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RELATIONSHIP BETWEEN FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH:

CASE STUDY OF GEORGIA

BY: GIORGI LOMIDZE

STUDENT NUMBER: 100099293

WORD COUNT: 7236

A dissertation submitted to the School of Economics, University of East Anglia, in partial

fulfillment of the MSc degree in international business finance and economics

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RELATIONSHIP BETWEEN FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH:

CASE STUDY OF GEORGIA

I certify that the work contained in this dissertation, submitted for the degree of MSc in

International Business Finance and Economics is my own original work except where explicitly

stated otherwise, and has not been previously submitted for a degree at this or any other

university.

I agree that this dissertation can be used as an example for the instruction of future UEA

students.

--------------------------

GIORGI LOMIDZE

POSTGRADUATE STUDENT, MSc in International Business Finance and Economics

Email: g.lomidze@uea.ac.uk

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Acknowledgment

Firstly I would like to express my gratitude to my supervisor Dr. Duncan Watson for his support and

motivation. His guidance helped me overcome difficulties while working on this dissertation. I

cannot imagine having a better advisor for this kind of work.

Besides my supervisor my sincere thanks to Professor Peter Moffatt and Dr. James Watson for

their support though the year of study in the University of East Anglia and for all the motivation

and immense knowledge provided by them.

I am grateful to all my friends in UEA, for supporting me and for all the fun and sleepless nights we

had during the year of study. I want to than Mr. Roman Atwood for inspiring me and making me

smile every day throughout my year study in the UK.

I would like to thank my family: my parents and my brother for supporting me spiritually

throughout writing the dissertation. Last but not least I want to thank my girlfriend for being with

me, supporting me throughout last year and my life in general.

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TABLE OF CONTENTS

PAGE NUMBER

1. ABSTRACT---------------------------------------------------------------------------------------------------------------- 5

2. INTORUDCTION--------------------------------------------------------------------------------------------------------- 5

3. LITERATURE REVIEW-------------------------------------------------------------------------------------------------- 7

3.1. FOREIGN DIRECT INVESTMENT INFLOW, GENERAL REVIEW----------------------------------------- 7

3.2. FOREIGN DIRECT INVESTMENT INFLOW, IMPACT ON ECONOMIC GROWTH-------------------- 10

3.2.1. FOREIGN DIRECT INVESTMENT INFLOW AND TECHNOLOGY TRANSFER----------------------- 10

3.2.2. FOREIGN DIRECT INVESTMENT EFFECTING HUMAN CAPITAL------------------------------------- 11

3.2.3. FOREIGN DIRECT INVESTMENT, ECONOMIC GROWTH AND INTERNALIZATION------------- 12

3.3. FOREIGN DIRECT INVESTMENT AND FORMER SOVIET UNION --------------------------------------- 13

3.3.1. FORMER SOVIET UNION BACKGROUND REVIEW------------------------------------------------------13

3.3.2. RELATIONSHIP BETWEEN ECONOMIC GROWTH AND FOREIGN DIRECT INVESTMENT,

ISSUES OF CORRUPTION------------------------------------------------------------------------------------ 14

3.4. GEORGIA, BACKGROUND AND GENERAL CONDITIONS IN ECONOMY------------------------------ 17

4. MODEL SPECIFICATION AND DATA----------------------------------------------------------------------------------18

4.1. MODEL SPECIFICATION-------------------------------------------------------------------------------------------18

4.2. DATA-------------------------------------------------------------------------------------------------------------------19

5. EMPIRICAL RESULTS---------------------------------------------------------------------------------------------------- 19

6. CONCLUSION--------------------------------------------------------------------------------------------------------------23

7. BIBLIOGRAPHY------------------------------------------------------------------------------------------------------------25

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1. ABSTRACT

The main objective of this dissertation is to understand the relationship between foreign direct

investment inflow and economic growth, especially in case of Georgia from 1997 to 2013. For

achieving this objective dissertation investigated general trends and conditions for attracting

foreign direct investment inflow. In the last part of the paper case study of Georgia was examined

for proving/disapproving the effects that FDI inflow may have on the economic growth of a small

and newly independent country. After theoretical search in literature review, it was clear that

Georgia may have the advantage over other former soviet union countries in economic freedom

and fighting corruption, and this lead to the idea that relationship between economic growth and

foreign direct inflow is positive. After testing some simple empirical model main finding that this

dissertation had in the literature review, has been proven in the case of Georgia. Results show that

FDI and some other variables do have a positive impact on GDP of the host country.

