Foreign Direct Investment and Islamic Banking: A Granger Causality Test

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1 Foreign Direct Investment and Islamic Banking: A Granger Causality Test Gholamreza Tajgardoon Department of economics of research and training institute for management and development planning President of Sadr International Institute for Researches & Studies in Islamic Banking info@isibanking.com Khosro Noormohamadi Expert of President Deputy Strategic Planning and Control noormohamadi004@yahoo.com Mehdi Behname Department of Economics of Ferdowsi University of Mashhad (FUM), Mashhad, Iran, mehdi_behname@yahoo.com ABSTRACT The purpose of this article is studying causality relationship between FDI and Islamic banking. Panel unit root tests show that the variables are stationary at level. Pedroni test indicates that there is not log run relationship between FDI and Islamic banking. We have chosen 9 countries from Organization Islamic Conference (OIC) over the period The results show that there is a bidirectional relationship between these variables (the feedback relationship). It means that FDI reinforce Islamic banking and Islamic banking attracts foreign direct investment. For FDI attraction governments should devote attention on Islamic banking. Keywords: Foreign Direct Investment; FDI; Islamic Banking; Islamic Countries; Causality JEL Classification: F, O6. INTRODUCTION The Western countries have propagated foreign direct investment for use of natural and human resources from World's countries. Therefore, before of globalization process developing countries have believed that foreign direct investment is a symbol of domination of developed countries. These countries believed that we fired out imperialism from door but, it come back from window. In these years, developing countries applied barriers to prevent foreign direct investment, but after years 980s these countries recognized advantages of FDI and searched the solutions for FDI attraction even if, they granted points to multinational firms for this investment. After these years FDI has begun to rapid growth so that the growth of FDI has been more than the growth of export, import and GDP in the World. Economic theories indicate that investment is engine of economic growth but, developing countries have the problems for preparing of investment funds. One solution is borrowing from abroad but, there is a crisis from loan repayment. Therefore, nowadays FDI is the most option for capital preparing in these countries. In 990s, multinational firms' outputs from abroad have been 6% from World's total industrial output (Lipsey (998)). In this connection, countries members of Organization Islamic Conference (OIC) in the two decade have a rapid growth in financial market and banking systems and FDI inflow share in these countries has consistently augmented as compared with the entire World. So that, this rate in the period has been 4.6 and 996 has been 5.5 (UNCTAD 000). Therefore, we can find a positive relationship between financial markets and FDI. UNCTAD (004) indicate that over the period OIC countries on the average have attracted percent FDI inflow to developing countries. In this connection, the countries such as Malaysia, Turkey and Morocco have had the better situation. Nowadays, with due attention to FDI advantages developing countries have the competition for attraction of FDI. Thus recognition of FDI attraction factors helps these countries to 8

