Role Of Foreign Direct Investment And Economic Growth

Published Date: 02 Nov 2017

Abstract

Foreign Direct Investment (FDI) supports the national economic when it facing the lack of internal investment resources and it can cover the gap of investment resources and national investment. In this way, Foreign Direct Investment can affect the economic development and increase the speed of economic development. In this regards, among other countries, especially developing countries, that coped with the lack of internal financial resources have more interest to use Foreign Direct Investment. Since 1970 until now, the Foreign Direct Investment has been strongly growth and it outstrips from the trade growth and its causes to double exports of goods and services.

In other words, the Foreign investment in the developed world’s economy is development of transnational companies for improving competitiveness, higher profit, accessing to cheaper labor market and reaching a broader consumer market.

Malaysia is one of those developing countries that promote Foreign Direct Investment in order to increase speed growth and development. Foreign Direct Investment has cooperated a significant role in capital formation in Malaysia and the developing economy that has enhanced quickly.

CHAPTER 1

INTRODUCTION

1.1Introduction

Malaysia is one of the fastest country in growing economy in the Asia area with GNP growth of around eight plus percent per year. The Malaysian economy has shifted from agriculturally to further differentiate and also export oriented one after its independence in 1957. It is identified the Malaysian market is openly oriented with almost non existent non tariff blockade and averaging just about 50 percent and foreign exchange organize. Malaysian open trade is sustained by the two way trade approximately to 120 percent of Gross National Product (GNP). It has been demonstrated that from the established political environment, enhancing capita revenue, and the prospective for local integration all over the ASSOCIATION OF SOUTH EAST ASIAN NATIONS (ASEAN), Malaysia is a gorgeous view for FOREIGN DIRECT INVESTMENT (FDI) (see Graph 1.1). Foreign direct investment in Malaysia is a significant catalytic parameter, enhancing exports, awareness and offers an economic tool in the direction of the Malaysia 2020 vision.

Some empirical researches show that the economic growth has been established in the past 6 years at the above seven percent per year. In this regards the inflation rate has been remained below four percent, decreasing the unemployment rate, balancing the payments. Echange rate is as a significant factor in the Malaysian Foreign direct investment (FDI) in the general economy. Malaysian Bank Negara does not formally peg the Ringit (RM) to definite currencies and currency floats. In fact, Malaysian Bank Negara has been charged of depreciating the cost of the Ringit (RM) in order to encourage exports. On the other hand, Malaysia’s focus on Foreign direct investment, increasing exports, has provided it well and supplied to its 8 years of over 8 percent growth.

Graph 1.1: Central Government’s expenditures as a percentage of Gross National Product

1.2 Foreign Direct investment (FDI)

Several definitions have been proposed for Foreign direct investment. The international monetary fund defines Foreign direct investment following: Foreign direct investment is a type of investment that to achieve sustainable benefits in the country except for the home country of investor and the investor’s objective is as an important role in the management of the organization (Bengoa and Blanca 2003). Foreign direct investment is considered dependable for enhanced well-being in the host country due to the benefits related to introduction of new innovations and technologies, improvement of extra abilities, enhances capital, improving work stations in host countries (Fizari, Asari et al. 2011). A study by Bengoa and Sanchez-Robles (2003), it is defined that Foreign direct investment is the most important contributor to the economic growth in the country. Foreign direct investment is considered as a significant resource of inflows in numerous countries, especially in emerging developing economies. In fact, Foreign direct investment is evidenced in the capital account of balance of payment (Chaudhary, Shah et al. 2012).

1.3Economic Growth

Economic growth is the enhance in the quantity of the services and goods manufactured by an economy over time. It is calculated as the percent rate of enhance in actual GDP (gross domestic product). Foreign direct investment has been a significant resource of economic growth in Malaysia, transporting in capital investment, management and technology knowledge necessitated for economic growth (Mun, Lin et al. 2008). In developing countries such as Malaysia, Foreign direct investment has a positive effect on economic growth and it also depend on some the other key factors, like: human capital base in host countries, the degree of openness in the economy (Lean 2008).

1.4 The role of Foreign direct investment and economic growth

There is an extensive view that the role of foreign direct investment (FDI) on economic growth is unclear (Greenway 2004; Azman-Saini, Law et al. 2010). One possible reason for this finding is picked up from the failure of model contingency achieves in the relationship between foreign direct investment and Growth. From the traditionally studies, the exchange rate had not composed a significant factor in the analysis of economic growth (Omankhanlen 2011).

1.5 Exchange rate and inflation

There are various studies have seemed to the effect of exchange rate or inflation on direct investment (AHN, ADJI et al. 1998). Naturally, it identifies the negative effect of inflation by itself on direct investment. Exchange rate movements can affect foreign direct investment by affecting the current cost of gaining overseas (Froot and Stein 1991). For instance, a reduction in domestic currency value against foreign currency value of the domestic exchange rate will create it fewer expensive for foreign investor. In this regards, depreciation of the exchange rate will create inflows of foreign direct investment in that country rise (Erdal and Tatoglu 2002; Tsen 2006).

1.6 Problem statement

Malaysia has a growing open economy. Malaysia had 29th level as the largest economy with GDP $357.9 billion in 2007 (Bank 2007). It is identified that foreign direct investment has been observed as a major driver underlying the strong growth performance occurrence by the Malaysian economy. Malaysia has got a substantial quantity of foreign direct investment in its industry over the past decades. Despite the significance of foreign direct investment (FDI) to the Malasia, there has been a little study the determinants of the foreign direct investment such as inflation and exchange rate. Most of the earlier researches use cross-sectional or panel data to find the determinants of foreign direct investment.

