Foreign Direct Investment In Sri Lanka: Determinants And .

Foreign Direct Investmentin Sri Lanka: Determinants and ImpactKonara Mudiyanselage Palitha Senarath Bandara KonaraThesis submitted for the degree ofDoctor of PhilosophyUniversity of YorkManagementSeptember 20131

AbstractSri Lanka is a relatively small sized island economy possessing significant resource andlocation advantages and demonstrating impressive human capital indicators, which onlyfew countries are fortunate to have. At the same time, the country is recovering fromnearly three decades of civil war, which ended in 2009. However, Sri Lanka hasperformed 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 researchgap, 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 providean analytical piece that set out the environmental context of Sri Lanka before providingdetails focusing on FDI. This is followed by three empirical chapters on the determinantsand impact of FDI in Sri Lanka. With regard to determinants of FDI, special attention isgiven to civil war, human capital and stock market price level. For the impact, the focus ison the impact of FDI on productivity.Civil war is a major source of political instability and is likely to discourage FDI. Basedon the nearly three decades of civil war in Sri Lanka during the period of 1983-2009, thefirst empirical study demonstrates that presence of war can have a negative effect onincoming FDI. Though this is unsurprising, this study demonstrates different levels ofimpact of war on FDI in manufacturing and services. The negative effects are muchhigher in manufacturing than in services. Investigating the impact of war by marketorientation of manufacturing FDI, this study further finds that there is a higher negativeimpact 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 alsoemphasise the importance of stock market in attracting FDI. Given Sri Lanka‘simpressive human capital indicators and recent development of stock market, the secondresearch study explores these two determinants by conducting a panel study based onannual FDI inflows to a sample of countries in Asia. It shows that the relationshipbetween human capital and FDI flows was significantly negative for Sri Lanka while, in2

general, human capital has been a positive determinant of FDI flows to the rest of thecountries in the sample. Further analysis shows that Sri Lanka is constrained to capitaliseon its human capital due to linguistic limitations of human capital and qualitativeweaknesses in the education system. Although the importance of human capital inattracting FDI is widely recognised in the theoretical consideration, empirical evidence isinconclusive, particularly for developing countries. In this context, findings of this studyhighlight the importance of recognising country specific limitations in human capital inunderstanding the relationship between human capital and FDI. This study also revealed asignificant negative relationship between host country stock market valuations andFDI in the context of Sri Lanka and other countries with under-developed stockmarkets. These results indicate that cheap assets hypothesis (and expensive assetshypothesis) is likely to be applicable in the context of countries with under-developedstock markets, and therefore, in the context of Sri Lanka.Based on the firm level data for Sri Lanka, the third empirical study revealed that foreignfirms are quite distinctive from local firms. Compared to domestic firms, foreign firms arelarger, more productive and more profitable. Foreign firms also tend to hire highproportion of skilled workers, pay higher wages and undertake more in-house trainingprogrammes. They are more active in R&D and more innovative. They are more exportoriented but rely more on inputs of foreign origin. A cross sectional econometric studyestimating direct and indirect effects of FDI on firm level labour productivity indicated apositive own firm effects of FDI and negative spillover effects of foreign firms on localfirms and other foreign firms in the same sector.In summary, Sri Lanka‗s economy is characterised by a lower level of industrialisationand is narrowly concentrated in a few sectors with little participation in technicalintensive sectors. Foreign firms, through their distinctive characteristics identified in thisthesis, are likely to bring in much needed expertise and skills that could help to overcomethese structural deficiencies. However, Sri Lanka‘s mediocre performance in attractingFDI, poor performance in attracting FDI into technology intensive sectors, and absence ofpositive spillovers from foreign firms to local firms may all have resulted in poorperformance of local firms in terms of upgrading their firm specific capabilities. The goalof the national FDI policies are twofold. First a country should attract the right type ofFDI. Second, the country should devise appropriate policies to extract benefits from it. It3

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 thedevelopment 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, dueto issues with quality of education and linguistic limitations of human capital, the extentto which Sri Lanka can exploit its impressive human capital indicators to lure FDI israther limited. Weak institutional environment, poorly managed exchange rate policy andpoor infrastructure appear to be major issues in terms of boosting future FDI inflows toSri Lanka.4

Table of ContentsAbstract . 2Table of Contents . 5List of Tables . 9List of Figures . 11Acknowledgement . 12Author’s Declaration . 13Chapter 1 : Introduction . 141.1 Introduction . 141.2 Motivation for the Study . 161.3 Chapter Framework . 19Chapter 2 : Literature Review . 212.1. Introduction . 212.2. Theories and Hypotheseson FDI . 232.2.1 Typology of FDI . 232.2.2 Differential Rate of Return Hypothesis . 242.2.3 Portfolio Hypothesis . 252.2.4 Output and Market Size Hypotheses . 262.2.5 International Division of Labour . 262.2.6 Dunning’s Eclectic Paradigm . 272.2.7 Investment Development Path . 292.2.8 Concluding Remarks . 312.3. Determinants of FDI . 342.3.1. Introduction . 342.3.2 Size and Growth of Host Country’s Economy . 342.3.3. Trade Openness . 362.3.4. Political Instability . 372.3.5. Human Capital . 382.3.6. Institutional Environment. 402.3.7. Domestic Stock Market Development . 432.3.8. Exchange Rate. 455

