Economic Freedom and Private Capital Inflows in Selected South Asian Economies: A Dynamic Panel Data Evidence

Introduction

Majority of the countries throughout the world have been incited to welcome private capital inflows, supported by the notion of manifold advantages being brought by augmented capital flows, such as efficiency enhancement in the apportioning of global resources. This initiative resulted in upsurge of private capital flows in the past few decenniums (Lane & Milesi-Ferretti, 2003; Vo, 2010). Caprio, Hanson and Honohan (2001) and Prasad et al. (2003) proposed that countries can pull in more capital flows through deregulating their domestic financial activities and to make the transactions of their capital account and equity market more liberal. They further explicated that such policies can encourage private capital inflows through transaction costs reduction and by enhancing returns on assets. Conspicuous breadth and depth have been witnessed in the domestic financial market through lending of foreign banks and portfolio investment. Some of the advocates are of the view that good policies devised should be rewarded while bad policies should be penalized, provided by the fact that free mobility of capital flows across borders encourages more regimented macroeconomic policies and minimizes the frequency of errors in policies. Some of the proponents also have rationale that trade openness bears fruitful benefits in the shape of cross-border trade in goods and services as well as in financial instruments trade. Foreign capital inflows enable an economy to smooth out its expenditures when faced by some untoward exogenous shocks. At the same time, both the developed and developing market economies can offer portfolio diversification and risk management on behalf of investors through an open capital account.

South Asian economies are cognizant of the fact that private capital inflows, especially foreign direct investment (FDI), have many advantages such as capital creation, technological and skill transfer and global market access. The most striking feature of private capital inflows is that they do not generate principle or interest repayment (Bhagwati, 1994). The policy of import substitution was followed by South Asian economies since 1950s. To appeal more private capital inflows, efforts have been made by India and Pakistan in the shape of liberalization and deregulation of their economies. In early 1990s, the procedure of liberalization was further speed up in the region. It is worthy to cite here that South Asian economies have not gained their likely growth notwithstanding the process of liberalization and deregularization. Possibly the multinational enterprises still regard the South Asian region to be exceedingly regulated and are indecisive to invest more. South Asian countries require adopting privatization, deregularization and liberalization, so that their economies should become further opened up to entice more private capital inflows to the region. Put differently with the objective of attracting more foreign investors, they require propitious domestic investment climate in the shape of economic freedom. According to international experience, for the attainment of sustainable economic growth and attraction of more private capital flows, favourable domestic investment climate is a premier choice (Quazi, 2007).

The development economists took keen interest regarding the significance of private capital flows in economic growth, and ample empirical literature has germinated regarding the determinants of private capital inflows. The roles of umpteen variables have been inquired in those empirical studies both separately and collectively. Nonetheless, referenced to the South Asian region, the literature has escaped relationship between economic freedom and private capital inflows. The prime motivation behind this study is to dig into whether, succeeding other orthodox variables employed in the literature pertaining determinants of private capital inflows, economic freedom is also a premier variable. According to Gwartney, Lawson and Block (1996), economic freedom for an individual means ‘the right to acquire and use his property without any coercion, fraud or theft, for the purpose of trade or any other commercial activity stipulated with the condition that all of his actions are deemed legal’. Moreover, the research findings will help the authorities to devise polices regarding private capital inflows in selected South Asian region.

The rest of the article has been organized as follows: The second section presents some of the main previous empirical research work pertinent to the study, and the third section showcases theoretical underpinning and hypothesis. The fourth and fifth sections discuss model, data and methodology; the sixth section presents results; and finally conclusion and policy implications have been presented in the seventh section.

Previous Studies

In the context of developing countries, a plethora of literature has evolved regarding factors that lure foreign capital inflows. The focus of the literature is on different types of private capital inflows and their determinants, such as FDI and foreign portfolio investment (FPI). In the perspectives of comparative advantages, institutional analysis has been widely used as a policy tool recently. Research evidence highlights the fact that institutional environment is the major predictor of foreign investment (Bevan & Estrin, 2004; Delios & Henisz, 2003). The cognizance that institutional environment affects the enterprise performance and strategies is gaining importance along with the fact that different form of enterprise responses vary across national contexts.

