IMPACT OF FOREIGN DIRECT INVESTMENT ON

ECONOMIC GROWTH OF NEPAL

A Thesis

Submitted to Department of Economics, Ratna Rajya Laxmi Campus

A Faculty of Humanities and Social Sciences, Tribhuwan University, Kathmandu Nepal

In Partial Fulfillment of the Requirement for the Degree of

MASTER OF ARTS

in

ECONOMICS

By

Pratichi Pokhrel

Exam Roll No: 400170

T.U Registration No: 6-3-453-275-2014

Symbol Number: 400170

December 2020
 DECLARATION

I, hereby, declare that the work – entitled Impact of Foreign Direct Investment on
Economic Growth of Nepal presented in this dissertation---is a genuine work done
originally by me and has not submitted elsewhere for the award of any degree. All
sources of information have been specifically acknowledged by reference to the author(s)
or institution(s).

……………………………………………….

Pratichi Pokhrel

December, 2020

i
 LETTER OF RECOMMENDATION

This is to certify that Ms. Pratichi Pokhrel has completed this dissertation work
entitled Impact of Foreign Direct Investment on Economic Growth of Nepal, as a partial
fulfillment of the requirements of M.A Economics under my supervision and guidance.

To my knowledge, this research has not been submitted for any other degree, anywhere
else.

I, therefore, recommend the dissertation for acceptance and approval.

….…………………………………………
Bashu Dev Dhungel
Associate Professor
Thesis Supervisor
Date:

ii
 LETTER OF APPROVAL

This dissertation entitled Impact of Foreign Direct Investment on Economic Growth

of Nepal, submitted by Ms. Pratichi Pokhrel to the Department of Economics, Ratna
Rajya Laxmi Campus, a Faculty of Humanities and Social Science, Tribhuwan
University is examined and accepted as a partial fulfillment of the requirement of M.A
Economics.

Evaluation Committee

………………………………..

Krishna Raj Acharya, PhD

Associate Professor
Head Department of Economics

………………………………..

Bashu Dev Dhungel

Associate Professor
Date:

iii
 ACKNOWLEDGEMENTS

This study is the requirement for the partial fulfillment of Masters of Arts at
Tibhuwan University (TU). It is an honor to express my sincere gratitude to my
supervisor Associate Prof. Bashu Dev Dhungel, for his continuous guidance and
encouragement. Without his constructive comments, untiring help and practical
suggestion this work not have been successful.

I also want to acknowledge respected Associate Prof. Dr. Krishna Raj Acharya, Head
of Economics Department for his valuable time, cooperation and inspiration during the
performance of this thesis.

Furthermore, I thankful to my friend Ismith Pokhrel for his help and lastly I am
obliged to my friends and other organization members who helped me to find and collect
secondary data used in thesis.

Pratichi Pokhrel
December, 2020

iv
 ABSTRACT

Rapid industrialization, globalization, sharing of knowledge and resources are essential in

modern world to keep pace with its development needs. However, in context of Nepal,
these aspects are not blossoming compare to other part of the world. The prime reasons
are because of obstacles of low rate of gross domestic saving, investment and meager
growth of technology. For progressive economic growth country must focus on capital
formation and resource mobilization. For progressive economic growth it is a key to
allure foreign investors and foreign currency inside country. Thereby understanding its
importance, study is an attempt to figure out what FDI is doing at Nepal.

The main objective besides attempting the thesis was to find the “Impact of Foreign
Direct Investment on Economic Growth” in both long run and short run. On the process
of understanding affect few impactful variables of FDI was used: Trade Openness
(TON), Financial Development (FINDEV) and Foreign Direct Investment (FDI) itself.
The study examined a data over the period from FY1996/97 to 2018/2019, which
included a data of twenty-two years. On the methodology portion of the dissertation,
impact of FDI study, was based on the descriptive analysis and the model was based on
Solow neoclassical growth. Furthermore, on the process, the variables were found to be
stationary at level or I (0) so simple ordinary least square techniques was used. The
variables are also found to be stationary at first difference i.e. at I(1) so Engel Granger
technique was used for the estimation of long-run relationship. Likewise, the
compilations of data are made through various sources like: World Development
Indicators (WDI), International Financial Statistics (IFS), Nepal Rastra Bank, World
Bank, UNDP and Central Bureau of Statistics.

Although, some literature review reveal negative impact of Foreign Direct Investment at
Gross Domestic Product on an Economy but the thesis findings and outcome at
dissertation showed a significant result. The finding display that there is long run
relationship between Foreign Direct Investment and Economic Growth by using Engle-
Granger test.

v
 TABLE OF CONTENTS

Page

DECLARATION…………………………………………………………………………..i

LETTER OF RECOMMENDATION ……………………………………………............ii

LETTER OF APPROVAL ………………………………………………………………iii

ACKNOWLEDGEMENTS………………………………………………………………iv

ABSTRACT ……………………………………………………………………................v

TABLE OF CONTENTS ………………………………………………………...............vi

LIST OF TABLES…………………………………………………………………..........ix

LIST OF FIGURES ………………………………………………………………………x

LIST OF ABBREVIATIONS & ACRONYMS …………………………………………xi

CHAPTER ONE: INTRODUCTION …………………………………………(1-5)

1.1Background of the Study …………………………………………………………….1

1.2 Statement of the Problem……………………………………………………….……..2

1.3 Objective of the Study………………………………………………………………...2

1.4 Hypothesis of the Study …………………………………………………………….2

1.5 Significance of the Study …………………………………………………………….3

1.6 Purpose of the Study ………………………………………………………….....3

1.7Limitations of the Study …………………………………………………………….4

1.8Organization of the Study……………………………………………………………...5

CHAPTER TWO: REVIEW OF LITERATURE………………………………. (6-18)

vi
2.1 Overview of Foreign Direct Investment………………………………………………6

2.2 Theories of Foreign Direct Investment ………..……………………………………9

2.3 Theoretical Review ……………………………………………………………11

2.3.1 Types of Foreign Direct Investment ……………………………………………11

2.3.2 Different Forms of Foreign Direct Investment ……………………………………12

2.4 Foreign Direct Investment Framework in Nepal ……………………………………12

2.5 Empirical Literature Review……………………………………………………(14-17)

2.5.1 International Context………………………………………………………………14

2.5.2Nepalese Context ……………………………………………………………16

2.6 Research Gap …………………………………………………………………...18

CHAPTER THREE: RESEARCH METHODOLOGY………………………..(19-27)

3.1 Introduction …………………………………………………………………...19

3.2 Conceptual Framework ……………………………………………………………19

3.3 Research Design…………………………………………………………………..….21

3.4 Sample Period………………………………………………………………………..21

3.5 Source of Data………………………………………………………………………..21

3.6 Model Specification………………………………………………………………….21

3.7 Definition and Measurement of Variables…………………………………………...22

3.8 Econometric Methodology………………………………………………………......22

3.8.1 Unit Root Test……………………………………………………………………..26

3.8.2 Testing of Co-integration…………………………………………………………..26

vii
3.8.3 Long-run estimation……………………………………………………………….27

3.8.4 Error Correction Model……………………………………………………….

…...27

CHAPTER FOUR: DATA ANALYSIS AND INTERPRETATI…………… (28-49)

4.1 Introduction………………………………………………………………………….28

4.1.1 FDI and Economic Growth………………………………………………………...29

4.2 Graphical Analysis…………………………………………………………………...30

4.3 Descriptive Statistics…………………………………………………………………38

4.4 Correlation Analysis…………………………………………………………………39

4.5 Unit Root Test………………………………………………………………………..40

4.6 Testing of Co integration ……………………………………………………………41

4.7 Long Run Estimation………………………………………………………………...42

4.8 Short Run Dynamics…………………………………………………………………44

4.9 Diagnostic Test………………………………………………………………………46

4.9.1 Serial Correlation Test……………………………………………………………..47

4.9.2 Heteroscedasticity Test…………………………………………………………….48

4.9.3 Normality Test……………………………………………………………………..49

CHAPTER FIVE: MAJOR FINDINGS AND RECOMMENDATION……….(50-51)

REFERENCES…………………………………………………………………….(51-55)

viii
 LIST OF TABLES

Table No. Title Page. No

Table 4.1 Trend of FDI and GDP in Nepal from 1996-2019 30

Table 4.2 Trend of GDP and OPN in Nepal from 1996-2019 33

Table 4.3 Trend of FDI and FINDEV in Nepal from 1996-2019 36

Table 4.4 Descriptive measures of the FDI variables 38

Table 4.5 Correlation Matrix 39

Table 4.6 Augmented Dickey Fuller Test 41

Table 4.7 Engle-Granger co integration test results 42

Table 4.8 Regression equation 42

Table 4.9 Error correction Model 44

Table 4.10 Serial correlation test 47

Table 4.11 Heteroscedasticity Test 48

ix
 LIST OF FIGURES

Figure Title Page.

No. no

Figure2.1 Theoretical review of FDI 11

Figure2.2 Foreign Direct Investment procedure in Nepal 13

Figure3.1 Conceptual Framework of FDI 20

Figure4.1 Trend of FDI and GDP in Nepal from 1996-2019 32

Figure4.2 Trend of GDP and OPN in Nepal from 1996-2019 34

Figure4.3 Trend of GDP and Financial Development in Nepal from 1996- 37

2019

x
 LIST OF ABBREVIATIONS & ACRONYMS

ASEAN Association of Southeast Asian Nations

BITs Bilateral Investment Treaties
CBS Central Bureau of Statistics
DOI Department of Industry
DTTs Double Taxation Treaties
ECM Error Correction Model
EXP Export Goods and Services
EXDT External Debt
FDI Foreign Direct Investment
FINDEV Financial Development
FITTA Foreign Investment and Technology Transfer Act
GCF Gross Capital Formation
GDP Gross Domestic Product
GNI Gross National Income
IBN Investment Board of Nepal
IMF International Monetary Fund
IMP Import of Goods and Services
LSA Location specific advantages
LDC Least Developed Country
MEXP Military Expenditures
MIGA Multilateral Investment Guarantee Agency
MNE Multinational Corporation
MOF Ministry of Finance
xi
M&As Mergers and Acquisitions
NRB Nepal Rastra Bank
NLSS Nepal Living Standards Survey

NPC Nepal Planning Commission

OECD Organization for Economic Co-operation and Development
OLS Ordinary Least Squares
OPN Trade openness
PCI Per Capita Income
PPP Purchasing Power Parity
SAFTA South Asian Free Trade Area
SDC Sustainable Development Goal
UNDP United Nations Development Programme
UNCTAD United Nations Conference on Trade and Development
WTO World Trade Organization
WIPO World Intellectual Property Organization

CHAPTER-I
xii
 INTRODUCTION

1.1Background of Study

Foreign Direct Investment (FDI) plays an important role in an economy of the world. It is
a good source of capital formation which helps in economic growth. Foreign Direct
Investment is prominent at transfer of technological knowledge and human capital. It
enhances international trade, creates job opportunities, mobilize resources, strength
enterprise. An innovative concept designed from the brain of modern human is Foreign
Direct Investments. In fact, the concept of foreign investment is not new. However, it was
not given a formal foundation, while now, it is an emerging concept embraced almost at
every corner of the world.

