Azam
University, Pakistan
noreen123qau@gmail.com
Author’s Contributions: 1, 5, 7

Qasim Raza Syed*

Assistant Director, National tariff
commission Pakistan, Pakistan
qasimrazasyed.economics@gmail.com
Author’s Contributions: 1, 5, 7

Keywords Please cite this article as:

Corruption; Trade Bukhari, W. A. A., Bukhari, A. A. A.,
openness; FDI; Panel Khalid, N., & Syed, Q. R. (2020). Do
ARDL; SAARC countries corruption and trade openness impede
FDI?, Kashmir Economic Review, 29(1),
63-71.
JEL Classification
F23, C23, R38

* Correspondence author
Author’s contribution in the article: 1-Conceived and designed the analysis, 2-Reviewed and compiled the literature,
3-Collected the data, 4-Contributed data or analysis tools, 5-Performed the analysis, 6-Wrote the paper, 7-Financial support for
the conduct of the study, 8-Other

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1. INTRODUCTION
Foreign direct investment (FDI) is one of the indispensable factors that contributes to economic growth of
both developed and developing countries. There is plethora of studies which reports that FDI ameliorates
economic development, income inequality, poverty, and unemployment (Feridun & Sissoko, 2011; Herzer
et al., 2014; Magombeyi & Odhiambo, 2018; Zeb et al., 2014). Given the imperativeness of FDI, countries
try to escalate it. However, social, economic, and political situation of developing countries hinders FDI
inflows, which mitigates sustainable economic development and economic welfare. Thus, it is necessary to
probe the influencing factors of FDI especially for developing countries.

Parallel to this, corruption has been an imperative socio-economic issue across the globe. Over the time,
corruption has surged in almost each and every county. On the top of its social impact, corruption also has
economic impacts (Alola et al., 2019). The prior literature notes that corruption has both positive and
adverse effect on GDP growth. Several studies conclude that corruption is grease for the economic wheel,
implies that corruption increases GDP growth (Leff, 1964; Acemoglu & Verdier, 1998). On the contrary,
there exists a strand of literature which reports that corruption hinders economic growth (Farooq et al.,
2013). Moreover, corruption can also affect FDI. There are several studies which report that corruption
effects FDI, however, there is dearth of literature that explores the relationship between corruption and FDI
for developing countries. Hence, there is need to examine the impact of corruption on FDI to devise policies
in order to ameliorate FDI inflows in developing countries.

In addition to this, Trade Openness (TO) be regarded as one of the prime factors that affect FDI. However,
TO can either increase or plunge FDI. TO, through free trade agreements and low trade barriers, can attract
FDI inflows. Whereas, TO can mitigate FDI through exchange rate and interest rate. The relationship
between TO and FDI is ambiguous, therefore, it should be re-investigated for developing countries to
provide additional evidence, which can complement the existing related studies.

Given the above backdrop, the study aimed at probing the effect of corruption and TO on FDI for selected
SAARC countries: namely Pakistan, India, Maldives, Bhutan, Sri Lanka, Bangladesh and Nepal. The
SAARC countries are set of developing countries that grow at impressive speed along with several socio-
economic issues (e.g., corruption). The present study extends the existing body of knowledge by probing
the impact of corruption and TO on FDI for SAARC countries. To the best of our knowledge, there does
not exist any study that analysis the aforementioned objective in the case of SAARC countries.

2. LITERATURE REVIEW
The current section highlights previous research related to corruption, trade openness, and FDI. Mauro
(1995) conclude that corruption impedes FDI. Similarly, Epaphra and Massawe (2017) employ corruption
perception index and control of corruption (as proxies for corruption) and conclude that corruption
decreases FDI.

On the contrary, Peres (2018) notes that corruption increases the FDI inflows in developing countries while
there is negative relationship between corruption and FDI for developed countries. Similarly, Azam et al.
(2013) reveal that corruption boosts the FDI inflows. The modern literature regarding foreign direct
investment and corruption has not reached at final decisive solution. Some researchers provide evidence
that corruption negatively affect foreign direct investment, while some favor that corruption lead to more
friendly environment for foreign investors. Woo and Heo (2009) empirically test the relationship between
level of corruption and foreign direct investment in context of non-OECD Asian countries. The study
concluded that corruption in non-OECD countries retard FDI level.

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 Do corruption and trade openness …

Similarly, Cuervo-Cazurra (2006) probes the impact of corruption on investment inflow for 106 host
countries. The study concluded that investors belong to OECD member countries not hesitate to do
investment in countries with high degree of corruption. The ground reality is that investors formalized with
corrupt officials to deal in such environment are well known for them. Alemu et al. (2011) empirically
verified that corruption decline investment. The researchers reached to decisive point that corruption
adversely affect economic sovereignty by incorporating insecurity and unconducive relationship, which
badly hit inflow of FDI.