According to Scott (2001), ‘The economic and political environment of a country is the product of the interaction among a number of regulative, normative and cultural-cognitive institutional elements.’ Such elements are counted in the institutional environment and the investment behaviour of individuals, and firms is markedly determined by institutional environment of a country. Henisz and Swaminathan (2008) stated that institutional environment is a combination of various interdependent systems and structures within a country. The quality of institutional environment can be judged from the fact that how conducive is the environment for investment or what is the level of economic freedom in a country (Meyer et al., 2009). To determine the FDI inflows, Jayasuriya (2011) utilized the ease of doing business ranking as a proxy for capturing business regulations in 84 countries for the period of 2006–2009. He established a significant positive association between business regulations and FDI inflows. Nonetheless, the result came out to be inconclusive for developing countries alone. The multinational enterprises’ investment character is highly sensitive to the institutional environment changes (Cantwell et al., 2010). The macroeconomic consequences of political and economic freedom on FDI were analysed by Sambharya and Rasheed (2015). Their study included a panel of 95 countries for the period from 1995 to 2000. They concluded that to enjoy the benefits of foreign inflows, countries should ensure better economic management pertaining monetary policy, fiscal burden, banking and finance. They further concluded that minimum government intervention, low-level corruption and strong property rights entice FDI inflows. Bissoon (2011) analysed the role of institutional and macroeconomic variables in 45 developing countries for the year 2000. He found that minimum level of corruption, low rate of inflation and political stability play a vital role in the predictability of inward FDI. The author established that in the context of developing, quality institutions can entice more inward FDI.

The liberalization of equity markets can entice more inflows of portfolio investment (Campion & Neumann, 2004; Kaminsky & Schmukler, 2003). In this regard, removing of restrictions on foreigners to acquire domestic equity and tax incentives plays a vital role. When there are no quantitative restrictions pertaining domestic equity, it will ultimately increase the pie of foreign investment in the equity market, whereas transaction costs will be reduced due to tax provisions incentives. Such measures will also increase the stock prices and expected returns (Prasad et al., 2003). Moreover, liberalized equity markets can boost more FDI inflows through facilitations of mergers and acquisitions processes (Bekaert, Harvey & Ng, 2005; Montiel & Reinhart, 1999).

While investigating the investment behaviour of foreign investors, previous empirical studies have identified numerous factors, such as market size, trade openness, exchange rate, per capita GDP, natural resources and political risk. To the best of our knowledge, in the context of South Asian economies, economic freedom, which is a yardstick for measuring the institutional quality of a country and entices more foreign private capital inflows, still remains unnoticed. To fill the void in the extant literature, this study will take into account economic freedom as a determinant of foreign private capital inflows along with other conventional variables, such as market size growth, official development assistance, inflation, exchange rate and natural resources.

Theoretical Underpinning and Hypothesis

North (1990) introduced the theory of institutions. This theory mainly advocates the role of institutions in the attraction of foreign investment. Foreign investors are attracted towards the country which has strong institutions. Initially, individuals and corporations pay greater attention towards economic institutions. Chacar, Newburry and Vissa (2010) have a view that ‘Institutions in the product, financial, and labour markets affect the size of pools of exchange partners and the types of exchanges allowed and condoned’. As foreign investment has a sizable share in capital formation of poor countries and is considered to be one of the permanent sources of capital; the promotional effect of foreign investment through quality institutions can have marked impact on their growth and development. Pedersen (2010) states that ‘Nations and governments not only restructure formal institutions and coordinate different policies and departments, but also intervene in the attitudes, values, aspirations, and interests of citizens and firms in attempts to use behaviour change as a means to create comparative advantage.’ The theory of international finance advocates that FPI takes place because of portfolio balancing strategy, that is, diversification of risk, and for the achievement of higher returns. Some of the proponents of cross-country diversification are Grubel (1968), Grauer and Hakansson (1987), and De Santis and Gerard (1998). The Dunning eclectic paradigm theory tells us about different types of the entries towards a market, that is, licensing exports or FDI based on the advantages of ownership, location and internalization factors. Taking insights from this theoretical framework, we can add an institutional factor in the shape of economic freedom within the location advantages of OLI (Dunning, 1988; Dunning & Lundan, 2008). Quality institutions and foreign investment go hand in hand (Grosse & Trevino, 2005; Lucke & Eichler, 2016; North, 1990). Based on previous literature, this research work also supports the notion that quality institutions (in the shape of economic freedom) and private capital inflows are positively associated with selected South Asian economies.

Model

According to the literature, private capital inflows are also dependent on their past values (Brafu-Insaidoo & Biekpe, 2014). In this regard, we opted for dynamic panel data as our estimation methodology. Dynamic panel data model tackles the endogeneity issues in the presence of the lagged outcome variable and is therefore the right choice for our analysis (Roodman, 2009). We have proposed the following model for empirical specification.

The general form of the equation is

P C F i t = β 0 + β 1 P C F i , t − 1 β 2 E F i t + β 3 G G D P i t + β 4 X R i t + β 5 I N F i t + β 6 O D A i t + β 7 N R E S i t + U t

(1)

PCFit includes of FDI and FPI. Subscript ‘i’ depicts country while, ‘t’ depicts time period.

where

PCFi,t−1= Lagged private capital inflows,

PCF = Private capital inflows (US million dollars),

EF = Economic freedom (Index),

GGDP = Growth in GDP (annual percentage),

XR = Exchange rate (rupee/US dollar),

INF= Consumer price index (annual percentage),

ODA = Official development assistance (current US dollar),

NRES = Natural resources (ratio of ores and metals/merchandise exports) and

Ut= Residual term (Normally distributed).