This study will examine two macroeconomic parameters, explicitly exchange rate and inflation, that effect on foreign direct investment and economic growth in Malaysia over a period from 1995 to 2009. Since the economic growth is one of the key determinants accountable for advanced foreign direct investment inflow (Fedderke and Romm 2006; Kiat 2008), this study want to examine foreign direct investment and its relation to economic growth. The aim of this study is to test whether any relationship between foreign direct investment and economic growth regarding its inflation and exchange rate. The relationship between foreign direct investment and economic growth is not clear in Malaysia. So, there is a need to carry out extra research on this relationship.

1.7 Research questions

On the basis of the above mentioned problem statement, the following research questions are suggested:

RQ1: what is the effect of inflation on FDI and economic growth?

RQ2: what is the effect of exchange rate on FDI and economic growth?

RQ3: what is the effect of FDI on economic growth?

1.7. Research objectives

The objective of this thesis is to study the effect of inflation and exchange rate on FDI and its relation to economic growth in Malaysia from 1995 to 2009.

The objectives of this study are:

RO1: To evaluate the effect of inflation on FDI and economic growth.

RO2: To evaluate the effect of exchange rate on FDI and economic growth.

RO3: To evaluate the effect of foreign direct investment on economic growth.

1.8 Theoretical framework

Figure 1.1. The effect of inflation, exchange rate, FDI and economic growth

1.9. Scope of study

The study will focus on the influence of inflation and exchange rate on FDI in Malaysia. Since, Foreign direct investment in Malaysia is a significant catalytic parameter, enhancing exports, awareness, thus it has a significant role in the economic growth of the country. And Malaysia has been encouraging FDI in its economic contribution.

1.10. Significant of study

Foreign direct investment has played a significant role in the capital formation and the economic development that has enhanced rapidly. On the other hand Malaysia has been one of the majority successful Association of Southeast Asian Nations (ASEAN) countries in being a focus for FDI. In this regards, it is important to find a relationship between inflation, exchange rate and Foreign direct investment in Malaysia.

Significant for this research can be explained following:

1.10.1. To the researcher

By doing this study, the researcher finds more experience, exposure and knowledge of the way of conducting a proper research.

1.10.2. To academic area

This research might be added to the library. The outcomes of this research can be utilized for future students. In fact, this study could help other students to collect information.

1.10.3. To government

The results of this research would be references to the government to know the direction of the Malaysian economy. And government is able to make decision in the right way.

CHAPTER 2

LITERATURE REVIEW

2.1Introduction

The purpose of this chapter is review literatures relavant to topic under study so the objectives formulated in chapter one can be presented in more measurable terms.

This chapter first reviews the literature relavent foreign direct investment.Second exchange rate and inflation also review.Third focuses on using of economic growth.

2.2 Foreign Direct Investment (FDI)

One of the most striking developments during the last two decades is the spectacular growth of FDI in the global economic landscape. This unprecedented growth of global FDI in 1990 around the world make FDI an important and vital component of development strategy in both developed and developing nations and policies are designed in order to stimulate inward flows. Infact, FDI provides a win – win situation to the host and the home countries. Both countries are directly interested in inviting FDI, because they benefit a lot from such type of investment. The ‘home’ countries want to take the advantage of the vast markets opened by industrial growth. On the other hand the ‘host’ countries want to acquire technological and managerial skills and supplement domestic savings and foreign exchange. Moreover, the paucity of all types of resources viz.

financial, capital, entrepreneurship, technological know- how, skills and practices, access to markets- abroad- in their economic development, developing nations accepted FDI as a sole visible panacea for all their scarcities. Further, the integration of global financial markets paves ways to this explosive growth of FDI around the globe.

FDI is a key means of attracting inward flows of capital and technology, together with associated innovation in management techniques, the organisation of work and distributional networks. It is associated with the import of capital, work organisation and technological advantages to a host economy, thereby potentially improving aggregate productivity, facilitating

the rising skill level of the workforce through the provision of high-skill employment opportunities. FDI provides the UK with a significant proportion of high value-added, manufacturing jobs and is perceived as having potential to improve employment opportunities and promote regional economic evelopment.

There are many determinants of FDI, including demand- and supply-side factors, however this paper concentrates upon one variable identified in the literature, namely the degree of labour market flexibility.

The internationalisation of economic processes has prompted considerable interest in Foreign Direct Investment (FDI) as a key means of attracting inward flows of capital and technology, together with associated innovation in management techniques, the organisation of work and distributional networks.

Foreign Direct Investment (FDI) may be defined as capital invested for the purpose of acquiring a lasting interest in an enterprise, whilst simultaneously exerting a degree of influence on its operations. It is this combination of ownership and control that distinguishes FDI from other forms of trans-national investment and/or production, such as portfolio investment (i.e. ownership of financial assets without the same degree of direct control) and franchising (i.e. control over production technology and process but without ownership) (Dunning, 1979).

The international business literature proposes that firms tend to consider FDI once they have developed certain competitive advantages that they feel they can more effectively exploit by engaging in a strategic location of production abroad, rather than export goods and services, but maintain their direct control over the process to minimise transaction costs, retain control over technological and other elements of the production process together with organisation knowledge (Morgan, 1997). Assuming rational action, firms must be responding to, firstly, incentives to locate production abroad, rather than export from their existing home base, and secondly, a separate set of incentives to internalise the production process. The latter may centre upon the perceived risk inherent within the principal-agent problem, whereby the reliance upon an agent to fulfil objectives established by the principal might lead to sub-optimal solutions, due to differences in self-interest, and may require costly solutions, involving the provision of additional incentives for the agent or otherwise intensive monitoring of their activities. Risk of this nature may include the threat of theft of technological knowledge, or, less dramatically, the provision of greater opportunities for the diffusion of technological knowledge, and hence

erosion of competitive advantage, together with possible loss of reputation and goodwill due to the operations of low quality franchise operations.

The United Nations World Investment Report (UNCTAD, 1998) argued that FDI arises due to a combination of, firstly, host country (or locational) determinants, based upon the social and economic factors together with the attractiveness of government policy framework for the attraction of FDI.

