The Causal Relationship between Foreign Direct Investment and Savings in Jordan: An Error Correction Model

[Abstract] The present paper intends to investigate empirically the causal relationship between foreign direct investment (FDI) and net domestic savings in Jordan over the period 1971-2005. In fact, the ultimate goal of the paper is to answer the question of whether the FDI inflow is a complementary or a substitute to domestic savings in Jordan. The paper utilizes the error-correction model (ECM) to establish the causal relationship between domestic savings and FDI inflow. The paper performs the unit root test to test for the stationarity of the time series. Applying the Johansen cointegration approach tests the existence of the long-run linear combination between FDI and domestic savings. The unit root test results show that the series are integrated of order one, I(1), and become stationary at their first difference. This result means that the ordinary least square (OLS) approach is invalid and provides a spurious correlation. The Johanson cointegration test shows that there is a long-run equilibrium. The empirical results of the ECM show that FDI is complementary rather than substitutive. That is, a positive casual relationship runs from FDI to net domestic savings. Based on this result, the paper advises Jordan's government to attract FDI by implementing a set of policies. [Keywords] Foreign direct investment, saving, Jordan, error correction model Introduction An important consequence of the New World Order is globalization, which encourages trade as well as capital liberalization across countries. One aspect of such capital liberalization is foreign direct investment (FDI) that becomes an important source of external finance, since it adds to capital formation and facilitates the transfer of production technology across countries (William, 1998). Foreign Direct Investment is known as "Investment made by multinational business enterprises in foreign countries to control assets and manage production activities in those countries" (Padma, 1999). The enormous body of literature on the issue of the FDI is concerned with the diverse impact of FDI inflows on various macroeconomic variables (economic growth, private investment, manufacturing productivity, exports, employment, etc.) in host countries, specifically developing countries. Two major, opposite views of the ultimate impact of FDI on the level of economic growth constitute the core of the concern. One side supports the positive impact that FDI inflow exerts on economic development, since FDI promotes and improves efficiency and raises the rate of economic growth. The other side believes that FDI inflow has a negative impact on economic growth in developing countries by replacing rather than supplementing domestic savings (Chung, 1995). The empirical findings on this issue indicate the positive impact of FDI on economic growth in the host countries. Yet, the causal direction is mixed, depending on the long-run and short-run effects, the heterogeneity among countries, and the degree of openness (Savi, 2004; Shoter, & Abdulrazag, 2001; Chakraborty, 2002; Borensztien, 1998; Usha & Diana, 2001; Parantap, 2003). Chang, (1995) investigated the relationship between savings and FDI. The empirical findings supported the complementary relationship and that FDI promotes savings rather than hindering it. The FDI inflow into Jordan experienced a fluctuating trend over the research period. It increased from MJD (0.1) in year 1971 to MJD (230.6) in year 1999, with an average of MJD (38.9) over the 1971-1999 and (983.2%) growth rate, and achieved a (21.4%) compound growth rate. The statistical data reported on the FDI inflow in Jordan reveals that the period (1990-2005) witnessed a noticeable volume. The major objective of this study is to investigate empirically the nature of the causal relationship between FDI and net domestic savings and determine weather or not FDI exerted a positive effect on net savings in Jordan over the period 1970-2005. …