Keywords: Economic growth, foreign direct investment, former soviet-union, Georgia

JEL classification: O4, C32, F21, P2, H50

2. INTRODUCTION

Foreign investment may have several forms including; foreign direct investment, portfolio

investment, and foreign loans. According to Nimanl Sarderatne (2011), foreign direct investments

that flow in industries and services are the most important and useful for the host country. In

general foreign direct investment (FDI) is explained as the long-term financial participation of

investor from one country in an enterprise of another country, by having an influence on that

particular enterprise (IMF, OECD). FDI is considered as one of the factors that helps to develop an

economy and contribute in the economic growth. According to the OECD report (2002), FDI is one

of the main sources for the economic development. “The significance of private FDI is that such

investments are risk-free to the country and bring with it the advantages of advanced technology,

management practices, and assured markets. In due course, there is a technology transfer as the

local workforce gains knowledge of the manufacturing processes and management practices”.

(Nimanl Sarderatne: 2011).

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It is generally accepted that the most countries tend to attract FDI and try to increase their

spending to become more attractive for foreign investors. Evidence from literature review suggests

that FDI is playing increasing role in the world economy. And most of the countries are looking

forward to getting benefits of inward FDI such as resource and technology transfer and a boost of

the economic growth. Even though there are lots of factors that determine FDI inflow in the

country, mainly this dissertation has found out that improvement of FDI inflow may also be linked

to the improvement of government and the economic freedom of the host country.

In the past decades, FDI inflow in the world has increased and reached the point when FDI inflow in

developing economies is higher than in the developed economies (table 1). The dissertation

research objective is to understand a relationship between FDI inflow and economic growth and

development. Understanding main trends in FDI inflow and what are the main obstacles for

reaching positive relationship.

It is important to understand this relationship especially in case of Georgia, because there is lack of

research on this topic (as will be shown in the literature review), and further research of this

dissertation showed that Georgia may be having good domestic conditions for achieving positive

relationship between economic development and growth and FDI inflow. Thus, this dissertation

will try to understand the relationship between FDI inflow and economic growth and development

in developing and transition economies, including the case study of Georgia from 1997 to 2013.

The literature review will be the crucial part of the paper, divided into several different parts. First

two part will be the review of the FDI inflow distribution between development countries and the

rest of the world, general FDI trends, and the major turns in the world FDI inflow trends.

Questioning if there is positive or negative impact by FDI inflow in general studies?

The third part is going to be the literature review of the papers and researches about the former

Soviet Union countries economic growth and FDI inflow relationship. What are the trends, and why

this or that country is getting more FDI inflow? Understand if there is prove that the FDI inflow has

the positive effect on the economic growth. Last part of the literature review will be concentrated

on the Georgia. The trend in this country. What were the main turns in Georgia`s economy and

how the FDI inflow has been changing from 1997 to 2013. This kind of the structure is important

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for understanding FDI inflow effects step by step, from general to a single case, and compare case

study of one country to the trends around the world.

The literature review will be followed by the empirical model test. This model will be testing the

Georgia`s economy growth and the FDI inflow relationship. And will include the FDI and GDP

annual data, for 1997-2013. The test will be followed by the results presentation. As the further

study showed, several pieces of research suggest that in the former soviet union countries

corruption and economic freedom is the issue that may become an obstacle for FDI inflow and

further development. Since Georgia is in the leading position among other former soviet union

countries in world ranking of economic freedom and corruption, thus decision was made to test

the Georgia`s economy with the empirical model and compare the result to the general studies

and empirical tests. Compared to other countries in region Georgia has no natural resources and as

in the case of Estonia, Georgia is relatively small country. So objective of the dissertation is to

understand the relationship in economic growth and FDI inflow on a small transaction economy,

with lack of natural resources (Which always plays important role in development, but in case of

Georgia according to international institutions in last decades this country had made several big

steps to development through its reforms, without having natural resources as other countries in

the region.).

The first part of the test will be the model specification and the explanation why the model was

chosen and why it will provide the results that can be taken into consideration. The second part

will be the presentation of data used. Prove that this data is applicable to this research. Followed

by the actual test and the test result presentation. The test result presentation will include the

small conclusion of the results and will be followed by the full conclusion. Including the paragraph

wat was done, and if the main trends of FDI inflow and economic growth relationship positive, and

how Georgia is reflecting these trends, does it follows or is relationship between FDI inflow and

Georgia`s economy growth different.

3. LITERATURE REVIEW

3.1 FOREIGN DIRECT INVESTMENT INFLOW, GENERAL REVIEW

For the first part of the literature review, this study will be concentrating on the general trends in

inward FDI distribution around the world, trends in time, and the major turns in the FDI inflow. This

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part of the literature review is crucial to understanding the main impacts FDI can have on the

economic growth and what is the trend of FDI and economic growth relationship. “Theoretically,

FDI is considered to have direct as well as indirect effects on economic performance of the

developing countries. Direct benefits include the reduction in cost of capital and complementation

to limited domestic savings in the developing countries. Indirect flows stem from an increase in

productivity, knowledge, competition and exports. Empirically, the views regarding FDI benefits are

far different. Some studies acknowledge the positive effect of FDI while many others deny it.”