2.3.9. Infrastructure . 462.3.10. Regional Integration . 472.3.11. Labour Costs . 512.4. Impact of FDI on the Host Country . 522.4.1 Introduction . 522.4.2 FDI and Productivity . 552.4.3 Other Potential Effects of FDI . 582.4.4 Concluding remarks . 67Chapter 3 : Geographic, Demographic, Policy and Economic Environment in SriLanka. 693.1. Introduction . 693.2 Geography, Resource Endowments and Demography. 703.3 Post-Colonial Context and Policy Environment . 713.4 FDI Policy Framework . 743.5 Economic and Financial Indicators . 763.5.1 Economic growth and composition of GDP. 763.5.2 Savings and Investments . 783.5.3 Human Development Indicators . 803.5.4 External Trade . 823.5.5 Fiscal and Monetary sectors . 863.6 Civil War and Internal Conflicts . 883.7 Concluding Remarks . 91Chapter 4 : FDI in Sri Lanka . 924.1. Introduction . 924.2 FDI in Sri Lanka: an Overview . 934.3 Dimensions of FDI: Distribution by Sector and Origin . 954.4 FDI Potential in Sri Lanka . 1014.4.1 Resource-seeking FDI . 1014.4.2 Market-seeking FDI . 1024.4.3 Efficiency-seeking FDI . 1034.5. Factors that can Influence FDI in Sri Lanka: a Preliminary Overview. 1054.5.1. Introduction . 1054.5.2 Size and growth of the economy . 1056

4.5.3. Trade regimes and degree of trade openness . 1054.5.4. Political instability . 1064.5.5. Human capital . 1084.5.6. Institutional Environment. 1094.5.7. Domestic stock market development . 1134.5.8. Exchange rate. 1144.5.9. Infrastructure . 1184.5.10. Labour cost and productivity . 1234.5.11. Regional context and the degree of regional integration. 1244.6. Concluding Remarks . 130Chapter 5 : Civil war and FDI –A time series and a panel data study . 1325.1 Introduction . 1325.2 Effect of War on FDI . 1335.3. Impact of Civil War on FDI by Sector . 1385.4 Time Series Study Based on Aggregate FDI Inflows and FDI in Manufacturing andServices . 1405.4.1 Methodology. 1405.4.2 Results and Discussions . 1485.5. Panel Study Based on Annual Industry-wise Manufacturing FDI Inflows. 1555.5.1 Methodology. 1555.5.2 Results of the baseline model . 1615.5.3 Effect of Civil War on FDI by Industry . 1615.5.4 Effect of Civil War on FDI in Export-Oriented/Local-Market-OrientedManufacturing Industries . 1635.6 Concluding Remarks . 166Chapter 6 : Determinants of FDI – A Country Level Study . 1696.1 Introduction . 1696.2 Human Capital and FDI . 1706.3 Stock Market Valuations and FDI inflows. 1736.3.1. Stock market valuations and FDI inflows: Sri Lanka’s experience . 1746.4 Methodology and Results. 1786.5 Analysis and Discussion of Results . 1906.5.1 Human capital as a determinant of FDI . 1907

6.5.2. Stock market valuations as a determinant of FDI. 1986.5.3. Other FDI determinants . 1996.6 Concluding Remarks . 202Chapter 7 : FDI Spillover Effects: Evidence from Sri Lanka . 2037.1. Introduction . 2037.2. FDI and Firm Productivity . 2037.3. Data, Descriptive Statistics and Preliminary Investigation at Own Firm Effects ofForeign Firms . 2097.4. Direct and Indirect Effects of FDI on Firm Level Productivity: a Cross SectionalEconometric Study . 2157.5. Concluding Remarks . 229Chapter 8 : Conclusion . 2338.1. Research Findings . 2348.2. Key Contribution. 2368.3. Policy Implications . 2398.4. Research Limitations and Future Research . 244List of Abbreviations . 247References . 2498

List of TablesTable 3-1: Economic growth rates under distinctive periods . 76Table 3-2: Composition of economic sectors (as a share of GDP) . 77Table 3-3: Growth in GDP by economic sector . 77Table 3-4: Key economic indicators of selected Asian countries . 79Table 3-5: Human Development Indicators in selected Asian countries . 81Table 3-6: Composition of Exports . 83Table 3-7: Composition of Imports .

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.