Saudi Arabian Economic Growth Effect on Foreign Direct Investment

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Table of Contents

Introduction
Previous Literature
Conceptual Framework
Data
Results
Limitations of the analysis
Conclusion
Works Cited
Appendix: Tables of Results

Introduction

The Kingdom of Saudi Arabia is a significant economy in the Middle East and North Africa (MENA) region. The economy heavily relies on oil and revenues from the oil sector constitute between 90 and 95 percent of total export earnings. In addition, the oil sector contributes about 35-40 percent of the country’s gross domestic product (GDP). Due to its heavy reliance on oil, the country was under pressure to diversify, liberalize and reform its economy. These efforts led the government to put in measures that would encourage privatization and promote investment. The country encouraged foreign direct investment (FDI) as a tool for revitalizing the economy and diversifying its product base as well as raising income and employment rate.

Foreign direct investment in the Kingdom of Saudi Arabia can be analyzed from the point of view of contracted and realized FDI. Between 1970 and 2000, the Kingdom experienced a positive trend in both the contracted and realized cumulative FDI. There were significant inflows of FDI in the early eighties and in particular in the petrochemicals sub-sector. The inflows continued steadily throughout the nineties and skyrocketed towards the end of the decade.

Foreign direct investments are an important component of any economy. For an economy to grow, it requires massive investments into its economic sectors. However, many factors can affect the inflows of FDI. Factors such as political stability (or instability), business environment, and security status are among the many factors that have been shown to affect the inflows of foreign direct investment by directly affecting the rate of return on investment. Investors would want to invest in an environment in which the rate of return is high.

The purpose of this study is to examine the effect of economic growth rate on foreign direct investment in the Kingdom of Saudi Arabia. The study will try to address the question: does economic growth rate have any effect on the inflows of foreign direct investment in the Kingdom of Saudi Arabia? The study is important because many studies that have analyzed the relationship between economic growth and FDI have examined the effect of FDI on economic growth. Very studies have actually examined the role played by economic growth in influencing FDI inflows. This study will, therefore, help to narrow the gap that exists in the economic growth-FDI literature.

The paper will be organized as follows: the second section will provide a review of the literature on the relationship between economic growth and foreign direct investment. Section 3 will give the conceptual framework on which the study is based. Section 4 will discuss the nature of the data used in the study while section 5 will present the econometric model that will be tested by the study. Section 6 will present and discuss the results while the last section will conclude the study and give policy implications.

Previous Literature

The relationship between economic growth and FDI has been extensively studied by different scholars in different countries and regions. This relationship has two directions: 1) the effect of FDI on economic growth, and 2) the effect of economic growth on FDI. Of the two directions, the first one – the effect of FDI on economic growth – has attracted the interest of more researchers than the second one. Most studies conducted on the effect of FDI on economic growth have found a positive effect, that is, FDI encourages economic growth.

Other studies however found a negative or no effect at all. Alfaro (14) found that FDI affects growth but the effect varies significantly from one sector to another. The effect is positive in the manufacturing sector but negative in the primary sector. In another study, Ajayi (12) examined the relationship between FDI and economic development in Africa. He argued that one of the reasons why Africa has been lagging behind development-wise is because the continent has not been attracting adequate foreign direct investment. He further states that FDI affects economic growth and development in various ways such as capital accumulation, technological transfer and an increase in exports.

In contrast to the results of these studies, Lyroudi, Papanastasiou, and Vamvakidis (108) found no significant relationship between FDI and economic growth. Their study was conducted in a number of transition countries. The key message drawn from the review of these studies is that the effect of FDI on economic growth depends on the nature of the countries/regions under investigation as well as on the economic sector to which the FDIs flow.

The second direction – the effect of economic growth on FDI – has not been studied extensively but a number of studies exist. For instance, Dhakal, Rahman and Upadhyaya (2004) identified this literature gap and conducted a study to examine how FDI affects economic growth as well as how economic growth affects FDI in several Asian countries. In short, they conducted Granger causality tests on these two variables.

They found that the causality varies greatly across countries, with some countries showing causality in one of the two directions, others in both directions, and others showing no causality at all (18). They also found that the positive effect of FDI on economic growth is more significant in countries with greater openness to trade and lower levels of incomes and which receive low levels of foreign aid. On the other hand, the positive effect of economic growth on FDI is more pronounced in countries with greater democracy and where the rule of law is limited.

In sum, there is no clear-cut evidence on the relationship between economic growth and FDI. The FDI-economic growth and economic growth-FDI linkages both depend on various political, social and economic factors prevailing in the countries.

Conceptual Framework

The question of whether economic growth affects FDI inflows was motivated by the fact that few studies have actually tried to address it yet many studies have examined the reverse of the relationship. However, economic growth argues that there is a direct and causal relationship between these two economic variables. Economic growth can induce FDI flows into the country if the country in question has an adequate consumer market. In such a case, FDI can be substituted for commodity trade. Economic growth can also have a significant effect on FDI flows if the economic growth is accompanied by greater economies of scale and if the country becomes cost-efficient following the period of growth (Dhakal, Rahman and Upadhyaya 3). Based on this theory, the expectation of the researcher is that there is a positive effect of economic growth on FDI in the Kingdom of Saudi Arabia.

Data

The data used is panel data and consists of data on six units covering the period between the years 2006 and 2010. The units of analysis consist of the members of the Gulf Cooperation Council (GCC) namely: Bahrain, Kuwait, Oman, Qatar, the Kingdom of Saudi Arabia and the United Arab Emirates).