Bellos and Suasat (2012), and Helmy (2013) also report the negative impact of corruption on FDI for several
set of countries. On the other hand, recent study by Gossel (2018) for Sub-Saharan African region concluded
that corruption boost FDI inflow. However, Dinko et al. (2001) note that corruption is harmful for the
overall economy, because it effects the state’s regulation. Also, the study finds that foreign direct
investment is negatively correlated with corruption. Moran (2012) argues that, although FDI ameliorates
the welfare of the society yet it exerts adverse effects on various sectors. In addition to this, corruption
started to increase, and if there persists more corruption then more FDI will inflow.

Parallel to this, Ang (2008) concludes that trade openness, financial development, and infrastructure
increase FDI inflows.. The findings conclude that trade openness positively and significantly affect FDI.
Kakar and Khilji (2011) also examine the nexus between FDI and trade openness in case of Malaysia and
Pakistan. The results report that there is positive relationship between FDI inflows and trade openness in
case of both countries. Abrego (1999) conclude that trade openness plunges FDI in Costa Rica and OECD
countries. Babatunde (2011) reveals the relationship between trade openness and FDI. Also, FDI merely
depends on trade openness. Adebayo et al. (2021) investigate the relationship between FDI and selected
macroeconomic variables. For this analysis, authors employ wavelet approach, ARDL, FMOLS, and DOLS
methodologies. The results depict that trade both openness and exports have positive impact on FDI inflows.

Similarly, Liargovas and Skandalis (2012) also report that FDI in developing countries has positive
relationship with trade openness, and the strength of the relationship is relatively strong for developing
economies. Aizenman and Noy (2006) explain that two way causality between FDI and trade openness
exists for selected dataset. Cantah et al. (2018) argue that trade openness has positive impact on FDI inflows,
while analyzing Sub-Saharan Africa. Bibi et al. (2014) scrutinize the relationship of FDI with selected
macroeconomic variables, i.e., inflation, trade openness, real exchange rate, export, and import in Pakistan.
Contrary to the existing literature, the study notes that trade openness impedes FDI inflows in Pakistan.

3. DATA
The key purpose of this study is to probe the effect of corruption and TO (trade openness) on FDI (foreign
direct investment) for SAARC countries. Hence, the dependent variable of this analysis is FDI, whereas the
key independent variables are corruption (measured by corruption perception index – CPI) and TO. In
addition to this, we employ economic growth (real GDP per capita – GDP) as control variable. The study
covers the time 1990-2015 for SAARC countries: namely Pakistan, India, Maldives, Bhutan, Sri Lanka,
Bangladesh and Nepal. We exclude Afghanistan from this analysis since the data for Afghanistan is not
available. Also, we transform all data series into natural logarithmic form to control the issues of non-
normal distribution and heterogeneity. Table 1 reports the summary of data.

The descriptive statistics are presented in Table 2. Also, all variables are converted into logarithmic form
to control heterogeneity and to achieve normal distribution. Further, as can be seen from Table 2 that mean
value is highest for GDP, which is 13.22. On the contrary, CPI has lowest mean value, which is 1.65. The
most volatile variable of this analysis is FDI since the standard deviation for FDI is 0.43. Kurtosis explains
that variables of this study do not have thick tails. Moreover, all selected variables are negatively skewed,

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as can be seen from the values of skewness. Additionally, Jarque-Bera test statistics reveal that all selected
variables are non-normally distributed.

Table 1: Data description

Variable Measurement scale Source
Foreign Direct Investment Percentage of flows in country relative to GDP World Development Indicators
(FDI)
Corruption Perception Index An index based on 13 different assessments and Transparency International
(CPI) surveys about perceived corruption in a country
Trade Openness index (TO) Volume of exports plus imports divided by GDP World Development Indicators
Real GDP per capita (GDP) Constant per capita $2005 World Development Indicators

Table 2: Descriptive statistics

FDI CPI GDP TO
Mean 6.38 1.65 13.22 10.28
St. Dev. 0.43 0.31 0.27 0.22
Kurtosis 2.11 1.98 1.87 2.32
Skewness -0.10 -0.09 -0.17 -0.21
Jarque- Bera (0.00)*** (0.00)*** (0.00)*** (0.00)***
Note: All variables are transformed into logarithmic form. (.) denotes P-value. Further, ***, **, * represents level of significance
at 1%, 5%, and 10%, respectively.