There are three common motives of foreign direct investment: Resource seeking, market
seeking and efficiency seeking. Resource seeking investments are made in order to have
access of cheap resources. This include: raw materials, labor and infrastructures. On the
other side, market seeking FDI deals with market size, market growth, structure of
domestic market and local market. Lastly, in case of efficiency seeking FDI investments
come into a country seeking to benefit from factors that facilitate it to compete in an
international market. (Dunning & Sarianna, 2008)

The importance of FDI is increasing from wider perspective so the developing countries
and those countries in transition consider it as a good source of economic development.
Foreign Direct Investment is helping world to narrow down through globalization,
modernization, income growth and employment. FDI’s diversified investments are
attracting people all over the globe to move towards certain destination in a search of
better life and opportunities. In fact, the impact of Foreign Direct Investment can be
considered in terms of numerous indicators. Those indicators includes: technology and
skills; establishment of industries, export promotion; formation of new investors; creation
of linkages with, and associated upgrading of local enterprises. Furthermore, role of
Foreign Direct Investment (FDI) in the economic growth of the host countries is
important from wide perspective and FDI accelerates host countries’ growth by various
factors. (i) Augment domestic savings and investment, (ii) Transfer of technology (iii)
Increase competition in the host country’s domestic market, (iv) Increase exports and
earn foreign exchange, and (v) Impart several other types of positive externalities to the
economy at large.

Apart from that, there are views that suggest FDI do posses some of the shortcomings.
FDI could be unhealthy if certain regulations are not followed and there are few
evidences in world that have proved FDI as worse in certain context. FDI vanish local
and indigenous enterprise through global competition especially due to strong economic
power of multinational companies. It is a contributor of pollution. The industrialization
and waste generated from industries are not acceptable in an eye of environmentalist.
Furthermore, on process of knowledge and technology sharing there are chances that
country might erode their cultural and ritual norms. It also target host country domestic
market and decrease export from the host county. FDI creates distortions in the host
country’s social and economic structures by infusing inappropriate social and cultural
norms and behavior patterns (Ram & Kevin, 2002).

1.2 Statement of Problems

The economic condition of Nepal is unsteady. It is among least developed country in

South Asia with low economic growth, low productivity, low saving and investments.
The growth of the country has been averaged 4 percent over the last decade (NPC, 2015).
In case of Nepal, high cost of transportation and inaccessibility of sea routes including
trenchant geographical condition hinders the economic growth. Import based county with
low technological advancement and lower initiation on research and development is
damaging Nepal’s growth. The gap amid total investment and gross domestic saving
remained voluminous since long. As proportionate to total GDP, the shares of gross
domestic savings and total investments are 15.0 percent and 51.7 percent, respectively, in
the fiscal year 2017/18, resulting to saving investment gap at 36.7 percent of GDP in
current fiscal year 2017/18 (MOF, 2018). Nepal’s low domestic saving, low capital
formation, low human development index and uneven utilization of remittance in
unproductive sector is an important reason behind the need of FDI. Theories suggest that
FDI is a good source of employment generation and resource mobilization which is a
primary requirement in context of Nepal for progressive economy. Thereby, FDI is a
boon for economic growth if it is used strategically for the development of countries
economy. However, ignoring its cons and attempting to bring FDI inside country might
be problematic as it does behold numerous disadvantages that are unhealthy in economy
at long run.

1.3 Objective of Study

 To examine the impact of Foreign Direct Investment on economic growth

of Nepal
 To examine the relationship between Foreign Direct Investment and
Gross Domestic Product in long run and short run

1.4 Hypothesis of Study

The fundamental hypothesis in the study helped in finding out the flow of foreign direct
investment and its impact on economic growth of Nepal. The hypothesis guided in
understanding some of the research question that was ignited on the process of
accomplishing this work. Some of those research questions that occurred during the
completion of this work were: Do Foreign Direct Investment has relationship with
Nepal’s Gross Domestic Product? What role Trade openness, Financial Development and
FDI have in economic growth of a county? Furthermore, understanding the objective of
the study, following hypothesis was tested.

Hypothesis H0: there is no significant impact of FDI on economic growth of Nepal.

1.5 Significance of the Study

Foreign Direct Investment serves as a medium for economic development of Nepal. In

view of the fact that, Nepal is a least developed country (LDC) characterized by slow
economic growth rate and poor social economic condition. At past, country saw drastic
political and social fragile-conflict situation and simultaneously it is yet struggling from
structurally generated poverty and inequality. In fact, Nepal is under a deep entrenched
form of social exclusion and stigmatic chaos. However, despite of these, traumatic
political and social challenges Nepal economic growth is averaged 4 percent over the last
decade with an absolute poverty decrease from 42 percent in 1995 to 25 percent in 2010
(NLSS2011). The data of this decreased poverty seems satisfactory but there remains a
larger disparity in the rates of poverty by gender, social group and geographical area.

Thereby, Nepal dreams to emerge as an inclusive, equitable and prosperous middle-

income country by 2030 with the goal of being welfare state through sustainable poverty
reduction. The country has set the goal of graduating from LDC status by 2022. Of the
three criteria for graduation - Per Capita Gross National Income (GNI), Human Assets
and Economic Vulnerability are among those the country is likely to achieve. Thus, with
target set by government of Nepal and implementation of new structure of government, it
was pertinent to study the significant impact of Foreign Direct Investment on economic
growth.

1.6 Purpose of the Study

Foreign Direct Investment occurs when an investor based in one country (the home
country) acquires an asset in another country (the host country) with a purpose to manage
that asset. Theories of FDI suggest that if national and foreign investors of private
enterprise are permitted to operate in the market like Nepal it can offer the best prospect
for faster national economic growth. This leverage to invest would undoubtedly provide
opportunity to add new resources, capital, technological management and marketing to
the host economy ensuring efficient and stimulate change.

The purpose of the thesis helped us to understand the area of foreign direct investment
and its role at Nepal’s economy. From this view, data of twenty-two years was used for
foreign investment, trade openness, gross domestic saving and financial development.
The variables used for the study of the impact was; Foreign Direct Investment, Trade
Openness and Financial Development. Therefore, on completion of thesis it assisted in
understanding the effect of Foreign Direct Investment in economic growth of Nepal since
1996-2018.

1.7Limitations of the Study

The research methodology is limited from many factors yet this limitation did not hamper
the significance and foundation of study. The main limitation encountered during the
process was on secondary time series annual data. The study analyzed a data of the period
from 1996 to 2018. Other growth factors like remittance, foreign aid, technology was not
included in the regression model. Furthermore, secondary data was used thereby there
was high chance of misinformation and misinterpretation of data.

Additionally, the thesis focused the data only up to twenty two years but analyzing
relation the more the data the better outcome could have produced. Furthermore, co
integration test is applied. The test is used to asymptotic properties (large sample size)
since a small sample size would produce unreliable results but our sample size is limited
and if the sample was large the thesis outcome could have been more reliable.

1.8Organization of the Study

This study was divided into five chapters, Chapter I includes general background,
framework of FDI, Statement of the problem, Research question, Objective of the study,
Significance of the study, purpose, Limitations and organization of the study. Similarly,
chapter II devoted for the brief review of literature available. Review of Books,
International and National research reports, Unpublished PhD dissertations M.Phil and
Master level unpublished dissertations, Journals articles, different planning and policies
by government etc was included in chapter two.

Further chapter III presents methodology used in the study. It consists of research design,
nature and sources of data, data collection techniques, method of sampling, data
processing and analysis. Chapter IV includes the data analysis and findings. In this
chapter, data collected from various relevant sources was presented and analyzed by
using various statistical and econometrics tools and finally in chapter V it includes
summary, conclusion and recommendation from the results of the study.
 CHAPTER-II

REVIEW OF LITERATURE

2.1 Overview of Foreign Direct Investment

Foreign Direct Investment (FDI) is an investment from a party in one country into a
business in another country with the purpose of launching a lasting interest. A foreign
Direct Investment is made by obtaining lasting interest or by diversifying one’s business
into a foreign land. Generally, the lasting interest is established when an investor obtains
at least a certain percentage of voting power in a firm. Foreign Direct Investment
includes mergers and acquisitions, building new facilities and reinventing profits also it
includes lasting management interest in an enterprise operating in an economy.

Basically, there are two inflows of FDI: Inward and Outward. Inward and outward FDI
was attributed to policy liberalization explained by market forces and technological
changes. The inward and outward FDI’s can impact economic conditions as firms are
able to expand internationally to other countries, specifically developing and less
developing economies. Inward FDI also called as direct investment is a type of
investment where investments are made in the reporting economy, it includes all
liabilities and assets transferred between resident direct investment enterprise and their
direct investors. Here, the investment comes into a country from foreign investors who
live in other countries and it is also known as a capital investment by companies,
organizations and individuals of one country into those of another country. Inward
investment is an opposite of outward. At outward investment; investment increases
counties investment competitiveness crucial for long term sustainable growth. It is a
business strategy in which a domestic firm expands its operation to a foreign country.
Outward direct investment is a natural progression for firms if their domestic market is
saturated and better business opportunities are available. Most of the developed nation
adopted such a strategy for extensive investment. This assimilation of investment affects
the FDI inflow from the host county that is basically challenging to reallocate their
resources to FDI beneficiary countries in an effort to maximize their profits through
globalization. (Adler & Hufbauer, 2008)

There are fundamental polices of foreign direct investment. The two main policies
associated with the fundamental purpose of FDI are: The first policy, FDI in the short
run, seeks to attract foreign investment, augmenting stock capital available to the nation.
The second policy views, a nation’s FDI achieving a competitive advantage over its
competitor by utilizing the value chain analysis (customer value as a chain of activities
transforming inputs into outputs). FDI not only affect country’s economy but it provides
spotlight to the world’s economy. (Kotler, 1997)