(“Public Spending, Foreign Direct Investment and Economic Growth”: Muhammad Iftikhar ul

Husnain et al. 2011).

Distribution of FDI inflow has dramatically changed in the last few decades. Even in the recent

years the major part of the FDI exchange was between the developed countries, in 1970 only 29%

of the world inward FDI was going to the developing countries. Which is relatively low comparing

to the 53.6% in 2013. (UNCTAD statistics)

After looking at the FDI inflow trends for the recent years (1990-2013) it is easy to find that in this

small period of time there have been several big downturns in FDI inflow, as in developing as well

in a developed economies in general. But observation shows, that in some cases FDI inflow was

affected only the developed economies and FDI inflow in developing countries still continued to

increase in a steady manner, despite the world trend.

According to the data provided by the United Nations conference on trade and development

(UNCTAD world investment report) the first downturn in this studies research period, was from

1990-1991 when there was 25% decline in FDI inflow overall, but in the same time FDI inflow in

developing countries has increased by 13%. Second and one of the biggest downturns was from

2000-2003 when from $1415016,85m in 2000 FDI inflow has fallen to $604303,94m in 2003. Due

to the world economic crisis starting from 2007, FDI inflow has decreased 38% and started to

recover only in the end of 2009.

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TABLE 1

Source: based on UNCTAD world investment report tables 2014. (Author`s elaboration)

The most recent downturn in FDI inflow was in 2011 causing 21% decline in one year. But as in

downturn of 1990-1991 the major impact was on the developed economies, and the developing

economies had 0.64% increase in FDI inflow. This one year period is significant and crucial because

it is the only year (2012) when the FDI inflow in developing countries exceeded the FDI inflow in

developed economies. This trend continued in 2013 as well. See table 1.

As already mentioned in the previous subsections, FDI inflow has changed in the last several

decades thus increased the interests in the effects it may have on the host countries economic

growth. This part of the literature review will be concentrated on the theoretical and empirical

considerations of negative or positive effects that FDI inflow can have on economic growth and

development of the host country.

Since last decades have shown the relatively increased FDI inflow to the developing countries

number of studies has been widely increased. Ozturk (2007) states that the most of the empirical

studies about economic growth and FDI relationship are based on two models: neoclassical and

-

200 000.0

400 000.0

600 000.0

800 000.0

1 000 000.0

1 200 000.0

1 400 000.0

FDI inflow, by economies. 1990-2013

Developed economies Developing economies Transition economies

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endogenous growth models. Compared to the neoclassical growth model, endogenous growth

theory is not that limited and determines ways of contribution that FDI can have to host country

economic growth; capital and technology transfer, human capital development, increasing the

competitiveness, globalizing the host country. These are determined to be the most effective

channels through which FDI can affect the host country and have effects on its economic growth

(OECD). The upcoming subsections of the section 3 (FDI inflow impact on economic growth) will be

focused on the different economic factors leading to the economic growth through the FDI inflow.

3.2 FOREIGN DIRECT INVESTMENT INFLOW, IMPACT ON ECONOMIC GROWTH

3.2.1 FOREIGN DIRECT INVESTMENT AND TECHNOLOGY TRANSFER

Transferring the technology and thus affecting the economic growth of the host country may have

a negative and positive impact. Main players on the field in this case, are multinational firms, which

according to Ford, T, J Rock and B Elmslie (2008) are one of the biggest sources for technology and

know-how transfer to the different economies. Mainly because that MNFs are spread all around

the world and in different economies, also the research and development spending of the MNFs

are high all over the world. (John H dunning, 1999)

The main way to transfer the technology in the host country is through information, improvement

of the facilities, training, assisting the host suppliers to get materials cheaper and help to go on the

new market. “Even though most of the R&D activities undertaken by multinational corporations

remain in their home country, recent years have witnessed a growing internationalization of R&D

efforts.”(Beata S. Javorcik, 2010). One of the important issues according to Kottaridi (2005) is that

MNFs invest and establish connections to the local institutes and research centers. This helps to

develop good chain for further technology transfer. Technology transfer may have negative effects

as well, such as becoming dependent to the transferred technology, leading to a decline of the

technology, produced in the home market by local firms.

As already mentioned the MNFs are playing an important role in delivering FDI to the host country

and one of the most common ways of doing it is through the transfer of technological know-how.

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Bus sometime host country is not fully ready for it and has not qualified labor force, which leads to

the necessity of labor skill enhancement.