4. METHODOLOGY
There are several channels through which corruption and trade openness effect FDI. For instance,
corruption affects GDP growth, inflation, crimes, inequality, and cost of production. On the other hand,
these aforementioned indicators mitigate FDI. Moreover, corruption propels foreign investors to pay bribe,
thus it discourages foreign investors to invest in a host country. In addition to this, corruption promotes
inefficiency, rent seeking, and merit-ignorance, causing FDI to plunge. Similarly, it is perceived that
investors are biased toward open economies. Further, less restrictions on trade and capital flows encourage
foreign investors to invest in host countries.

In the prior studies on the determinants of FDI (foreign direct investment), several economic indicators
have been embodied as potential drivers of FDI. However, the most widely employed determinants are
GDP per capita and trade openness index. Therefore, we also use these aforementioned variables in our
econometric model. In addition to this, we augment our model by incorporating corruption as another
determinant of FDI. The econometric model that we employ in this analysis is reported as follow:

𝐹𝐷𝐼 𝑖𝑡 = 𝛽0 + 𝛽1 𝐺𝐷𝑃𝑖𝑡 + 𝛽2 𝑇𝑂𝑖𝑡 + 𝛽3 𝐶𝑃𝐼𝑖𝑡 + 𝜀𝑖𝑡 (1)

In Eq. (1), FDI, GDP, TO, and CPI is foreign direct investment, real GDP per capita, trade openness index,
and corruption perception index, respectively. Subscripts i and t are cross-sectional units and time,
respectively. Additionally, 𝛽i (i= 0, …, 3) is coefficient, whereas 𝜀𝑖𝑡 is error term.

To investigate the dynamic relationship (i.e., short- and long-run estimates) among corruption (CPI), TO,
and FDI, the present study utilizes panel ARDL model developed by Pesaran et al. (1999). Further, we
employ PMG-ARDL specification of panel ARDL in lieu of MG-ARDL and DFE due to the fact that PMG-
ARDL renders homogeneous long-run estimates across all cross-sections. Also, panel ARDL (e.g., PMG-
ARDL) can be applied if the variables follow diverse order of integration (i.e., I(0) or/and I(1)). Moreover,

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panel ARDL is immune to panel data issues, e.g., cross-sectional dependence and heterogeneity. These
aforementioned reasons compel to employ panel ARDL in this study.

5. IMPLICATIONS AND SUGGESTIONS

5.1. Unit Root Test
Panel ARDL is not applicable if the order of integration in at I(2) or higher, therefore, we discern the order
of integration for all data series by employing Levin et al. (2002) unit root test. The findings from the
aforementioned test are posted in Table 3.

Table 3: Results from LLC unit root test

Variable I (0) I (1)
FDI -0.88 -4.23***
CPI -2.87 -2.95***
TO -1.06 -3.84**
GDP -6.22 -6.18***
Note: *, **, *** denote level of significance at 10%, 5%, and 1% respectively.

As Table 3 explains that unit root exists in all variables at I(0). However, all data series are integrated at I
(1), implies that data do not have unit root at first difference. In addition to this, we also employ CIPS unit
root test for robust findings. The results from CIPS unit root test are mentioned in Table 4.

Table 4: Results from CIPS unit root test

Variable I (0) I (1)
FDI -1.01 -2.88***
CPI -2.13 -3.63***
GDP -0.79 -2.71***
TO -1.56 -2.60***
Note: Critical value at 1% is -2.57. *, **, *** denote level of significance at 10%, 5%, and 1%, respectively.

The findings from CIPS unit root test, reported in Table 4, explain that we fail to reject the null hypothesis
of there is unit root at I(0). On the contrary, the null hypothesis could be rejected at I(1). Thus, all selected
variables of this analysis are integrated of order 1.

5.2 Long-run estimates

This section renders long-run results from panel ARDL approach. Further, Table 5 explains that the CPI
(corruption perception index) is negative as well as statistically significant. The value of -0.12 implies that
a 1% escalate in CPI decreases FDI by 0.12%. The possible reason behind the finding could be this, that,
corruption reduces the profit due to increase in the cost, which propel investors not to invest in country with
high corruption perception index. This finding, of the present study, is in line with the conclusion of Ohlsson
(2007).

Moreover, TO is also both positive and significant. The value of 0.08 indicates that 0.08% increase in FDI
is fostered by a 1% increase in TO. The possible reason for this finding could be the reality that an open
economy attracts more FDI as compare to the economy that imposes relatively high trade barriers. This
conclusion of the present study is in line with the findings of Ang (2008). The coefficient of control variable
(i.e., economic growth) is positive yet statistically significant. Also, this describes that, in long-run,
economic growth does not boost FDI in SAARC countries.

