ECONOMETRICS I, ECON 3110 [SECTION 2]

SEMESTER 2, 2021/2022

FOREIGN DIRECT INVESTMENT

SUBMITTED TO: PROF. DR. SELAMAH BINTI ABDULLAH YUSOF

PREPARED BY: GROUP 11

NAME MATRIC NO CONTRIBUTION (%)

ANIS ARISSA BINTI ZAINUDIN 2111670 25

ERFAN EL-ZARIFF BIN 2013063 25

KHAIRIL ANUAR

AINA SAFFIA BINTI ZAMIMI 1910352 25

MA XIAOXUAN 1721547 25
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Table of content

Introduction 2

Literature Review 4

Data 6
Variables 6
Sources of data 6
Multiple regression model 7

Summary statistics 7

Initial estimated regression model 8

Diagnostic tests and remedial measures 8

Specification error 8
Multicollinearity 10
Serial correlation 13
Breusch-Godfrey LM Test 14
Heteroscedasticity 15
White test 15

Final model 16
Individual Significance 17
Test statistic and Critical value 17
P-value and α 18
Overall significance 18

Overall findings and conclusion 19

References 20
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1. Introduction
Foreign Direct Investment or also known as FDI is a well-studied topic with

numerous studies examining its association with various economics issues. Developing

countries, developing economies, and countries in transition are increasingly seeing FDI

as a source of economic development, modernization, income growth, and job creation.

According to Organisation For Economic Co-Operation and Development (2002), FDI is

defined as “an integral part of an open and effective international economic system and a

major catalyst to development” meanwhile United Nations Conference on Trade and

Development (1999, as cited in Ghahroudi et al., 2019) defined FDI as “an investment

involving a long-term relationship and reflecting a lasting interest and control of a

resident entity in one economy (foreign direct investor or parent enterprise) in an

enterprise resident in an economy other than that of the foreign direct investor (FDI

enterprise, affiliate enterprise or foreign affiliate)”.

There are two flows under Foreign Direct Investment, which are outflow and

inflow. The definition of outflow of FDI is the total value of outward overseas direct

investment made by the residents of the domestic country or reporting economy to

businesses based in foreign economies (Fdiindia, 2019), whereas inflow of FDI means

net of repatriation of cash and loan repayment, the value of non-resident investors'

inward direct investment in the reporting economy, including reinvested earnings and

intra-company loans (Global Economic Partnership, 2007).

Through FDI, there are opportunities for the foreign companies to transfer the

capital, knowledge and skills, and technology. This is important to ensure that there is

growth and improvement in building a skilled workforce in the country. According to

Research FDI, FDI is important because it can stimulate economic development for the

country. This is because it can attract more investors and foreign companies to invest in
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the local country due to a conducive and effective business environment. Other than that,

FDI also creates job opportunities for the local community as the investors build new

companies. The increase in income will lead to a high purchasing power and hence,

creating a better economic performance of the country. (ResearchFDI, 2021) Hence, we

can understand the importance of FDI in the country.

This paper is the culmination of the course's reading, writing, modelling, and

practise with research techniques. Data collection, report writing, problem solving,

management, and organisational skills application are examples of research techniques.

The objective of this study is to study the factors that affect the inflow of the Foreign

Direct Investment. This study is conducted to find out how these factors affect

unemployment and to what extent. Therefore, few inflow variables have been chosen

such as foreign direct investment which is the dependent variable, inflation rate, interest

rate, exchange rate and market size. With a thorough statistical analysis, we can predict

whether our findings will support or refute the theories investigated at the conclusion of

the inquiry. We hope that policymakers will use it as a guide in developing policies to

boost investment in the country.

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2. Literature Review
Based on our review of published research papers on our dependent variable,

we discovered that there are various variables that may have a positive or negative

association with the foreign direct investment (FDI). Studies have shown significant

correlations between FDI and inflation rate, interest rate, exchange rate and market size.

Based on the theories explored in journal articles, this study will analyse what kind of

relationship was discovered between these variables and foreign direct investment.

First and foremost, we can look at the correlations between interest rate and

FDI. The interest rate is the charge or cost of borrowing that is incurred or paid for the

use of money. It is also considered as an appealing factor for FDI as the country's

economic real interest rate, which captures the host country's return on investment.

According to Gross and Trevino (1996), a relatively high interest rate in a host country

encourages inward FDI. The real interest rate is inversely related to FDI. That is, when

there is a high FDI inflow, the real interest rate falls (Vidhya and Inayath, 2019).

However, if foreign investors rely on host country capital markets to raise FDI funds, the

estimated coefficient is positive in relation to FDI inflows.

