The impact of foreign investment, regulatory measures and black markets on a country's economic growth.

ABSTRACT

The study explores the impact of economics and institutional factors on a country's economic growth. These factors include: trade, taxation, government intervention in the economy, monetary policy, foreign investment, banking, wages and price policies, property rights, regulation, and black markets. The study estimates a formulated linear regression model. The results of the regression analysis demonstrate that despite the positive and low level contributions of the variables in a country's overall growth, three of the factors namely, absence of black market, lower level of government intervention, and unrestricted direct foreign investment show a more statistically significant impact on a country's growth (GDP).

1. INTRODUCTION

The phenomenon of value and growth has occupied a central position in the history of economic thought. Economists have considered it a challenge to provide an intellectually convincing and statistically testable explanation for the difference in the value of various commodities at the micro level and reasons behind variation in economic growth that different countries experience at the macro economic level. With the development of marginal analysis and the theory of supply and demand, the problem of valuation has long been laid to rest. The phenomenon of variability in growth on the other hand, has been found to be more intractable. Despite tremendous advances in economic development theory and methodology over the last few decades, the reasons for differences in the growth of GDP within and across nations are still hotly debated (Rostow, 1990). In the ensuing economic debate, these reasons have ranged from esoteric, such as geographic, cultural and environmental determinism to more mundane debate such as quality of human and material resources, differences in saving rates, technological development as well as nations' institutional and political framework.

According to data compiled by Maddison (1995) per capita world output in 1990 dollars for the period 1500 to 1820 increased from $565 to $651. In half such time from 1820 to 1992, on the other hand, it soared to $5145.00. Economists attribute this significant jump in output during the 19th and early 20th century, primarily to technological progress, which was achieved through new product discoveries, innovations, and human and physical capital growth. Although, these developments were spread worldwide, only a few politically and economically dominant more advanced economies benefited a great deal from these developments while the less developed economies of Asian and African nations lagged behind. The cause of poverty in the midst of plenty remained a puzzle throughout the world. Economist from Adam Smith in 1776 to Mancur Olson in 1996 although successfully identified a host of economic and institutional factors that contribute to promoting economic growth in a country, there is, however, disagreement on their relative importance (Smith, 1996 and Olson, 1996). While Adam Smith placed a heavy emphasis on the division of labor, specialization and capital growth through savings and entrepreneurship, David Ricardo championed the cause of free trade through comparative advantage (Ricardo, 1951).

In the decades from 1960s to 1980s, Solow's Growth Model emphasized savings and capital formation (Solow, 1956). During all this time, when economists were engaged in identifying the relative importance of various economic factors, the role of institutional factors in development remained implicitly hidden in the background. It was not until the publication of Paul Romer's article in 1986 that the role of institutional factors in economic development was explicitly acknowledged. Their role on development did not only receive a new impetus in mobilizing other resources for development but their positive influence on long-term growth also became fully recognized. A study conducted jointly by Heritage Foundation and the Wall Street Journal has recently identified and summarized the discussion on the role of institutional factors on development within the framework of the following ten factors (Holmeus et al., 1997). These factors include: (1) Trade Policy (2) Taxation Policy (3) Government Intervention in the Economy (4) Monetary Policy (5) Capital Flows and Foreign Investment (6) Banking Policy (7) Wages and Price Constraints (8) Property Rights (9) Regulation and (10) Black Market.

The focus of our study is two fold. First to evaluate the impact of all ten economic factors on the GDP of 150 countries and secondly to delineate statistically significant factors on a country's growth. The study primarily relies on Heritage Foundation's ranking (Holmeus et al., 1997). However, unlike the Heritage research which is mainly concerned with establishing correlation between an overall combined index of all the ten factors on a country's GDP, our study concentrates on an evaluation of the impact of each individual economic factor on a country's GDP.