3.2.2 FOREIGN DIRECT INVESTMENT EFFECTING HUMAN CAPITAL

“Despite the dramatic increase in total foreign direct investment (FDI) flows to developing

countries in the last few years, the bulk of the inflows has been directed to only a limited number

of countries. It has been argued that developing countries might enhance their attractiveness as

locations for FDI by pursuing policies that raise the level of local skills and build up human resource

capabilities.” (Farhad Noorbakhsh, Alberto Paloni, 2001)

One of the tools that FDI uses to effect the economic growth of the host country is the human

capital. As mentioned already this effect may be positive or negative. Also, FDI might have not only

direct influence on the human capital but it may have some indirect and sometimes hard

noticeable effects.‘’Human Capital is about Knowledge, skills, and abilities, (KSA’s) of individuals or

we can call them the skilled labor or white and blue collar labor. These KSA’s if effectively utilized it

will defiantly contribute in a country’s growth. KSA’s can be utilized in several ways; one of the best

utilization of these KSA’s is to put these individuals in such activities that will help a country to get

foreign direct investment’’ (Khaliq Ur Rehman, Muhammad Awais Balooch, and Haseeb Mustafa:

2015)

Development of the human capital and increasing level of skills and the training is directly

connected to the multinational firms. These firms play an important role in the enhancement of

the human capital as well in the technology transfer. It is common that in the developing countries

the labor force is not able to use the new technology or the know-how which was introduced by

MNFs so this leads to the new training and improvement of the skills of the labor force.

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According to Lim (2001) this improvement does not stay only in one area or group of labor.

Knowledge helps certain individuals to create their own entities and once again transfer new skills

to other workers as well, thus increasing the benefits of the FDI for the host country. Another view

on this issue sometimes s different and refers to an indirect effect of the FDI and in this case MNFs

on the host country. This is the increased government spending in the human capital

enhancement. Helping developing countries to be more attractive for foreign investors and gaining

more FDI. (OECD annual report)

As already mentioned effects of FDI on economic growth and host countries economy is not always

positive, unlike the last example of the indirect effect, host country may reduce the government

spending in favor that MFNs that transfer new technology will provide the necessary training to

form the human capital. “Foreign Direct Investment and public spending have potential to impact

economic growth. FDI affects growth through improvement in technology, knowledge and physical

capital of the recipient country while public spending can affect growth by providing the most

necessary infrastructure, a pre requisite for economic development. However, controversy exists

on the positive role of FDI as well as public spending.”(Muhammad Iftikhar ul Husnain et al. 2011)

Ford, T, J Rock and B Elmslie (2008) suggest that this leads to the negative effect to the home firms

that get reduced support in education and the worker skill enhancement.

Motivations of MNFs also determine the economic growth of the country, these motives may

determine the role of the country in the world economy and promote its export and import flow.

This is another channel through which FDI can affect the economic growth of the host country.

3.2.3 FOREIGN DIRECT INVESTMENT, ECONOMIC GROWTH, AND INTERNALIZATION

Integration of the host country in a global economy is crucial for economic growth. FDI inflow may

boost countries ability of export (depending on MNFs motivation). OECD annual report (2002)

suggest that this boost will have positive effects if most of the FDI inflow is transformed to increase

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export from the country. In another word if MNFs are using the host country as an export platform

(using one country to export in another). This leads local firms to make connections to MNFs and

get involved in export.

As FDI is one of the best sources to diversify the problems MNFs may have in the home country

(country of origin), different suggestions are made by Mencinger (2003), stating the idea that FDI

may have bigger impact on an import of the host country. Many MNFs enter in different countries

because of cheap labor and local tax policies, and because of lack of the materials in the host

country they promote import. This issue brings back the main intensives of investment. And one of

them is that FDI may be used to enter the host market and supply it.

Even though that FDI helps host countries to have more open economy and provides opportunities

for economic growth, studies state that the economic growth depends on the intensives of

investors as well as no the host counties local authorities and the general domestic conditions

(Rosa Forte and Rui Moura, 2013). As well as the analyze of the cross-country empirical studies

about the FDI and economic growth relationship by Rosa Forte and Rui Moura (2013) have shown

that 50% of the studies have shown the positive impact of FDI on host countries economy.

According to the Faruk Gursoy and Huseyin Kalyoncu (2012) most of the researches that focus on

the less developed countries have found more and clear positive relationship between FDI and

economic growth, but studies concentrating on developed countries have found no benefits for

growth of the host country.

Another issue in this study will be the FDI and economic growth relationship in the Former Soviet

union economies. New evidence might be different from the general relationship, because these

countries are newly independent and the political and economic structure was different and

transformed in several decades. As already mentioned, local authorities and domestic conditions

are important to reach the positive relationship between FDI inflow and economic growth. So the

study will try to understand if there is any trend that all former soviet countries share derived from

the domestic conditions these countries had in common (soviet socialist formation of the country).

