Effect of foreign direct investment, remittances, and foreign aid on economic growth: Evidence from two emerging South Asian economies

• Date: 01 August 2020
• Published date: 01 August 2020
• DOI: http://doi.org/10.1002/pa.2043
• Author: Aurolipsa Das,Narayan Sethi

ACADEMIC PAPER

Effect of foreign direct investment, remittances, and foreign

aid on economic growth: Evidence from two emerging South

Asian economies

Aurolipsa Das | Narayan Sethi

Department of Humanities and Social

Sciences, National Institute of Technology,

Rourkela, India

Correspondence

Narayan Sethi, Department of Humanities and

Social Sciences, National Institute of

Technology, Rourkela, India.

Email: nsethinarayan@gmail.com

This paper analyzes the effect of foreign direct investment, remittances, and official

development assistance on economic growth in India and Sri Lanka. The study uses

annual time series data of both countries for the period 1980–2016. In order to find

the short-run and long-run relationship among the variables, we use Granger causal-

ity test and vector error correction model. We also carry out a vector decomposition

analysis to predict the forecast variance error of the future periods and impulse

response function to analyze the effect of shocks in the independent variables on

that of the dependent variable. Our results indicate that foreign direct investment

and remittances have a significant impact on economic growth in India, whereas in

Sri Lanka, foreign aid and remittances play an important role in enhancing economic

growth.

JEL CLASSIFICATION

F21; F35; F24

1|INTRODUCTION

Foreign aid or official development assistance (ODA), foreign direct

investment (FDI), and foreign remittances inflows have been a major

source of foreign exchange and external finance for all developing

countries. There have been extensive researches on the theoretical

and empirical significance of external inflows on economic growth

depending on the level of financial development, ease of doing busi-

ness, and domestic investment. There is a wide array of literature on

foreign aid, remittances, and FDI positively affecting growth both in

the short run and long run (Ahmad, Ahmad, & Hayat, 2013; Dalgaard,

Hansen, & Tarp, 2004; Hansen & Tarp, 2001; Meyer & Shera, 2017;

Whalley & Xian, 2010). There are other economists on the other hand,

who refute the same based on their econometric analysis (Tekin,

2012; Tang & Bundhoo, 2017; Pedersen, 1996).

FDI plays an indispensable part in enhancing a country's position

in the global platform by acting as a source of capital and technologi-

cal know-how (Diaconu, 2014). The multinational corporations supply

management experience, entrepreneurial abilities, and skills that are

passed on to the local peers, then carried on by “learning by doing”

process (Todaro, 1985). These positive spillovers amplify the growth

of the economy. ODA, on the other hand, is seen to fill the saving gap

as well as the foreign exchange gap of a country, which is based on

the two-gap model of Chenery and Strout (1966) at least in the short

run (Chowdhury, 2011). Foreign aid also seems to be effective in

countries with strong institutional and political will. However, econo-

mists like Milton (1958) argue that a country might become aid-

dependent leading to stagnation in the growth rates. Studies suggest

that FDI is more effective in accelerating economic growth than ODA

(Yiew & Lau, 2018). For developing countries, foreign remittances act

as the second source of external financial inflows after FDI (World

Bank, 2017). Remittances, on one hand, have multiplier effects on

consumption, improvement in financial intermediation, and use of for-

eign exchange and hence enhance economic growth, whereas under

other conditions, they might undermine productivity, and inflows may

lead to an appreciation in the real exchange rate of recipient country

thereby impeding growth (Meyer & Shera, 2017).

Among the developing countries worldwide, India and Sri Lanka

are the two emerging nations that have attracted huge FDI inflows in

the past few decades. The gross domestic product (GDP) per capita of

India has increased almost fivefolds from Rs.389.93 in 1980 to

Rs.1862.43 in 2016 and that of Sri Lanka by approximately four times

Received: 20 August 2019 Revised: 13 September 2019 Accepted: 22 October 2019

DOI: 10.1002/pa.2043

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