Foreign Direct Investment and Output Volatility Nexus: A Global Analysis
| Author | Muhammad Tariq Majeed,Aisha Tauqir,Sadaf Kashif |
| Published date | 01 August 2022 |
| DOI | 10.1177/00157325211042107 |
| Date | 01 August 2022 |
| Subject Matter | Articles |
Foreign Direct
Investment and
Output Volatility
Nexus: A Global
Analysis
Aisha Tauqir1 , Muhammad Tariq Majeed1
and Sadaf Kashif2
Abstract
Volatility in output growth remains a genuine concern around the globe because
of its detrimental effects on growth, poverty and welfare. In the realm of output
volatility, the role of FDI and its consistency is particularly important and worth
considering. This article examines the role of FDI inflows and specifically the
instability in it on output growth volatility using a panel dataset of 141 world
economies for the period 1971–2017. The study employs a variety of estima-
tion techniques like pooled ordinary least squares (POLS), LS fixed effects (FE),
LS random effects (RE), two stage least squares (2SLS) and generalised methods
of moments (GMM). Findings of the study suggest that FDI acts as the volatility
reducing factor, whereas uncertainty in it increases output volatility. On the policy
front, this study recommends policies that not only encourage FDI inflows but
also ensure the inflows to be more consistent and stable. Our results are robust
corresponding to various above-mentioned estimation techniques and sensitivity
analysis.
JEL Codes: C23, E32, F21
Keywords
Output volatility, foreign direct investment, foreign direct investment volatility,
panel data
Article
1 School of Economics, Quaid-i-Azam University, Islamabad, Pakistan.
2 Department of Business Administration, Iqra University, Islamabad Campus, Islamabad, Pakistan.
Corresponding author:
Aisha Tauqir, School of Economics, Quaid-i-Azam University, Islamabad 15320, Pakistan.
E-mail: ayesha.tauqir@hotmail.com
Foreign Trade Review
57(3) 283–309, 2022
© 2021 Indian Institute of
Foreign Trade
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DOI: 10.1177/00157325211042107
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284 Foreign Trade Review 57(3)
Introduction
Output volatility has emerged as a global challenge since many decades. The oil
price shock of 1977 and the global financial crisis of 2008 advocate output growth
to be highly volatile, subject to unpredictable fluctuations in growth rates.
Economists and policymakers have central concerns about instability in output
growth because it aggravates the business cycle. For poor and developing econo-
mies rise in output volatility has been documented extensively. This rise reflects
underdevelopment and the inability to insulate from both internal and exogenous
shocks. However, for emerging and developed economies (China and the US)
decline in growth volatility has been observed in the last decade. This decline is
also not well understood since economists are unable to identify what causes the
absence of a gradual trend or a structural break in growth rates.
Frequent fluctuations in output growth signal an uncertain economic environ-
ment and increased probability of facing risk. Increasing literature on macroeco-
nomic uncertainty has shown that aggregate instability in output growth is the
combination of inconsistent macroeconomic policies, weak institution environ-
ment, country-specific characteristics (Chami et al., 2012; Loayza et al., 2007) and
various external sources of instability; globalization measures, bilateral trade,
exchange and other development assistance agreements, and increased capital
inflows due to enhanced economic integration (Nicet-Chenaf & Rougier, 2014).
Other than the growth deteriorating effect of output volatility, the vulnerability in
growth rates also affects risk-averse economic agents. The direct effect on these
agents is in a form of welfare loss (by limiting consumption) as they incurred cer-
tain costs against hedging the risk. Moreover, the indirect effect also prevails since
output volatility disturbs overall income growth in the economy. Therefore, stabil-
ity and high growth rates of output have always been central policy objectives of
both developed and developing economies (Majeed & Noreen, 2017).
Many studies have investigated several causes of output volatility. These stud-
ies have linked output volatility with bank crisis (Hausmaan & Fernandez-Arias,
2000), economic growth (Lensink & Morrissey, 2001), welfare (Loayza et al.,
2007), FDI (Chung, 2010; Portes, 2007), foreign debt (Chung, 2010), remittance
(Craigwell et al., 2010; Chami et al., 2012; Bugamelli & Paterno, 2011), finance
(Gertler, 1992; Cermeno et al., 2012) capital flows (Federico et al., 2013; Nicet-
Chenaf & Rougier, 2014) and financial development (Hakura, 2009; Majeed &
Noreen, 2018). Among other important determinants of output volatility, fiscal and
monetary policy (Bugamelli & Paterno, 2011; Chami et al., 2012; Loayza et al.,
2007; Majeed & Noreen, 2017; Portes, 2007; Wang, 2017), country’s size (Chami
et al., 2012) and institutional quality (Chami et al., 2012; Loayza et al., 2007) are
also repeatedly explored.
Output volatility also depends on foreign capital flows and vulnerability in
them. Existing literature recognizes that the nature of foreign capital matters in
affecting output growth. On the other hand, when these foreign capital inflows are
unpredictable and volatile (regardless of their nature) they have a positive impact
on output volatility. Little attention has been put to linking FDI, its instability and
output volatility together in the literature. Generally, studies extensively focus on
the growth aspects of FDI mainly through its future prediction (Sidhu & Dhingra,
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