2. REVIEW OF LITERATURE

A review of the latest research provides substantial theoretical as well as empirical evidence on the effectiveness of these factors on development. The studies by Levine and Renelt (1990) and Gould and Ruffin (1993) indicate a positive impact of lower restrictions on foreign trade whereas Baldwin (1989) discovers an underestimation bias from gains of free trade in the old growth models. Studies by Barro (1991), Landau (1986), Marlow (1986), Engen and Skinner (1992), and Grier and Tullock (1989) demonstrate negative influence of Government's Spending and higher level of Government Intervention through an active fiscal policy on economic growth. King and Rebelo (1990) discuss the impact of taxes whereas Dowd (1994) and Fisher (1993) provide evidence for the distortionary effect of inflation on growth. The salutatory effect on growth of a sound banking and financial system is quite evident from King and Levine (1993) research. The evidence for economic distortion that wage, price, exchange, and other governmental regulations and controls create is furnished in Barro and Martin's (1995) recent work in economic growth. Knack and Keefer (1995) discuss the effectiveness of maintaining rule of law and property and contract right in maintaining all those robust economic institutions that contribute significantly to economic growth.

The positive role of the institutional variables on economic growth becomes even clearer when one compares the performance of the recently failed controlled economies with the robust economic growth of the free European and South Asian countries. In order to explain the significant difference in growth that various countries have experienced in the last few decades, Heritage Foundation has ranked all 150 independent countries on the basis of 50 independent variables, which have been further grouped into 10 factors. These economic factors as mentioned earlier are: trade, taxation, government intervention, monetary policy, foreign investment, banking, wage and price policies, property rights, regulation and black markets. Countries have been ranked on a scale of 1 to 5 on the basis of a concept of economic freedom. This concept is defined as the "absence of Government Coercion or constraint on the production, distribution or consumption of goods and services". On the basis of this definition a country which allows free and full unrestricted foreign trade receives a rank of 1 and one which restricts trade with heavy tariffs or complete government controls gets a rank of 5. The lower the country's score, the higher is its place on the scale of economic freedom.

3. EMPIRICAL MODEL AND DATA SOURCES

Our empirical model explores one main issue relating to the influence of foreign investment, regulation, and corruption on a country's economic growth. We investigate this issue by estimating the variant of the following equations:

           +   -   -  +   +   +   -   +   -  -
(1) Y = f (TR, TA, G, MP, FI, BK, WP, PR, R, BM)

where Y stands for economic growth (GDP), TR implies trade, TA is taxation, G is government intervention, MP is monetary policy, FI stands for direct foreign investment, BK is banking policy, WP is wage and price constraints, PR implies property rights, R is regulation, and BM implies black market. The signs above the variables indicate the a priori assumption for the respective regression coefficient in a linear model. The general model in equation (1) could be transformed into a linear formation as shown in equation (2) below:

(2) [Y.sub.i] = [alpha] + [[beta].sub.1]TR + [[beta].sub.2]TA + [[beta].sub.3]G + [[beta].sub.4]MP + [[beta].sub.5]FI + [[beta].sub.6]BK + [[beta].sub.7]WP + [[beta].sub.8]PR + [[beta].sub.9]R + [[beta].sub.10]BM + [mu]

A stepwise regression is performed on the above linear regression model and the result is reported in table 1 under analysis of results. The data on the ten economic variables for the 150 countries with a rank order ranging from a low of 1 to a high of 5 is made available in the Heritage Foundation Report (Holmeus et al, 1997). In this report, for example, black market variable for a country is ranked at 1 if there is negligible black market activity in that country and at 5 if such activities permeate the entire society to such a degree that it has become an acceptable practice in its entire business culture. In order to quantify these ranks we converted these ranking scales into dummy variables by assigning a variable X = 0 for ranks less than 3 and X = 1 for ranks 3 to 5. All ten independent variables were converted with this scheme. Growth for 150 countries was measured with 1994 GDP per capita at 1987 dollars and it was used as dependent variable in the multiple regression models.

The Variables: The ten variables were used in various regression equations for the following reasons.

Black Market: Black market includes all those illegal interactions between buyers and sellers that cannot mutually be performed in an open market. Individual researchers as well as various U.S. agencies have provided evidence on the existence of black markets in a number of developing countries. Smuggling, graft and bribes, general pay off for work done by governmental employees, existence of illegal labor markets, use of child labor, sale of pirated trade marks material and widespread existence of multiple exchange rates, are examples of black market activities. These activities are generally known to result from an extensive and often unwarranted intervention of the governmental agencies in the economy, the desire of the public to circumvent the unimplementable and unforeseeable rules and the regulations and laws that they are forced to follow in their business transactions. Since most of these activities remain unreported, they create a negative impact on GDP both through a lack of accounting as well as economic distortion.