3.3 FOREIGN DIRECT INVESTMENT AND FORMER SOVIET UNION

3.3.1 FORMER SOVIET UNION BACKGROUND REVIEW

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As mentioned in the previous subsections FDI and economic growth relationship depends on the

background and economic conditions in the host country (Rosa Forte and Rui Moura, 2013).

According to the Murat M. kenisarin and Philip Andrews-speed (2008), most of the states in the

former Soviet union need modernization of their economies which requires a solid level of FDI

inflow in this countries. Before 1989, many of soviet republics had almost zero FDI inflow so these

countries needed to develop the approach to increasing FDI inflow.

At the beginning of the 90s, two main approaches were developed – “Shock therapy” and

“gradualism” (Hamm, King, and Stuckler, 2012). While gradualism was more relied to the

governmental institutions, shock therapy was all about privatization and following the idea that big

and strong institutions would develop and promote the free and private market. FDI inflow had a

main role in increasing privatization (Bandelj, 2008) and with the promotion of the private market

FDI was reviewed as the main tool for modernization of the economies (Hunya, 2000). FDI was

seen as a main tool to speed up the internalization in the global market. Thus, all this transition

countries of the FSU had accumulated more FDI as a percentage of GDP than the rest of the world

(Kevin D. Curwin, Matthew C. Mahutga, 2014).

As all these countries accumulated a significant amount of FDI, purpose of the study is too find out

what was the impact of FDI inflow on their economic growth. What kind of the relationship was

developed in several decades between these two factors and if this relationship looks alike the

relationship discussed in the first part of the literature review.

3.3.2 RELATIONSHIP BETWEEN ECONOMIC GROWTH AND FOREIGN DIRECT INVESTMENT, ISSUES

OF CORRUPTION

As already mentioned it is important to understand how FSU countries development strategy and

results of the studies about their FDI inflow, economic conditions and development, this will give

the background of how some of the countries have managed to overcome difficulties , and by

reforming their economy and changing domestic market conditions and become leaders between

other FSU countries.

Since the main goal for FSU economies was to internalize their activities and become part of the

global market, as well as create their own free and private market, objective for these countries

was to reach the positive relationship between economic growth and FDI inflow. The way to create

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a better economic environment in the host country is to create the competitive firms, able to

create a free market and have the ability to compete in the global market. This brings the study

back to the discussion of MNFs increasing prosperity in the host country.

As the main policy in FSU was privatization it played crucial role, according to OECD (2002) if the

FDI inflow is increased by privatization, it helps and promotes MNFs to introduce and force

adoption of their own rules and procedures to the host country firms and make changes that are

important for further development and reorganization of the structure of individual firm and

economy whole. Of course, these changes will have the positive effect on economic growth and

development if the practices implemented by MNFS are more effective and efficient rather than

old practices used by host firms.

Implementing new policies and practices are undoubtedly connected to the technology and

knowledge transfer. As already discussed can have positive or negative effects on the economic

growth and show that there are different types of relationship between these factors. In the case

of countries of FSU, it is important to understand that technology transfer in not easy to be

noticed. Transferring the technology is only having the positive impact on economic growth if it is

not concentrated only in one sector.

After overviewing general economic growth situations and studies about FSU countries, several

main conclusions can be made about their development economic growth. In the empirical study

about the post socialistic countries, the results suggest that in there is the small increase in the FDI

this may lead to positive growth of economy, but relatively fast inflow may become the reason

causing economy decline. (Kevin D. Curwin, Matthew C. Mahutga, 2014). Another and important

conclusion made by Alexander Libman and Evgeny Vinokurov (2012) is that as whole, post-soviet

countries underperformed in GDP growth even though they had more accumulated FDI as a

percentage of GDP than the rest of the world (Kevin D. Curwin, Matthew C. Mahutga, 2014). But

there have been countries that have been performing well and have shown deviation from this

trend and been more successful in attracting the FDI, these countries include Georgia, Moldova,

Belarus and Ukraine. All of these economies have been more successful in attracting FDI than

central Asian countries.

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Several studies suggest that main reason why FSU countries underperformance and negative

relationship between FDI and economic growth is the issues that are connected to the home

market conditions. According to Murat M. Kenisarin and Philip Andrew-speed (2008), FDI inflow in

FSU may face issues of corruption and economic freedom. After analyzing the some of the studies

by local economists. Murat M. Kenisarin and Philip Andrew-speed (2008) concluded many of the

authors and local authorities have been considering only several subgroups of factors and thus

submitting the results which tend to mislead investors and policy makers. This kind of activity is

more or less connected to corruption and economic freedom. Issue of the corruption is also

brought in the study concerning the mass privatization. Bandelj (2008) states that some of the FSU

countries had been using the vouchers for selling the shares of the state-owned property to the

citizens, but sometimes government was selling whole enterprises to the wealthy nationals. Table

2 shows world ranking of FSU counties by indexes of economic freedom and corruption perception.

