Central Asia Journal No. 67

 

The Determinants of Foreign Direct Investment: Evidence from Azerbaijan and Kazakhstan

 Muhammad Azam*

Abstract

This study examines the influence of various determinants on foreign direct investment (hereafter FDI) for two Central Asian countries: Azerbaijan and Kazakhstan. For empirical investigation simple linear regression model and the method of least squares (LS) have been used. The empirical results reveal that market size of the host country proxy used (gross domestic product), official development assistance, one year lagged FDI and inflation are the significant determinants of FDI affecting FDI inflows in Kazakhstan during the period considered. The explanatory variables inflation, official development assistance, and one year lagged FDI found are statistically significant determinants of FDI inflows, while, market size found insignificant in case of Azerbaijan. However, the empirical results indicate strong effects by the regressors on FDI inflows in Kazakhstan than Azerbaijan. Thus, findings of the study suggest effective measures to augment FDI inflows.
 
Keywords: Determinants of FDI, Regression analysis, LS, Azerbaijan, Kazakhstan

Introduction

Growth of FDI to less developed countries is one of the significant features of globalization. FDI has now become an important source of private external capital for developing countries. It not only helps in filling the saving-investment gap and the foreign exchange gap in these countries but it is also a means of transferring to them production technology, managerial practices and  skills. Multinational corporations (MNCs) that are the main source of FDI in developing countries facilitate the growth of their exports through their global trading networks.
Foreign investment usually refers to investment made in the establishment of new firm by foreign company in other country of the investors, who sets up subsidiaries or acquires usually about 10 percent of the stock with voting rights, thus gaining influence in the foreign company's management and they have direct control on their investment. Majority of developing countries are ever more aware of the vital role of FDI as an engine of growth in their economic development. FDI not only  increases directly capital accum5aulation of the host economy but  infact it equally helps in improving of economic growth by providing modern technologies, modern production processes and techniques, managerial skills, and new types of capital goods too (Barro and Sala-i-Martin, 1995). Ikiara, (2003), discloses that policy makers need to adopt such best policy at the time of decision making because FDI brings not only benefits but also costs. Many studies conclude that FDI has been one of the most effective means of transferring technology and knowledge. Ajayi, (2006) shows that it is usually believed that FDI is important source of external capital and brings many benefits to the host country in the form of reducing unemployment, support domestic investors, bring advanced technology and such as bolster economic development and growth. The positive relationship in FDI and economic growth is not clear, however, the available FDI-growth literature indicates that there are almost three channels through which foreign investment can boost economic growth. (i): FDI helps in opining the binding restrictions on domestic saving and augment domestic savings in the process of capital accumulation. (ii): Modern technology and skill are transferring through FDI and the adoption of modern technology certainly promotes factor productivity and efficiency in the utilization of available resources, which boost economic growth. (iii) Equally FDI increase export volume due to enhanced capacity and competitiveness in domestic production. FDI improves social welfare of the society, increasing living standard, providing employment opportunities, increasing per capita income and reducing poverty (Azam, 2009). Hayami and Godo (2005) and Todaro and Smith, (2011) urges that FDI inflows could fill the gap between investment and saving, can enlarge tax revenues, encourage management, technology, and labor skills in the recipient countries.
The purpose of the present study is to know about the significance of FDI for economic growth and development for two countries from Central Asia: Azerbaijan and Kazakhstan in general, and to test quantitatively the influence of economic factors on FDI inflows in particular.
Cursory Overview on the Azerbaijan’s Economy