The theory of FDI in international production to invest in abroad if the host country
would offer Location specific advantages (LSA). These specific advantages could
classify into two categories. The first category was proprietary advanced technology and
expertise offered by the country providing the FDI. The second category of advantages,
provided by the receiving country, was a combination of vertical and horizontal
integration, economies of scales, and an internal financial market. The capability to
incorporate LSA has been widely recognized and personified with globalization. The
increasing ability to globalize the world’s economies has been significant by embracing
innovation through the expansion of FDI. Countries with economic stabilization and
expansion will potentially attract FDI. The theory has also been influential through the
use of innovation technological resources. The dominant technological paradigm of
international production related to the characteristic of MNE’s activity a offers a more
logical reason to set up production in a foreign country that is mainly due to ownership,
rival competition and easy access to operating in a foreign county will allow further
expansion over its competitors. (Dunning, 1988)

In a developed economy unskilled labor is not a distinctive resource, and it might be

employed in the market without networking effort. An investor in pursuit of cheap labor
typically operates in an enclave, in which all the resources except labor are brought in
from the home-based networks. Local presence is also useful in building local
relationships because it provides gravitational proximity to the foreign networks in which
activities are centralized .The ultimate purpose of FDI is for overseas investors to pursue
complicated local linkages, procuring and allowing components, parts, services, research
and development, and local financing to promote their migration in a foreign country. In
order to engage in international production in a given host country, a firm must possess
substantial advantages that offset its natural disadvantages to promote international
investment. (Yadoung & Peng, 1999)

FDI firms adapt their human resource management to powerful social institutions in a
transitional economy, such as the case with the People’s Republic of China, whose
human capital has allowed FDI to penetrate the country’s financial institutions and grow
within its transitional system, rather than FDI firms invading local institutions. Generally,
size of the market and its population is a measure of a country’s size because the
traditional concept that the land, labor, capital and knowledge not guarantee a host county
from investing in a foreign county. A logical way of investment includes measuring a
countries population to figure out whether the size of the county is a determinant factor
for investment. Other factors include the receiving country’s ability to expand markets.
(Law, Tse, & Zhou, 2003).

Firms invest if the conditions exist for market profitability, even if the country’s ability is
not conditioned for changes based on the political and economic conditions or
environmental influences under which the country operates. Such condition ensures
positive changes once FDI is transferred from the host country to the foreign country
receiving FDI. Thus, the country blessed with productive infrastructure in a host county
mostly attracts foreign direct investment (Kobrin, 1976).
2.2 Theories of Foreign Direct Investment

1. Production Cycle Theory of Vernon: Production cycle theory of Vernon was

developed by Vernon in 1996. The theory was used to explain certain types of
foreign direct investment made by U.S companies in Western Europe aftermath of
World War II in manufacturing industries. Vernon explained four stages of
production life cycle theory:
o Innovation: Vernon claim that in the first stage the U.S transitional companies
created a new innovative product for local consumption. After creation of
innovative product the surplus was exported to the foreign land and markets.
This was an introductory phase characterized by high expenses on market
research and market testing with possibility of financial losses.
o Growth: The second phase was growth. At this phase market grows and
competitors start to enter in the market. At growth stage, Increase in demand
may lead to enter foreign production also product is imitated and introduced in
the home country to capture growth in the home market.
o Maturity: At third stage market is in advanced condition. The product is
matured. Process gets standardized and price becomes the significant
competitive strategy. Due to strong competition, exporter-nations become
importers and capital intensity increases. It also increases the need for skilled
labor and is replaced by using low-skilled and semi-skilled labor.
o Decline: Market is saturated at this stage as product enters the decline stage.
The production bases move entirely too low-cost nations. The production
moved from innovator-country to other industrialized countries to developing
countries. The innovating-country becomes the importer. The pressure on
high-income countries is to turn toward innovation of new products which
starts the cycle over again.
2. The Theory of Exchange Rates on Imperfect Capital Markets: This is one
more theory which tried to explain FDI. In the beginning the foreign exchange
risk has been analyzed from the standpoint of international trade. The theory
analyzed the power of uncertainty in foreign direct investment. In the theory of
 exchange rates on imperfect capital market the real exchange rate increase
stimulated FDI made by USD, while a foreign currency appreciation has reduced.
However, currency risk rate theory cannot explain concurrent foreign direct
investment between countries with different currencies.
3. The Internalization Theory: The theory explains the growth of transitional
companies and their reason behind achieving foreign direct investment. The
internationalization theory identified two major determinants of FDI. One was the
removal of competition. The other was the advantages which some firms possess
in a particular activity. The transnational companies organize their internal
activities to develop precise advantages. Internalization theory is considered very
important also by Dunning, who uses it in the eclectic theory, but also argues that
this explains only part of FDI flows.
4. The Eclectic Paradigm of Dunning: The eclectic theory of Dunning is a mix of
three different theories of direct foreign investments (O-L-I):
o The ownership advantage: Ownership advantage is seen as the competitive
advantage that comes with the FDI. Ownership is the proprietorship of a unique
and valuable resource that cannot be easily imitated thereby creating a strong
competitive advantage against other foreign competitor. The disadvantages or
challenge is associated with FDI’s in terms of ownership. The challenge include
possible language barrier or lock of knowledge of the demand trends that are in
market.
o Location advantage: The potential business host countries face numerous
competitive advantages. Location is one of the advantages. The location
advantage focuses more on the geographic compensation of the host countries.
Other location advantages can include low-cost labor, low cost raw materials,
lower taxes and other tariffs.
o Internalization Advantage: For companies to decide which investment pathway
or technique is best appropriate for their needs, their management team must
analyze the internalization advantage.
2.3 Theoretical Review

Figure2.1: Theoretical review of Foreign Direct Investment

Foreign Direct Investment

Types of FDI
Horizontal

Vertical

Forms of FDI
Joint Venture

Mergers and Acquisitions (M&As)

Greenfield Investment

Source: Author Compilation

2.3.1 Types of Foreign Direct Investment

 Horizontal FDI: Horizontal FDI is the type of foreign investment that is done
from the home country to host country in the same industry. This type of
investment is performed when company wants to diversify business with the
motive to produce same or similar goods as it is producing at home county to the
host country. Product differentiation is a main reason for horizontal FDI to be
successful and it is taken for two main reasons. the first reason is that the
company can save a lot of low-cost inputs, such as labor, similarly, the second
one is that it is more profitable for the multinational company to be at the foreign
location. (MacInerney, 2005)
 Vertical FDI: The vertical FDI operates with the motive to acquire or build an
operation that accomplishes either the role of a supplier or the role of a
distributor. Vertical FDI occurs when the foreign investors affiliates in low-wage
countries often to the parent company.
2.3.2 Different Forms of Foreign Direct Investment

 Greenfield Investment: It is a type of investment and is a process where the

investors launch new production and distribution facilities in a host country. Host
country normally welcome these investment because it is a source of new
production capacity and jobs, it transfer technology also provide high value added
output and it lead to linkage to the global marketplace. (Moose, 2002).
 Merger and Acquisition: Merger and Acquisition is the process of merging with
a company in foreign country that is already in existence. Mergers occur when the
assets of firms from different countries are combined to give birth to a new legal
entity.
 Joint Venture: Joint venture is the process of creating partnership either with a
company in the host country or a leading institution. These ventures are often
created to share risk and enterprise. Generally, at joint venture, partner company
provide the technical skills and access financial means whereas another partner
provide local knowledge related to the market also laws and regulation.

2.4 Foreign Direct Investment Framework in Nepal

The legal arrangements that govern FDI in Nepal include some act: Foreign Investment
and Technology Transfer Act (FITTA,1992), Foreign Exchange Regulation Act 1962,
Investment Board Act 2010 and Industrial Enterprises Act 2016, Company Act 2017,
Investment Board Act 2011, Contract Act 2000, Arbitration Act 1999, Income Tax Act
2002, Labor Act 2017, and Privatization Act 1992. Similarly, Department of Industries
(DOI), Investment Board of Nepal (IBN) and Nepal Rastra Bank (NRB) are the agencies
for administration and implementation of rules and regulations related to Foreign Direct
Investment.

The FITTA defines the forms of foreign investment as (a) investment in share (equity) (b)
reinvestment of the earnings derived from the clause (c) investment made in the form of
loan or loan facilities. The minimum investment required for foreign investment approval
is Rs. 5 million per investor. The act also defines the technology transfer which is
allowed even in the area where foreign investment is not permitted. Use of technological
rights, specialization, formula, process, patent or technical know-how of foreign origin;
use of any trademark of foreign ownership and acquiring any foreign technical
consultancy, management and marketing service are the forms of technology transfer.

Furthermore, there are sector specific acts that should also be followed if the investment
to the given specific sectors. These acts are the Electricity Act, 1992, Nepal Petroleum
Act, 1983, Private Investment in Infrastructures Act, 2006, Mines and Mineral Resources
Act, 1985, Bank and Financial Institutions Act, 2017. In general, the required documents
differ according to mode of foreign equity participation in the industries. The categories
are: (i) foreign equity investment in a new industry and (ii) foreign equity investment in
an existing Nepalese Industry.

Figure 2.2: Foreign Direct Investment procedure in Nepal

Sourc
e: doind.gov.np
2.5 Empirical Literature Review

2.5.1 International Context

Zhang (2002) empirically studied FDI and growth linkage with low income and middle
income countries. They used three different proxies for FDI that gave same result.
Aggregate investment output ratio was found to be positive. Nexus between FDI and host
country’s growth was found to be positive. Education parameters shows considerable
variability, but it almost reaches significance at 10 percent.

Griozard (2006) explored the linkage between income growth rates and FDI inflows. No
strong relationship between FDI and income growth has been established. They argued
that countries need a sound business environment in the form of good government
regulations to be able to benefit from FDI. Using a comprehensive data set for
regulations, the hypothesis was tested and found evidence that excessive regulations
restrict growth through FDI only in the most regulated economies. This result holds true
for different specifications of the econometric model, including instrumental variable
regression.

Srivastava and chaudhary (2007) analyzed the direct impact of remittance on three
development indicators Gross Domestic Product (GDP), Gross National Income (GNI)
and Per Capita Income (PCI). Using multiple regression equation with and without log
linearizing the proposed model, the impact of remittance has been seen most remarkable
in the GDP and GNP both in nominal and real terms. In the nominal GDP and GNP, the
remittance shows 61 percent and 72 percent impact respectively while in real term it
shows 48 percent and 55 percent respectively. There was positive on PCI but was
comparatively low.

