Does private domestic investment crowd in or crowd out foreign direct investment (FDI) in Sri Lanka? Evidence from multivariate vector error correction model

Abstract

While private investment undoubtedly dominates the investment sector in Sri Lanka accounting for more than 75% of total investment, private domestic investment (PDI) comprises more than 95% of private investment. Although in order to attract FDI the government offers numerous incentives in the form of corporate tax incentives, import duties, tax on dividends, exemption on exchange control etc., its contribution to private investment has remained at minimal levels over the preceding decades. This study attempted to investigate the effect of PDI (crowding in or crowding out) on FDI applying a multivariate Vector Error Correction Model (VECM) for time series data from 1970 to 2014. Interestingly, short run dynamics suggested that FDI favors public investment at statistically significant levels. Conversely, associations between PDI and FDI in the short run were found to be insignificant. In conclusion, the effect of PDI is two-fold: complementary with public investment (crowding-in) but competing (crowding-out) for FDI in the long run investment equilibrium.