Table 2

COUNTRIES OF FSU ECONOMIC FREEDOM INDEX

RANKING IN THE WORLD

CORRUPTION PERCEPTION INDEX

RANKING IN THE WORLD

ARMENIA 52 94

AZERBAIJAN 85 127

BELARUS 153 123

ESTONIA (EU) 8 28

GEORGIA 22 55

KAZAKHSTAN 69 140

KYRGYZSTAN 82 150

LATVIA (EU) 37 49

LITHUANIA (EU) 15 43

MOLDOVA 111 102

RUSSIA 143 127

TAJIKISTAN 140 154

TURKMENISTAN 173 168

UKRAINE 162 144

UZBEKISTAN 160 168

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Source: Authors elaborations based on:” Transparency international” (corruption perception index

2013) and “The heritage foundation” (index of economic freedom 2015).

Next section of the study will include analyzing of the economic and other factors connected to

Georgia, and will be followed with the empirical study about the relationship between economic

growth and FDI inflow. As seen on Table 2, there are 4 leader countries that stand relatively high

not only between FSU but in the world as well. It is easy to guess that first 3 are: Estonia, Latvia

and Lithuania, which are the members of the European Union since 2004. Another country which

is a leader in this chart is Georgia, ranking 22nd in the world for economic freedom index (which is

even higher rank than Latvia has) and 55th in the corruption index list. Examining the data gave

results showing that none of other FSU countries has been ranked lower than 90th position in

corruption index or lower than 50th in economic freedom index. Murat M. Kenisarin and Philip

Andrew-speed (2008) suggest that many FSU economies had issues of corruption and thus

domestic conditions were not very favorable. So may of FSU countries did not have a positive

relationship of FDI and economic growth. Since we clearly see that results for Georgia is closer to

the EU member states, and there is the huge gap between Georgia and other FSU countries. The

study will continue examining the relationship between Georgia`s economic growth and FDI inflow.

Understand what the relationship can be when Country is relatively small and has not many

natural resources, also investment climate and other conditions (refer to table 2) are better than

in other FSU countries.

3.4 GEORGIA, BACKGROUND AND GENERAL CONDITIONS IN ECONOMY.

As mentioned in previous subsections, home country domestic conditions are important and this

part of the literature review will concentrate on the background of research objective country,

Georgia. Georgia gained independence in 1991 and after 70 years of being under the communist

regime, started to develop in a same way as many of FSU countries did. Georgia has faced

problems such as civil war and several ethnic crises. All this influenced the political and economic

stability and created many uncertainties for the investors. These factors linked to the criminal

conditions created lots of economic problems and hindered FDI inflow in the country (Economist,

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1993). According to Faruk Gursoy and Huseyin Kalyoncu (2012) by the end of 1996, Georgian

economy had shrunk to around one-third of its size in 1989”.

After some development and stabilization programs held by IMF and World Bank, the situation

started to change, but the actual and remarkable changes were made only after the 2003 Rose

revolution. Many political and economic stabilization programs were launched and this lead to an

increase of FDI inflow (Faruk Gursoy and Huseyin Kalyoncu, 2012). Powerful and right oriented

reforms led to the FDI increase which become 17% of GDP. But due to world economic crisis and

2008 August war FDI inflow declined and reached the lowest mark since 2004, $658million, just a

7% of the GDP (Edilashvili, 2011). Currently, the FDI Inflow is $1.01 Billion but remains same 7% of

GDP (UNCTAD statistics 2014).

Georgia has a relatively small market and lack of the natural resources as many of the countries in

the region (Azerbaijan, Turkmenistan, and Uzbekistan). But as Murat M. Kenisarin and Philip

Andrew-speed (2008) suggest (in case of Estonia), “it is not necessary to have huge natural

resource endowment like Kazakhstan and Azerbaijan in order to be successful in attracting FDI”.

Even there is factors of the geographic location, Murat M. Kenisarin and Philip Andrew-speed

(2008) conclude that main factors for increasing FDI are governance improvement, the perception

of corruption and economic freedom. As already discussed all this factors are improving in Georgia.

Georgia is a newly independent country so the lack of data makes it hard to and sometimes

uncertain how to conclude the empirical study of the relationship of economic growth and FDI. By

referring to the different empirical studies, including “Foreign Direct investment and growth

relationship in Georgia “ by Faruk Gursoy and Huseyin Kalyocny (2012), next part of the part of this

will be empirical study of the economic growth and FDI inflow relationship in Georgia.

