FOREIGN DIRECT INVESTMENT STOCK CONTRIBUTES

TO ECONOMIC GROWTH IN THE U.S. ECONOMY

Lucyna Kornecki, Vladislav Borodulin

Department of Economics, Finance, and Information System
College of Business
Embry-Riddle Aeronautical University (ERAU)
600 S. Clyde Morris Blvd. Daytona Beach, FL 32114
korneckl@erau.edu, phone: (386) 226-4963, fax: (383) 226-6696

ABSTRACT

The first part of this paper describes the foreign direct investment (FDI) as a factor facilitating
globalization process in the world economy and describes the long run economic growth in the
U.S. economy indicating the cyclical character of FDI. It includes analyzes related to inward and
outward FDI inflows and inward and outward FDI stock as a percentage of GDP.
The second part of this research has empirical character and focuses on the impact of inward FDI
stock on economic growth in the U.S. economy. The analyzed model of economic growth proved
the strong impact of FDI stock on output growth and verified the hypothesis that FDI stock, as
compared with domestic capital and labor constitutes an essential factor of economic growth in
the U.S. economy.

INTRODUCTION

The continuing growth of foreign direct investment in the United States (U.S.) brought a growing
interest in examining its impact on the rate of economic growth. The immense literature on
economic growth in the United States is composed of studies that concentrate on measuring the
domestic variables that affect U.S. economic growth. However, the impact of foreign direct
investment on the economic growth of the United States has not received the attention that it
deserves (Asheghian, 2004).
The period between 1978 and 1997 was characterized by a major influx of foreign direct
investment to the United States. In 1997, foreign controlled foreign firms accounted for 6.3
percent of US GDP, 4.9 percent of non-bank employment, 20 percent of US exports of goods, 30
percent of US imports of goods (Ford and Champion, 2002).
This research provided empirically tested evidence on the effect of FDI on economic growth in
the U.S. It examined the link between inward FDI stock and economic growth and found that
foreign direct investment has a significant impact on the United States economic growth.
 LITERATURE REVIEW

The inflow of FDI increased rapidly during the last two decades in almost every region of the
world. A number of empirical studies on the role of FDI in host countries suggest that FDI is an
important source of capital, complements domestic private investment, and is usually associated
with new job opportunities and enhancement of technology transfer, and boosts overall economic
growth in host countries (Chowdhury & Mavrotas, 2006).

The relationship between growing FDI stock and economic growth has motivated a voluminous
empirical literature in developed and developing countries. FDI has been acknowledged as most
crucial factor in enhancing economic development and the standard of living for emerging
economies. Based on references, the consensus seems to be that there is a positive correlation
between FDI inflows and economic growth, provided that the receiving countries have reached a
minimum level of educational, technological and/or infrastructure development (Hansen & Rand,
2006).

South Korea, Singapore, and Taiwan are examples of nations outside the OECD countries that
have greatly benefited from FDI and the integration in the global economy. In recent years,
China and India have made remarkable progress in attracting FDI and realizing technological
and economic success. A number of studies find that FDI inflows have a strong and positive
effect on economic growth in China (Tian, Lin, & Lo, 2004).

In Russia, FDI appears to have been an essential force in supporting the economy during the
initial chaos of transition (Brock, 2005). The CEE countries increased their participation in the
world economy since the fall of communism; particularly over the last few years. They accepted
the challenge of trade openness and attracted significant foreign direct investment (Cernat &
Vranceanu, 2002). The CEE countries acknowledge FDI as an essential tool in the development
and modernization of their economies (Kornecki & Raghavan, 2008).

