Impact of governance indicators on FDI net inflows: empirical evidence from Sri Lanka

Abstract

Introduction

The inflows of Foreign Direct Investment (FDI) are extremely crucial for the economic growth of developing countries. FDI provides investment capital for developing countries along with employment opportunities, management skills and updated technology which eventually leads the developing countries towards economic growth (Athukorala & Karunarathna, 2004; Nurudeen, 2010). Therefore, developing countries are attempting to obtain greater FDI inflows with the intention of strengthening their business and industries. Policies and procedures are revised continually to make it convenient for the investors to make investment in these countries (Zeshan & Talat, 2014). However, while several countries are successful in attracting greater FDI inflows, some have been facing problems in attracting FDI.

Enhancing FDI inflows is a sustainable solution for economic difficulties. FDI is critical for developmental projects, industrial growth, employment generation, technological advancement, enhancing of industrial production, reducing balance of payments deficit, increasing foreign reserves, improving infrastructure, building skilled human resources and eventually realizing economic growth (Zeshan & Talat, 2013). The economic growth of a country is also influenced by the political process including government selection process, monitoring and replacement of the governments; governmental ability to implement and formulate polies and procedures; respect of their people and position of institutions which administer social and economic interaction (Zeshan & Talat, 2014). There are six dimensions of governance mechanisms which may be useful to evaluate the governance level for the countries, identified as governance indicators (Kaufman, et al., 2009). These indicators are Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption.

There are several pieces of research that investigates the factors influencing inflows of foreign direct investment. Rusike (2008), in analysing the determinants and trend of inward FDI to South Africa for the period 1975- 2005, found exchange rates, openness and financial progress to be key variables in determining FDI inflows in the long-run. Masku and Dlamini (2009) probed locational determining variables of FDI in Switzerland by utilizing cointegration along with ECM techniques during 1980-2001. The variables tested were market size, openness of economy, infrastructure, domestic market attractiveness, external economic stability and internal economic stability. Research reveals that external economic stability, internal economic stability, infrastructure and economy’s openness had positive correlation whereas home market size and domestic market attractiveness had negative correlation with FDI stock (Masku & Dlamini, 2009). Azam and Kahttak (2009) evaluated the influence of political instability and human capital on FDI stock in Pakistan for the period 1971-2005 by utilizing least squares method. The estimated results reveal a positive and significant link between human capital and FDI stock. Anwar and Afza (2014) attempted to determine the relationship of governance indicators including voice and accountability, political stability, government effectiveness, regulatory quality, control of corruption and governance index with inflows of foreign direct investment in Pakistan for the period of 1996 to 2010 through applying ARMA and Ordinary Least Squares regression techniques. The results of the study have shown that governance indicators have a positive relationship with FDI inflows in Pakistan.

However, it is difficult to find literature on the relationship between FDI inflows and governance indicators in Sri Lanka. Further, there is a huge debate about the political stability and the governance of the country. Thus, there is a high need to observe whether there is a substantial relationship between FDI inflows and governance indicators of the country.