4. MODEL SPECIFICATION AND DATA

4.1 MODEL SPECIFICATION

To investigate the impact of foreign direct investment on the economic growth of the host country,

this dissertation will use GDP as the measure of the economic growth. And this approach will be

used in every empirical test.

For the further tests following empirical model will be used:

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GDP=β0+β2FDI

Variable GDP and FDI represent a gross domestic product and foreign direct investment inflow of

Georgia. This model will use dummy variables as well. As mentioned in the literature review, host

country conditions are important to attract FDI and many developing countries are using economic

and political reforms to change the investment climate. Since 2003 (after the `rose` revolution in

Georgia) new government started powerful and oriented reforms. Dummy variables are used to

test the importance of this reforms and measure of the actual effect of FDI on economic growth. It

is important to state that all the variables used in the model are expressed in the natural

logarithms.

The model will be tested by adding different variables, it is important to understand how FDI`s

effect on GDP changes when country is more open to trade and investment so two variables that

will be added to the model will be trade and investment indexes of Georgia.

After the simple regression method, this dissertation will try to examine the causal relationship

between foreign direct investment inflow and the gross domestic product. As mentioned by Faruk

Gusroy and Huseyin Kalyoncu (2012) “it is very important to understand the direction of the

directions between FDI and GDP, in order to establish the policies that will encourage private

investors, especially in developing countries.”

4.2 DATA

Georgia in a newly independent country, so this dissertation had problems with collecting data.

Only annual data was available and since there are several examples of using this sample that has

similar size decision was made to analyze the model despite the lack of data and update the results

of the previous studies. (Study of “foreign direct investment and growth relationship in Georgia”

Faruk Gursoy and Huseyin Kalyoncu, 2012)

All the empirical analysis will employ the annual data of GDP and FDI inflow over the period of

1997-2013. All the data of GDP and FDI inflow was obtained from the World Bank database,

additional data of import and export was obtained from the national statistics office of Georgia.

Data was expressed in natural logarithms.

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Data of different indexes of Georgia was obtained from heritage foundation and the web site

theglobaleconomy.com, this is data from 1997 to 2013 and provides indexes to understand the

openness of Georgia`s economy.

5. TEST RESULTS

In the first part of the empirical study simple regression was used to estimate the effects of the

Foreign direct investment`s effects on the GDP of Georgia. Main regression result show the FDI has

a positive effect on GDP and this effect is significant. As presented on the regression table 1, in

regression 1.1 (Presented on TABLE 3) coefficient of FDI is positive and significance level is less than

1%, R2 is 0.79 proving that model fits the data. As already mentioned this dissertation is focusing

on examining the effects of the government`s reforms after 2003 so in regression 1.2 (Presented

on TABLE 3) dummy variable is introduced, where it is 0 for the year 1997 to 2003 and 1 from 2004

to 2013. In regression 1.2 FDI still remains positive and statistically significant, but its coefficient is

halved. However, a dummy variable for the rose revolution and reforms gets large and significant

value. It can be concluded that real effect of the FDI on the GDP of Georgia is reached after the

revolution and when the government started reforming the country. This proves the theoretical

results that this study has shown in the literature review. That the FDI is more attracted when host

countries institutions start reforming working better and government creates more investor

friendly environment.

In the regression, 2 more variables are added to the model. In regression 2.1 (presented on TABLE

3) dummy variable of trade index is added. Variable has value 0 if the trade index is lower than 70

and value 1 is the trade index is more 70. This variable is added to understand how openness to

trade effects GDP and also observe the effect on the coefficient of FDI. Results in the regression 2.1

show that the level of openness to trade does matter and the coefficient is positive and strongly

significant. Also, the coefficient of the FDI has decreased showing the actual effect on the GDP.

This result proves the previous discussions in the literature review that openness to trade does

matter.

Another part of the regression 2.2 is dropping the trade openness variable and adding the dummy

variable of investment freedom. Where the dummy equals to 0 if freedom index is below 50 and is

1 if it`s higher than 50. Results (presented on TABLE 3) of this regression shows that investment

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freedom has even higher coefficient than openness to trade, coefficient of FDI is still positive and

highly significant even though it has almost halved from what was observed in regression 1.1. The

result of this regression once again proves the result that was gained in the literature review, that

freedom of investment is crucial for foreign investors to be attracted by the host country.