Dunning John H.14 (2004) in his study "Institutional Reform, FDI and European Transition Economics" studied the significance of institutional infrastructure and development as a determinant of FDI inflows into the European Transition Economies. The study examines the critical role of the institutional environment (comprising both institutions and the strategies and policies of organizations relating to these institutions) in reducing the transaction costs of both domestic and cross border business activity. By setting up an analytical framework the study identifies the determinants of FDI, and how these had changed over recent years.

Tomsaz Mickiewicz, Slavo Rasosevic and Urmas Varblane73 (2005), in their study, "The Value of Diversity: Foreign Direct Investment and Employment in Central Europe during Economic Recovery", examine the role of FDI in job creation and job preservation as well as their role in changing the structure of employment. Their analysis refers to Czech Republic, Hungary, Slovakia and Estonia. They present descriptive stage model of FDI progression into Transition economy. They analyzed the employment aspects of the model. The study concluded that the role of FDI in employment creation/ preservation has been most successful in Hungary than in Estonia. The paper also find out that the increasing differences in sectoral distribution of FDI employment across countries are closely relates to FDI inflows per capita. The bigger diversity of types of FDI is more favorable for the host economy. There is higher likelihood that it will lead to more diverse types of spillovers and skill transfers. If policy is unable to maximize the scale of FDI inflows then policy makers should focus much more on attracting diverse types of FDI.

Iyare Sunday O, Bhaumik Pradip K, Banik Arindam28 (2004), in their work "Explaining FDI Inflows to India, China and the Caribbean: An Extended Neighborhood Approach" find out that FDI flows are generally believed to be influenced by economic indicators like market size, export intensity, institutions, etc, irrespective of the source and destination countries. This paper looks at FDI inflows in an alternative approach based on the concepts of neighborhood and extended neighborhood. The study shows that the neighborhood concepts are widely applicable in different contexts particularly for China and India, and partly in the case of the Caribbean. There are significant common factors in explaining FDI inflows in select regions. While a substantial fraction of FDI inflows may be explained by select economic variables, country – specific factors and the idiosyncratic component account for more of the investment inflows in Europe, China, and India.

Andersen P.S and Hainaut P.3 (2004) in their paper "Foreign Direct Investment and Employment in the Industrial Countries" point out that while looking for evidence regarding a possible relationship between foreign direct investment and employment, in particular between outflows and employment in the source countries in response to outflows. They also find that high labour costs encourage outflows and discourage inflows and that such effect can be reinforced by exchange rate movements. The distribution of FDI towards services also suggests that a large proportion of foreign investment is undertaken with the purpose of expanding sales and improving the distribution of exports produced in the source countries. According to this study the principle determinants of FDI flows are prior trade patterns, IT related investments and the scopes for cross – border mergers and acquisitions. Finally, the authors find clear evidence that outflows complement rather than substitute for exports and thus help to protect rather than destroy jobs.

John Andreas32 (2004) in his work "The Effects of FDI Inflows on Host Country Economic Growth" discusses the potential of FDI inflows to affect host country economic growth. The paper argues that FDI should have a positive effect on economic growth as a result of technology spillovers and physical capital inflows. Performing both cross – section and panel data analysis on a dataset covering 90 countries during the period 1980 to 2002, the empirical part of the paper finds indications that FDI inflows enhance economic Growth in developing economies but not in developed economies.

This paper has assumed that the direction of causality goes from inflow of FDI to host country economic growth. However, economic growth could itself cause an increase in FDI inflows. Economic growth increases the size of the host country market and strengthens the incentives for market seeking FDI. This could result in a situation where FDI and economic growth are mutually supporting. However, for the ease of most of the developing economies growth is unlikely to result in market – seeking FDI due to the low income levels. Therefore, causality is primarily expected to run from FDI inflows to economic growth for these economies.

Klaus E Meyer34 (2003) in his paper "Foreign Direct investment in Emerging Economies" focuses on the impact of FDI on host economies and on policy and managerial implications arising from this (potential) impact. The study finds out that as emerging economies integrate into the global economies international trade and investment will continue to accelerate. MNEs will continue to act as pivotal interface between domestic and international markets and their relative importance may even increase further. The extensive and variety interaction of MNEs with their host societies may tempt policy makers to micro – manage inwards foreign investment and to target their instruments at attracting very specific types of projects. Yet, the potential impact is hard to evaluate ex ante (or even ex post) and it is not clear if policy instruments would be effective in attracting specifically the investors that would generate the desired impact.

The study concluded that the first priority should be on enhancing the general institutional framework such as to enhance the efficiency of markets, the effectiveness of the public sector administration and the availability of infrastructure. On that basis, then, carefully designed but flexible schemes of promoting new industries may further enhance the chances of developing internationally competitive business clusters.

Klaus E Meyer, Saul Estrin, Sumon Bhaumik, Stephen Gelb, Heba Handoussa, Maryse Louis, Subir Gokarn, Laveesh Bhandari, Nguyen, Than Ha Nguyen, Vo Hung (2005) in their paper "Foreign Direct Investment in Emerging Markets: A Comparative Study in Egypt, India, South Africa and Vietnam" show considerable variations of the characteristics of FDI across the four countries, all have had restrictive policy regimes, and have gone through liberalization in the early 1990. Yet the effects of this liberalization policy on characteristics of inward investment vary across countries. Hence, the causality between the institutional framework, including informal institutions, and entry strategies merits further investigation. This analysis has to find appropriate ways to control for the determinants of mode choice, when analyzing its consequences. The study concludes that the policy makers need to understand how institutional arrangements may generate favourable outcomes for both the home company and the host economy. Hence, we need to better understand how the mode choice and the subsequent dynamics affect corporate performance and how it influences externalities generated in favour of the local economy.