The optimistic economic growth of Azerbaijan during 2009 was due to smooth performances in the oil and gas sector. Despite the global financial crisis and decrease in global oil prices from their 2008 high, economic growth slipped only a little to 9.3 percent in 2009, as it was 10.8 percent in 2008. Agricultural growth fell by almost half to 3.5 percent in 2009 due to expensive inputs, low credit facility, and water shortages in rain-fed agriculture areas, most agriculturists continued to focus on subsistence wheat production. As oil export income fell due to sliding international prices, the trade account is estimated to have posted a surplus of mere US$ 14.6 billion, decreased from US$ 23.0 billion in 2008. This decline was diminished by an estimated US$ 1.1 billion fall in imports, largely because of lower food prices and a fall in oil companies’ demand for investment machinery. External debt rose slightly to US$ 3.4 billion (8.8 percent of GDP) in 2009 from US$ 3.0 billion a year earlier. High public investment was made by the State Oil Fund (SOFAZ), and it became an important source of financing for important socioeconomic and investment projects (Asian Development Outlook, 2010) . The Economist Intelligence Unit (2007), indicates that FDI inflows to Azerbaijan have been almost enhances by its oil and gas areas. In the hydrocarbons sector little FDI during the period 2004-06 were enhanced and it is all due the unhealthy investment environment, bureaucratic obstructions, and infrastructure constraints . However, AZPROMO (2011), claims that Azerbaijan economy provides friendly investment environment because of political stability, quality infrastructure, plenty resources, encouraging location on the crossroads of Eurasia, and Azerbaijani hospitality- these all factors play significant role in the foreign investors decision. In the Azerbaijan economy during the last 15 years almost US$ 95 billion were invested where more than a half invested by foreign investors. See figure 1 for FDI inflows into Azerbaijan during the period from 1992 to 2010.

Cursory Overview on the Kazakhstan’s Economy

According to the Asian Development Outlook (2010) report, contraction in economic performance of Kazakhstan took place due to international slow down in prices and recession in 2009, as GDP contracted by 2.2 percent in the 1st 3 quarters, but managed a marked rebound to post growth of 1.2 percent for the year on the impetus of strengthening oil and commodity prices.  Inflation rate fell was estimated at 7.3 percent in 2009, and it was recorded 17.3 percent in 2008, due to frail domestic demand and low international commodity prices. In order to overcome the problem of banking crisis, the Kazakhstan’s government in 2009 effectively nationalized two of the leading Banks and provided two financial institutions with relatively smaller amounts of capital. During 2009, however, four financial institutions defaulted on external debt obligations, and all are now in negotiation with their creditors to restructure a total of about US$ 20 billion in external debt. Export earnings decreased by 38.9 percent in 2009, and imports by 25.2 percent primarily because of frail domestic demand, slimming the trade surplus by more than half to US$ 15.2 billion. Private sector external debt rose quickly over the years through end 2007 to US$ 95.3 billion (78 % of GDP), when bank debt reached at US$ 46 billion. Similarly, there was only a moderate increase in private debt to US$ 108.5 billion at end 2009, and bank debt diminished to US$ 30.1 billion. Foreign capital inflows more than covered the current account deficit, generating an estimated overall balance of payments surplus of US$ 2.5 billion. The Economist Intelligence Unit (2007) shows that Kazakhstan’s has sound minerals reserves of oil and gas, chromium, uranium, gold, and diamonds for the enhanced level of FDI inflows. Though, the country has been attracted more foreign investors in the past due to stable government, and an improving legal, tax and regulatory framework but currently in particular towards Western investors, the business environment has become noticeably more hostile. See figure 1 for FDI inflows into Kazakhstan during the period from 1992 to 2010. According to Energy Information Agency, (2009), Kazakhstan’s economy has significant oil and natural gas reservoirs due to which it is important to the world energy markets. While, the Index of Economic Freedom (2011), indicates that in Kazakhstan foreign investment is deterred by ad hoc barriers and favoritism toward local firms. It is all due to the weak rule of law, corruption and insecure property rights.