Data and Estimation Technique

According to availability, this research work has utilized data from 2002 to 2011. Moreover, the selected South Asian countries ¹ in our research work were also determined by the availability of data. Private capital inflows data have been obtained from International Monetary Fund (IMF), balance of payments statistics. Exchange rate data are collected from the source of IMF. The data of GDP growth, inflation, official development assistance and natural resources have been collected from the World Bank online database. Finally, the Heritage Foundation (2011 estimations) has been resorted for the data of economic freedom. The index of economic freedom is comprised of investment climate, business freedom, trade freedom, property rights, freedom from corruption and financial freedom. The scale assigned to the components ranges from 0 to 100. Higher scores depict that the economic environment is conducive and vice versa. In order to deal with biasness, each item in the index carries equal weight. For the purpose of data smoothening, we have converted all the variables into their logarithmic form.

The Sargan Test

This test is employed for instruments validity under the null hypothesis by checking the over-identifying restrictions, which should be asymptotically distributed as Chi-square. Due care should be taken while interpreting the results for Sargan as its power properties and size have not been adequately established as yet. The standard over identification tests can result to the null hypothesis rejection even if small intra-group association is present (Hoxby & Paserman, 1998). The Sargan test sometimes over reject the identification restrictions validity (Arellano & Bond, 1991) (Table 1).

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Table 1.

Variables, Definitions and Expected Signs

Variable	Definition	Expected Sign
EF	Index of economic freedom	Positive
GGDP	GDP growth (annual percentage)	Positive
XR	Exchange rate (rupee/US dollar)	Positive/Negative
INF	Consumer price index (annual percentage)	Negative
ODA	Official development assistance (current US dollar)	Positive
NRES	Ratio of ores and metals/merchandise exports	Positive

Source: Authors’ own calculations.

Results and Discussion

Table 2 exhibits the main estimated model. Descriptive analysis (Table A1), correlation analysis (Table A2) and Variance Inflation Factor (VIF) test (Table A3) have been discussed ahead of the main results.

Descriptive analysis of all variables included in the study has been presented in Table A1 (given in the appendix). In the given table, it is observed, that all the variables are highly skewed towards their respective maximum value. The mean value obtained for private capital inflows suggests the surge of private capital inflows in the region under the studied era. Among the studied variables, official development assistance displays higher inclination towards its maximum value and, hence, gives indication of its viability to be potent variable for attraction of private capital inflows to the region. The mean value of economic freedom is also exhibiting its potential to be counted as vital variable for luring private capital inflows towards selected South Asian region. Reasonable description has been showed by the rest of the variables.

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Table 2.

Economic Freedom and Private Capital Inflows in Selected South Asian Economies

Dependent Variable: Private Capital Inflows (PCF)
	System GMM
	Coefficient	Probability
PCF i,t− 1	0.6173(0.0524)	0.000
EF	3.7557(1.2480)	0.003
GGDP	0.6864(0.2523)	0.007
XR	−0.6546(0.2098)	0.002
INF	−0.3188(0.4111)	0.438
ODA	0.4950(0.0664)	0.000
NRES	0.3441(0.3127)	0.275
Constant	−70.476(13.90)	0.000
Wald χ 2	110.04	0.000
Observations	40
No of Groups	06
No of Instruments	37
Instrument ratio, r = n/i	1.08
AR2 test	0.343
Hansen test for over identification	0.960

Source: Authors’ own calculations.

Note: Wald χ2 is the variables joint significance test. In Hansen test, H0 is instruments and residuals are not correlated while, the H0 of AR(2) test is errors in first difference regression do not show serial correlation of the second order. The parenthesis values depict: heteroskedasticity robust standard errors. Moreover, system GMM has reduced the total number of observation to 40 because of the one-year lagged outcome variable.

Table A2 given in the appendix) presents the correlation analysis. The relationship between private capital inflows and growth in the market size is positive and significant. Economic freedom, official development assistance and natural resources all of them exhibit positive relationship with private capital inflows. Exchange rate and inflation are exhibiting significantly negative relationship with private capital inflows. Hence, all the variables included in the study are carrying their expected signs.

The VIF test values for the impulses have been presented in Table A3 (given in the appendix). No issues of multi-collinearity problem were detected among the variables while estimating the model, because overall mean value obtained is 1.48, which is less than 5 (Nachane, 2006).