TABLE 3

Independent

variables

Regression #

Coefficient

(standard error)

1.1 1.2 2.1 2.2

FDI 0.598***

(0.077)

0.333**

(0.146)

0.328***

(0.073)

0.508***

(0.069)

Reform Dummy # 0.578*

(0.28)

# #

Investment index

Dummy

# # 0.689***

(0.141)

#

Trade openness

Dummy

# # # 0.394***

(0.131) R2 : 0.7972

Adj-R2 : 0.7837

R2 : 0.8444

Adj-R2 : 0.8222

R2 : 0.9250

Adj-R2 0.9143

R2 : 0.8769

Adj-R2 : 0.8593

*- significant at 10% level, **-significant at 5% level, ***-significant at 1% level

TABLE 4

Independent

variables

Regression #

Coefficient

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(standard error)

3.1

GOV 0.893***

(0.106) R2 : 0.8243

Adj-R2 : 0.8126

*- significant at 10% level, **-significant at 5% level, ***-significant at 1% level

As mentioned government of the host country can have significant effect to attract investors.

Mentioned I the previous discussion government spending may influence FDI inflow. So in the

regression 3.1(Presented on TABLE 4) simple regression is used to understand if government

spending in Georgia has effect in the increase of FDI inflow. Results show that coefficient of the

independent variable ( is this case government spending is high and strongly significant so, this

proves that government spending, if increased in the right way can influence FDI inflow.

Next part of the test is Augmented Dickey-Fuller test. The results show that the hypothesis of unit

root in GDP and FDI cannot be rejected but hypothesis of unit root has been rejected when using

the first difference of the variables at 5 % level of confidence for FDI and 10 % level of confidence

for GDP. This result gives an indicator that all variables are integrated on the same order one I(1).

After establishing the order of variables next step, is Engle-granger`s residual based ADF test

(presented on table 5). On the first stage of the test regression equation and then residuals has

been estimated. After testing the stationarity of the residuals by ADF test, results show that there

is no co-integration between this variable.

After finding that there is no co-integration between variables, further investigation will include

the causality among them. As mentioned by Faruk Gursoy and Huseyin Kalyoncu 2012, Granger

(1998) states that if there is a co-integration between variables, then there is causality among

them, at least in one direction. As there is no co-integration results of the granger test show that

these 2 variables don’t have a causal relationship (presented on table 6). Which is different from

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the conclusion made by Faruk Gursoy and Huseyin Kalyoncu, 2012. The reason of this may be the

additional data and also the cause of the findings in the co-integration test results of which are

totally different from what this dissertation has provided. The only similarity is that this

dissertation has also concluded that all variables are in same order.

TABLE 5

ADF residual based test.

Test 1% Critical 5% Critical 10% Critical

Statistic Value Value Value

--------------------------------------------------------------

Z(t) -1.046 -3.750 -3.000 -2.630

TABLE 6

Null hypothesis F-statistics Prob. results

FDI does not

granger cause GDP

.76049 0.4927 Cannot reject

GDP does not .3077 0.7419 Cannot reject

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Granger cause FDI

Number of lags = 2

6. CONCLUSION

Increase in the FDI inflow all over the world in past decades, has attracted many researchers, but

as can be seen form the literature review, there is no clear decision, about the effects that FDI

inflow can have on the economic growth of the host country. Many researchers suggest that FDI

may have a negative effect as well as positive. Suggesting different approaches and different ideas

about using data available.

The main conclusion of this dissertation is that FDI does have an effect of the economic growth of

the country. As the empirical test results show FDI has a positive effect on Georgia`s economic

growth. This results also prove that reforming the economy can cause an increase in FDI inflow in a

host country. In general last part of the dissertation has given some evidence that for small and

transition country like Georgia it is important to have open economy and investment freedom to

achieve better economic growth and the government`s role in achieving this is important, this is

proved by the positive effect of the government expenditures on FDI inflow.

The main effect that is important to be noticed is the effect of the reforms in the host country. As

Georgia is transition economy these reforms play crucial role in development of the market and

helping to promote the trade and economic openness, which has been proven to be decisive

factors for attracting foreign direct investment in the country. Results show that Georgia is moving

in the right direction, and if it continues strong and oriented reforms it may be able to achieve the

same results as the Baltic state countries like Estonia which may be one of the best examples to be

followed by the Georgian government, because of the similarities that can be seen between this

two countries. Even though natural resources may play an important role in attracting FDI it is

important to understand that openness to trade is also decisive while talking about FDI inflow.

Yet there is much more to be learned and suggestions from this dissertation is that it is important

to understand and find out more about the roles of a host institutions, human capital, and

technology transfer in economic growth and attraction of FDI in the country. For the dipper

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research, it is important to take into consideration the effect of the war in 2008 between Georgia

and Russia. That may have influenced the political and economic stability of the country.

Ultimately, there are factors that are influencing economy well and host country gets benefits from

them, but on a whole long run relationship of FDI and economic growth still stays unclear, because

of so many different factors that may influence it. Another suggestion for further research is that it

is important to get the more specified data and try to convert annual data used in this dissertation

in quarterly data so estimations will become more specific.

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