Salehizadeh, Asheghian and others confirm the existence of a positive and significant
relationship between FDI and the economic growth in the United States (Asheghian, 2004). He
examines the determinants of economic growth in the United States over time uses a model
based on the postulates of de Mello based on and found a causal relationships between FDI
growth and economic growth is uni-directional, running from economic growth to FDI and a
causal relationships between FDI growth and total factor productivity growth is uni-directional,
running from FDI to total factor productivity

According to the U.S. Bureau of Labor Statistics a rapid inflow of foreign investment paralleled
the brisk productivity growth, suggesting a positive link between the growth of productivity and
foreign capital. Applying a Cobb-Douglas production function to data from 1988 to 1999, it is
found that foreign capital accounted for almost 16% of overall U.S. productivity growth (Goss,
Wingender & Torau, 2007). Salehizadeh regression estimates confirm the existence of a positive
and significant relationship between FDI and US economic growth rates (Salehizadeh, 2005).
 RESEARCH METHODOLOGY

The goal of this study is to investigative relationship between FDI and economic growth and
determine the extent to which foreign capital contributes to U.S. productivity growth. Over the
last two decades, the U.S. has attracted more inflows of foreign direct investment than any other
country. This research analyzes the relationship between foreign capital inflow and U.S.
economic growth including FDI stock, as one of the determinants influencing growth of the U.S.
economy. In the past studies did not attempt to relate FDI to productivity growth. Instead,
researchers focused on FDI impact on manufacturing sector and employment (Goss, Wingender
& Torau, 2007).

Research methodology related to FDI and economic growth relationship in the literature has
been based mostly on the production function model (Brock, 2005). The production function
model investigates the relationship between labor (L), capital (K) and the economic growth, with
the GDP shown as a function of labor and capital (Sawyer, 2006).
The theoretical framework of this study is based upon the economic growth model with output
determined by the L (labor) and K (Gross Fixed Capital Formation) plus inward FDI stock and
export (X) as an additional factors influencing output and productivity in the economy.

A modified Cobb-Douglas Production function will be used based on a pooled cross section data
for the U.S. for the period of 1981-2007 to study the impact of inputs such as labor, domestic
capital plus inward U.S. FDI stock and export on economic growth. The model assumes that
inward FDI helps to increase capital stock in the U.S. economy which in turn increases the rate
of economic growth. It shows economic growth coupled with the growth in FDI stock. Applying
a Cobb-Douglas production function to data from 1981 to 2007, it is found that foreign capital
accounted for almost 23,28% of overall U.S. economic growth.

Our data is obtained from the United Nations Conference on Trade and Development
(UNCTAD), Bureau of Economic Analysis, Bureau of Labor Statistics, United Nations
Economic Commission for Europe (UNECE), World Investment Reports, as well as other
selected databases.

FDI FACILITATES GLOBALIZATION PROCESS

The FDI constitutes an important factor facilitating the globalization process in the world.
Globalization is a dynamic process of liberalization, openness, and international integration
across a wide range of markets, from labor to goods and from services to capital and technology.
Globalization is based upon the freedom to trade with the rest of the world and to capitalize on
each country’s comparative advantage, the freedom to invest where returns on capital are
greatest (Guillermo de la Dehesa, 2006, p.1).
Globalization signifies a process of intensification of economic, political, and cultural
interconnectedness among the various actors in the global system. In the economic arena it
represents a process of integration of national economies with the global economy
(Kidane Mengisteab, 2005).

Maler empirically examined globalization and considered FDI as one of three modes of
globalization together with foreign trade, and international financial flows (Kahai and Simmons,
2005).

Kearney’s index, ranks World inward FDI and includes opinions about the FDI of the World
largest 1,000 firms and responses from participating executives of 68 countries
( table 1). It tracks the impact of likely political, economic and regulatory changes on the FDI.
The index reveals FDI flows and the factors that drive corporate decisions to invest abroad.
Companies included in the survey are responsible for about 70 percent of global FDI flows and
generate more than $27 trillion in annual revenues
(http://www.atkearney.com/main.taf?p=5,3,1,140,1). The major findings in A.T. Kearney's 2005
FDI report indicates that China and India, emerging market countries are the 1st and 2nd most
attractive FDI locations in the world and have achieved unprecedented levels of investor
confidence. The United States dropped to 3rd place on corporate investors' lists, but remains a
strong FDI magnet. Western Europe, other than the United Kingdom, lost FDI confidence due to
increasing

