A Study on the U.S. contagion effects on foreign direct investment flows in developing countries

Abstract

Contagion has been one of the most widely investigated and challenging problems in recent economic research, especially, why some crises appear to be contagious and why some developing countries appear to be vulnerable to contagion. This study aims to measure the lower tail dependence as risk contagion from the U.S. economy to 18 developing countries affecting FDI inflows, by using time-series data from 2005 to 2019. Firstly, the research utilizes four dynamic copula models, namely, Student-t, Clayton, rotated survival Gumbel, and rotated survival Joe, to measure the tail dependence structure between the U.S. and each developing country's real GDP growth. Secondly, the regression model is used to explore the contagion effect on FDI inflows. The empirical results show that there is evidence of the tail dependence between the U.S and developing economies, indicating the presence of the contagion effects. Primarily, it is observed that the degree of contagion effect of the global financial crisis varies across countries; strong effect is observed in the Chinese, South African, Russian, Colombian, and Mexican economic growth. Furthermore, it is found that significant contagion risk effect FDI inflows positively in China, Indonesia, Colombia, and Morocco, where fire-sale transactions may occur during the crisis period, the initial short-term capital outflows and sell-offs of foreign portfolios during the crisis would then lead to an inward flow of foreign direct investment due to the reform of the foreign investment policy of the local government. The abolishment of old policies which deter FDI, and the desperation for cash by local firms, will encouraged FDI inflows. Moreover, these countries exhibit special characteristic that produce this effect. China sustained its economy during the crisis through stimulus package maintaining its attractiveness. Indonesia has low share of manufactures in its total exports, of inter-regional trade in total trade, and of export-led growth, mitigating its exposure to the crisis and hastening the recovery process. Colombia's rise in FDI inflows was fueled mainly by commodity prices which remained high throughout the crisis. Morocco registered its highest peak in FDI capital investments during the crisis, due to a combination of factors of economic reforms, the infrastructure quality, and strong commercial relations with its neighbors. Conversely, significant contagion risk effect FDI inflows negatively in the Philippines, Bulgaria, and South Africa, where the financial crisis lessens FDI inflows as the macroeconomic performance became more uncertain. Both the owners of firms in developing countries and the potential foreign buyers in developed countries will have been affected by the severe liquidity constraints. Thus, it is expected that fire sale FDI may not be observed if the main source countries have been involved in the financial crisis. Similar to the above, these countries contain characteristic that produce this effect. The Philippines' constitution limits foreign investment, threat of terrorism, and political instability resulted in investor avoiding risk. Bulgarian is strongly dependent on export earnings and foreign investment, has weak competitiveness on international markets, is absent of protection mechanisms, and has a high degree of energy intensity of production, Thus, it is then impossible to allocated funds for production. South Africa is more exposed to the commodity price cycle than others. Increased scarcity of financial resources from the crisis is then conductive to apartheid and social class problem, leading to social unrest. The policy implication for both type of developing countries should then reflect their unique circumstance. In case of countries with positive growth of FDI inflows during crisis, they should strengthen their environment climate and macroeconomic performance to engage with large capital inflows from shifting of market sentiment during crisis period and ensure the political environment in order to make more favorable environment for foreign investors. In contrast, for countries that contagion has discouraged FDI inflows, public investment programs and bilateral / regional investment agreements can help encourage foreign investment, retaining existing foreign investment can be done through international coordination, and capital account liberalization can be applied to isolate the domestic economy from the volatility of global financial cycles. This study demonstrates the usefulness of the copulas model in terms of examining contagion. The findings shed light on the influence of sound policies and regulations to cope with both positive and negative consequences of the contagion on the capital movement.