Fig. 1.
Source: International Country Risk Guide (2011), The PRS Group
FDI-A= FDI in Azerbaijan, FDI-K= FD in Kazakhstan
Previous Empirical Studies

A large amount of literature exists on the determinants of FDI, however, contribution of Dunning (1973, 1981), which exhibits an inclusive analysis based on ownership, location and the internationalization (OLI) paradigm. The empirical works done by Agarwal (1980) and Schneider and Frey (1985) on the determinants of FDI are no doubt a great contribution in literature. Several studies identified empirically the main determinants of FDI like Resmini (2000), results show statistically significantly positive relationship between FDI and market size, wage differential, and trade openness. Shah and Ahmed (2003), finds that the inflows of FDI have long run relationship with the factors such as market size, cost of capital, expenditures on transport and communication and political stability in Pakistan. The bilateral official development assistance has a significant and positive influence on FDI inflows. In addition, the result also finds significant positive relationship in openness of trade, exchange rates and FDI inflows (Yasin 2005). Asiedu (2005) finds significant effects of inflation, markets size, infrastructure, educated population, openness, less corruption, political stability and a reliable legal system on FDI inflows. Sahoo (2006) finds that market size, infrastructure, labour force, and trade openness are the important determinants of the FDI inflows in South Asian countries. Nunes et al (2006) empirically proved that market size, infrastructure, inflation, and wages, are the significant determinants of FDI flows during the period 1991-1998 in Latin American countries, while, openness of the economy found insignificant but with expected positive sign. Agiomigianakis et al., (2006), results reveal that GDP and trade openness are significantly correlated with FDI inflows. Kang and Lee (2007) assert that market size and quality of labor, and transport infrastructure play a positive role in deciding location. Azam and Naeem (2009), finds that trade openness, domestic investment, market size, physical infrastructure and return on investment significant determinants of FDI in Pakistan. Azam (2010), find the positive effect of market size, official development assistance on FDI and negative effect of inflation on FDI inflows in Turkmenistan. Market size and inflation in Armenia, and market size and official development in Kyrgyz Republic found statistically significant. But the effect of official development assistance in Armenia and the effect of inflation on FDI inflows in Kyrgyz Republic found insignificant. Vijayakumar et al., (2010), finds that market size, infrastructure, labour cost, currency value and gross capital formation are the significant determinants of FDI inflows. However, the result shows that inflation rate, industrial production, and trade openness are seem to be the insignificant determinants of FDI inflows of the BRICS countries.

Motives for Foreign Direct Investment

FDI is carried out through MNCs and usually it is believe that the broad objectives of the investors are to earn maximal profit. Therefore, MNCs may invest in other countries to take advantage of low production costs. If MNC is to be able to compete with local firms in a foreign market, it must have some advantages that the local firms do not have. Moreover, investors from advanced countries come into developing countries because they know that the return on capital is less in their own countries and also multinationals desire to utilize cheaper labour and abundant raw materials of the host country in order to minimize their production cost and earn more profit. However, the motives for firms to engage in foreign production or invest in abroad, there are four main motives (i.e., natural resources seeking investment, market seeking, efficiency seeking and strategic asset seeking investment) have been identified in the available .  

Description of Selected Explanatory Variables

The available literature indicates many economic determinants of FDI but this study considers explanatory variables like host country market size, inflation, trade openness, previous year FDI, and official development assistance. Needless to say, explanatory variables are minimum but this is all due to the non availability of consistent desired data. The dependent variable is FDI. Brief justifications of the selected explanatory variables are hereunder;

Inflation: Inflation is an important determinant of FDI in the eyes of investors. Usually, high rate of inflation in a country can reduce the return on investment and is an indicator of macroeconomic instability. High inflation rate is a sign of internal economic tension and unwillingness of the government to stable its budget and weakness of the central bank to adopt adequate monetary policy (Schneider and Frey 1985). Nunes et al (2006) and Asiedu (2005) found the effect of inflation on FDI inflows statistically significant with expected negative sign but Nnadozie (2000) finds the effect of inflation on FDI inflows statistically to be insignificant. This study also expects negative effect of inflation on FDI inflows.

Market Size: Various studies emphasize on the importance of market size of the host country and growth in enhancing FDI. Market size has been considered to be the most important determinants of FDI, particularly for those FDI inflows that are market seeking. The importance of the market size and positive effect on FDI inflows has been found in many previous empirical works (see Schneider and Frey, 1985; Bevan and Estrin, 2004; Hubert et al., 2004; Asiedu 2005; Chen 2009; Vijayakumar et al., 2010). In the literature, several proxies for market size are available but market size is normally measured by real GDP or GDP per capita, and GNP (Shatz and Venable, 2000; Fung et al., 2000).  This study also uses GDP as proxy for host country market size and expects positive impact of GDP on FDI inflows.

