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Foreign Direct Investment (FDI) and Financial Development in Sri Lanka

Updated on May 15, 2013

FDI and Financial Development in Sri Lanka: History and Future Prospects

By Dr Chalaka Subasinghe

PhD (Monash), MA, ACMA, CGMA, CPA

Cite as:

Subasinghe, C. (2013). FDI and Financial Development in Sri Lanka: History and Future Prospects. Certified Management Accountant March 2013:6-10.


Direct investment accounts for the bulk of all foreign capital deployed in developing countries. It is considerably larger than the combination of official development assistance, private debt and private equity (UNCTAD, 2004). Foreign direct investment (FDI) is likely to lead to higher rates of capital accumulation, output and growth. Moreover, foreign capital also provides many indirect growth enhancing benefits. The accumulated stock of FDI generates spillover effects through the transfer of advanced technology, novel production processes, managerial skills, labour training, access to international production networks and the transfer of knowledge. Financial development implies not only financial deepening but also an increase in the level and efficiency of financial intermediation and the development of capital markets. Insofar as these processes generate allocative efficiency gains they will enhance the effectiveness of the deployment of foreign capital in the host country. The interaction between the foreign capital stock and financial development is, therefore, likely to exert a positive effect on output. The object of this study is the investigation of the trivariate relationship between foreign direct investment, financial development and economic performance.

What is FDI and how does it arise ?

The IMF and the OECD define a foreign firm or direct investment enterprise “as an enterprise in which a foreign investor owns 10% or more of the ordinary shares or voting power” (IMF, 1993; OECD, 1996). Even though the foreign direct investor can be an individual or a government, most often they are large private enterprises referred to as transnational (or multinational) corporations (TNCs or MNCs). Foreign direct investment is the process by which a host country accumulates its stock of foreign capital. Caves (1971) explains three firm level motivations for undertaking foreign direct investment revolve around the ownership of intangible assets, multi-plant production and the availability of excess entrepreneurial resources. Unique knowledge assets, with public good characteristics, owned by the investing firm can be transferred to an affiliate where they earn a positive return in excess of their marginal cost of deployment. Secondly, nonproduction economies of the firm (advertising, administration, managerial and purchasing economies) that extend beyond the cost minimisation output of the efficient scale plant provide incentives for the formation of a MNC. Lastly, foreign direct investment may also be weakly motivated by excess entrepreneurial capacity within the investing firm.

How does FDI lead to Economic Growth ?

In addition to the direct effect of the foreign-owned capital stock on host country output, foreign capital exerts indirect effects on output through spillover effects. A firm theoretical foundation for these spillover effects is provided by the endogenous growth theory. Romer (1986) develops a model with endogenous technological change in which long-run growth is determined by the accumulation of knowledge (intangible capital) which in turn is subject to positive external effects and exhibits an increasing marginal product.

The spillover effects of foreign capital are strongly related to the determinants of endogenous growth theory. In Romer’s (1986) model, the spillover effects are likely to enhance the stock of technological knowledge in the host economy. Multinational corporations (MNCs) are at the forefront of global R&D and they possess unique knowledge assets accumulated over a period of time as a result of substantial investments in R&D. They are likely to spread this knowledge to domestic firms through backward and forward integration (vertical expansion). For example, sourcing local inputs due to cost advantages is likely to result in the development of local suppliers. Improvements in domestic technological knowledge may also occur through competition effects on domestic firms. However, the empirical literature offers mixed evidence of the power of these effects. Some studies identify positive effects of foreign direct investment on growth while others find those positive effects to be conditional on country specific structural features.

The effect of Financial Development on the FDI – Growth Nexus

The analysis of this study is informed by the hypothesis that financial development and, importantly, its interaction with the stock of foreign captial, influence technology and investment efficiency in the host country. The presence of an effective, broad and deep financial system facilitates the operational activities of MNCs. Developed financial intermediaries also exert a beneficial effect on foreign mergers and acquisitions. Spillover effects from the stock of foreign captial are likely to be enhanced by the developments in the financial sector that facilitate borrowing by foreign firms for backward and forward integration as well as easing the financing constraints of domestic firms involved in establishing linkages with foreign firms. This promotes technology transfers, knowledge spillovers and labour training.