2 foreign direct investment attraction. One of these factors is financial market and banking. Purpose of this paper is studying of the relationship between FDI and Islamic banking. We search that whether FDI is the cause of Islamic banking or Islamic banking is the cause of FDI. Adam and Tweneboah (009) have found a long run relationship between FDI and financial market in Ghana. Al Nasser and Soydemir (00) have conducted Granger causality tests between FDI and financial market for Latin American countries. They have shown a unidirectional relationship from banking sector to FDI and not the reverse. Kholdy and Sohrabian (008) and Dutta and Roy (0) have shown that political risk factors can influence the relationship between FDI and Banking. Soumaré and Tchana (0) with the various variables for financial market have indicated that some of the financial market and FDI variables have bidirectional and others unidirectional relationship. THEORETICAL BASIS Macroeconomics theories show that investment is function of interest rate and national income that interest rate is capital cost. When in host country there is a strong financial market, this means the capital cost is low then, it attracts FDI. On the other hand, FDI bring with them a large funds for host country, therefore, there is a feedback between these sectors. Desai et al (006) and Henry (000) believed that increasing in FDI inflow increases funds available and improve financial markets and banking sector. When developed countries invest in host countries; they support politically financial and economic market in this country thus economic and political risks decrease. A low risk in host country attracts FDI. FDI bring the high technology in banking and lead to improve the banking sector. Desai et al (006) believed that the existent of smart financial market in economy is a sign for openness and dynamic economy and an economy with low risk that these factors attract FDI and prepare a good environment for FDI. FDI inflow affects on banking in tow ways: direct and indirect. FDI directly bring the funds for private investment and indirectly these firms have the relationship with international finance markets that this relation strengthens financial market in the host country. Henry (000) has shown that a strong banking increases FDI and private investment. Because improvement of financial market has a positive correlation with other changes that decrease operational risk in multinational firms. Soumaré and Tchana (0) in their article discuss that "Desai et al (006) answer the following question theoretically as well as empirically: how do capital controls affect the cost of capital for foreign investors? Their theory is that because most often a considerable portion of the funding for the local affiliates of multinational investors comes from local loans, the higher interest rates that result from capital controls increase the cost of capital and can be expected to discourage FDI. Capital controls affect local investments by multinational firms because they influence local borrowing rates and increase the cost of repatriation. Furthermore, the costs associated with capital controls undoubtedly discourage many potential investors from establishing affiliates in the first place. Supporting this theory are data from United States-based multinational firms that suggests that capital controls are accompanied by high interest rates and that firms respond to capital controls by distorting profit reports and dividend repatriation policies, incurring substantial organizational and regulatory costs in the process. Liberalizing capital controls appears to initiate periods of considerably faster growth in the local activities of multinational firms". We add that the different between Islamic and conventional banks is that in Islamic banking interest rate isn't fixed. METHOD AND DATA We have chosen 9 countries from Organization Islamic Conference (OIC) over the period The countries are: Bahrain, Iran, Malaysia, United Arab Emirates, Pakistan, Kuwait, Saudi Arabia, Qatar, and Turkey. The limitation of country and period selection come from lack of data for certain countries. Following Kolstal and Villanges (004) we have divided foreign direct investment to GDP and fixed capital formation (FCF) for normalization of FDI. Of course, some of the researchers apply population for normalization (Harms 9

3 (00)). For these variables we have applied World Bank's World Development Indicators data base and UNCTAD. Therefore, our variables for FDI are the ratio of FDI to GDP (FDIGDP) and the ratio of FDI to FCF (FDIFCF). Other variable for this study is the ratio of Islamic bank assets divided by central bank assets plus Islamic bank assets (IBA). This variable reveals Islamic banking effects on foreign direct investment. The sources of data for this variable are Bankscope database, IMF and World databank. We computed the average of each variable for each country. For studying of relationship between Islamic banking and foreign direct investment in Islamic countries we have applied a Granger causality model following Arellano (003). We consider specifications of a bivariate VAR () model for the FDI and IBA variables. Individual and time effects are included in both equations. The form of the model is: FDI it t t ) t ) IBA t ) IBA t ) ECT t i it I IBA it IBA t ) IBA t ) t ) t ) ECT t i it II where t and t capture the time effect and ηi and ηi capture the individual effect. The hypothesis that FDI does not Granger-cause IBA, conditional on individual and time effects imposes the restrictions λ = λ = 0. Conversely, to test whether IBA Granger-causes FDI, we examine the restrictions β = β = 0. We first estimate the VAR model including of equations (I) and (II) and then use a Wald-type test to validate these two non-causality restrictions. We apply two-step generalized method of moments (GMM) estimator. RESULTS For studying the correlation of the variables we have calculated the below table. Table : correlation between FDI and Islamic Banking FDIGDP FDIFCF IBA FDIGDP FDIFCF 0.93 IBA Table indicates positive correlation between FDIGDP, FDIFCF and IBA. Since, the correlation between two variables of investment FDIGDP and FDIFCF is 0.93 thus, we delete the variable of FDIFCF from our model. The correlation between foreign direct investment and Islamic banking is positive. In the table, for avoid from spurious regression we have done the unit root tests. Our tests include LLC, IPS, ADF-F and PP-F. These tests indicate that the variables of FDIGDP and IBA are stationary at level, then it has avoided from spurious regression. For studying of long run relationship between FDIGDP and IBA we have run the co-integration test in table 3. 0