Vittorio Daniele and Ugo Marani78 (2007) in their study, "Do institutions matter for FDI? A Comparative analysis for the MENA countries" analyse the underpinning factors of foreign Direct Investments towards the MENA countries. The main interpretative hypothesis of the study is based on the significant role of the quality of institutions to attract FDI. In MENA experience the growth of FDI flows proved to be notably inferior to that recorded in the EU or in Asian economies, such as China and India. The study suggests as institutional and legal reform are fundamental steps to improve the attractiveness of MENA in terms of FDI.

2.3 Determinants of FDI

2.3.1 Minimising Risk

TNCs prefer to minimise the risk associated with their investments, and therefore they prefer the combination of a stable political climate together with a dependable macroeconomic framework (Wheeler and Mody, 1992).

Indicators of the latter include low rates of inflation, budget deficits and government debt, together with a relatively stable exchange rate. High rates of any or all of these variables threaten to erode the financial value of the assets purchased or developed by the inward investor, and thereby increase the risk premium of FDI in that particular nation. Interestingly,

given the relevance to the issue for the membership of the Euro, this does not necessarily imply a preference for a fixed exchange rate, but does indicate a general dislike of excessive exchange rate variability. Inward investors additionally minimise risk through their preferences for operating within a secure and transparent legal framework, designed to protect their property and security of their business contracts. Additional attractive policy-related factors include the maintenance of a reasonable rate of economic growth, low costs of borrowing (via a low rate of interest), low levels of taxation and/or the provision of specific investment incentives intended to lower the cost of inward investment. Furthermore, the potential offered by privatisation, through potential undervaluing of former state assets and/or the opportunity provided to purchase strategically valuable assets, has further encouraged increases in FDI throughout the past two decades.

2.3.2 Cost Factors

In addition to demand factors, FDI is influenced by the relative cost of production and distribution within potential host nations. This is determined by the quality and reliability of physical and communications infrastructure, relative unit costs, the cost and ease of access to raw materials and the cost of capital. The latter could be eased by monetary policy maintaining a relatively low rate of interest and/or full integration within international financial markets. The existence of capital controls and other types of financial regulations would be perceived as generally unattractive. Furthermore, relative unit costs can be influenced by government policy.

2.3.3 Demand Factors

The international business literature suggests that there are many interrelated determinants of FDI, and that the ultimate decision for a TNC to invest in a particular country will depend upon a composite of these various variables (see Appendix One for a partial summary of this literature).

Evidence tends to suggest that investors prefer nations with relatively liberal trade regimes, perhaps some type of regional supra-national trade arrangement, such as the European Union single market, NAFTA, ASEAN and so forth. The size of the national and/or regional market is therefore of great significance, since it is primarily to serve this market by localized production, rather than export from the home nation, that FDI occurs (Culem, 1988; Jost, 1997; Pain and Lansbury, 1997). The relative affluence and growth rates enjoyed by the host market are of similar significance for potential entrant firms. Furthermore, in addition to market conditions which will influence the potential demand for the firms’ products, there are additional nation-specific factors which may influence location of FDI. These may relate to the existence of a natural resource, technology or production method protected by legal patent, to which the TNC wishes to gain access (Cantwell, 1989: Caves, 1996: Neven and Siotis, 1996;Dunning, 1988).

2.3 Exchange Rate and and FID

Foreign Direct Investment (FDI) is an international flow of capital that provides a parent company or multinational organization with control over foreign affiliates. By 2005, inflows of FDI around the world rose to $916 billion, with more than half of these flows received by

businesses within developing countries.2 One of the many influences on FDI activity is the

behavior of exchange rates. Exchange rates, defined as the domestic currency price of a foreign currency, matter both in terms of their levels and their volatility. Exchange rates can influence both the total amount of foreign direct investment that takes place and the allocation of this investment spending across a range of countries.

When a currency depreciates, meaning that its value declines relative to the value of another currency, this exchange rate movement has two potential implications for FDI. First, it reduces that country’s wages and production costs relative to those of its foreign counterparts.

All else equal, the country experiencing real currency depreciation has enhanced "locational advantage" or attractiveness as a location for receiving productive capacity investments. By this "relative wage" channel, the exchange rate depreciation improves the overall rate of return to foreigners contemplating an overseas investment project in this country.

The exchange rate level effects on FDI through this channel rely, on a number of basic considerations. First, the exchange rate movement needs to be associated with a change in the

relative production costs across countries, and thus should not be accompanied by an offsetting increase in the wages and production costs in the destination market for investment capital.

Second, the importance of the "relative wage" channel may be diminished if the exchange rate movements are anticipated. Anticipated exchange rate moves may be reflected in a higher cost of financing the investment project, since interest rate parity conditions equalize risk-adjusted expected rates of returns across countries. By this argument, stronger FDI implications from exchange rate movements arise when these are unanticipated and not otherwise reflected in the expected costs of project finance for the FDI.

Some experts on FDI implications of exchange rate changes dismiss the empirical relevance of the interest-parity type of caveat. Instead, it is argued that there are imperfect capital market considerations, leading the rate of return on investment projects to depend on the structure of capital markets across countries. For example, Froot and Stein (1991) argue that capital markets are imperfect and lenders do not have perfect information about the results of their overseas investments. In this scenario, multinational companies, which borrow or raise capital internationally to pay for their overseas projects, will need to provide their lenders some extra compensation to cover the relatively high costs of monitoring their investments abroad.

Multinationals would prefer to finance these projects out of internal capital if this were an option, since internal capital is increasing in the parent company’s wealth. Consider what occurs when exchange rates move. A depreciation of the destination market currency raises the relative wealth of source country agents and can raise multinational acquisitions of certain destination market assets. To the extent that source country agents hold more of their wealth in own currency-denominated form, a depreciation of the destination currency increases the relative wealth position of source country investors, lowering their relative cost of capital. This allows the investors to bid more aggressively for assets abroad.