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Table 5: Long-run results from panel ARDL

Variable Coefficient Prob.
CPI -0.12 0.00***
TO 0.08 0.00***
GDP 0.03 0.12
Note: *** represents level of significance at 1%.

5.3. Short-run estimates

Table 6 reports short-run results from panel ARDL approach. Further, the ECT (error correction term) is
negative as well as statistically significant. It indicates that 96% of a shock converges in 1 year. Moreover,
lag of TO is negative yet statistically significant. This implies that a 1% increase in TO plunges FDI by
0.07%. In addition to this, all short-run estimates are statistically insignificant. This indicates that CPI and
GDP do not effect FDI.

Table 6: Short-run results from panel ARDL

Variable Coefficient Prob.
CPI -0.71 0.18
CPI (-1) 0.15 0.65
TO -0.03 0.55
TO(-1) -0.07 0.01**
GDP -0.02 0.57
GDP (-1) -0.05 0.74
ECT -0.96 0.03**
Note: ** denotes level of significance at 5%.

4.4. Country-wise short-run estimates

Table 7 reports the country-wise short-run estimates. The ECT (error correction term) in case of all
countries is negative as well as significant. Moreover, this implies that there exists co-integration among
CPI, TO, FDI, and GDP. Also, in short-run, CPI mitigates FDI in all SAARC countries except Bangladesh
and India, where CPI escalates FDI. Further, TO upsurges FDI in case of India, Maldives, and Sri Lanka.
However, CPI decreases FDI in case of Bangladesh, Bhutan, Nepal, and Pakistan. In addition to this, GDP
escalates FDI in all selected countries except Bangladesh, where there exists insignificant relationship
between GDP and FDI.

Table 7: Country-wise short-run results

Variables Bangladesh Bhutan India Maldives Nepal Pakistan Srianka
ECT -0.07 ** -3.39*** -0.45 *** -0.21 ** -0.19*** -0.27 ** -0.18 ***
CPI 0.75 ** -0.61*** 0.06 -2.34 *** -0.072** -0.72 * -0.14***
TO -0.06 *** -0.27*** 0.16 ** 0.05 * -0.02 ** -0.12 *** 0.05**
GDP 0.02 -0.03 *** 0.15 *** 0.06*** -0.02 ** 0.32 * 0.01 *
Level of significance: * denotes 10%, ** denotes 5%, and *** denotes 1%.

6. CONCLUSION
FDI (foreign direct investment) is an inevitable ingredient that contributes to sustainable economic
development. However, several factors hinder FDI inflows in developing countries. Hence, the current
study explores whether corruption (CPI) and trade openness (TO) impede FDI in case of SAARC countries.
We borrow panel ARDL methodology to examine the short and long-run estimates. The findings reveal
that CPI decreases the FDI in long-run, whereas TO escalates the FDI in long-run. Further, we report
heterogeneous results in country-wise short-run analysis.

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 Do corruption and trade openness …

On the basis of present study’s findings, we propose that government officials and policy makers should
control corruption by initiating ethical and moral building programs. Further, there should be laws, rules,
and punishment (e.g., imprisonment) to control corruption. In addition to this, SAARC countries should
move towards cash-less economy in order to mitigate corruption. Parallel to this, SAARC countries need
to cut the trade barriers to ameliorate FDI. The policy makers and government officials should rationalize
the trade barriers and adopt trade liberalization for high FDI inflows. Governments should provide
incentives to foreign investors who wants to invest in host countries. Additionally, there should be tax
exemption schemes and subsidies to foreign investors. The cost of commencing and doing business is
relatively high in developing countries, therefore, policy makers should devise policies to reduce these type
of costs. Further, policymakers should sign agreements on free trade, which will surge trade openness that
ultimately increases FDI inflows in SAARC countries.

There exist a few limitations of this study. First, we ignore the issue of cross-sectional dependence and
slope heterogeneity, which may lead to spurious results. Second, we do not employ co-integration test
explicitly and test co-integration with the help of ECT (error correction term). For future research directions,
researchers can employ second and third generation panel data methods to control cross-section dependence
and slope heterogeneity. Further, quantile based models could also be used to explore the non-linear
(asymmetric) relationships.

Acknowledgement
I would like to express my sincere gratitude to Prof. Waseem Shahid Malik (University of Peshawar) and
Prof. Abdul Jalil (Pakistan Institute of Development Economics) for their comments and suggestions to
improve the quality of the article. I am also thankful to the reviewers for their valuable comments and
suggestions.

Funding Source:
The author(s) received no specific funding for this work.

Conflict of Interests:
The authors have declared that no competing interests exist.

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