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Foreign Direct Investment in Sri Lanka: Determinants and Impact

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Foreign Direct Investment in Sri Lanka: Determinants and Impact Konara Mudiyanselage Palitha Senarath Bandara Konara Thesis submitted for the degree of Doctor of Philosophy University of York Management September 2013 1 Abstract Sri Lanka is a relatively small sized island economy possessing significant resource and location advantages and demonstrating impressive human capital indicators, which only few countries are fortunate to have. At the same time, the country is recovering from nearly three decades of civil war, which ended in 2009. However, Sri Lanka has performed poorly in terms of attracting FDI. Research in FDI in the context of Sri Lanka is limited. Only a handful of studies (Wijeweera & Mounter, 2008; Athukorala & Jayasuriya, 2004; Athukorala, 2003; Athukorala, 1995) have looked at FDI in the context of Sri Lanka. To fill the research gap, this thesis attempts to formulate systematic and in-depth studies of FDI in Sri Lanka, investigating the determinants, impact and policy issues. First, efforts are made to provide an analytical piece that set out the environmental context of Sri Lanka before providing details focusing on FDI. This is followed by three empirical chapters on the determinants and impact of FDI in Sri Lanka. With regard to determinants of FDI, special attention is given to civil war, human capital and stock market price level. For the impact, the focus is on the impact of FDI on productivity. Civil war is a major source of political instability and is likely to discourage FDI. Based on the nearly three decades of civil war in Sri Lanka during the period of 1983-2009, the first empirical study demonstrates that presence of war can have a negative effect on incoming FDI. Though this is unsurprising, this study demonstrates different levels of impact of war on FDI in manufacturing and services. The negative effects are much higher in manufacturing than in services. Investigating the impact of war by market- orientation of manufacturing FDI, this study further finds that there is a higher negative impact on FDI in export intensive manufacturing than in market-seeking manufacturing. Human capital is often considered to be a determining factor for FDI. Recent studies also emphasise the importance of stock market in attracting FDI. Given Sri Lanka‘s impressive human capital indicators and recent development of stock market, the second research study explores these two determinants by conducting a panel study based on annual FDI inflows to a sample of countries in Asia. It shows that the relationship between human capital and FDI flows was significantly negative for Sri Lanka while, in 2 general, human capital has been a positive determinant of FDI flows to the rest of the countries in the sample. Further analysis shows that Sri Lanka is constrained to capitalise on its human capital due to linguistic limitations of human capital and qualitative weaknesses in the education system. Although the importance of human capital in attracting FDI is widely recognised in the theoretical consideration, empirical evidence is inconclusive, particularly for developing countries. In this context, findings of this study highlight the importance of recognising country specific limitations in human capital in understanding the relationship between human capital and FDI. This study also revealed a significant negative relationship between host country stock market valuations and FDI in the context of Sri Lanka and other countries with under-developed stock markets. These results indicate that cheap assets hypothesis (and expensive assets hypothesis) is likely to be applicable in the context of countries with under-developed stock markets, and therefore, in the context of Sri Lanka. Based on the firm level data for Sri Lanka, the third empirical study revealed that foreign firms are quite distinctive from local firms. Compared to domestic firms, foreign firms are larger, more productive and more profitable. Foreign firms also tend to hire high proportion of skilled workers, pay higher wages and undertake more in-house training programmes. They are more active in R&D and more innovative. They are more export oriented but rely more on inputs of foreign origin. A cross sectional econometric study estimating direct and indirect effects of FDI on firm level labour productivity indicated a positive own firm effects of FDI and negative spillover effects of foreign firms on local firms and other foreign firms in the same sector. In summary, Sri Lanka‗s economy is characterised by a lower level of industrialisation and is narrowly concentrated in a few sectors with little participation in technical intensive sectors. Foreign firms, through their distinctive characteristics identified in this thesis, are likely to bring in much needed expertise and skills that could help to overcome these structural deficiencies. However, Sri Lanka‘s mediocre performance in attracting FDI, poor performance in attracting FDI into technology intensive sectors, and absence of positive spillovers from foreign firms to local firms may all have resulted in poor performance of local firms in terms of upgrading their firm specific capabilities. The goal of the national FDI policies are twofold. First a country should attract the right type of FDI. Second, the country should devise appropriate policies to extract benefits from it. It 3 appears that Sri Lanka has performed poorly in both of these aspects, and this has in turn, deprived the country the much needed skills and technologies, and decelerated the development of the country. End of the civil war has given renewed hopes for Sri Lanka. Sri Lanka‘s impressive human capital indicators appear as a key strength. However, due to issues with quality of education and linguistic limitations of human capital, the extent to which Sri Lanka can exploit its impressive human capital indicators to lure FDI is rather limited. Weak institutional environment, poorly managed exchange rate policy and poor infrastructure appear to be major issues in terms of boosting future FDI inflows to Sri Lanka. 4 Table of Contents Abstract ............................................................................................................................... 2 Table of Contents ............................................................................................................... 5 List of Tables ...................................................................................................................... 9 List of Figures ................................................................................................................... 11 Acknowledgement ............................................................................................................ 12 Author’s Declaration ....................................................................................................... 13 Chapter 1 : Introduction ................................................................................................. 14 1.1 Introduction .............................................................................................................. 14 1.2 Motivation for the Study .......................................................................................... 16 1.3 Chapter Framework .................................................................................................. 19 Chapter 2 : Literature Review ........................................................................................ 21 2.1. Introduction ............................................................................................................. 21 2.2. Theories and Hypotheseson FDI ............................................................................. 23 2.2.1 Typology of FDI ................................................................................................ 23 2.2.2 Differential Rate of Return Hypothesis ............................................................. 24 2.2.3 Portfolio Hypothesis ......................................................................................... 25 2.2.4 Output and Market Size Hypotheses ................................................................. 26 2.2.5 International Division of Labour ...................................................................... 26 2.2.6 Dunning’s Eclectic Paradigm ........................................................................... 27 2.2.7 Investment Development Path ........................................................................... 29 2.2.8 Concluding Remarks ......................................................................................... 31 2.3. Determinants of FDI ............................................................................................... 34 2.3.1. Introduction ...................................................................................................... 34 2.3.2 Size and Growth of Host Country’s Economy .................................................. 34 2.3.3. Trade Openness ................................................................................................ 36 2.3.4. Political Instability ........................................................................................... 37 2.3.5. Human Capital ................................................................................................. 38 2.3.6. Institutional Environment................................................................................. 40 2.3.7. Domestic Stock Market Development
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