In the final estimated model being showcased in Table 2, the significance of 1-year lagged outcome variable exhibits that private capital inflows are also dependent on their past values. In Table 2, economic freedom, which is our variable of interest, is exhibiting a significant and positive association with the inflows of private capital at a level of 1 per cent. The index of economic freedom used in this study consists of wide array of components such trade freedom, property rights freedom, freedom from corruption, financial and labour freedom. Thorough understanding of the state development and the quality of institutions can give more insights about foreign investment towards a country (Daude & Stein, 2007; Grosse & Trevino, 2005). While making their investment abroad, investors always take into account the quality of institutions (Bevan & Estrin, 2004). Institutional efficiency has been identified as a major determinant of investor enterprise performance. Firms’ strategic divisions revolves around the national institutions (Benito, Grøgaard & Narula, 2003; Delios & Henisz, 2003). Foreign investors judge the position of economic freedom in the country of investment and take decision accordingly. For instance, more foreign capital inflows will be attracted by the country, if the administrative obstacles are low. Likewise, when corruption level is low in a country, it indicates that there are high quality institutions; hence, more foreign investors will be inclined towards that country for investment which will ultimately boost the economic prosperity (Bénassy-Quéré, Coupet & Mayer, 2007).

The market size growth is exhibiting a significant positive relationship with private capital inflows. This variable is significant at level of 1 per cent. Foreign investors assess market size of host country and take investment decision accordingly. Countries having large market size assist foreign companies to minimize their production cost via economies of scale. Current market denotes existing demand of the economy, whereas growth rate depicts its prospective potential. Persistent growth of the market is very vital for enticing more private capital inflows (Clegg & Scott-Green, 1998). The larger the size of the market, the higher will be the inflows of private capital (Ghura & Goodwin, 2000; Zhang & Markusen, 1999). In the results, exchange rate has been found to be negatively linked with the inflows of private capital. If the host country exchange rate shows depreciation, the currency of home country will automatically show appreciation. Hence, foreign investors will earn more foreign currency, purchase additional raw materials and hire labour cheaply. Resultantly, the inflows of private capital increase in the host country. Our results are akin to Froot and Stien (1991) and Lim (2001) in the literature. On the other hand, regular depreciation of host country currency gives indication towards uncertainty, and foreign investor is discouraged by this phenomenon (Garg & Dua, 2014). Uniform consensus has not been established between exchange rate and private capital inflows in the literature and most of the results are mixed. Inconclusive results were obtained pertaining the association of inflation and natural resources with private capital inflows nonetheless; their coefficients still carry the expected signs.

The variable of official development assistance is significant at 1 per cent, thereby depicting that it is a robust variable for attracting private capital inflows towards selected countries of South Asian region. Likewise, results were obtained by Luger and Shetty (1985), McGillivray (2009) and Mottaleb and Kalirajan (2010). They concluded that such kind of funds play a pivotal role in the attraction of private capital inflows and the advancement of developing countries. These funds not only shape the infrastructure of developing countries but also give indication of nation’s relationship in global arena.

Conclusion and Recommendations

This research pursued the role of economic freedom in the attraction of private capital inflows towards selected South Asian economies. By using dynamic panel data model, that is, system GMM, this research endeavour transpires economic freedom to be a robust variable in the determination of inflows of private capital towards selected South Asian region, previously unearthed in the existing literature. Other utilized impulses of the study are in conformity with the extant literature, that is, market size growth and official development assistance show positive and significant relation with private capital inflows, whereas exchange rate has significant negative relationship with inflows of private capital. The relationship between inflation and natural resources with private capital inflows came out to be inconclusive.

Management authorities shall ensure economic freedom in the region so that they can further attract foreign investors. Strategies shall be devised to further long-term economic freedom in the region. The management authorities need to provide investment friendly climate to foreign investors in the shape of tax breaks in different sectors, reducing trade barriers, equity market liberalization and control of corruption. They should also ensure consistency in their policies. Incentives to foreign investors should be given with due care as sometimes incentives become disadvantage for the home country.

The investment decisions of foreign investors are markedly affected by the macroeconomic conditions since they influence their risk/return. In this regard, economic growth is observed with due care by foreign investors. This research found that market size plays a profound role in attraction of private capital inflows. The market growth is slim in the region compared to other regions in the world. It is due unstable macroeconomic environment and unreliable policies. Proper arrangement should be made pertaining this issue so that more investors can be attracted towards the region. The multiple exchange rate abolition initiatives can entice more inflows of foreign capital through elimination of economic distortions and will reduce exchange rate risk at the time of capital repatriation. Policy reforms of this kind will create a signalling effect regarding country’s commitment of market discipline and efficient economic policies. Finally, official development assistance funds shall be channelized for the better of infrastructure. Control of corruption in such kind of funds is indispensable. These funds not only shape the infrastructure of developing countries but also give indication of nation’s relationship in global arena.