Empirical support for this channel is provided by Klein and Rosengren (1994), who show that

the importance of this relative wealth channel exceeded the importance of the relative wage channel in explaining FDI inflows to the United States during the period from 1979 through 1991.

Blonigen (1997) makes a "firm-specific asset" argument to support a role for exchange rates movements in influencing FDI. Suppose that foreign and domestic firms have equal opportunity to purchase firm-specific assets in the domestic market, but different opportunities to generate returns on these assets in foreign markets. In this case, currency movements may affect relative valuations of different assets. While domestic and foreign firms pay in the same currency, the firm-specific assets may generate returns in different currencies. The relative level of foreign firm acquisitions of these assets may be affected by exchange rate movements. In the simple stylized example, if a representative foreign firm and domestic firm bid for a foreign target firm with firm-specific assets, real exchange rate depreciations of the foreign currency can plausibly increase domestic acquisitions of these target firms. Again, this channel predicts that foreign currency depreciation will lead to enhanced FDI into the foreign economy. Data on Japanese acquisitions in the United States support the hypothesis that real dollar depreciations make Japanese acquisitions more likely in U.S. industries with firm-specific assets.

In addition to these arguments supporting the effects of levels of exchange rates, volatility of exchange rates also matters for FDI activity. Theoretical arguments for volatility effects are broadly divided into "production flexibility" arguments and "risk aversion" arguments. To understand the production flexibility arguments, consider the implications of having a production structure whereby producers need to commit investment capital to domestic and foreign capacity before they know the exact production costs and exact amounts of goods to be ordered from them in the future. When exchange rates and demand conditions are realized, the producer commits to actual levels of employment and the location of production. As Aizenman (1992) nicely demonstrated, the extent to which exchange rate variability influences foreign investment hinges on the sunk costs in capacity (i.e. the extent of investment irreversibilities), on the competitive structure of the industry, and overall on the convexity of the profit function in prices. In the production flexibility arguments, the important presumption is that producers can adjust their use of a variable factor following the realization of a stochastic input into profits. Without this variable factor, i.e. under a productive structure with fixed instead of variable factors, the potentially desirable effects on profits of price variability are diminished.

By the production flexibility arguments, more volatility is associated with more FDI ex ante, and more potential for excess capacity and production shifting ex post, after exchange rates are observed.

An alternative approach linking exchange-rate variability and investment relies on risk aversion arguments. The logic is that investors require compensation for risks that exchange rate movements introduce additional risk into the returns on investment. Higher exchange-rate variability lowers the certainty equivalent expected exchange-rate level, as in Cushman (1985, 1988). Since certainty equivalent levels are used in the expected profit functions of firms that make investment decisions today in order to realize profits in future periods. If exchange rates are highly volatile, the expected values of investment projects are reduced, and FDI is reduced accordingly. These two arguments, based on "production flexibility" versus "risk aversion", provide different directional predictions of exchange rate volatility implications for FDI.

The argument that producers engage in international investment diversification in order to achieve ex post production flexibility and higher profits in response to shocks is relevant to the extent that ex post production flexibility is possible within the window of time before the realization of the shocks. This suggests that the production flexibility argument is less likely to pertain to short term volatility in exchange rates than to realignments over longer intervals. When considering the existence and form of real effects of exchange rate variability, a clear distinction must be made between short term exchange rate volatility and longer term misalignments of exchange rates. For sufficiently short horizons, ex ante commitments to capacity and to related factor costs are a more realistic assumption than introducing a model based on ex post variable factors of production. Hence, risk aversion arguments are more convincing than the production flexibility arguments posed in relation to the effects of short-term exchange rate variability. For variability assessed over longer time horizons, the production flexibility motive provides a more compelling rationale for linking foreign direct investment flows to the variability of exchange rates.

As exposited above, the exchange rate effects on FDI are viewed as exogenous, unanticipated, and independent shocks to economic activity. Of course, to the extent that exchange rates are best described as a random walk, this is a reasonable treatment. Otherwise, it is inappropriate to take such an extreme partial equilibrium view of the world. Accounting for the co-movements between exchange rates and monetary, demand, and productivity realizations of countries is important. As Goldberg and Kolstad (1995) show, these correlations can modify the anticipated effects on expected profits, and the full presumption of profits as decreasing in exchange rate variability. Empirically, exchange rate volatility tends to increase the share of a country’s productive capacity that is located abroad. Analysis of two-way bilateral foreign direct investment flows between the United States, Canada, Japan, and the United Kingdom showed that exchange rate volatility tended to stimulate the share of investment activity located on foreign soil. For these countries and the time period explored, exchange rate volatility did not have statistically different effects on investment shares when distinguished between periods where real or monetary shocks dominated exchange rate activity. Real depreciations of the source country currency were associated with reduced investment shares to foreign markets, but these results generally were statistically insignificant.

Although theoretical arguments conclude that the share of total investment located abroad may rise as exchange rate volatility increases, this does not imply that exchange rate volatility

depresses domestic investment activity. In order to conclude that domestic aggregate investment declines, one must show that the increase in domestic outflows is not offset by a rise in foreign inflows. In the aggregate United States economy, exchange rate volatility has not had a large contractionary effect on overall investment (Goldberg 1993).

Overall, the current state of knowledge is that exchange rate volatility can contribute to the internationalization of production activity without depressing economic activity in the home market. The actual movements of exchange rates can also influence FDI through relative wage channels, relative wealth channels, and imperfect capital market arguments.

