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Chapter 2: Analytical Framework

24 The positive slope of I F needs a certain but not counter-intuitive assumption over the parameter See details in the Appendix 2.

2.3.2 Human Capital

Human capital in host countries is another factor that plays a crucial role in conditioning the gains from FDI. The role of human capital is derived from the concept of absorptive capability, proposed by Nelson and Phelps (1966), Abramovitz (1986) and Benhabib and Spiegel (1994). The entry of MNE affiliates is associated with advanced technology, so the level of human capital development in host countries is needed to turn the opportunities into reality and enhance technological capability.

Borensztein et al. (1998) propose a theoretical model to illustrate how FDI and human capital affect gains from FDI measured in terms of output growth, and empirically test the model across developing countries. This model is based on endogenous growth theory. FDI inflows in the model affect economic growth in host countries because they are usually associated with the introduction of advanced technology. Hence, this generates technological progress.

Yt = A,H*K)-S (2.25)

*.=n x'rdjf*

(2.26)

where Y = output

A = the exogenous state of environment H = human capital

K = physical capital th

Xj = j capital goods

In this model, the physical capital in equation (2.26) is defined as a composite of a continuum of varieties of capital goods, Xj. The number of capital goods available, N, plays a crucial role in determining economic growth in the host countries. The larger the value of N, the higher the economic growth. This is analogous to expanding the variety of intermediate products, as in Römer (1990), Grossman and Helpman (1991); Barro and Sala-i-Martin (1995). In the model, FDI inflows play two important roles in determining economic growth. Firstly, FDI inflows enhance the variety of capital stocks that favourably affect economic growth. That is, N is positively related to the presence of FDI in this model. Secondly, as applying new capital goods into the production process incurs fixed costs from learning how to use the goods efficiently as well as how to adjust them to the local environment, the presence of FDI saves such fixed costs. This is because it is likely to be cheaper to imitate products and/or processes already in existence than those that are at the frontier of innovation.

This does not mean acquiring such technology is costless. To absorb and utilize the technological benefits effectively, host countries must first surpass a certain threshold level of human capital development. Beyond this threshold level, the higher the absorptive capability, the lower the cost to apply the new capital goods. In other words, the relationship between FDI and economic growth is not linear but is conditional on the level of human capital development in the host country.

Empirical studies examining the role of human capital have emphasized macro­ level analysis. Nevertheless, there is a puzzle about the role of human capital in conditioning gains from FDI inflows. Except for Borensztein et al. (1998), the level of human capital development seems unsatisfactory to explain the various outcomes of the FDI-growth nexus. For example, Nair-Reichert and Weinhold (2001) examine the relationship between FDI and economic growth in 24 developing countries over the period 1970-95, and introduce both human capital and trade policy regime to condition the growth-enhancing effect of FDI. The coefficient corresponding to the trade policy regime is the only one found statistically significant. Carkovic and Levine (2002) and

Ram and Zhang (2002) find the same outcome as Nair-Reichert and Weinhold (2001), based on experience from both developed and developing countries.

One explanation for this unsatisfactory outcome could be the measurement problem of how to quantify the level of human capital development. All of these studies measure the level of human capital development based on education indicators because of data availability. In fact, Abramovitz (1986) and Blomström et dl. (1994) argue that human capital measured by the level of attainable education is one of several ways to build a country’s absorptive capability. Indeed, absorptive capability widely covers the level of education, political stability, openness to competition, and the freedom to operate business, etc. (Abramovitz, 1986: p.389). Similarly, it is argued by Parente and Prescott (2000: p.66) that evidence that a certain industry performs better in one country than in another, and vice versa, points out the limitations in solely focusing on human capital as the key factor in determining gains from FDI.

Besides trade policy and human capital, a recent study by Alfaro et al. (2004) proposes that local financial markets play a role in determining gains from FDI. The key proposition is countries with better financial systems can exploit FDI more efficiently. While the econometric results support the role of local financial markets, it seems more reasonable that the level of financial development seems to have an impact on FDI gains only at a certain level, i.e. a threshold level. In countries whose financial development levels pass this threshold level, the financial system would no longer condition FDI gains. For example, it does not seem reasonable that levels of financial systems among developed countries could condition FDI gains. In addition, their study examined the relationship between economic growth and FDI rather than FDI technology spillover, in which the impact on locally non-affiliated firms is emphasized. It is unlikely that MNEs are constrained by the financial system in host countries. For these reasons, financial intermediation is not included in the analytical framework of determinants of gains from FDI.