Foreign direct investment and economic growth in small island economies : the case of Solomon Islands : a thesis presented in partial fulfillment of the requirements for the degree of Master of Arts in Economics at Massey University, Palmerston North, New Zealand

Abstract

The role of foreign direct investment (FDI) has been recognised as a catalyst in the growth of developing nations in that it brings additional sources of capital investment and foreign savings. In addition to its primary aim as a source of capital formation, FDI also brings productive benefits, which include employment creation, technology transfer and associated spillover effects; skills development; trade and competitiveness; and access to foreign markets. As such, FDI is viewed in many studies as a key driver of economic growth, since it enhances profitability of domestic investment; transforms the host country’s ownership structure of total investment; complements funding for domestic investment and improves the productive sectors of the economy. This study examines several hypotheses relating to the linkage between FDI inflows and economic growth in the case of Solomon Islands. First, the study investigates the contribution of FDI to economic growth (i.e. the FDI-led growth nexus) in Solomon Islands. Second, it examines the main determinants of FDI (i.e. the growth driven-led FDI nexus). Finally, the productivity effects of FDI (i.e. the FDI-productivity nexus) on the main sectors of primary, manufacturing and services are evaluated. The directions of causality between selected variables for these three hypotheses are also examined. Using time series data for the period from 1970 to 2010, the autoregressive distributed lag approach to cointegration is utilised to evaluate the FDI-led growth nexus and the growth driven-led FDI nexus. The Granger causality approach is adopted to evaluate the direction of causality between the selected FDI and growth variables. The FDI-productivity nexus is analysed using the stepwise and Granger causality approaches for the period 1985-2010. The empirical findings of the FDI-growth nexus show that FDI inflows, domestic investment, trade openness and labour are major influential factors of economic growth in the Solomon Islands. For the growth driven-led FDI nexus, the empirical findings show that economic growth, domestic investment, openness, exports, and infrastructure are all important determinants of FDI inflows. However, the civil strife and political instability, and high inflation deter FDI inflows and are detrimental to economic growth. In the FDI-productivity nexus, the primary and services sectors benefit the most from the productivity effects of FDI inflows complemented by better institutions, education, infrastructure and a stable political environment. The findings not only have important policy implications for the Solomon Islands but also for other small island economies.