Banking: Free privately owned unrestricted and least regulated banking system is essential for an economically viable and efficient flow of saving to investment channels and to GDP growth. If due to restrictions, excessive regulation or micro-management investment demand is not efficiently satisfied, GDP will be negatively impacted.

Monetary Policy: Inflation directly affect a country's GDP through the valuation of its goods and services, value of its exports and imports and by creating distortions in the relative contribution of its resources to its growth. Therefore, the degree of inflation that a country experiences, provides a gauge to the effectiveness of its monetary policy. A country, which maintains a proper balance in the growth of money supply, will enjoy a stable price level. The rate of inflation growth in a country, therefore, provides a measure whose impact on GDP is expected to be negative.

Taxation: In all free societies taxes are viewed as a necessary evil. They are necessary because public services cannot be financed without them and evil because they transfer resources from individuals to the state thus limiting individual economic freedom while at the same time increasing the coercive power of the state. Since governmental bureaucracy is assumed to be inherently inefficient, higher taxes take away extra purchasing power from an efficient economic unit--the individual to an inefficient unit--the state. Therefore, higher taxes are expected to create a negative impact on GDP.

Governmental Intervention: In the discussion of taxes it was pointed out that a tax represents a transfer of economic resources from an efficient economic unit to an inefficient one. Therefore, a country with higher tax rates on the average individual is expected to experience a negative impact on its GDP. The same negative impact on a larger scale will be evident if the governments' bureaucracy, which is represented through a public sector, either consumes a major portion of its production, or accounts for a larger percentage of the total GDP. There are a number of ways a government can intervene in an economy. It can get involved in the economy through a major public service program, through a large defense establishment or even worst, by directly engaging in production and distribution of economic resources through the ownership and control of state enterprises. When a state carries out a large defense program through a policy of subcontracting outlays on various defense production and procurement items, the resources although controlled by the state are still coming back to the economy through competitive and efficient allocation to private producers and enterprises. On the other hand when the state directly owns a steel mill or a hospital and either fully produces or distributes the products or services or competes with other privately owned enterprises, it is distorting and disturbing the free flow of resources to the most efficient channels. Therefore, one can safely assume that the proportion of the size of the state owned enterprises to the total GDP of the country will constitute the best measure of the governmental intervention in the economy. On the quantitative scale one can therefore expect a negative correlation between this variable and GDP growth. The recent failure of the socialist as well as semi-socialist economies provides convincing evidence to this effect. It is further confirmed by our analysis.

Regulation: Colonialism in Asia and Africa and communism in the rest of the world survived as long as they did because they were sustained primarily on two well designed and thought out policies. Firstly, they exacerbated and exaggerated the differences in color, race, ethnicity and religion among the inhabitants of a country. Secondly, they established a system of rules, regulation, orders and procedures to such a degree that an individual's personal and economic life became totally subjected to control and manipulation by state appropriated and controlled bureaucrats. This policy may have been conceived to be a way for establishing a perpetual political and economic bondage. Although, colonialism and communism are both dead, their legacy of licensing rules and regulations are still alive and ticking in a large number of developing countries. The colonial business culture has been so deeply rooted in these societies that very little economic activity is initiated without government's approval or involvement. The distortionary effect of these regulations on GDP has invariably been negative. Our analysis verifies this adverse effect on GDP.

Foreign Investment: Foreign investment provides a supplement to domestic savings. When it is freely allowed, officially encouraged and legally protected, its unencumbered flow within the framework of stable currency regime, will contribute significantly to a country's economic growth. South East Asian countries provide a testament to the productive role of foreign investment. Despite recent currency turmoil these countries experienced during the last quarter of 1977, they are still way ahead of others, such as India, Russia and China, who placed heavy restrictions on foreign capital in the early stage of their development. In view of the positive role that free flow of foreign capital plays in a country's development, it is expected that a country that places heavy restrictions on foreign investment will experience a negative impact on its GDP and its growth. This conclusion is borne out by our regression analysis.