Next, we analyse the relation between inflation rate and FDI. According to

Wint and Williams (1994), a stable economy tends to attract more FDI, thus a low

inflation environment is preferred in countries that encourage FDI as a source of capital

flow. Mustafa (2019), found that the relationship between inflation and FDI is significant

as one of the important determinants of the process of economic growth and development

of Sri Lanka. The high inflation rate impacts FDI inflows into the economy and slows the

process of economic development and growth. FDI has a positive relation with inflation

since it implies that FDI will increase as the inflation rate has increased.
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Third, we study the relation of exchange rate with FDI. Exchange rates can

affect FDI through an imperfect capital market channel (Froot and Stein, 1991). When a

country's exchange rate rises, domestic exports become more affordable, increasing

demand for export goods. As a result, demand for international goods will rise while

imports will fall, affecting FDI. This will create a competitive advantage in international

trade. When the exchange rate rises, imports will also become more affordable and the

country's inflation rate falls (Mansoor, 2018). The correlation between the exchange rate

and FDI is strongly positive. Which means as FDI inflows increase, the value of the

exchange rate will also increase.

Lastly, we look at the correlation between market size and FDI. Akin (2009),

stated that FDI perceives the market size in developing countries not on a per capita

basis, but rather on an aggregated level. More specifically, FDI will most likely

concentrate on regional areas with significantly higher purchasing power rather than a

nationwide expansion. Market size has a direct impact on investment return and profits,

and greater market growth indicates the potential for a larger market and more promising

opportunities for products manufactured (Petrovic-Randelovic, 2017). There is a direct

relationship between market size and FDI since any increase in market size will increase

the inflow of FDI.

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3. Data

a. Variables

There are five variables that are incorporated in this study. The first variable is foreign

direct investment which is the dependent variable. This variable is defined as the net

inflows of investment to acquire a lasting management interest (10 percent or more of

voting stock) in an enterprise operating in an economy other than that of the investor. It is

the sum of equity capital, reinvestment of earnings, other long-term capital, and

short-term capital as shown in the balance of payments. This series shows net inflows

(new investment inflows less disinvestment) in the reporting economy from foreign

investors, and is divided by GDP.

Next, inflation rate is one of the four explanatory variables to be used in the mode.

This variable is represented by the consumer price index that reflects the annual

percentage change in the cost to the average consumer of acquiring a basket of goods and

services that may be fixed or changed at specified intervals, such as yearly. As for the

interest rate, the data is adjusted for inflation as measured by the GDP deflator.

The third explanatory variable is exchange rate. It is represented by a real effective

exchange rate. It measures the development of the real value of a country’s currency

against the basket of the trading partners of the country. Lastly, the fourth explanatory

variable used in this study is market size. For this variable, it is represented by the GDP

for the country.

b. Sources of data

For this study, cross sectional data is collected for all the variables used. The countries

are chosen randomly from various parts of the world. The data used in the study are

secondary data that are collected from various resources. The data for real effective
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exchange rate is collected from the Bruegel database. As for other variables which are FDI

Inflow (USD), exchange rate (%), interest rate (%), and market size (GDP), the data are

extracted from The World Bank.

c. Multiple regression model

The estimated multiple regression model that will be used in this study is as below:

𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i = β0 + β1𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β2𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i + β3𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i +

β4𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i + εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1 ,..., 76

The variables for FDI inflow, market size, and exchange rate are in natural log form

as have been reviewed from the past studies.

4. Summary statistics

Table below shows the summary statistics for our model. The availability for interest

rate data is limited hence we have to minimize our sample set. The number of data

collected is 76 and it is assumed to be sufficient to conduct our study.

Variables Mean Median Minimum Maximum Deviation

FDIINFLOW 2.17E+10 1.66E+09 -5.27E+09 5.11E+11 6.97E+10

(FDI inflow)

INTERESTR 7.897125 6.201464 -12.28293 39.48937 8.319712

(Interest Rate)

INFLATIONR 3.123518 1.570711 -3.749145 48.69986 6.438631

(Inflation Rate)

MARKETSIZE 7.57E+11 7.06E+10 4.37E+08 1.82E+13 2.52E+12

(Market Size)

EXCHANGER 113.5488 114.6400 66.1400 163.9900 19.79633

(Exchange Rate)
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5. Initial estimated regression model

From the result above, we can see the value of coefficient for each of the variables.

The values can be incorporated in our initial regression equation mentioned above.

Therefore, our estimated regression equation is as below:

𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i = − 2. 650738 − 0. 019081𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i − 0. 030347𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i +

0.881503𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i + 0.493264𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i + εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1 ,..., 76

For the next section, we will test our regression equation by performing diagnostic

tests for specification error, multicollinearity, serial correlation, and heteroscedasticity.

