Causality analysis of the determinants of FDI in Bangladesh: fresh evidence from VAR, VECM and Granger causality approach

TLDR: In this paper , the causality between FDI and its determinants in Bangladesh in the presence of structural break harnessing Vector Autoregression (VAR) model and Granger causality test was tested.

Abstract: We tested the causality between FDI and its determinants in Bangladesh in the presence of structural break harnessing Vector Autoregression (VAR) model and Granger causality test. Regressors such as GDP growth rate, inflation, interest, corporate tax, exchange and wage rate, and trade openness (TO) have been used. VAR model finds that interest, tax, wage, and exchange rate do not affect inward FDI. However, the inflation rate and TO significantly impact the inward FDI in Bangladesh. The Granger causality test reveals a bidirectional causality in the FDI–inflation and FDI–TO nexus, whereas other explanatory variables do not cause the FDI granger. Variance decomposition (VDC) and impulse response function (IRF) assessment approve strong, moderate, and poor or no explanatory power of TO, inflation, and other explanatory variables, respectively. Regarding FDI–inflation bidirectional causality, we observed both natural (inflation truly causes FDI) and fake causality (FDI does not necessarily cause inflation). Therefore, when inflation causes FDI, then Bangladeshi Taka (BDT) becomes strong against USD, which increases import and reduces export (import > export). Due to the negative trade balance, this is true for Bangladesh. However, if FDI causes inflation, it will depreciate BDT; consequently, the export will surpass the total import, which is not the case in Bangladesh. Therefore, inflation causes FDI in Bangladesh, and this punch line ends the ongoing debate in the FDI–inflation–exchange rate nexus in Bangladesh. Finally, we recommend decreasing the lending interest rates to encourage further investment, adopting tax holidays, developing a skilled and semi-skilled workforce to harness the advantage of lower wage rates, and being more open to facilitating FDI-led development.