Property Rights: Most economic activities are undertaken with a pecuniary motive. Entrepreneur, risk takers and producers, make commitments to an enterprise primarily in view of its future profitability. The incentive for profit is not however sufficient for risk takers. They should be fully granted not only a protection of their profits but also their rights to accumulate and enhance their properties and wealth. Freedom of ownership and full legal protection from any expropriation as fundamental economic rights are needed for the establishment of a stable investment climate. Countries that provide complete control and ownership of property to the producing business enterprises will experience higher GDP and economic growth.

Wages and Prices: One of the basic features of the functioning of a free enterprise private economy is the freedom that it allows by law and the guarantees it provides to the individual entrepreneur to work within the framework of the market determined wages and prices. Any time a public body or an instrument of government intervenes in the market in order to arbitrarily formulate wages or prices, market determined efficient allocation is disturbed and, maximum returns from resource utilization are adversely affected.

Foreign Trade: In the current expanding global trade environment, the principle of comparative advantage remains the cornerstone of economic analysis. Recent economic history convincingly demonstrates that countries that have recognized this principle and have formulated their foreign trade policies on the basis of this principle have achieved remarkable economic growth. On the other hand, those guided by narrow economic or national consideration and have chosen protectionist trade policy have experienced much slower economic growth. Europeans as well as South East Asian tiger economies owe their rapid industrialization and GDP growth to unhindered and free foreign trade. Lower tariff, lack of import licensing, absence of import restrictions and inspections, and lack of trade quotas indicate a country's commitment to free trade policy that could contribute positively to internal resource allocation and GDP growth.

4. ANALYSIS OF RESULTS

Three different tests were conducted in order to separate the effect of the variables as well as to evaluate the incremental effect of the independent variables in the regression equation. The first regression tested for regulatory measures with respect to GDP. As shown in table 1 (factor 1), the dependent variable is significant but negatively correlated, justifying our earlier assumption that excessive regulation could be detrimental to the growth of the economy. The R-square shows a 52.9% level of explained variable. Table 1 (factor 2) tested for black market and regulation. The result and signs were consistent with our a priori assumptions that black market activities and government regulations tend to have negative effect on the growth of the economy. There is improved result for the R-square over the first test with a 68.2%. Table 1 (factor 3) tested for black markets, direct foreign investment, and government regulations. The result of the regression and their signs were consistent with our prior assumptions and significant at 95% level. The R-square showed improved level in explaining the variation in the regression equation with a value of 72.4%.

5. CONCLUSION

Economic growth is a complex phenomenon. Starting an economy on a growth path and maintaining a proper growth rate and avoiding or minimizing unexpected shocks that may derail it from a steady growth path requires not just economic discipline and resource mobility but also a free and stable political, social and institutional environment. An environment that is transparent, fairly honest, regulation free and one that global investors can find profitable as well as accountable is desirable. The results of our analysis demonstrate that although numerous variables contribute to a country's economic growth, the absence of black markets, government regulations, and restrictions of foreign investment would have significantly more important impact on a country future growth than the host of many other economic and non-economic factors. These three factors are more significant because the absence of black markets provides transparency in business interactions that is needed for building and maintaining confidence in the economy. The absence of regulations and restrictions on foreign investment establish an environment of economic freedom within as well as outside the country. Both types of freedoms when established and promoted will provide an environment for the entrepreneurs and providers of risk capital to contribute to a country's economic growth with investment as well as to benefit from its growth when such investments turn out to be profitable.