Dutt and Mukhopadhyay (2008) it examined the causality between foreign direct
investment (FDI) and economic growth for 66 developing countries. The Time series
analysis for each country is conducted, based on a method introduced by Toda and
Yamamoto (1995) for testing Granger causality in the presence of non stationary time
series. The main findings of this article was: FDI causes growth in several of the
developing countries, but the mechanism through which this works differs across
countries and reverse causality from growth to FDI exists for many countries.

Majagaiya (2010) the study carried out to find out the linkage between Foreign Direct
Investment (FDI) and economic growth in terms of Gross Domestic Product Growth Rate
(GDPGR) for Nepal over the period 1980-2006 (using the Granger Causality test, Unit
root test and Co-integration test). The results showed that there exit a long term
relationship between the variables and direction of causality runs from FDI to GDPGR.
Co-integration test was used to find out the long-term relation between the variables.
Furthermore, ordinary least square method was used to assume the hypothesis that there
was no relationship between Foreign Direct Investment (FDI) and Economic Growth in
terms of GDP (GDPGR).

Ali (2014) thesis focused on the issue of foreign direct investments in Algeria and their
impact on economic growth. The aim of the thesis was to test the importance of FDI,
imports and domestic investments on economic growth in Algeria. According to the
results of the analysis, there were made some recommendations which showed how it
helped at increasing FDI impact in Algerian economy and also to attract new foreign
investors. It used the "Cobb-Douglas" production function to measure and describe the
effect of foreign direct investment on economic growth in Algeria during the period
2000-2011.

Awan (September 2014) the multiple linear regressions model was applied to study the
relationship between explanatory variables and explained variable. Empirical results
showed that gross capital formation, exports, gross national income, significantly and
positively affected Pakistan FDI inflows. It explained external debt also notably affected
Pakistan FDI inflows but its relation with FDI was negative. It selected the variables
which was affecting the FDI inflow in Pakistan from the period of 1988 to 2012.
2.5.2Nepalese Context

Shrestha (2010) studied the effect of structural change on economic growth of Nepalese
economy over the period of 1965 to 2009. The study focus was based on the result of
IMF and World Bank structural adjustment programme during mid-80s. The result
showed that the performance of Nepalese economy has not been improved after series of
structural adjustment. The study also found that Poverty was widespread and per capital
income was low with higher inequality.

Rijal (2010) studied structure of FDI and its attraction for economic growth from the
period of 1980 to 2008. The result showed foreign firms plays significant role in some
sectors like carpets and garment exports but their exports are largely motivated by some
incentives like system of preference and MFA quotas rather than comparative advantage.
Majority of foreign firms are involved in import substitution activities characterized by
high capital intensity. Contribution to FDI to employment generation has been negligible.
The study suggested that FDI has failed to make significant contribution to productive
growth of manufacturing sectors. In absence of supportive services like transportation,
political stability and good business environment, Nepal has failed to achieve investment
in its potential sectors.

Gurung (2010) has conducted a descriptive statistical analysis and an empirical analysis
to establish the relationship between real gross domestic product and foreign direct
investment stock. Using time series econometrics tests for the period 1980-2008, the
empirical results indicated the existence of a long-run relationship between the
determinants. It applied the two-step residual test of Eagle and Granger (1987) also
applied Ordinary least squares(OLS) to the regression equation in which all variables are
found to be integrated of the same order. It run error correction model (ECM) to test the
significance of the error correction term.

Chamlagai (2015) investigated relation between remittances, foreign aid and FDI on
economic growth of Nepal. The ARDL bounds testing approach was conducted for
analyzing data over period 1970 to 2014. The study concluded that remittances and labor
are very important driving forces for economic growth both in long-run and short-run of
Nepalese economy. It also suggested that FDI and aid do not have any significance
impact on output growth in both long-run and in short-run. Error correction model was
used to confirm existence of stable long-run relationship and approve a deviation from
long run equilibrium following short-run shock which was corrected by almost 16
percentages after each year.

Bista (March 2017) This research examined the relationship between Foreign Direct
Investment (FDI) and Gross Domestic Product (GDP) along with the impact of FDI
determinants on FDI inflow. Researcher applied an econometric model based on Cobb
Douglas Production Model and a theoretical growth model based on Solow Growth. The
result indicated the positive relationship between GDP and FDI. This researcher used the
Econometric Model. It showed there is a functional relationship between GDP, FDI, and
Export in economic liberalization policy environment. This relationship was illustrated
by econometric model to estimate whether FDI affects GDP. It revealed that if GDP is a
dependent variable and FDI, Export, GDP ratio, privatization, and liberalization are
dummies an independent variable.

Mishra1, Degtereva, & Paneru (2017) it explained the effect of foreign direct investment
on economic growth of Nepal. It examined the impact of the total number of industries
and the total number of positions approved for foreign investment on the gross domestic
product (GDP) per capita and the real GDP growth rate of Nepal. The paper used data
from fiscal year 2004/05 to fiscal year 2013/14. The analysis showed the positive impact
of foreign investment on real GDP growth rate but insignificant impact on GDP per
capita of Nepal.
2.6 Research Gap

Meanwhile there are some research gaps on the study of foreign direct investment in
economic growth of Nepal. The research examines the impact on economic growth of
Nepal at both long and short run. The Regression Analysis is used for the estimation of
relationships between a dependent variable and independent variables. Although,
regression analysis is a powerful statistical tool it examine the data of many time interval.
However, the research focuses on the data of only twenty two years. Therefore, the data
are of limited time interval. Apart from that, the thesis would produce significant result if
more variables were used while the thesis is limited upon few variables basically trade
openness and financial development including FDI.

In case of Nepal, at theoretical ground political instability is an important variable to be

studied for better outcome. However for the study, data is not available so thesis had to
give up such an impactful variable. Similarly, human capital, sector wise analysis, gross
capital formations are not included in thesis which is not leading thesis to be more
accurate in terms of its result. Furthermore, there are more powerful econometric tools
but our research is confined to Enger’s- Granger’s technique.
 CHAPTER III

RESEARCH METHODOLOGY

3.1 Introduction

The study focused on the impact of FDI on economic growth of Nepal. After review of
literature, it provided a step by step guide to a detailed research design and
methodologies that were employed in testing various hypotheses, data collection method,
while also gave a general overview of the macroeconomic variables under analysis.

3.2 Conceptual Framework

Foreign Direct Investment is a unique concept at Nepal after the beginning of trade
liberalization polices. Since, the expansionary polices on trade were welcomed at Nepal,
so does the Concept of FDI. However, after many turbulence and struggle, today Nepal is
a country with sound trade liberalization polices. In fact, FDI in Nepal is a boon for
economic development. For better future of the country if Nepal can open the trade route
it can enjoy the pie of newer technology, skills and investment. As we are aware, Nepal is
a country with sufficient resources basically at trenchant water resources and marvelous
climatic conditions and nature. In fact, the country is blessed with natural beauty and a
virgin land with huge opportunities for investment. Nepal offers countless things that
incite the investors here. In Addition, Nepal has adopted flexible trade rules along easy
bureaucracy for investment; furthermore, it is a buffer nation enclosed from two most
emerging power of world. If Nepal can work and design a strategy diplomatically it can
get huge benefit from its neighbor at North and South.

Despite, these there are many weaknesses for welcoming FDI at Nepal. The major
challenge Nepal is facing currently is the tie amid China and India. China and Nepal
political interest is currently playing a bigger role in FDI of Nepal. China’s investment is
problematic for India so does the India. Therefore, these ties act as a detrimental effect at
Nepal economic development from FDI. Apart from that, in spite of virgin and
resourceful land Nepal does not attain sufficient trade port also unavailable sea route is a
challenge. Furthermore, for India and China it is quite a small market in comparison to
their market and population volume. In spite of these constraints if FDI in Nepal can
flourish it will eventually lead to economic growth of a county. Therefore, enter of FDI
leads to economic growth thereby it is best option to reduce challenges and increase
number of FDI.

Figure: 3.1 Conceptual Framework of FDI

Trade Openness
 Provide access to goods and services
 Improve factor productivity and expand
production
 Increase returns to scale
 Economic specialization
Financial Development
 Facilitate technological progress
 Provide information
 Facilitate productivity
about possible
investment
 Allocating capital
Economic Development  Monitoring firms
 Exerting corporate
governance
Foreign Direct Investment  Trade diversification
 Manage risk
 Source of capital formation
 Mobilization savings
 Technology to spillover
 Supports human capital formation
 Enhances trade integration
 Creates competitive environment
 Strengthens enterprise development
Source: Author Compilation
3.3 Research Design

The study was based on the descriptive and analysis research design in order to meet the
objective of the study. On process of analyzing, the impact of foreign direct investment
on economic growth of Nepal, related information were collected, tabulated, listed and
analyzed through the help of various statistical tools. The study has focused on previous
relevant studies in Nepal and other countries to evaluate the impact of foreign direct
investment, financial development, and trade openness on economic growth. In addition,
the study employed analytical design, a data of twenty two years in order to explore the
relationship between foreign direct investment and economic growth of Nepal.

3.4 Sample Period

The study has employed annual data of twenty two years time interval from 1996-2018.

3.5 Source of Data

The nature of data is descriptive as well as analytical. The sources of the data are
Quarterly Economic Bulletin (NRB), Economic Survey Reports (MOF, GON), Statistical
Year Book of Nepal (CBS) and UNDP report as well as various economic survey
published by Ministry of Finance, GoN.

3.6 Model Specification

The model based on Solow neoclassical growth began with classical production function
as stated below

Y t =f (OPN , FINDEV , FDI t )……………………………….3.1

The transformed function in cob douglas production form the equation becomes

α β γ
Y t = At OPN FINDEV FDI t ……………………………………3.2

Where,

Y t =¿Output level of real GDP at time period t

At = level of technology at time period t

 γ
FDI t =¿Foreign direct investment at time period t

OPN= trade openness given by export plus import to GDP

FINDEV= financial development given by domestic credit to GDP.

From equation 3.2 excluding the technology variable to include in residual and taking log
linear form were appropriate to study the impact for real GDP which was applied by
Gerking and Boyes (1980).

ln Y t =αln OPN t +γ lnFDI t + β lnFINDEV t +e

Where, e is error term of the model.

3.7 Definition and Measurement of Variables

Furthermore, there are some detailed summary of those data that was employed in the
impact of FDI in economic growth of Nepal. The variables are used to explain the impact
of FDI in Nepalese economic growth and also explain about the determinants of FDI.