The Gulf Cooperation Council is a regional organization that was created to promote the political, economic and social institutions of the member countries. The members of the GCC are Arab countries that are situated along the Gulf and whose goal was to overcome the problems they experienced from their neighboring environment. The scope of the GCC activities extends “economy, politics, security, culture, health, information, education, legal affairs, administration, energy, industry, mining, agriculture, fishery and livestock,” (Hashem 5). The physical features of the GCC countries and the similarity of their laws, economic and societal factors, as well as the nature of their challenges are the aspects that led to the formation of the GCC.

The dependent variable is a foreign direct investment (FDI) measured in million US dollars at current prices and current exchange rates. These data were obtained from the UNCTAD website. The explanatory variable is the economic growth rate whose proxy is gross domestic product measured in billion U.S. dollars at current prices. The data were obtained from the International Monetary Fund website in particular the World Economic Outlook report of 2011.

The summary statistics for the FDI and GDP variables are presented in Table 1 in the appendix. The table shows that the mean of the FDI and GDP is 7732.849 and 161.3852, respectively. The median for FDI and GDP is 3465.735 and 112.07 respectively while the skewness is 1.65215 and 0.8446908, respectively. The kurtosis for the two variables is 4.696368 and 2.390447, respectively.

Results

Interpretation of the Fixed Effects Model

Table 2 shows the results of the Fixed Effects Model estimation using the LSDV approach. In estimating the LSDV model, STATA omits one unit of observation, which in this case happens to be the country Bahrain. When interpreting the results, what is important is the magnitude and sign of the coefficients. The interpretation of the LSDV results is as follows:

There are unobservable effects in Kuwait which tend to reduce FDI flows by 6417.963 units as GDP increases
There are unobservable effects in Oman which tend to reduce FDI flows by 687.1815 units as GDP increases
There are unobservable effects in Qatar which tend to reduce FDI flows by 247.3737 units as GDP increases
There are unobservable effects in Saudi Arabia which tend to increase FDI flows by 5908.297 units as GDP increases
There are unobservable effects in United Arab Emirates which tend to reduce FDI flows by 4932.976 units as GDP increases

The main focus of this study, however, is on the Kingdom of Saudi Arabia. From the results, it seems that GDP has a positive effect on FDI, that is, as GDP increases FDI flows also increase.

Interpretation of the Random Effects Model

Table 3 shows the results of the REM estimation. In estimating the REM model, STATA does not give the coefficients. However, the output gives some results which are crucial for interpretation. The corr(u_i, x) = 0 (assumed) presents the basic assumption about the Random Effects Model.

Rho shows the percentage of variance due to variation across countries. The results, therefore, show that 53.45% of the variance is due to variation across countries.

Interpretation of the Hausman test

The Hausman test is used to determine which of the two models – REM and FEM – is appropriate. The test statistic is given as:

If the REM is the correct model, then the difference between the RE estimate and the FE estimate should be 0. On the other hand, if the FEM is the correct model, then the difference between the RE estimate and the FE estimate should not be 0. Table 4 shows the results of the Hausman test. The results show that the difference between the RE estimate and the FE estimate is 8.98, which is greater than 0. The conclusion is that the Fixed Effects Model is the correct model for the data.

Limitations of the analysis

As with any time-series data, it is important to conduct unit root tests and co-integration tests to check whether the series is stationary or non-stationary before any other tests or analysis is done. If non-stationary, the series should be converted into stationary before further analysis is done. The main limitation of this analysis is the assumption that the two series of data are stationary in nature and yet they may not be. This may have affected the results of the analysis. In addition, the period covered is too short hence the need to increase the years covered in the future.

Conclusion

The aim of this study was to examine the effect of economic growth on foreign direct investment flows in the Kingdom of Saudi Arabia. The study used panel data drawn from the countries making up the Gulf Cooperation Council, of which Saudi Arabia is a member. The data comprised of six units of observation (the GCC countries) covering a 5-year period (between 2006 and 2010). A Fixed Effects Model (FEM) and Random Effects Model (REM) were estimated using STATA 10 after which the Hausman test was conducted to determine which of the two models is the correct one.

The results showed that the FEM was the appropriate model for the data. In addition, it was determined that economic growth has a negative effect on foreign direct investment in four of the six countries examined. On the other hand, economic growth has a positive effect on foreign direct investment in the Kingdom of Saudi Arabia, which is the main interest of the study. The results, therefore, support the study conducted by Dhakal, Rahman and Upadhyaya. This study is however limited in the sense that no panel unit root tests were conducted to determine whether the data were stationary or non-stationary in nature.

Works Cited

Ajayi, Ibi. FDI and Economic Development in Africa. Ibadan: University of Ibadan, 2006.

Alfaro, Laura. Foreign Direct Investment and Growth: Does the Sector Matter? Boston, MA: Harvard Business School, 2003.

Dhakal, Dharmendra, Saif Rahman, and Kamal Upadhyaya. Foreign Direct Investment and Economic Growth in Asia. Nashville, TN: Tennessee State University, 2004.

Hashem, Ahmad. Cooperation Council for the Arab States of the Gulf. Pennsylvania: Carlisle Barracks, 2007.

Lyroudi, Katerina, John Papanastasiou, and Athanasios Vamvakidis. “Foreign Direct Investment and Economic Growth in Transition Economies.” South-Eastern Europe Journal of Economics, 1 (2004): 97-110.