2.4 Inflation and FID

In recent years interest in understanding the determinants of foreign direct investment (FDI) has intensified hand in hand with an increasing volume of FDI flows. From 1990 to 2005, the total worldwide FDI inflows increased from $203 billion to $974 billion. Almost all developing countries are competing to attract a major share of these inflows. In fact, the share of net FDI inflows in the gross domestic product (GDP) of middle income countries has risen from 0.74% in the 1970s to 1.08% between 1985 and 1994, and to 2.85% between 1995 and 2005. (1) The intensified competition to attract more FDI has led to changes in the regulatory frameworks provided by almost all countries. According to the recent World Investment Report (UNCTAD 2003), during the period 1991-2002, around 95% of the changes in worldwide laws governing FDI have been favorable to multinational firm activity. Establishment of investment promotion agencies as well as provision of fiscal incentives have accompanied these improvements in local regulatory environments. Given the objectives of host countries to attract high-quality investments and to ensure benefits from such foreign activity, it is important to fully understand the factors influencing the FDI flows. 

This article primarily studies the role of inflation among the factors that drive FDI. Inflation rates have increased from around 5 to 10% on average in developing countries during the 1970s, followed by an increase of 49% on average among developing countries between 1985 and 1994. This trend of increasing inflation rates has been reversed in the late 1990s; the inflation rates in developing countries have on average declined to 9.2% during 1995-2004, a period during which the net FDI inflows as a share of GDP have more than doubled in the middle income countries. Given the focus among developing countries to attract more FDI, it is interesting to analyze whether the increasing inflation rates in the 1970s and 1980s might have been a deterrent for FDI inflows and whether their reversal in the 1990s might have contributed to the increase in FDI inflows to these economies. Despite not providing conclusive evidence, the coincidences of high inflation and low FDI versus the low inflation and high FDI inflows into these developing countries motivates investigation of the possible links between the two variables.

2.5 Economic Growth

The economic growth and development have been debated for centuries. Industrialization had brought forth permanent changes in the economic and human activity. After the Depression of the 1929-1933 span, the importance of these processes increases. Overcoming any economic difficulties, whether we speak about the decreasing of the unemployment rate or about the external equilibrium, a correlation was made with the economic growth and development. Any decision made at a state or supra-state level aimed at reaching these two objectives. Today, more than anytime, in a recessionary, liberalized economy, in a world marked by a strong demographic increase, by the depletion of natural resources, by changes of climate and of ecosystem destruction, we are more preoccupied than ever by the problems of economic growth and development. Hereinafter will make, an epistemological analysis of these two processes.

Though no unanimously accepted definition has been forgotten by now, most of the theoreticians think of the economic development as a process that generates economic and social, quantitative and, particularly, qualitative changes, which causes the national economy to cumulatively and durably increase its real national product.

In contrast and compared to development, economic growth is, in a limited sense, an increase of the national income per capita, and it involves the analysis, especially in quantitative terms, of this process, with a focus on the functional relations between the endogenous variables; in a wider sense, it involves the increase of the GDP, GNP and NI, therefore of the national wealth, including the production capacity, expressed in both absolute and relative size, per capita, encompassing also the structural modifications of economy.

We could therefore estimate that economic growth is the process of increasing the sizes of national economies, the macro-economic indications, especially the GDP per capita, in an ascendant but not necessarily linear direction, with positive effects on the economic-social sector, while development shows us how growth impacts on the society by increasing the standard of life.

Typologically, in one sense and in the other, economic growth can be: positive, zero, negative. Positive economic growth is recorded when the annual average rhythms of the macro-indicators are higher than the average rhythms of growth of the population. When the annual average rhythms of growth of the macro-economic indicators, particularly GDP, are equal to those of the population growth, we can speak of zero economic growth. Negative economic growth appears when the rhythms of population growth are higher than those of the macro-economic indicators.

Economic growth is a complex, long-run phenomenon, subjected to constraints like: excessive rise of population, limited resources, inadequate infrastructure, inefficient utilization of resources, excessive governmental intervention, institutional and cultural models that make the increase difficult, etc.

Economic growth is obtained by an efficient use of the available resources and by increasing the capacity of production of a country. It facilitates the redistribution of incomes between population and society. The cumulative effects, the small differences of the increase rates, become big for periods of one decade or more. It is easier to redistribute the income in a dynamic, growing society, than in a static one.

There are situations when economic growth is confounded with economic fluctuations. The application of expansionist monetary and tax policies could lead to the elimination of recessionary gaps and to increasing the GDP beyond its potential level.

Economic growth supposes the modification of the potential output, due to the modification of the offer of factors (labour and capital) or of the increase of the productivity of factors (output per input unit).

When the rate of economic growth is big, the production of goods and services rises and, consequently, unemployment rate decreases, the number of job opportunities rises, as well as the population’s standard of life.

Other economists think that if the rate of growth of the real GDP per capita were maintained at 2% a year, then the GDP per capita would double every 35 years and, therefore, each generation could hope for a better standard of life than in the present. Fr this reasons, we should take into consideration the fact that the small differences in the rate of economic growth over long periods lead to big differences between the standard of life of the different successive generations. The economic growth is also the process that allows the receding of phenomena with a negative economic and social impact, like unemployment or inflation. But, obviously, a durable economic growth sustains human development.

According to Leszek Balcerowicz, economic growth is a process of quantitative, qualitative and structural changes, with a positive impact on economy and on the population’s standard of life, whose tendency follows a continuously ascendant trajectory.

Leszek Balcerowicz thinks that the economic development has four dimensions :

- The initial level of development (reflected, for instance, by the income per capita) or the level existing when the rhythm of development starts being determined;

- The human capital or the people’s level of education and professional training;

- The internal economic condition or the economy’s structures;

- The external economic circumstances.

The last three factors should be related to the period for which the rhythm of economic evelopment is determined, which, in its turn, is the result of different interactions between the four groups of factors.

The initial level of development is essential for the subsequent rhythm of development. Staying behind involves certain impulses of acceleration – the countries with a lower rhythm of development can reach a faster one compared to the richer countries because a state not keeping pace can us at an institutional and technological level the solutions that the developed countries have already found and could learn from their mistakes, an aspect that Balcerowicz deem more important than the former one.