Table 1. Kearney Foreign Direct Investment Confidence Index 2005

China 2.197
India 1.951
USA 1.421
UK 1.398
Poland 1.363
Russia 1.341
Brazil 1.336
Austria 1.276
Germany 1.267
Hong Kong 1.208
Hungary 1.157
Chech
Republic 1.136
Turkey 1.133
France 1.097
Japan 1.082
Mexico 1.081
Spain 1.075
Singapore 1.072
Italy 1.055
Thailand 1.051
http://www.atkearney.com/main.taf?p=5,3,1,140,1
 ECONOMIC GROWTH IN THE U.S. ECONOMY

Over the last two decades, the U.S. has attracted more inflows of foreign direct investment (FDI)
than any other country. General indications have pointed to FDI inflows as being a positive
contributing factor to key US macroeconomic indicators.

The U.S. economy have experienced alternating periods of expansion and contraction in
economic activity. Economic fluctuations are the rise and fall of economic activity relative to the
long-term growth trend of the economy.

A long run economic growth rate in the U.S. economy and shows periods of rapid expansion, as
well as slow economic growth and decline in output. The ups and downs in the level of economic
activity represent the business cycle in the U.S. economy.

The decline during the Great Depression of the early 1930’s last long period of time and reduced
the nation’s total production by 30% accompanied by 26% of unemployment rate. Since then,
there have been recessions but no depression. The national Bureau of Economic Research
(NBER) have traced the U.S. economy back to 1854. The economy experienced 32 peak-to
trough-to peak cycles. The longest contraction lasted five years from 1873 to 1879 and the
longest expansion lasted nearly 10 years, beginning in 1991.

Despite the ups and downs of the U.S. economy measured by real GDP has grown dramatically
over the long run. Between 1976 and 2006 the output of the economy measured by real GDP
increased more then 3 times (Figure #1).

Figure 1. Real GDP in the U.S. Economy

(in thousands, 1976 – 2006)

14,000,000

12,000,000

10,000,000

8,000,000
Series1
6,000,000

4,000,000

2,000,000

-
1970 1975 1980 1985 1990 1995 2000 2005 2010

UNCTAD Handbook of Statistics On-line / VII. Indicators of development / 7.1 Population,

area and gross domestic product (1992-2006)
The figure #2 shows the rate of economic growth in the United States in the long run between
1977 and 2007. It shows a periods of economic expansion and contraction and includes three
economic recessions: recession of 80’s, recession of 90’s and the recession of 2001. The current
economic recession of 2008- 2009 in not included in the research as statistical data are not
available yet. Current economic crises have been caused by a combination of several factors
including the US mortgage lending policies and an insufficient financial policies and regulations.
The financial crisis started in the US and spread quickly into the world banking sectors. Financial
institution around the globe, investment and commercial banks suffered massive losses, and a
number of well-established financial institutions faced bankruptcy (Lehman Brothers, Merrill
Lynch etc.).

During the 1980’s the U.S. entered in eight year of continuous economic growth. The key factor
that sustained the economic expansion was the ability of the U.S. to attract capital inflows from
abroad. The economic expansion in the United States has been sustained by the willingness of
foreign investors to provide capital. If foreign investors had not provided the U.S. with the
capital during the 1980, the economic expansion would have been brought to an end by rising
interest rates (Henriks& Marc,1990).