Official Development Assistance: ODA is an important explanatory variable affects FDI inflow. According the World Bank, (2004b) report, ODA flows which consist of grants and loans from both bilateral and multilateral official agencies are usually considered as vital sources of funds for capital expenditures for the low-income and middle-income countries.  Studies like (Frey 1984; Schneider and Frey 1985) also show that a positive linkage between bilateral official development assistance and FDI inflows are exist. Generally, it is believed that countries receiving greater bilateral official development assistances are also expected to get more FDI. Luger and Shetty (1985), indicates that ODA encourages the confidence of foreign investors to invest in these countries. Yasin (2005) suggests that the policy implication of the positive and significant influence of the bilateral official development assistance on FDI is that the recipient countries need to formulate policies that promote their economic conditions with the donor countries to enhance more FDI from the MNCs located in these countries. This study expects a positive impact of ODA on FDI inflows.

Trade Openness: Trade openness is also an important factor determining FDI inflows. Earlier studies like (Agiomigianakis et al., 2006; Sahoo 2006; Anyanwu 2011) provide evidences that trade openness is a positive and statistically significant determinant of FDI affecting the magnitude of FDI inflows. However, Akhtar (2000) and Nunes et al., (2006) finds insignificant results.  In the literature, the ratio of export plus import to gross domestic product is usually uses as a measure of trade openness of a country. This study also uses the same measure and expects that the higher level of openness would enhance more FDI inflows.

Materials and Method

Model Specification

The following linear regression model is used in this study to investigate the impact of various selected economic determinants on FDI inflows. Model for FDI uses in this study is based on the work of Bevan and Estrin, (2004); Asiedu, (2005); Eli and Isitua, (2006), however, explanatory variables have been accorded on the basis of availability of data and the model can be expressed symbolically as;

FDI= β0 + β1 SIZE + β2 P + ODA + β4TO+ β5FDI-1+ µ                (1)
The β’s are to be estimated
Where;
FDI= foreign direct investment, SIZE= Gross domestic product used as proxy for the host country market size, P= Inflation rate, TO= Trade openness (export + import to GDP ratio), ODA=Official development assistance, m= Stochastic term and it shows effects of the other factors. The explanatory variables and error term m followed the least squares assumptions.
The expected signs of the different variables for equation (1) are as follows:
(a): The market size, trade openness, one year lagged of FDI, and official development assistance is postulated to be positively related to the FDI inflows;
(b): The expected impact of inflation rate is postulated to be negatively related to the FDI inflows.

Table - I:          List of Variables and data sources

Variables	Descriptions
Dependent variable used: Foreign direct investment	FDI in US dollar taken from the world development indicator, and International Country Risk Guide
Explanatory variables used:
Gross domestic product	Gross domestic product used as proxy variable for the host country’s market size. The data are in US dollar taken from the world development indicator.
GDP Per Capita	GDP per capita used as proxy variable for market size. The data are in US dollar taken from the world development indicator.
Inflation rate	Inflation rate in percentage taken from the world development indicator.
Official development assistance	Official development assistance in US dollar taken from the world development indicator.
Trade openness	Trade openness (export + import to GDP ratio) in US dollar, taken from the world development indicator

Estimation Techniques

The study is based on secondary data for the period ranging from 1992 to 2010. For analysis the data have been utilized from the World Bank, World Development Indicator (2010-2011) and International Country Risk Guide (2011). Simple linear regression model has been used and the method of least squares (hereafter LS) has been applied as an analytical technique for parameters estimation. The data have been converted into log form for overcoming the non-linearity problem in data but only the dependent variable FDI in case of Azerbaijan is not in log because where two FDI values are in negative. The E.Views computer software has been used for computation analysis.