The developing countries have an out-of-date economic structure, most of the population working in fields of low productivity, especially in agriculture, but there are possibilities to transfer resources towards more productive domains. The third factor is characteristic to formerly socialist countries and refers to the disproportion between the relatively high level of education of the population and the possibilities to exploit this training. The high level of education represents an advantage for the

countries that joined the economic development trend.

It is also worth pointing out that between economic growth and economic development there are similarities and differences [6]. Similarities refer to the fact that:

- Growth and development are continuous processes, with stimulating effects in economy;

- Both processes involve the allotment and utilization of resources and the increase of

efficiency;

- The finality of growth and development is the improvement of the standard and quality of

life;

- Growth and development are cause and result of the general trend, influencing its rhythm

and ensuring passages from one level to the other.

The differences between economic growth and development refer to the fact that, while economic growth concerns the quantitative side of economic activity (the increase of results, of quantities, of sizes), development has a larger scope, including qualitative changes that take place in economy and society. In fact, development is a qualitatively higher step of macro-economic evolution. We often refer to growth theories when we speak about the developed countries and to the theories of development when we approach the economic problems that are specific to the developing or less developed countries.

A country is able to develop fast when:

- industries and people have the possibility to plan their activity on the long run, which

requires political, legislative and monetary stability;

- the results of economic activity depend on free initiative, on the efficient utilization of

resources, on efficient labour, etc.

- investments are not sacrificed in favour of immediate consumption. When most of the

current incomes are reinvested, the productive capital increases and, consequently, the real

incomes too;

- the decisions regarding investments and production are correct, and the wealth

accumulated in time is adequately used to achieve assets as efficient as possible from an

economic standpoint;

- the degree of education and civilization rises and records a leap forward at the level of

consciousness;

- any decision takes into consideration the protection and conservation of eco-system

(durable development);

- economic, social, spiritual values are respected.

Economic growth and development determine social progress, that is the progressive evolution of the society, which involves an improvement of the human condition, a step higher on the scale of the human being’s standard [8], based on economic progress. The accentuation of the social side of

economic development should not be understood as abandonment of economic growth. The economic achievements create bases for the improvement of the standard of life, for adequate conditions of medical care, for the improvement of the educational system and a better redistribution of incomes in society.

Thus, economic growth remains a priority, while the correlation of economic problems with social ones should lead to the development of any national economic system, especially when structural crises demonstrate that the limits of the system are about to be reached.

The final purpose of economic growth and development is, undoubtedly, the fulfilment and Multilateral development of human personality, the increase of the people’s material and spiritual wealth, their stepping higher on the scale of civilization and culture.

In the General Assembly of the United Nations in September 2000, also known as the Millennium Summit, the status of human development was analysed, considering all its diverse aspects, and a set of eight objectives, with phases and deadlines, was adopted. The diversified approach of the wide topic of this process allows for a series of aspects, alarmingly intense and dramatic in different

countries and areas, to be examined. Among other topics, the ones concerning extreme poverty, illiteracy, the lack of utilities and particularly the lack of access to running water, as well as the pollution of the environment, were considered. In the 21 st century, in a phase of economic and socialevolution dominated by knowledge, the gaps of development get sharper. Many voices considered that liberalization and, implicitly, globalization could be the salutary solution for the eradication of negative phenomena existing at an international level. On the one hand, the advantages associated with economic openness proved to be beneficial, on the other hand, we have seen how strong nations, playing the good Samaritan, used the natural and human resources of the poor states that they enslaved for their benefit, and emptied of their own possibilities of development, under the promise of a better future. Any hope for the better disappeared once the current economic crises began, whose sizes are much bigger than we could have anticipated. Of course, the wish for economic growth and development, fully justified, remains, but hope in the case of developing and less developed countries dies while their dependence upon the powerful states of the world rises. Economic and social vulnerability is the weak feature that the centres of power of the world would not hesitate to profit from. Yet, the differentiation of the two analyzed phenomena is obvious. If, theoretically, we continue talking about them as a pair, in practice there is a gap between them. We can notice how the focus is placed on growth, quantity, wealth at any price. We are aware of how much knowledge we can find, we have possibilities to stock and to use it, but we do not have the will to assimilate and to correlate them in order to give value judgments. It is not actually possible to accumulate it all, and there is also a huge gap between the volume of existing information and the one that most of the people hold.

Knowledge will bring down those who will not be able or willing to assimilate, and will render efficient those able to capitalize it; it will strengthen personality, change ways of action and of life.

The human being’s intelligence, imagination and intuition will become more and more important compared to machines in the decades to follow [10]. The developing countries aim at catching up with the developed ones. In terms of wealth, obviously. Focusing on richness, people forget, more or less deliberately, how important education and solidarity are. The chase for money leaves time only for ignorance, and this is the source of wrong decisions. The mechanism works. Due to the mirage of globalization and to the desire to "sit with the rich", many countries accepted to be manipulated,

accepted to grow and not to develop. This is how the current economic-social situation emerged.We do not blame liberalization or globalization, which are good if they are based on correct principles, but the lack of morality, of education and spirituality that transform masses of people into weak, ignorant characters, avid for money. Economic and social growth and development should be considered together, and the increase of quantities should have an equivalent in the increase of the humanity’s standard of life and degree of consciousness. It would not be a bad thing to change the direction of the paradigm referring to economic growth and development. A step was made when the concept of sustainable development was brought forth. The next step would be the introduction of the concept of sustainable development in solidarity, based on moral and spiritual values as well.

Under these circumstances, granted by economic and social reality, any policy of economic development should consider three main objectives:

1. new possibilities to achieve and distribute the goods that satisfy the society’s basic needs,

starting from the inequality limited resources and unlimited needs;

2. the increase of the standard of life that involves high incomes, low unemployment rate,

the increase of the level of education, etc.;

3. the increase of the level of economic and social opportunities available for persons and

countries.