Figure #2

Annual U.S  R eal GD P  Growth R ate from 1977 to 2005

8.0%
A n n u al  R eal  G D P   G ro wth   R ate

6.0%

4.0%

2.0%

0.0%

‐2.0%

‐4.0%
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

Ye a rs

UNCTAD Handbook of Statistics On-line / VII. Indicators of development / 7.1 Population,

area and gross domestic product (1992-2004)

During the second part of the 1990s, the U.S. experienced exceptional economic growth.
The data in the next chapter shows the increasing importance of FDI to the U.S. economy in this
period of time. Paralleling the growth in output was a rapid increase in the FDI inflow suggesting
a positive link between the productivity and foreign capital inflow (Goss, Wingender & Torau,
2007).
 INWARD FDI IN THE U.S.ECONOMY

FDI refers to an investment made to acquire lasting interest in enterprises operating outside of
the economy of the investor. The investor’s purpose is to gain an effective voice in the
management of the enterprise. Some degree of equity ownership is almost always considered to
be associated with an effective voice in the management of an enterprise and a threshold of 10%
equity ownership qualifies an investor as a foreign direct investor (the Balance of Payments
Manual BPM5: Fifth Edition, International Monetary Fund, 1993)
(www.unctad.org/Templates/Page.asp?intItemID=3146&lang=1).

Starting from 1960s, the theories of FDI tried to find out the elements that stimulated a U.S.
firm’s decision to invest abroad, as most of the FDI originated from the United States and were
connected to the U.S. multinational corporation. Most empirical study has concentrated on
assessing the factors that induce a U.S. firm to invest in a foreign country.

In the early 1970s the direction of FDI changed and the United States became a significant
recipient of FDI. The U.S. became a host for foreign affiliates as well as a home for multi-
national firms. (Hendriks & Mark,1990). The period between 1978 and 1997 was characterized
by a major influx of foreign direct investment to the United States.

The flow of international capital supported the U.S. economy in the 1980s and has been a key
factor expanding economy. The importance of FDI into the U.S. has risen during the 1980’s. A
number of developments in the 1980s encouraged the flow of capital to the U.S. from abroad.
Foreign capital gravitated to the U.S. in the 1980s because of favorable factors, such as:
institutionalization of savings, deregulation of capital control, the diversification of portfolios,
shrinkage of the U.S. banks foreign operations, a rise in non -banking activities in the
U.S.(especially Japan) and attractive investment returns in the U.S. for a European companies. In
1987, FDI from Japan has accelerated, as Japan set up production facilities in the U.S.

The inward FDI in the U.S. economy originated from a developed European countries, such as:
France, Germany, Switzerland, United Kingdom, Netherlands plus from Canada and Japan.

Inflow of FDI from Europe in the 1980s took place as a result of stagnating European economy.
Higher inflow of FDI from the U.K. reflected long-standing historical ties with the United States
and a reluctance to move into the new developing European markets of Eastern Europe.
 Figure #3

U.S  F D I Inflows  (billions  of US  dollars )  1976 to 2005

F DI Inflows , in billions  of $ 350.00
300.00
250.00
200.00
150.00
100.00
50.00
0.00
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Ye a rs

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Based on the data in Figure #3 the FDI inflows dropped during the recessionary economy:
between 1981and 1984, 1990 and 1993 and between 2001 and 2004- indicating cyclical
character of the foreign direct investment.

Following the decline of the economic activities during the recessionary economy the FDI
inflows had been declining. This implies that foreign capital was responsive to the U.S. business
cycle over analyzed period of time.

INWARD FDI VERSUS OUTWARD FDI

Based on Figure #4 inward FDI outperformed outward FDI in the U.S. economy during the
1980’s (1981-1990). The outward FDI exceeded inward FDI during the 1990’s recession and
during the years following the recession (1991 to 1995). The outward FDI exceeded inward FDI
in 2002, 2003 and 2004, the three years after 2001 recession. To summarize, during the
economic recessions the inward FDI had been declining when outward FDI had been increasing
indicating outflow of the capital from the U.S.