Results and Discussion

A summary of the LS results are reported in Table II and III. The LS results are reported with t-ratios of the estimated coefficients in parentheses and standard errors are in brackets, and R2 measuring the goodness of fit. The main criteria for selecting the reported estimates are that the relevant coefficients have the expected signs; estimated coefficients are statistically significant and there is a satisfactory overall level of explanation high R2 values.
Table II indicates empirical results on Kazakhstan. Overall the results are statistically significant on the basis of R2 and  criteria and strongly supports the study hypotheses. The LS result shows no multicollinearity and autocorrelation econometric problems. At first the impact of every individual explanatory variable has been investigated through regression analysis, where the impact of host country market size, inflation rate, official development assistance, one year lagged FDI have been found statistically to be significant at one percent level of significance (see Table II columns 1, 2, 3, 4). Than two explanatory variables impacts i.e., markets size and one year lagged FDI on FDI inflows have been investigated and found statistically significant at one percent level of significance. The R2 value shows 89 percent variation in FDI inflows by market size and one year lagged FDI (see Table II column 5). Table II column 6 shows results where all explanatory variables have been introduced in the model, where  indicates 90 percent variation in FDI inflows by the explanatory variables. The impact of market size found statistically to be significant at one percent level of significance and the effect on FDI inflows is 90 percent. The impact of inflation found is statistically to be significant at five percent level of significance and the effect on FDI inflows is -37 percent. The impact of one year lagged FDI found statistically significant at one percent level of significance and the effect on FDI inflows is 50 percent. Though the impact of official development assistance found is statistical significant but with wrong sign. Likewise, the impact of trade openness found significant but with expected positive sign.
Table III shows empirical results on Azerbaijan. Overall the results are statistically significant and strongly support the study hypotheses. In case of Azerbaijan two proxies have been used for market size. Hence, the results found on both proxies are statistically insignificant but with positive expected signs. The impact of inflation, one year lagged FDI and official development assistance on FDI inflows, when investigated individually are found statistically significant at one percent level of significance (see Table III columns 3, 4, 5). After that introduced two explanatory variables i.e., inflation rate and official development assistance which shows statistically significant effects at 5 and 10 percent level of significance (see Table III column 6). Table II column 8 indicates empirical results where all selected explanatory variables have been introduced, so, the result shows that inflation and official development assistance are statistically significant at 5 and 10 percent level of significance but market size found insignificant but with expected positive sign and trade openness found statistically significant but with unexpected sign. The empirical results on market size, one year lagged FDI and official development assistance show positive effects on FDI inflows, while, inflation negatively affecting FDI in Azerbaijan and Kazakhstan as hypothesized in this study. The results of this study are consistent with the findings of other studies by (Hubert et al., 2004; Asiedu, 2005; Chen, 2009). However, only in case of Azerbaijan, results on market size found statistically insignificant but with expected positive sign, hence, other previous studies like (Loree and Guisinger 1995; Ancharaz 2003) have also found insignificant results. In both countries the effect of trade openness on FDI inflows has been found weak, while, Banga (2003) also found insignificant results.

Conclusions

This study represents an initial attempt to examine the influences of different economic determinants on FDI inflows for two Central Asian countries: Azerbaijan and Kazakhstan. FDI is usually considered a vital source of capital since it complements local investment, generates new jobs opportunities and transferring technology, which indeed bolster economic growth and development. The positive relationship between FDI inflows and economic growth has been proved empirically by many researchers available in the literature. Results of the present study indicate positive effects of host country’s market size, official development assistance, and one year lagged FDI on FDI inflows and negative effect of inflation on FDI inflows during the study period covering from 1992 to 2010. The empirical results on the host country market size found are statistically insignificant in case of Azerbaijan and the effect of trade openness on FDI found statistically insignificant in both countries. However, in case of Kazakhstan the overall empirical results exhibits strong effects by the explanatory variables on FDI inflows, if compared with empirical results found on Azerbaijan. Thus, findings of the study suggest that the policy makers need to formulate appropriate policies which are conducive to the encouragement of higher level of FDI inflows.

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