Table 1: Analysis of Variance among Countries By factors
Dependent Variable: Gross Domestic Product 94

Factor 1. Regulation

Multiple R              .72762
R Square                .52942
Adjusted R Square       .52158
Standard Error      1958.08836

Analysis of Variance

                  DF     Sum of Squares      Mean Square

Regression          1    258815208.78777   258815208.78777
Residual           60    230046600.69610     3834110.01160
F =          67.50333   Signif F = .0000

Variables in the Equation

Variable          B            SE B        Beta       T      Sig T

Regulation   -6455.953247   785.774200   -.727615   -8.216   0000
(Constant)   7274.571429    740.087834              9.829    .0000

Variables not in the Equation

Variable                  Beta In      T      Sig T

Banking                   -.056688   -.621    .5369
Black Markets             -.426310   -5.321   .0000
Foreign Investment        -.248055   -2.970   .0043
Government Intervention   -.088913   -.978    .3323
Monetary Policy           -.064628   -.717    .4763
Price Rights              -.282513   -3.209   .0022
Taxation                  -.199655   -2.270   .0269
Trade                     -.327771   -3.572   .0007
Wage & Prices             -.070995   -.725    .4715

Factor 2. Black Markets

Multiple R              .82585
R Square                .68203
Adjusted R Square       .67125
Standard Error      1623.15151

Analysis of Variance

               DF     Sum of Squares     Mean Square

Regression      2    333419180.13284   166709590.06642
Residual       59    155442629.35103     2634620.83646
F = 63.27650        Signif F = .0000

Variables in the Equation

Variable             B            SE B        Beta       T      Sig T

Black Markets   -4048.967466   760.890873   -.426310   -5.321   .0000
Regulation      -4941.534247   710.823290   -.556933   -6.952   .0000
(Constant)      9588.267123    751.944752              12.751   .0000

Variables not in the Equation

Variable                  Beta In      T      Sig T

Banking                   -.082774   -1.099   .2762
Foreign Investment        -.207362   -2.981   .0042
Government Intervention   -.100680   -1.344   .1840
Monetary Policy           -.041169    -.549   .5852
Price Rights              -.168020   -2.091   .0409
Taxation                  -.127594   -1.687   .0970
Trade                     -.230922   -2.843   .0062
Wages & Prices             .044375     .526   .6006

Factor 3. Foreign Investment

Multiple R              .85104
R Square                .72427
Adjusted R Square       .71001
Standard Error      1524.46752

Analysis of Variance

               DF     Sum of Squares    Mean Square

Regression      3    354069738.71909   118023246.23970
Residual       58    134792070.76478    2324001.22008
F = 50.78450        Signif F = .0000

Variables in the Equation

Variable             B            SE B        Beta       T      Sig T

Black Markets   -3812.508413   719.019483   -.401413   -5.302   .0000
Foreign
  Investment    -1166.975383   391.483957   -.207362   -2.981   .0042
Regulation      -4893.576354   667.800644   -.551528   -7.328   .0000
(Constant)       9953.279971   716.765211              13.886   .0000

Variables not in the Equation

Variable                  Beta In      T      Sig T

Banking                    .002565    .033    .9739
Government Intervention   -.015445   -.197    .8448
Monetary Policy           -.075053   -1.060   .2935
Price Rights              -.099417   -1.206   .2330
Taxation                  -.107494   -1.499   .1395
Trade                     -.15395    -1.729   .0893
Wages & Prices             .101959    1.269   .2094

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Dr. Imtiaz Ahmad received his Ph.D. from the State University of New York, Buffalo in 1968. He has several journal articles in the areas of applied economics and quantitative methods. Dr. Ahmed was an Associate Professor of quantitative methods in the Department of Business, Management and Accounting, University of Maryland Eastern Shore, Princess Anne, Maryland.

Dr. Dinesh K. Sharma earned his Ph.D. at the Chaudhary Charan Singh University, India in 1999. He has published several journal articles. His research has focused on goal programming, nonlinear programming, and applied business studies. Dr. Sharma is an Associate Professor of quantitative methods/computer applications in the Department of Business, Management and Accounting at University of Maryland Eastern Shore, Princess Anne, Maryland.

Dr. Julius A. Alade received his Ph.D. from the University of Utah in 1981. He has authored and co-authored several journal articles/abstracts. In his research, he has combined theoretic economics with financial and operations management, using linear and goal programming models. Dr. Alade is an Acting Chair and Associate Professor of production management/ quantitative methods in the Department of Business, Management and Accounting, University of Maryland Eastern Shore, Princess Anne, Maryland.