The trivariate relationship between foreign direct investment, financial development and growth has not received much attention in the literature. It has been examined explicitly in four cross-country studies and in a single time series study (Hermes and Lensink (2003), Omran and Bolbol (2003), Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004), Alfaro, Kalemli-Ozcan and Sayek (2009)
and Ang (2009)). The main finding of these studies is that the interaction between foreign direct investment and financial development generates a significantly positive impact on growth even though foreign direct investment alone may play an ambiguous role. Countries with higher levels of financial development are likely to gain significantly more from foreign capital accumulation.

The background of FDI in Sri Lanka

At the time of independence in 1948 Sri Lanka was an attractive host for foreign direct investment. A large number of foreign (mainly British) firms owned most of the export plantations with tea, rubber and coconut being the main crops (Bruton, Abeysekera, Sanderatne and Yusof, 1992). In Sri Lanka, the period 1948-1955 remained open and conducive to foreign investment which included foreign owned plantations, trading and insurance companies. In contrast, tight import controls were imposed during 1956-1964 in support of the overall ISI policy, together with tight exchange controls. Foreign owned oil companies were nationalised. During 1970-1976 while countries such as Malaysia opened up their economies to foreign capital, Sri Lanka was never able to benefit fully from foreign capital due to her closed economy. As a result of the land reform laws in the early 1970s the majority of plantation lands were transferred from private to public ownership (Bruton et al., 1992). The nationalisation of British owned tea plantations led to the boycott of Ceylon tea in the U.K.

Following the change of government in 1977 there was a radical change towards pro foreign investment policies in Sri Lanka. Regulations relating to the repatriation of profits and dividends were relaxed and foreign investors were allowed to import capital equipment duty free (Rajapatirana, 1988). However Sri Lanka lagged behind countries such as Malaysia by nearly 10 years in fully opening up her economy to foreign capital and as a result lost out on many opportunities. Export Processing Zones (EPZs) were established commencing in 1978 that proved to be highly successful in attracting foreign investors (World Bank, 1992). However the EPZs failed to attract the large multinationals or high technology manufacturers.

The incentives offered in the EPZs included exemption from corporation tax for 7 to 10 years, tax exemptions on dividends and royalty payments during the tax holiday period, exemption of foreign remittances from exchange controls and exemption from import and export duties and harbour dues. Even though the FDI policies in Sri Lanka were unconditional and liberal, Sri Lanka lost many opportunities to attract foreign capital due to the commencement of the war. In the early 1980s major foreign investors including electronics MNCs and international banks had plans to invest in Sri Lanka but decided against investing after 1983. During the 1980s East Asian economies such as Malaysia and Thailand achieved significant benefits from Japanese direct investment. Sri Lanka missed this opportunity mainly as a result of the LTTE blowing up a passenger airline in 1986 which was about to transport a group of Japanese tourists, scaring off Japanese investment (Kelegama, 2006).

However, there has been evidence of FDI spillover effects in Sri Lanka especially during the 1980s. Several international buying groups linked to foreign firms in the garment and light manufacturing industries were established and provided significant assistance to local export firms to penetrate international markets. Many local entrepreneurs acquired production and marketing skills through joint ventures with foreign firms, enabling them to set up separate manufacturing operations (Athukorala, 1995). The portion of imported inputs in garment manufacturing declined by approximately 24% from 87% in 1986 to 66% in 1995 while locally sourced inputs increased. A number of domestic firms became competitive producers by acquiring skills based on successful garment expansion. Some of these firms set up operations abroad in low income countries and also diversified into other labour intensive export activities. The Sri Lankan government promoted the establishment of linkages between foreign firms and the domestic economy by offering a package of incentives for new domestic firms producing inputs for foreign garment exporters (Kelegama and Foley, 1999).