The decline of the FDI inflows during economic recessions and increase of the FDI outflows
during recessionary period indicate the cyclical character of inward and outward FDI.
 Figure #4

C omparison of U.S  F DI Outflows and Inflows (billions of US  $)  1976 to 2005

350.00 
F D I   F l o w s   b i l l i o n s   o f  $ 300.00 
250.00 
200.00 
150.00 
100.00 
50.00 
‐  
‐50.00 
19 6
19 7
19 8
79
19 0
19 1
19 2
19 3
84
19 5
19 6
19 7
88
19 9
19 0
19 1
92
19 3
19 4
19 5
96
19 7
19 8
20 9
00
20 1
20 2
20 3
20 4
05
7
7
7

8
8
8
8

8
8
8

8
9
9

9
9
9

9
9
9

0
0
0
0
19

19

19

19

19

19

20
Years
InF lows OutF lows

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INWARD FDI AS A PERCENTAGE OF GDP

The figure below examines the FDI inflows as a percentage of GDP in the U.S. economy. Inward
FDI as a percentage of GDP in the U.S increased sharply from 1% in 1996 to 3.25% in 2000 and
reached the highest historical level.

The figure #6 indicates that till 1991 outflows as a percentage of GDP were below 0.5% and in
the 1990’s increased significantly reaching the pick in 2001(2.3%) and in 2004 (2.4%).

Figure #5
U.S  F D I Inflows  as  a P erc entag e of R eal G D P ,  1976 to 2005

3.50%
F D I  In flo w s   A s   %   o f  G D P

3.00%

2.50%

2.00%

1.50%
1.00%

0.50%

0.00%
19 76
19 77
19 78
19 79
19 80
19 81
19 82
19 83
19 84
19 85
19 86
19 87
19 88
19 89
19 90
19 91
19 92
19 93
19 94
19 95
19 96
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05

Yea rs

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 Figure #6
U.S  F DI Outflows  as  a P erc entag e of R eal GDP ,  1976 to 2005

3.0%

F D I  O u tfl o w s   A s   %   o f  G D P
2.5%
2.0%
1.5%

1.0%
0.5%

0.0%
‐0.5%
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
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2001
2002
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2004
2005
Years

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FDI STOCK AS A PERCENTAGE OF GDP

This part of the paper focuses on the inward FDI stock as a percentage of GDP. Discussed
previously inward FDI flow measures the amount of FDI entering a country during a one year
period, while the FDI stock is the total amount of productive capacity owned by foreigners in the
host country. FDI stock grows over time and includes all retained earnings of foreign-owned
firms held in cash and investments (Kornecki, 2007).
According to the data in Figure #7 the inward U.S.FDI stock as a percentage of GDP climbed
from 2% to 6% during 1980,s and from 6% to 10% during 1990’s reaching a peak of almost 15%
in 2005. The foreign capital as a percentage of GDP bottomed out in 1992 and 2002, the years
following the recession of the early 1990s and 2001.

The relatively high percentage of the FDI stock in GDP indicates important role of the FDI in
the U.S. economy.

Figure #7
U .S  Inward F D I S toc k As  a P erc entag e of R eal G D P ,  1980 to 2005

16.0%
Inward F DI S tock As  %  of GDP

14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

Y e a rs

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 REGRESSION MODEL

A modified Cobb-Douglas production function based on a pooled cross section data for the U.S.
economy (1981-2007) was used to study the impact of inputs such as: labor, domestic capital,
FDI stock and multifactor productivity (MFP) on economic growth. Multifactor productivity
index reflects the joint effects of many factors including new technologies, economies of scale,
managerial skill, and changes in the organization production.

Our production-function model is explained below.

(1)

Where:
Y = Real Gross Domestic Product (GDP)
C = Scale parameter
MFP = state of economic environment (factors of productivity other than export and direct
investment)
K = Gross Fixed Capital Formation (GFCF)
L = Labor Force
elogR = The rate of productivity change over time.