 Foreign Direct Investment (FDI)

 Trade openness (OPN)
 Financial Development(FINDEV)
 Gross Domestic Product (GDP)
 Time period t. (t)
 level of technology At t

3.8 Econometric Methodology

The objective of this study was to determine impact of foreign direct investment in GDP
of Nepal and their relationship. In order to identify impact and its relationship simple
linear regression is not suitable as data are in time series. Time series data are not
stationary and estimated parameter based on simple linear regression are unreliable
because of the fact that they generate spurious regression. Non-stationary time series data
causes spurious regression or non-sense regression. So time series framework was chosen
for analysis as it was relevant for the study. Selecting wrong model could have result
misleading interpretation.

Furthermore, testing of unit root was primary stage of selecting appropriate model. Unit
root was tested based on Augmented Dicky Fuller (ADF) test. The variables were found
to be stationary at level or I (0), then simple ordinary least square techniques was used.
Here, the variable are found to be non-stationary but stationary at first difference i.e. at
I(1) so Engel Granger technique was used for the estimation of long-run relationship.
Long run co integration equation and short run dynamic equation is estimated based on
error correction model that ties long run relation to short run dynamics. Furthermore,
there are various Econometric techniques used at thesis and some of them are: Time
Series Properties of the Variables, Co integration, Error Correction Model, Diagnostic
Tests (JB Test for Normality), LM Test for Serial Correlation, Heteroscedasticity Test.
Furthermore, it used Adjusted R2 criterion, Augmented Dickey-Fuller (ADF) Test.

1) Time Series Properties of the Variables: A time series is said to be stationary if

its mean, variance and auto covariance remain the same no matter at what point
they are measured; i.e. they are time invariant. Such a time series tends to return
to its mean and fluctuations around this mean have broadly constant amplitude .If
a time series is not stationary, it is called a non-stationary time series (Gujarati,
2007).
A stationary time series is also called a time series integrated of order zero or I
(0) process. If a time series is non-stationary at level but stationary at first
difference, it is said to be integrated of order one or I (1) process. In general, if a
non-stationary time series has to be differenced d times to get a stationary series,
it is said to be integrated of order d or an I(d) process. Most economic time series
are generally I(1); that is , they generally become stationary only after taking their
first differences (Granger,1986).

2) Co integration: The regression analysis on time series has been much benefited
from the concept of co integration by Engle and Granger. They showed that using
OLS in case of I(1) variables could be dangerous because a non-stationary series
 violates the basic assumptions of OLS and as such one cannot get the best linear
unbiased estimators (BLUE) and also there may exist the spurious or non-sense
correlation between non-stationary variables. In the case where the variables are
non-stationary at levels but are difference stationary, co integration methodology
allows researchers to test for the presence of long run equilibrium relationships
between economic variables. If the separate economic time series are stationary
after differencing or they are integrated of order one, but a linear combination of
their levels is stationary, then the series are said to be co integrated. In other
words, two or more I (l) time series are said to be co integrated if some linear
combination of them is stationary. Formally, given X t and Y t are integrated of
order one [I (1)] or are difference stationary processes, they are said to be co
integrated if there exists a parameter 𝛼 such that U t =¿ y t yt-−α X t is a stationary
process or is integrated of order zero [I (0)]. Tests for co integration seek to
discern whether or not a stable long-run relationship exists among such a set of
variables. The existence of a common trend among the variables means that in the
long run the behavior of the common trend will drive the behavior of the
variables. Shocks that are unique to one time series will die out as the variables
adjust back to their common trend (Engle & Granger,1987).

t t
3) Error Correction Model: Even if Y and X variables are co integrated, i.e.
there is a long run equilibrium relationship between them, there may be
disequilibrium in the short run. Thus the error term U t =¿ Y t −β 1−β 2 X t in the
regression equation Y t =β 1+ β 2 X t +ut is called the equilibrium error. This error
term can be used to tie the short run behavior of Y to its long run value. The Error
correction Models (ECM) first used by Sargan and later popularized by Engle and
Granger corrects for disequilibrium. (Sargan, 1984).

4) Normality test: Normality test is an asymptotic large sample test based on the
OLS residuals. The test statistic is defined by:
2
S2 ( K −3 )
JB=n [ + ]
6 24
 Where n= sample size
S= skewness coefficient
K = kurtosis coefficient
For a normally distributed variable, S= 0 and K = 3. Therefore, normality is a test
of joint hypothesis that S and K are 0 and 3 respectively. If Probability value of
JB statistics is low then residual are normally distributed. If Probability value of
JB statistics is high then residual are normally distributed.

5) Heteroscedasticity test: It is used for testing the variances of residual term are
constant over time. If it is constant then error term are said to be homoscedastic
otherwise heteroscedastic. Based on Breuch-Pagan-Godfrey test for
Heteroscedasticity the null hypothesis is no heteroscedasticity and alternate
hypothesis is presence of heteroscedasticity. Variance of error term is described as
2
σ i =α 1+ α 2 Z 2 i+ … .+α m Z mi........................................................................................
Where, σ 2i is error variance which is function of non-stochastic Z variables
The function is linear function of Z’s if α 2=… .=α m=0 and σ 2i =α 1 which is
constant. This means error term is homoscedastic.

6) Test of Goodness of Fit with R-squared: After estimation of parameter and

determination of least square regression line, second step is to identify how good
the fit of this line to sample observation is. R squared measures the degree of
goodness of the model. Closer the observation to the line, better the goodness of
fit. It measures the variation of dependent variables about mean that is explained
by regression line. It shows the percentage of total variation of dependent variable
that is explained by independent variables. Higher the values of R-squared better
the goodness of the model. It is given by ratio of explained sum of square and
total sum of square.
2 ESS
R= Where, ESS= explained sum of square
TSS
 TSS= total sum of square, Since TSS= ESS+ RSS, Where, RSS=
RSS
residual sum of square. Therefore, RSS=1−
TSS

3.8.1 Unit Root Test

Time series data is said to be stationary if it is integrated at level or order zero i.e. I(0)
and non-stationary at level but stationary at first difference then it is said to be integrated
at order one i.e. I(1). In general if data are stationary at ‘n’ difference then it is said to be
integrated at order ‘d’ i.e. I (d). Dicky-Fuller test, Augmented Dicky- Fuller (ADF) test
and Phillip Perron test is used for identifying their stationary at certain order. ADF test is
appropriate technique than Dicky Fuller test because it eliminates the autocorrelation
problem encountered by Dicky-Fuller test (Gujarate, 2009).

The study used ADF test for stationary. ADF test used following equation for unit root
test.

m
∆ Y t=μ+ δ Y t−1 + ∑ φi Y t −1+ γ t……………………………………………(3.3)
i=1

The equation 3.3 is the difference equation for identifying stationary in variable Y t .
Using OLS technique above equation identifies presence of unit root (non-stationary)
with intercept only i.e. a time series posing a random walk with drift. The test used the
null hypothesis (δ=0) against the alternative hypothesis (δ<0) at 5% level of significance.

(Note: If P-value found to be greater than 5% we cannot reject null hypothesis that is
there is presence of unit root or series is non-stationary or series has a random walk with
drift. If P-value found to be less than 5% we reject null hypothesis that is series is
stationary.)

3.8.2 Testing of Co-integration

Co-integration test is necessary to establish a long-run relationship between variables.

General Criteria is that variables must be stationary at first order i.e. I (1) that showed
there might exist long-run co-integration relationship. More specifically, co-integration
occurs when two or more non-stationary time series i) have long-run relationship, ii)
move together in time and iii) share an underlying common stochastic trend. Technically,
two or more time series are co-integrated if their linear combination results a stationary
series. Engle-Granger co-integration test is tested based on whether error term series is
stationary at level. If error term series estimated by simple regression is stationary at level
than we can say variables are co-integrated or it has long run relation. Simple regression
is estimated by

ln GDPt =θ 0+θ 1 ln FDI t + θ3 lnOPN +θ 4 lnFINDEV + ωt …………….3.4

3.8.3 Long-run estimation

After conducting co-integration test long run co-integration equation was estimated by
using Engle-Granger technique. The long-run equation is given below.

ln GDPt =θ 0+θ 1 ln FDI t + θ3 lnOPN +θ 4 lnFINDEV + ωt ………………….3.5

3.8.4 Error Correction Model

Error Correction Model (ECM) showed the divergence of short-run around long-run
equilibrium relation. If two variables are co-integrated then relationship between two can
be expressed in ECM (Engle & Granger, 1987).

The model helped to estimate parameter of short-run dynamics with error correction
coefficient that showed speed of adjustment towards equilibrium relation. The model is
derived from long-run regression which is shown below

∆ lnGDP t=δ 0 + δ 1 ∆ lnFDI t +δ 2 ∆ ln FINDEV t +δ 3 ∆ ln OPN t + α ECM t −1+∈t .......(3.6)

Where ∆lnGDP and ∆lnFDI are first difference of natural log of real GDP. ECM t is one
period lagged residual of equation (3.5). δ 1is coefficient of short-run elasticity of FDI. α
is coefficient of error correction that measures the speed of adjustment towards long run
equilibrium relation and ∈t white noise is error term. ECM is derived from long-run
equation (3.5) given by

ECM t −1=ω t−1=lnGDP t−1−θ 0−θ1 FDI t −1−θ2 FINDEV t−1−−θ 3 OPN t−1......(3.7)
All the variables in equation (3.6) are stationary so OLS method can be used for
estimation.
 CHAPTER IV

DATA PRESENTAION AND ANALYSIS

4.1 Introduction

Foreign direct investment means international capital flows in which a firm in one
country creates or expands a subsidiary in another. The unique character of FDI is that it
involves not just transfer of resources but also acquisitions of control. Economic
development is regarded as a concept that beholds technological progress, structural
reform, and comprehensive qualitative improvements in social-economic aspects. It is an
increase in value of the goods and services created through economy that lead to a
betterment of people lives. (Obstfeld, 2006)
There are generally, direct and indirect effects of foreign direct investment. Direct affect
deals with Natural-resource-seeking FDI, Market-seeking FDI, Efficiency-seeking FDI
and strategic assets seeking FDI. While on the other hand there are indirect effects of
FDI. Indirect affect deals with: technology spillover, knowledge sharing, and innovation
sharing. Infrastructural development also deals within the indirect affects. In fact, the
source of economic growth in the new industrialized countries is through astonishing
mobilization of resources. In current situation, in many developing countries like
Bangladesh, India, Srilanka growth seems to be driven by surprising growth in inputs like
labor and capital. Thus, the indirect effects of FDI are eventually important for economic
growth.
The dramatic improvement in productivity achieved not only through physical capital
formation but also through improved human skill and identified three ways in which
employment is created through: (i) Employment for operations in the domestic economy
(ii) Backward and forward linkages (iii) Growth in the economy that leads to further
employment generation in the economy (Maddison,1991)

4.1.1 FDI and Economic Growth

Nepal has an ability to allure FDI in comparison to most other low income countries
because of numerous advantages. Some of them are: large and friendly neighboring
nations with huge market potential, mushrooming entrepreneurial culture and established
international recognition. The economic growths are affected by FDI through various
methods and these are basically: Size effects, Technology effect and Employment effects.
Size effects are all about net contribution of FDI to the host countries saving and
investment which affects the growth rate of the production. Likewise, technology effects
FDI is one of the most important source of skills and transfer of technology.