4 CO-INTEGRATION TEST In order to study the long-run relationship between FDIGDP and IBA we use Pedroni co-integration test. If H hypothesis is rejected, there is a long-run relationship between the two variables. The maximum lag in panel 0 co-integration model is based upon SIC criterion. Based upon the statistics of table 3, zero hypothesis indicating lack of co-integration relationship is accepted. Therefore, we can not apply long-run VAR model for the two FDIGDP and IBA variables and we only apply short-run Granger causality test. Table : Panel unit root tests Method FDIGDP IBA Stat Prop Stat Prop Level Levin, Lin and Chu Im, Pesaran and Shin ADF-Fisher PP-Fisher Table 3: Pedroni Panel Co-integration Test Panel weighted statistics (probability) Panel -statistic.9 (0.3) Panel -statistic 0.03(0.43) Panel pp-statistic -0.89(0.05)* Panel ADF-statistic 4.74(0.05)* Group statistic (probability) Group -statistic 0.83(0.4) Group pp-statistic -4.(0.7) Group ADF-statistic -4.34(0.05)* Table 4 presents short-run results of Granger causality. This test has been performed in two phases. First, the equation FDIGDP = α it + δ i t+ γ t IBA it + ε it has been estimated and then, its residual has been used for estimating the coefficient of error term. According to equation I, foreign direct investment has a positive effect on Islamic banking, and Islamic banking is the cause of FDI.

5 An examination of the sum of the lagged coefficient on the respective variables indicates that there is a bidirectional relationship in short run. In general, it can be concluded that the causality relationship between Islamic banking and FDI is bidirectional. That means there is a feedback between these variables. It means that foreign direct investment reinforces Islamic banking and Islamic banking attracts foreign direct investment. These results are for short run, because, Pedroni test has indicated that there isn't long run relationship between Islamic banking and FDI. Therefore, at least in short run we can expect Islamic banking attracts foreign direct investment. Soumaré and Tchana (0) achieved the same results in their study but, Adam and Tweneboah (009) have found a long run relationship between these variables. Al Nasser and Soydemir (00) have conducted a unidirectional relationship from banking sector to foreign direct investment. Table 4: Panel Causality Tests Result Dependent variable sources of causation (independent variables) short-run FDIGDP IBA () FDIGDP (0.08) 0.0 a 0. 0 a (3) IBA 7.3 (0.5) b a Values in brackets are t-statistics. Values in parentheses are p-values associated with Wald test statistics. c(b,a) denotes statistical significance at the0%, 5% and % levels respectively. CONCLUSION The aim of this article is studying of the relationship between FDI and Islamic banking. For this subject first, we have chosen three variables FDI to GDP, FDI to fixed capital formation and Islamic Banking (Islamic bank assets divided by central bank assets plus Islamic bank assets). Since the correlation table has indicated that FDIGDP and FDIFCF are 0.93 correlations thus, we have deleted the FDIFCF. Unit root tests have shown that the variables are stationary in level. Pedroni co-integration test reveal that there isn't long run relationship between these variables. Thus we have applied short run Granger causality. Granger causality test in short run show that there is feedback relationship between Islamic banking and foreign direct investment. This means Islamic banking reinforce FDI and FDI reinforce Islamic banking. Islamic banking is a part of financial market that affects foreign direct investment. Investment requires usually to funds therefore, a strong banking could prepare the funds for firms. Existent of smart banking shows that host country has a low risk and dynamic economy then, it is suitable environment for FDI. FDI itself brings funds in host economy because the multinational firms have the relationship with international finance markets and they spend the funds for investment. Therefore, FDI can reinforce banking systems. Our article shows that Islamic banking brings FDI and FDI reinforce Islamic banking therefore, these countries (Islamic countries) could devote attention on Islamic banking for more FDI. REFERENCES Adam, A. M. and G. Tweneboah, 009, Foreign Direct Investment and Stock market Development: Ghana s Evidence, International Research Journal of Finance and Economics, 6, Al Nasser, O. M. and G. Soydemir, 00, Domestic and International Determinants of Foreign Direct Investment in Latin America, FMA Annual Meeting, New York, USA. Arellano, M., 003, Panel Data Econometrics, Oxford University Press. Arellano, M. and O. Bover, 995, Another Look at the Instrumental Variable Estimation of Error-Components Models, Journal of Econometrics, 68(), 9-5

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