Rewriting (1) in terms of the rate of change over time:

(2)

In our model, the productivity change (R) is assumed to be positively influenced by both the
foreign direct investment stock (FDI) and the rate of export growth (X). The productivity change
defined as X (export) growth plus FDI growth:
− − −
R = c X + d FD I (3)

Substituting equation (3) into equation (2) we have

(4)

Where:
−
Y = The average annual rate of growth of GDP
= The average annual rate of growth of MFP
−
K = The average annual rate of growth of capital (GFCF)
−
L = The average annual rate of growth of labor force
−
X = The average annual rate of growth of export
−
FDI = The average annual rate of growth of inward FDI stock
 Table 2. Results of Production Function Estimation (1981-2007)

Constant Capital Labor Export Inward Stock MFP 2

RA
0.0095 0.1591* 0.4482 0.0172 0.0519* 0.601* 0.8668
(4.358) (1.303) (1.022) (2.63) (5.132)
*
Denotes that variables are significant at the 5 percent level.
t-values are shown in brackets
*
RA denotes adjusted R2 adjusted for degrees of freedom.

All the examined variables in Table 2 except export and labor growth are significant at the five
percent level (* over the variables). From the estimated coefficients we constructed the sources
of economic growth decomposition in Table 3.

From Table 3 we can see that the FDI stock shows relatively high rate of growth (0.50) in
comparison with domestic capital (0.42%). However growth rate of labor (0.56%) is higher then
growth rate of capital in the U.S. economy.

FDI stock contributes more to GDP growth (23.28 %) then domestic capital (19.68%) while
labor contributes the most (26.05%). This illustrate that results the FDI as compared to domestic
capital has a significant influence on GDP growth in the U.S. economy and constitutes crucial
factor determining economic growth. This study tested the hypothesis that the FDI contributes
significantly to the economic growth of the U.S. economy.

Table 3. Sources of Economic Growth in U.S. Economy (1981-2007)

Growth Ratea Share Average Growth

Rateb
Factors of Production
Domestic Capital .42% 19.68% 2.66%
Labor .56% 26.05% 1.25%
Productivity Change
Export 0.06% 2.77% 3.46%
FDI 0.50% 23.28% 9.64%
MFP 0.61% 28.22% 1.01%
Total (GDP) 2.15% 100%
a
The numbers of this column is obtained by multiplying the estimated elasticity’s by the
average rate of growth of the factors concerned.
b
Average values of various variables (Mean values)
 CONCLUSIONS

This study implies that foreign capital in the U.S. economy was responsive to the U.S. business
cycle over analyzed period of time. Following the decline of the economic activities during the
recessionary economy the FDI inflows had been declining but FDI outflows had been increasing
indicating the cyclical character of inward and outward FDI. During analyzed periods of
economic recessions FDI outflows outperformed FDI inflows. The recent recession in the U.S.
economy (2007-2010) is not included in this study as statistical data is not available. Authors are
planning on focusing on current recession and its impact on FDI inflows and outflows in the near
future.

This research indicates that FDI contributes greatly to the economic growth in U.S. economy and
constitutes a crucial factor determining economic growth. The inward FDI has increased in the
U.S. in the past twenty six years to become the common type of capital flow. It is important for
the U.S. economy to continue to attract foreign investment. This calls on the U.S. policy makers
to formulate policies that are conducive to increasing the amount of foreign direct investment in
this country. The key factor that sustained the economic expansion during the 1980’s and the
second part of 1990’s was the ability of the U.S. to attract capital inflows from abroad. The
economic expansion in the United States has been sustained by the willingness of foreign
investors to provide capital.

The regression analyzes indicates that the FDI stock in the U.S. economy shows relatively higher
rate of growth in comparison with domestic capital and contributes 23.28 % to the GDP growth
in comparison with domestic capital contributing 19.68%. This results point out that the FDI as
compared to domestic capital has a significant influence on GDP growth in the U.S. economy
and constitutes crucial factor determining economic growth.

This study tested the hypothesis that the FDI contributes significantly to the economic growth in
the U.S. economy, however the future regression model will include more factors influencing
output of the U.S. economy. The authors will incorporate the following factors in the regression
model: business cycle factor, federal fund rates and the exchange rates.

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