Lastly, in employment effects the vertical FDI consequences in shifts of production from
home to host country in order to take benefit of differences in factor prices since the aim
of vertical FDI is to minimize production costs. The FDI and economic growth are deep
rooted. The growth of FDI eventually leads to growth in economic development. In
context of Nepal, there are many factors that lead to economic growth.

o Saving and Investments: Foreign direct is a good pool of savings and

investment. In Nepal, if investment are made. The resources of Nepal are
mobilized thereby creating better job opportunities. Once the unemployment rate
is decreased people are likely to save and eventually use saving for better
outcome. Unless saving is made there is no ground for investment.
o Technology transfer and innovation: Technology dominant countries are those
they are developed in all horizons while in case of Nepal it is technologically
backward Nation.FDI in Nepal is a best source of technology transfer. Youth
along the coming generation gets opportunities to learn advance technology and
the technology simultaneously generate innovative ideas.
o Entrepreneurship linkage: Apart from generating new ideas FDI do help in
creating entrepreneurship linkage. The linkage helps in creating new entrepreneur
inside a country with innovative ideas.
4.2 Graphical Analysis

Table 4.1: Trend of FDI and GDP in Nepal from 1996-2019

Date FDI GDP

1996/1997 2219.9 366224.7
1997/1998 2395.5 376999.32
1998/1999 2000.3 393902.92
1999/2000 1666.4 417992.09
2000/2001 1417.6 441518.49
2001/2002 3002.6 442048.99
2002/2003 1209.7 459488.31
2003/2004 1793.8 481004.32
2004/2005 2764.8 497738.96
2005/2006 1635.8 514485.63
2006/2007 2606.3 532038.16
2007/2008 3186 564516.9
2008/2009 9812.6 590107.2
2009/2010 6255.1 618529.15
2010/2011 9100 639694.08
2011/2012 10053.2 670279.36
2012/2013 7138.3 697954.23
2013/1014 19818.7 739754.36
2014/2015 20107.4 764335.7
2015/2016 67480 767491.58
2016/2017 15139.6 825048.86
2017/2018 55730.3 887455
2018/2019 24999.2 950033
Source: data.worldbank.org (1996-2019)

The Net FDI inflow to Nepal in 1996 up to 1999 is increasing while suddenly from 2000
it is at fluctuating trend. However, the good indication of improvement began from year
2006. Despite such a progressive graph the inflow of FDI decline once again at year
2012, 2015 and also decrease at year 2018/2019. Hence, it can be concluded that the
inflow of FDI is fluctuating depending on many types of external and internal factors.
Similarly, the GDP trend is quite different in compare to FDI because GDP is increasing
since 1996 except at 2014/2015 at decline. Instead of being well aware of the potential
areas for FDI in Nepal the trend of FDI is not increasing voluminously. There is
hydropower, tourism; industrial manufacturing, agriculture, construction and mining are
the major source of Nepal where investment is possible. FDI provides a noteworthy value
for a county like Nepal where there is massive quantities of untouched resources awaiting
strong funding.

The databank of the United Conference on Trade and Development (UNCTAD) FDI
trends in Nepal from 1996 up to 2006 display an irregular pattern. It transparently shows
that the foreign investors are suspicious of investing in conflict-driven societies like
Nepal. Since the fact shows, during the era of Maoist conflict where the investment was
meager while between 2007-2014 Nepal experienced progressive and augmentation in
the flow of FDI. Aftermath , the decline of Maoist conflict Nepal started to display sharp
rise in FDI inflows yet the county’s political system was in transition phase. The main
reason behind impact on FDI from the transition is because of frequent change in
government and void of concrete policy on foreign investment. As an outcome, FDI did
not flourish into Nepal as it was expected.

However, the positive scenario twinkled between 2015 and 2018 when the political
transition was normal with new constitution. The significance Nepal has given to foreign
investment protection and promotion after the county reflected it major participation at
investment summits and these initiation is actually attracting FDI. Apart from that, the
government made a bid if foreign investment and technology and transfer act to handle
the fear of foreign investors. FITA proved to be inclusive for foreign investor to
investment. It contains requirements like countrywide treatment, most-favored nation
treatments, expropriation and an investor-state dispute settlement mechanism. The
Foreign Investment and Technology Transfer Regulation strengthen the Foreign
Investment and Technology Transfer Act.
 Figure4.1: Trend of FDI and GDP in Nepal from 1996-2019, (Rs Million)

80000 1000000

70000 900000
800000
60000
700000
50000 600000
40000 500000 FDI
400000 GDP
30000
300000
20000
200000
10000 100000
0 0
97 99 01 03 05 07 09 11 13 15 17 19
/19 /19 /20 /20 /20 /20 /20 /20 /20 /20 /20 /20
96 998 000 002 004 006 008 010 012 014 016 018
19 1 2 2 2 2 2 2 2 2 2 2

Source: Compilation from table 4.1

Trade Openness:

Trade Openness is one measure of the degree to which a county is engaged in the global
trading system. It is usually measured with the ratio i.e. ratio between the sum of exports
and imports and gross domestic product. The ratio of trade to GDP might increase
through the help of globalization and trade liberalization. Trade openness has been
attaining momentum since the time of globalization. Furthermore, theoretical models
reveal that trade openness helps in allocation of efficient resources through comparative
advantage that is leading to increase income level (Grossman & Helpman, 1991).

Trade openness is an expression of how liberated or limited a county is in trade relation

with outer world. It show that in the long-run, trade openness can potentially improve
economic growth by providing right of entry to goods and services, achieving efficiency
in the allocation of resources and improving total factor productivity through technology
dispersal and knowledge distribution .

Table 4.2: Trend of GDP and OPN in Nepal from 1996-2019

Date OPN GDP

 1996/1997 4.068305 366224.7
1997/1998 4.159438 376999.32
1998/1999 4.037944 393902.92
1999/2000 3.962088 417992.09
2000/2001 4.02017 441518.49
2001/2002 4.021772 442048.99
2002/2003 3.833644 459488.31
2003/2004 3.789808 481004.32
2004/2005 3.831838 497738.96
2005/2006 3.785619 514485.63
2006/2007 3.801359 532038.16
2007/2008 3.797269 564516.9
2008/2009 3.829428 590107.2
2009/2010 3.851837 618529.15
2010/2011 3.828313 639694.08
2011/2012 3.733572 670279.36
2012/2013 3.776391 697954.23
2013/1014 3.874237 739754.36
2014/2015 3.956139 764335.7
2015/2016 3.972088 767491.58
2016/2017 3.886735 825048.86
2017/2018 3.938927 887455
2018/2019 4.00887 950033
Source: data.worldbank.org (1996-2019)

The trade openness allows economies to expand production, increasing returns to scale,
and economics of specialization. Trade openness advance transfers of new technologies,
facilitating technological progress and productivity, and these benefits depend upon the
degree of trade openness. However, the relationship between Trade Openness and Gross
Domestic Product in Nepal shows fluctuating trend. (Grossman & Helpman ,1991)

At few years, in spite, of increasing ratio of trade openness the GDP seems decreasing or
nearly constant. However, the literature on trade openness claim that trade openness help
at improving Nation productivity through technology transfer, infrastructural investment.
In case of Nepal, the trade openness is divided into four parts (I) Agriculture (ii)
Manufacturing, (iii) Energy and Service. Among these sector trade openness are
diversified. Although, after liberalization Nepal open its trade relationship with globe
while also joined trade organization and today it is active participant too. Nepal trade
relation relies on India even though it joined numbers of bilateral treaties with other
country. Furthermore, the Nepalese trade is in huge deficit and it is unable to increase
export while spending huge proportion of dollar on import. Hence, this trade imbalance is
also a prime reason behind such fluctuating effect on GDP despite increasing trade ratio
in some years since 1996.

Figure4.2: Trend of GDP and OPN in Nepal from 1996-2019

900000 4.2
800000 4.1
700000
4
600000
500000 3.9
400000 3.8 GDP
300000 OPN
3.7
200000
100000 3.6

0 3.5
97 99 01 03 05 07 09 11 13 15 17
/ 19 / 19 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20
96 98 00 02 04 06 08 10 12 14 16
19 19 20 20 20 20 20 20 20 20 20

Source: Compilation from Table 4.2

Financial Development

Financial development is developments in the size, efficiency and stability of and access
to the financial system. Financial Development is development to the financial system.
Before, understanding what Financial Development is? It is important to learn what a
financial system is? A Financial system is a system that allows swap of funds amid
financial market’s participants. The financial market participants are: investors, lenders
and borrowers. Financial market provides an efficient and regular linkage between
investors and depositors. Money, credit and finance are used as a medium of exchange in
financial systems and they serve as a medium from which goods and services can be
exchanged. A modern day financial system is banks, financial market, financial
instruments and financial services. Financial system allows funds to move between
economic sectors.

Financial Development at core deals about these private sectors thereby before learning
financial development it is essential to understand financial systems. Financial
development deals with development of private sector and strategy to stimulate economic
growth and reduce poverty. Financial development means improvement in possible
investment, allocating capital, monitoring firm, trading, diversification, mobilizing and
pooling of saving. It refers to the fulfillment of financial system by eliminating market
distortions of financial system. Therefore, it involves the organization and extension of
institutions, instruments and market that support this investment and growth. It is an
inextricable part of economic development.

The Financial Development and Economic Growth are interlinked. The Financial
Development deals with private sector of an economy. The private sector of an economy
is further subdivided into different parts. They are Financial System and further it is
divided into few sub groups; Financial intermediaries, Financial Markets, and Financial
Assets. Financial intermediaries is an entity that work as middleman between parties in
financial transaction , such as, in commercial banks, investment banks, pension fund etc.
Similarly, in financial market trading of securities occur. Thereby, these sector are deeply
connected with FDI because enter of FDI affect these sector of economy. FDI brings new
technology, mobilize resource and create job placement and once these welcomed
automatically these sector are affected and finally help to boost economy in long term.