Notwithstanding the protracted war, foreign capital has been the driving force behind the expansion of manufactured exports which grew at an annual average rate of over 30% during 1978-1995. During 1978-1995, 875 export oriented foreign firms were established under the BOI, compared to 82 firms during the preceding decade. However unlike countries such as Malaysia, these investments have been limited to simple labour intensive products such as garments, leather goods, footwear, toys, plastic products, gem cutting and jewellery rather than more advanced intermediate goods (White and Wignaraja, 1992).

FDI reached Rs 14.1 billion in 1999 with 153 new enterprises being registered with the BOI, of which approximately 60% were infrastructure projects. The largest ever BOT foreign direct investment project, a new container terminal (Queen Elizabeth Quay) at the port of Colombo commenced construction during 1999 (CBSL, 1999). FDI increased steadily during 2002-2005, surpassing the previous peak level of 1999, with several privatisations and a large number of foreign direct investment projects launched through the BOI in spite of the recommencement of the war. In 2007 FDI reached a record level of Rs 66 billion (as a % of GDP) with the implementation of the 300 enterprises programme, the commencement of the construction of four major freeways, three power plants and a new international airport (CBSL, 2007).

Data and Brief Methodology

Annual data for the period 1961-2007 are used in this study. Data on FDI, financial development, real GDP and domestic investment in local currency units for Sri Lanka have been obtained from various issues of the Annual Report and the Review of the Economy of the Central Bank of Sri Lanka. Considering the nature of the interrelationships between output, the stock of foreign capital, financial development, their interaction and the domestic capital stock, and the fact that these five variables are endogenous and cointegrated I(1), a Vector Error Correction Model (VECM) is employed in this study. This method explicitly recognises the endogeneity of all underlying variables and is superior to growth regressions. The unit root properties of the data were examined using the Augmented Dickey Fuller (ADF) test and the Phillips-Perron (PP) test. The cointegration tests were based on the Johansen (1988) methodology. The estimation is based on the following equation developed by the author:

The variables are as follows: = Real GDP, = Real foreign capital stock, = Four alternative measures of financial development. (M2 = The ratio of M2 to nominal GDP, M3-M1 = The ratio of M3 minus M1 to nominal GDP, PC = The ratio of commercial bank credit to the private sector divided by nominal GDP and STN = Stock market turnover divided by nominal GDP). = The interaction term between KF and the four alternative measures of Financial development. = Real domestic capital stock net of foreign direct investment. All variables are in natural logs. The real foreign capital stock and the real domestic capital stock for Malaysia and Sri Lanka are computed using the perpetual inventory method. The initial stock of real foreign capital and real domestic capital is constructed using the annual average growth rate of real FDI and real total investment net of FDI, respectively, with a depreciation rate of 10%. Dummy variables were included to control for the war during 1983-2009.


The basic finding is that there is a significant cointegration (long term, underlying) relationship between KF, financial development and output. The most important finding in the below table is that the coefficients of all KF-financial development interaction terms are positive and significant at the 1% level in both countries. This indicates that KF generates a significantly positive impact on output through its interaction with the financial sector in the host country. The fact that significant positive coefficients are obtained for the interaction terms involving each of the alternative measures of financial development provides ample evidence of the KF-financial development relationship. This confirms the main hypothesis of this study, namely that the complementary relationship between KF and financial development generates a significantly positive impact on output. The positive sign and significance of both the KF term and the interaction term in specifications 1 and 3-4 also indicate that the direct positive effects of KF are enhanced by the level of financial development. The coefficient of the domestic capital stock term has the theoretically expected positive sign and is significant in most of the specifications. The results indicaate that the coefficients of financial development are significantly negative for all specifications. These negative coefficients are a likely result of the other three variables capturing the quantitative and qualitative channels through which financial development affects output.

Cointegrated Equation



GDP=2.597+0.428KF ***-1.611M2***+0.162KF xM2***+0.463KD ***




GDP=-9.892+0.029KF -4.004M3-M1***+0.387KF xM3-M1***+1.644KD ***




GDP=-13.862+0.126KF * -4.758PC***+ 0.457KF xPC***+1.819KD ***




GDP=-1.178+0.694KF *** -0.879STN***+0.089KF xSTN***+0.524KD ***



*, ** and *** indicates significance at the 10%, 5% and 1% level respectively.