Although the issue of economic development pertains, first of all, to the economy of each country, the effects at a world level are particularly important. Presently, the economic, technological and cultural gaps grow larger and larger, instead of being reduced. Some states do not hold resources to compensate the imports of assets necessary to economic growth, sometimes not even for those meant for basic needs, while the economically developed countries have inefficient commercial surpluses(Japan’s case at the moment when Asian crisis started), high unemployment rate, difficulties in dissimulating the results of an increasingly productive and complex economy.

The internal problems of the developing countries are numerous and ample, and the pressure created by these problems make difficult a classification of priorities. Approaching those needs sustained internal efforts, a democratic framework and a competent governing. John Keneth Galbraith said, about this, that the "success of an economy depends on a stable, efficient and active governmental structure, that would support and guide it. If it is absent, none of the main conditions of economic development could be fulfilled" . There should be as many equitable societies as possible, but "in an equitable society, nobody can suffer from starvation or for lacking a home. The first condition is that of a sufficient number of job and gain opportunities, that would not stimulate inactivity" .

Though there are countries facing problems like unemployment or poverty, we could state that all of the world states are in a process in which individuals and wealth multiply and develop. thought that the world goes towards progress and freedom. He was right, but we realize that freedom and wealth are for the rich, not for the poor, according to the famous principle that "we are all equal, but some are more equal than others", to paraphrase George Orwell . Starting with 1990, the level of economic and social development is estimated by the calculation of the HDI (Human Development Index).

The permanent presence in the world reports of the human development index (HDI) as a basic synthetic indicator, determined the Nobel prize winner for economics in 1998, Amartya Sen, to state that this indicator became the "emblem of the World Report on human development".

Analysing the extreme values of HDI one can easily notice that in the field of human development some progress was obtained reflected in the increase of its extreme values, and in the decrease of the relation between these values. On the other hand, maintaining a high level of the amplitude of extreme values reflects the level of disparities existing at a world level.

Being a composite indicator, the HDI is a function of three elements: life expectancy at birth, education and incomes, and it does not take into consideration essential qualitative elements. HDI is calculated starting from a basket of measurable indicators that do not reflect the evolution at the level of human values.

The final purpose of practical utilization of the theories of economic growth and development and of the application of the policies of economic growth is the improvement of the quality of life, which is not the same thing as the increase of the standard of life, as this is just one component of the quality of life. "The standard of life reflects only the degree of fulfilment of the vital needs of a country’s population, of a social group or of a person. The quality of life, on the other hand, reflects the totality of natural, technical, economic, social, political, cultural, ethical, etc. conditions that ensure the integrity and the biological, social and spiritual progress of the human being" .

For the process of economic growth to have positive effects, it must be accompanied by economic growth as well, that is by the increase of the quality of life per capita from one phase to the other, and by progress at the level of the moral and spiritual human values. It is possible for a country to record economic increase, but not to achieve economic development. Thus, it is possible for the GDP/per capita to increase and no improvement of the standard of life and of the quality of life to be recorded, no improvement, therefore, in the demographic structure, in the structure and amount of incomes and in the goods and services consumption by the population, in the work conditions, health condition, access to education and culture, while the natural and social environment could degenerate. Many countries have led and continue to lead a policy of increase of the military power, they wasted great amounts of resources by irrational macro-economic policies and by investments in inefficient huge projects, damaging the standard of life and the quality of life. For that, it is necessary for the economic growth to be recorded together with a policy of rational utilization of resources, in order to achieve individual and social progress in each country.

The ideal situation, from the standpoint of the standard of development, would be equality, if a wide range of opportunities existed that would allow a faster development and would bring forth as few inequalities as possible. Between development and progress there are a series of contradictions that we will approach in the following.

One of the contradiction of development and progress for any economy is the one between its limited resources (raw materials, power, capacity of production, labour, financial means) and the increasing productive and individual consumption needs, more and more diversified. This calls for each country to act for a better capitalization of the resources it has, for their saving, for the discovering the attraction in the economic circuit of new resources, for the promotion of the technical-scientific progress, etc. The system of social needs, specific to each country, and the necessity to fulfil the continuously regenerating, evolving and diversifying needs maintain the progress of nationaleconomies. We should take into consideration the fact that between needs, their generation and their fulfilment, come production, distribution of incomes, the market and its varied mechanisms, the social system, provoking big discrepancies and distortions in the system of needs, in their evolution, in the degree and manner of fulfilling them.

Another contradiction is that between the great potential of resources of a country in certain fields and its limited or insufficient possibilities of assimilation, processing and effective utilization of this potential. This could be solved by increasing internal and external investments, by creating new job opportunities, by raising the technical level of production, etc. A different contradiction emerges between the needs of consumption, of growth, of diversification, and the possibilities to fulfil them. This stimulates the development of production of consumer goods and services.

In some countries, one can notice a contradiction between the level of the production forces and their structure, and the forms of organization and management of the economic activities. A country can hold rich natural resources, and yet be deprived of the technical and financial possibilities necessary in capitalizing them and fulfilling needs. The adoption of some systems and methods of organization and management adapted to the changes that occur systematically create a framework that encourages economic progress.

The existence of these contradictions is a warning signal as for the factors on the basis of which higher rates of growth are recorded and as for the way in which the results of the process of growth are transposed in the economic and social development.

2.6 Relation between Exchange & Inflation Rate and Economic Growth

From traditionally standpoint, the real exchange rate had not constituted an important dimension in the analysis of economic growth. The first generation of neo‐classical economists did not consider exchange rate  in  the  growth  models  or  in  their  practical  policy  incarnations that  focused  on  savings  and  investment  as  determinants  of  growth.  The  above  indicates  that  these  were  closedâ