Table 4.3: Trend of FDI and FINDEV in Nepal from 1996-2019

 Date GDP FINDEV
1996/1997 366224.7 0.931595
1997/1998 376999.32 0.992074
1998/1999 393902.92 1.029651
1999/2000 417992.09 1.096081
2000/2001 441518.49 1.115855
2001/2002 442048.99 1.111392
2002/2003 459488.31 1.065762
2003/2004 481004.32 1.077085
2004/2005 497738.96 1.082121
2005/2006 514485.63 1.098022
2006/2007 532038.16 1.110936
2007/2008 564516.9 1.362014
2008/2009 590107.2 1.407364
2009/2010 618529.15 1.298238
2010/2011 639694.08 1.440583
2011/2012 670279.36 1.625982
2012/2013 697954.23 1.607044
2013/1014 739754.36 1.64719
2014/2015 764335.7 1.666218
2015/2016 767491.58 1.664785
2016/2017 825048.86 1.638909
2017/2018 887455 1.692783
2018/2019 950033 1.618318
Source: data.worldbank.org (1996-2019)

The financial development and GDP relationship from the table seems progressive. As
increase in ratio there is also increase at GDP. It clearly, mentions that when the financial
development of Nepal is progressing so does the GDP and have a direct relationship. This
data signifies that in case of Nepal it accumulates capital from the source of financial
development. Financial development is connected with financial systems while financial
system as a whole deals with various private sector including multinational chains and
foreign investment. The MNC’s and investment automatically create various
opportunities at diverse sector that create job opportunity, increase saving, expending
capacity which flowing the chain of economy help at maintaining proper financial
development and lastly it make direct impact at GDP. Thereby, these are the reason
behind increasing trend of GDP as increase in ratio of financial development.

Figure4.3: Trend of GDP and Financial Development in Nepal from 1996-2019

900000 1.8

800000 1.6

700000 1.4

600000 1.2

500000 1

400000 0.8 GDP

FINDEV
300000 0.6

200000 0.4

100000 0.2

0 0
97 99 01 03 05 07 09 11 13 15 17
/ 19 / 19 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20 / 20
96 98 00 02 04 06 08 10 12 14 16
19 19 20 20 20 20 20 20 20 20 20

Source: Compilation from Table 4.3

4.3 Descriptive Statistics

Regression model direct analysis is insufficient because learning about the characters of
data and its idea is very important. The data clearly exhibit the shape, size and
distribution of it .However these are the following table that shows various descriptive
measures of the variables.

Table4.4: Descriptive measures of the FDI variables

 LNGDP LNFINDEV LNFDI LNOPN
Mean 13.25444 1.320870 8.624229 3.902861
Median 13.24373 1.298238 8.066521 3.874237
Maximum 13.76425 1.692783 11.11959 4.159438
Minimum 12.81100 0.931595 7.098128 3.733572
Std. Dev. 0.283076 0.271956 1.203006 0.112841
Skewness 0.122239 0.155708 0.589232 0.494731
Kurtosis 1.885075 1.354325 2.194428 2.272209
Jarque-Bera 1.248543 2.688342 1.952819 1.445854
Probability 0.535652 0.260756 0.376661 0.485330
Sum 304.8522 30.38000 198.3573 89.76579
Sum Sq.Dev. 1.762910 1.627116 0.280130 31.83893

Observations 23 23 23 23
Source: author’s calculation

Table demonstrates synopsis information of log of Foreign Direct Investment (LNFDI),

log of Real Gross Domestic Product (LNGDP), log of Financial Development
(LNFINDEV)and log of Trade Openness (LNOPN) . Mean value of FDI is 8.624229
while that of GDP is 13.2544 also the Mean value of LNFINDEV and LNOPN is
1.320870 and 3.902861 respectively. Similarly, the Maximum value of LNFDI and
LNGDP is 11.11959 and 13.276425 respectively likewise that of FINDEV is 1.692783
and OPN is 4.159438. Furthermore, the std. Deviation of FDI is 1.203006, Skewness of
0.589232 and std. Deviation of GDP is 0.283076 and Skewness is of 0.122239. (I.e to say
the standard deviation lies between -0.5 to 0.5 so distributions is approximately
symmetric whereas its peak is flatter than normal distribution). Also the std. Dev of
FINDEV 0.271956 and OPN is 0.1128. Similarly, distribution of LNGDP is also found to
be symmetric and peak is also flatter than normal distribution. This indicates that the
distribution of LNFDI, LNGDP, LNFINDEV, LNOPN are nearly normal which is seen
through the help of Jarque-Bera test. Apart from that, the Sum of LNFDI is 198.3573 and
Sum of LNGDP is 304.8522 whereas LNFINDEV is 30.38000 and the other is 89.76.
The Sum Sq. Dev of LNFDI is 31.83893 and LNGDP is 1.76291 whereas observations of
all variables are equal that is 23.

4.4 Correlation Analysis

Here the correlation matrix is obtained through covariance analysis and correlations with
probabilities using E-views. Correlation matrix is used to find out correlation among
variables thereby the result is presented in table.

Table4.5: Correlation Matrix

LNGDP LNFINDEV LNFDI LNOPN

LNGDP 1 -
LNFINDEV 0.94588 1 -
LNFDI 0.88795 0.9100 1 1 -
LNOPN -0.31221 -0.2583 -0.0113 1 1
Source: author’s calculation

Correlation is a statistical tool that is used to measure the degree of relationship between
variables. However, the correlation analysis helps at showing relationship but it is unable
to show that casual relation while it is able to show only a direct relationship between
variable. Hence, here at correlation matrix, it shows a direct relationship between FDI
and GDP. The correlation of FDI and GDP is highly correlated. The LNGDP and LNFDI
are 0.8879553038638991 while LNFDI and LNGDP are 0.8879553038638991.
Therefore, it clearly displays a high correlation amid GDP and FDI. Apart from that the
correlation between LNFDI and LNFINDEV is 0.9100 while LNFDI and LNOPN are -
0.0113.

4.5 Unit Root Test

A unit root (also called a unit root process or a difference stationary process) is a
stochastic trend in a time series, sometimes called a “random walk with drift”. If a time
series has a unit root, it shows a systematic pattern that is unpredictable. Whereas,
Estimation is a statistical tool that estimates the parameter and this Estimation is only
consistent if data are stationary. In spite of requirement of stationary condition, there are
many time-series data that are non-stationary in character.

On the other hand, Augmented Dickey Fuller test (ADF Test) is a common statistical test
used to test whether a given Time series is stationary or not. It is one of the most
commonly used statistical tests when it comes to analyzing the stationary of a series.
Stationary is very important factor on time series. In fact, (ADF) test is conducted to see
if series are stationary. The Augmented Dickey-Fuller test can be used with serial
correlation. The ADF test is capable of handling complex models than the Dickey-Fuller
test, and it is also more powerful so one should be wary because similar to unit root tests
it has a relatively high Type I error rate.

Furthermore, at ADF unless series are not found to be stationary at levels then it is not
co-integrated at different orders to make them stationary. At ADF the series do have unit
root if it is non-stationary. Apart from that, ADF test is depended on the acceptance or
rejection of null hypothesis i.e. the series have unit root against alternative hypothesis
(series have no unit root) at 5% level of significance.

Table4.6: Augmented Dickey Fuller Test

Variables t-statistcs critical value @ 5% Remark

LnFDI 0.27015 -3.0123 unit root
LnGDP 1.318896 -3.0048 unit root
LnFINDEV -1.010964 -3.0048 Unit root
LnOPN -2.836841 -3.0123 Unit root
d(lnFDI) -9.97175* -3.0123 Stationary
 d(lnGDP) -3.89595* -3.0123 Stationary
d(LnFINDEV) -4.353926 -3.0123 Stationary
d(lnOPN) -4.678540 -3.0206 Stationary
Source: author’s calculation

(Notes: LnFDI and LnGDP signify natural log of Foreign Direct Investment and Gross
Domestic Product. Critical value based on McKinnon (1996) one side P-value. And *
represents significant at 5 % level. ADF test is conducted with drift parameter. )

Here at this table it clearly mentions that the P-value is greater than 5% for all the
variables at levels. Therefore, the null hypothesis is unable to reject and there is presence
of unit root. On the other hand, variables are found to be stationary at their first difference
since their P-value is less than 5% and there is rejection of null hypothesis. This shows
that all variables are integrated at order I (1) and their might exist co-integration relation
between the series. Further co-integration test can be conducted.

4.6 Testing of Co integration

Co integration test is used to establish if there is a correlation between several time series
in the long term. Co integration tests identify scenarios where two or more non-stationary
time series are integrated together in a way that they cannot deviate from equilibrium in
the long term. The tests are used to identify the degree of sensitivity of two variables over
a specified period of time. Co -integration is used to identify the long-term relationships
between two or more sets of variables. The uses Engel-Granger co integration test by
testing the stationary of error term estimated by regression model. The result obtained is
as follows

Table4.7: Engle-Granger co integration test results

t-statistics Critical P-value Remark

value@5%
Residuals -2.62533 -1.957204 0.0112 Stationary at Level
Source: author’s Calculation
(It Indicate that result appears to be stationary at level i.e. I(0). Null hypothesis for non
stationary is rejected. The result indicates variable GDP, FDI, OPN &FINDEV are co
integrated as there is long run equilibrium relationship between them.)

4.7 Long Run Estimation

Most of the time, there exist a long run relationship between variables. Here also there
shows a long run relationship between FDI and GDP also relationship within FDI, OPN
and FINDEV. Long run equation is estimated by using simple regression.

Table4.8: Regression equation

Dependent variables: LnGDP

Independent variables coefficient Prob.

lnFINDEV 0.593212* 0.0105

LnFDI 0.086470** 0.0734

LNOPN -0.403500** 0.0683

C 13.29996* 0.0000

R-squared 0.915586

Note: * & ** indicate significance at 5% and 10% level.

Source: calculation from Table 4.8

Table shows long run cointegration equation. The result indicates financial development
is significant at 5% level since its probability value is less than 5% whereas FDI and trade
openness is significant at 10% level since its probability value is less than 10%.
Estimated coefficient of LnFINDEV is 0.593212 and FDI is 0.086470.Estimated
coefficient of trade openness is -0.403500.The result indicates there is positive long run
relationship between FDI and GDP and financial development and GDP whereas there is
negative relationship between trade openness and GDP. Estimated coefficient of trade
openness is -0.403500.
Ln GDP=13.29996+0.086470LnFDI-
0.403500lnOPN+0.593212LnFINDEV .............................................................3.8

Dependent Variable: LNGDP

Method: Least Squares
Time: 14:16
Sample: 1996 2018
Included observations: 23

Variable Coefficient Std. Error t-Statistic Prob.