LM is the Lagrange Multiplier test statistic with H0= no first order serial correlation in the residuals.

Recent developments in FDI






FDI (Rs Billion)






FDI as a % of GDP






Source: Own calculations based on CBSL Annual Reports

As shown in the above table, even though FDI increased in 2008, it did not surpass the record (as a

percentage of GDP) level of 2007. During the following two years the inflows of FDI declined in the aftermath of the 2008 Global Financial Crisis and the commencement of the 2008-2011 Global Recession. In 2011 nominal FDI increased substantially nearing the US$ 1 Billion mark. But in spite of the wide acclaim of the government, FDI as a percentage of GDP in 2011 is below the level of 2007. As stressed in this study and taking the Malaysian experience as an example, in terms of its contribution to the economy the most advantages type of FDI for a developing country is High Technology Export Manufacturing (HTEM) which results in spillover effects which improve the level of domestic technology and also leads to export growth which is vital for economic sustainability. This goal is not likely to be achieved by FDI inflows into the tourism sector (as observed recently) nor even though FDI in infrastructure (mainly transport) development, even though the latter will lead to substantial long term economic benefits. Though the attraction of HTEM FDI may be beyond the immediate capability of Sri Lanka, it is the target towards which policies should be directed.

Summary and Policy Implications

The empirical results confirm the hypothesis which this study set out to test. A distinctive feature of the cointegration findings is the consistency of the results, in terms of signs and significance of the coefficients, when different measures of financial development are employed. This contrasts with the literature where findings differ significantly depending on the particular measure of financial development used. The KF-financial development interaction term generates a significant long-term positive impact on output with all four measures of financial development. It is noteworthy that this positive effect has taken place in spite of an ongoing war lasting 26 years. The findings confirm the hypothesis that the interaction, or complementary relationship, between the stock of foreign capital and financial development generates a significantly positive impact on output. This is the single most important finding of this study. The fundamental message is that policies to promote economic development should incorporate strategies for developing the domestic financial system in order to maximise the benefits from foreign capital. One robust insight from the present investigation is that the positive effects of the stock of foreign capital on output are enhanced by financial development.

Sri Lanka has an opportunity with the ending of the war to improve her foreign investment performance considerably. Reforming outdated and unnecessary regulations and reducing administrative delays in the public sector are policy measures which can supplement the range of incentives presently offered to foreign investors. The quality of foreign investment should be improved along with its quantity. The gradual attraction of high technology oriented foreign capital should be targeted by improving infrastructure facilities and this is an area where the government is focusing its attention.

Several general foreign investment policy lessons are evident. Openness to foreign investment is crucial since trade and other barriers tend to discourage foreign investors. Excessive regulatory controls, administrative delays in the approval of projects, lack of transparency in government decision making and delays in obtaining work permits for expatriates are factors which hinder foreign investment. A stable political environment is important since some foreign investors are easily scared off by signs of internal conflict in the host country. These basic policies lay the foundation for the successful utilisation of foreign capital.

Once a host country has established herself as an attractive host for foreign capital, a policy framework should be designed and implemented that incorporates foreign capital into the overall development vision for the country. Selective approval of foreign investment projects and industry specific incentives can direct these investments into desired sectors of the economy. The experience of Malaysia provides an excellent example of a dual strategy of providing incentives tied to technological deepening and exports in order to promote foreign capital in the export manufacturing sector while at the same time promoting the domestic owned key heavy manufacturing industry through direct government intervention.

Increasing the level of domestic technology promotes complementarity between domestic and foreign firms. Incentives such as tax concessions to encourage investment in plant and machinery, and training grants are likely to promote domestic technological development and are especially beneficial for domestic firms establishing linkages with foreign firms. Additional policies include increasing government spending on R&D and education, establishing vocational training institutions and promoting upgrading schemes for occupational skills. Financial development is found to enhance the direct positive effects of foreign capital on output. Policies aimed at the development of the financial sector should be implemented along with those aimed at promoting foreign investment in order to maximise the benefits from foreign capital.


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