The Relationship between Foreign aid and FDI in South Asian Economies

Abstract

This study investigates whether or not foreign aid attracts foreign direct investment (FDI) in South Asian economies. Using various econometric techniques, the investigation is performed based on the concept of substitutable and complementary relationship between FDI and classified foreign aid. Foreign aid classified into aid in the shape of physical capital, and aid for human capital and infrastructure development. The results suggest that both aid in the shape of physical capital and aid for human capital and infrastructure development serve as complementary factors to foreign direct investment rather than being substitutable in South Asian economies. Thus, we conclude that aid flow in South Asian countries attract FDI into the region. 1. Introduction Although the concept of foreign aid and foreign direct investment (FDI) arose 40 years before, time to time numerous theories and analyses related to aid and FDI have been entering into the scene of research due to the dynamic trend of regional and global economies because both aid and FDI are crucial factors and play vital role in the way of formation of physical and human capital, and directing the recipient countries towards economic growth and development. In this respect, the relationship between these two factors is considered as a topic of this study with respect to the South Asian economies. In this study, South Asian used to refer Bangladesh, Pakistan, India and Sri Lanka. Looking at the macroeconomic environment in South Asian counties, it seems supporting for promotion of more FDI flow into the region. Most of the South Asian countries are exhibiting strong and healthy macroeconomic performance in recent years. Economic growth is strong, which is one of the principle factors supporting the strong potential for FDI, with savings and investment rates high, inflation moderate, and trade expanding and fiscal deficits lower. Moreover, integrated global environment, supportive institutions and liberalization policies during 1990s and early 2000s also support more FDI flow into the region. As a result of this context, recent years have seen a rise of FDI in South Asia (ADB, 2008). The studies of Sahoo (2006) and Asteriou (2008) have also suggested that there is a positive and significant correlation between FDI and GDP growth rates in South Asian economies. Despite the gains of recent years, the countries in South Asia remains a less attractive destination for FDI compared to other region. Some of the bottle necks are the reason, poor infrastructure is one of among them that could hamper