LNFINDEV 0.593212 0.208949 2.839029 0.0105

LNFDI 0.086470 0.045636 1.894787 0.0734

LNOPN -0.403500 0.208720 -1.933214 0.0683

C 13.29996 0.775709 17.14555 0.0000

R-squared 0.915586 Mean dependent var 13.25444

Adjusted R-squared 0.902258 S.D. dependent var 0.283076

S.E. of regression 0.088500 Akaike info criterion -1.854852

Sum squared residual 0.148814 Schwarz criterion -1.657374

Log likelihood 25.33079 Hannan-Quinn criter. -1.805187

F-statistic 68.69406 Durbin-Watson stat 1.224902

Probability (F- 0.000000

statistic)
4.8 Short Run Dynamics

An error correction model (ECM) belongs to a category of multiple time series models
most commonly used for data where the underlying variables have a long-run stochastic
trend, also known as co integration. ECMs are a theoretically-driven approach useful for
estimating both short-term and long-term effects of one time series on another. In fact, for
any long run equation there exits short run dynamic equation that shows the adjustment
towards long-run equation. This short run equation is explained by error correction
model. This study used Engle-Ganger method for the study of short run model.

Table4. 9: Error correction Model:

Dependent variables: ΔLnGDP

Variables Coefficient Prob.

ECT(-1) -0.146412** 0.0074

ΔLnFDI 0.014134** 0.0727

ΔLnFINDEV 0.061982 0.2907

ΔLnOPN 0.059381 0.3602

C 0.043336 0.0000

R-squared 0.194187

Source: author’s Calculation

Note: ** indicate significance at 10%

Table represents short-run dynamic equation based on Engle-Granger method. Error

correction term (ECT) that shows correction or adjustment of deviation from long run
equation is found to be significant since its probability value is less than 10% and sign of
parameter is as expected as shown in table. Coefficient of error correction term is -
0.1464. This implies that 14.64% of disequilibrium is corrected in a year. FDI is found to
be significant at 10% level and its coefficient is 0.0141. This shows in short run on
percent increase in FDI leads to 0.014% increase in real GDP. There is positive
relationship between FDI and real GDP in short run. Financial development and trade
openness is found to be insignificant in short run. The estimated short run equation is
given below

∆LnGDP=0.04336+0.0141∆LnFDI-0.1464ECT(-
1)+0.0619∆LnFINDEV+0.05938∆lnOPN...................3.9

Dependent Variable: DLNGDP

Method: Least Squares

Date: 12/05/20

Time: 12:40

Sample (adjusted): 1997 2018

Included observations: 22 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

DLNFINDEV 0.061982 0.056839 1.090470 0.2907

DLNFDI 0.014134 0.007388 1.913082 0.0727

DLNOPN 0.059381 0.063140 0.940455 0.3602

ECT -0.146412 0.051591 -2.837942 0.0074

 C 0.043336 0.004529 9.568147 0.0000

R-squared 0.194187 Mean dependent variance 0.043330

Adjusted R-squared 0.004584 S.D. dependent variance 0.018597

S.E. of regression 0.018554 Akaike info criterion -4.939516

Sum squared resid 0.005852 Schwarz criterion -4.691552

Log likelihood 59.33468 Hannan-Quinn criter. -4.881103

F-statistic 1.024177 Durbin-Watson stat 1.616464

Prob(F-statistic) 0.422993

4.9 Diagnostic Test

Diagnostic test are used for indicating model inadequacy. Parameter estimated based on
OLS methods are based on certain assumption any failure of particular assumption might
lead to inappropriate interpretation. So, it is crucial to test the reliability of parameter
estimated. Test like Normality, serial correlation and heteroscedasticity is tested for short
run estimation.

4.9.1 Serial Correlation Test

Serial correlation test shows the existence of autocorrelation between error terms. D-W
test is used for autocorrelation test. However, D-W test doesn’t accounts if model
contained lagged value of dependent variables and it is only appropriate for testing first
order autocorrelation of error term. Therefore, Lagrange multiplier test also known as
Breush-Godfrey test helped to encounter higher autoregressive scheme given as below
U t =ρ1 U t −1 + ρ2 U t −2+ … … … .+ P i U t −i+ e t..........................................................................

Where, e t is a white noise. Equation ... is ρi order autoregressive, AR(p), scheme.

LM test used to test the acceptance or rejection of null hypothesis i.e. no auto correlation
against alternate hypothesis i.e. presence of autocorrelation.

Null hypothesis (H0): ρ1= ρ2=ρ3=...=ρi=0

Alternate Hypothesis: ρi ≠ 0

Where, ρi is order of autoregressive scheme

Table 4.10: serial correlation test

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 2.314342 Prob. F(2,8) 0.1610

Obs*R-squared 7.330429 Prob. Chi Square(2) 0.0256

Source: author’s Calculation

Table shows P-value of F-stat is greater than 5% indicate acceptance of null hypothesis.
This means short run model doesn’t have serial correlation between error terms.

4.9.2 Heteroscedasticity Test

Heteroscedasticity test is used for testing the variances of residual term are constant over
time. If it is constant then error term are said to be homoscedastic otherwise
heteroscedastic. Based on Breuch-Pagan-Godfrey test for Heteroscedasticity the null
hypothesis is no heteroscedasticity and alternate hypothesis is presence of
heteroscedasticity. Variance of error term is described as

2
σ i =α 1+ α 2 Z 2 i+ … .+α m Z mi........................................................................................

Where, σ 2i is error variance which is function of non-stochastic Z variables.

The function is linear function of Z’s if α 2=… .=α m=0 and σ 2i =α 1 which is constant.
This means error term is homoscedastic.

Null hypothesis: α 2=… .=α m=0

Alternate hypothesis: α i ≠ 0

Table shows P-value of F-stat is greater than 5%. So, we fail to reject null hypothesis i.e.
there is no heteroscedasticity.

Table 4.11: Heteroscedasticity Test

Heteroskedasticity Test: Breusch-Pagan-Godfrey

F-statistic 1.131152 Prob. F(12,7) 0.4532

Obs*R-squared 13.19524 Prob. Chi-Square(12) 0.3550

Source: author’s Calculation

4.9.3 Normality Test

Normality test is used to test whether the error term are normally distributed. Jarque-Bera
test or J-B test is used to test acceptance or rejection of null hypothesis i.e. error term are
normally distributed against alternate hypothesis i.e. error term are not normally
distributed. JB-statistics is given by

2
S2 ( K −3 )
JB=n [ + ]
6 24

If Probability value of JB statistics is low then residual are normally distributed.

If Probalbility value of JB statistics is high then residual are normally distributed

Figure below shows J-B test for normality. Since P-value of JB stat is greater than 5%,
error terms are normally distributed.

6
Series: Residuals
Sample 1999 2018
5 Observations 20

4 Mean -1.80e-17
Median -0.000844
Maximum 0.017790
3 Minimum -0.016921
Std. Dev. 0.010304
Skewness 0.122270
2
Kurtosis 2.074220

1 Jarque-Bera 0.764057
Probability 0.682476

0
-0.020 -0.015 -0.010 -0.005 0.000 0.005 0.010 0.015 0.020

All the diagnostic test suggests that estimated parameter for short run equation are
reliable for interpretation.

CHAPTER V

MAJOR FINDINGS AND CONCLUSION

Findings

The purpose of this thesis is to analyze long-run and short-run relation between Foreign
Direct Investment and economic growth. The study used data on FDI, GDP, FINDEV
and OPN from period of FY1996/97 to 2018/2019 that include a data of twenty-two
years. In order to find long run and short run relationship the study uses Engle-Granger
that is used for identifying long run relationship between the variables. However
variables must be of same order for co integration test. In order to identify the stationary
of data Augment Dickey Fuller test (ADF) Unit root test is used for this study, Since, the
variables in time series data are not stationary that is to say it is fluctuating over time
period and it clearly shows presence of unit root. The study found that all the variables
are stationary at I (1). Long run and short run equation is estimated from Engle-Granger
technique and error correction model. Diagnostic test is conducted for reliability of short
run error correction model. And finally granger causality test is carried out for direction
relationship between the variables. This chapter depicts the conclusion derived from
analysis done in chapter 4. Following are the findings and conclusion drawn from this
study.

 Engle-Granger test showed that there is long run relationship between Foreign
Direct Investment, Gross Domestic Product, Financial Development and Trade
Openness.
 Long run regression equation shows coefficient of LNFDI is 0.086470. This
implies that 1% increase in FDI leads to 0.086% increase in Real GDP based on
ceterus peribus assumption. Similarly, coefficient of LNOPN is -0.403500 this
shows 1% increase in trade openness leads to 0.040 % decrease in real GDP
keeping other constant. Finally, estimated coefficient of LNFINDEV is 0.593212
this imply that 1% increase in LNFINDEV leads to 0.59% increase in GDP keep
other constant . The result indicates that there is positive relationship between FDI
and economic growth in long run.
 Error Correction Model shows that the short run dynamics relationship between
the variables in which error correction term that indentifies the deviation of short
run equation from long run equation is found to be -0.1464. This implies that only
14.64 deviations is adjusted every year between short run and long run equation.
 Only FDI significantly impact economic growths in short run whereas trade
openness, Gross Domestic Product and Financial Development has no impact in
short run.
 Diagnostic testing of short run equation reveals that there is no presence of
Heterocadasticity, autocorrelation and abnormality. Therefore, the equation is in
correct functional form.
  Granger Causality Test shows financial development does not granger cause
Gross Domestic Product also Foreign Direct Investment; Trade openness not
leads granger cause. However, only Gross Domestic Product and Financial
Development leads granger cause.

Conclusion

The impact of Foreign Direct Investment on Economic Growth of Nepal seems positive
in both short run and long run. If Nepal is able to attract more foreign investor,
undoubtedly it leads positive change in an economy according to the outcome of thesis.
The thesis also support theoretical concept of FDI when the result is significant.
Multinational Chains are good source of foreign revenue. It is a basis for technological
progress, dissemination of knowledge and employment opportunity. Despite, some
literature review shows negative outcome of FDI yet the result here is positive. Even after
positive result the Engle Granger test revel more progress required for enhancement of
FDI volume in Nepal. Furthermore, the Trade Openness and Financial Development
seem positive however the outcome is not satisfactory because on the sort run trade
openness and financial development result is not significant. Thereby, working on the
policy recommendations propounded from the experts and researcher on FDI the
situation of FDI can get improve and there are huge opportunities for Nepal to excel on
available benefit from Foreign Direct Investment by increasing Gross Domestic Product
of the Country.

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