6. Diagnostic tests and remedial measures

a. Specification error

A test is done to check misspecification in our regression model. We have to ensure

that our model does not violate the classical assumption number 1 which mentions that

the regression equation is linear, is correctly specified, and has an additive error term.

The model will have a specification error if there is an irrelevant variable that is
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included, a relevant and important variable is not included, and when an incorrect

functional form for the regression is used.

The Ramsey RESET test is performed to identify whether there is any specification

error in our regression model by combining non-linear combinations of our explanatory

variables and see if they are significant to the dependent variable. If the model is

specified properly, then the non-linear combinations of our explanatory variable should

not hold any significance over our dependent variable. The result for our Ramsey RESET

test is as below.
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𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i = β0 + β1𝐼𝑁𝐿𝐹𝐴𝑇𝐼𝑂𝑁𝑅i + β2𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β3𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i +

β4𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i + γ1𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i2 + γ2𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i3 + εi

H0: γ1 = γ2 = 0; Ha: γ1, γ2 not both zero

Significance value, α = 0.05

TS: F = 0.089519

CV: F0.05,2,70 = 3.128

The critical value obtained is 3.128 where it is based on the confidence level of 0.05

and degree of freedom of 2 and 70. Comparing the critical value and F-statistic value, we

fail to reject the null hypothesis. Hence, we can conclude that there is no specification

error in our regression model.

b. Multicollinearity

Next, we will test for multicollinearity for our regression model. We want to check

for imperfect multicollinearity that might exist in our variables from the regression

model. We have performed an auxiliary regression test where the regression is performed

on each of the explanatory variables as our dependent variable.

Then, we will observe the value of R-Squared for each of the results of the auxiliary

regression. If the value of the R-Squared is between 0.8 and -0.8, it shows that there is no

sign of multicollinearity. The results obtained for the auxiliary regression are shown

below.

1. Interest rate as the dependent variable.

𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i = β0 + β1𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i + β2𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i + β3𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i

+ εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1,..., 74

For this variable, INTERESTR is the dependent variable. It is regressed on other

variables which are INFLATIONR, LNMARKETSIZE, and LNEXCHANGER. The

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result is shown below. The R-squared obtained from this regression is 0.074447 which

the value is between 0.8 and -0.8. Hence, there is no multicollinearity problem for

INTERESTR.

2. Inflation rate as the dependent variable

𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i = β0 + β1𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β2𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i + β3𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i

+ εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1,..., 74

For this variable, INFLATIONR is the dependent variable. It is regressed on

INTERESTR, LNEXCHANGER, and LNMARKETSIZE. The result is shown below.

From the result, the value of R-squared is 0.112394. The value is between 0.8 and

-0.8. Hence, there is no multicollinearity found for INFLATIONR.

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3. Market size is the dependent variable.

𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i = β0 + β1𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i + β2𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β3𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i

+ εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1,..., 74

LNMARKETSIZE is the dependent variable and it is regressed on INFLATIONR,

INTERESTR, and LNEXCHANGER. The R-squared value shown in the result below

is 0.030648. The value is between 0.8 and -0.8. Therefore, there is no

multicollinearity problem for this variable.

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4. Exchange rate is the dependent variable.

𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i = β0 + β1𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i + β2𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β3𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i

+ εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1,..., 74

For this part, LNEXCHANGER is the dependent variable. It is regressed on the other

variables which are INTERESTR, INFLATIONR, and LNMARKETSIZE. The result

shows that the value of R-squared is 0.148075. Since the value is between 0.8 and

-0.8, we can conclude that there is no multicollinearity problem for this variable.

c. Serial correlation

For this test , we want to check if our regression model suffers from serial

correlation. It is to ensure that we do not violate the classical assumption number 4 which

states that the error terms are uncorrelated with each other. Since the data is collected

using cross sectional data, it is unlikely that our data has a serial correlation problem. If

there is a serial correlation problem, it is likely to be impure serial correlation and it has

to be fixed by checking the misspecification error. We acknowledge that there are

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missing observations in our dataset, hence we do not perform Durbin-Watson D test. We

will be performing the Breusch-Godfrey LM test.

i. Breusch-Godfrey LM Test

H0: γ1 = γ2 = 0; Ha: γ1, γ2 not both 0

Level of significance, α = 0.05

TS: F = 0.263568

CV: F0.05,2,60 = 3.150

The critical value obtained is 3.150 where it is based on the confidence level of 0.05

and degree of freedom of 2 and 60.Comparing the critical value and F-statistic value, we

fail to reject the null hypothesis. In conclusion, there is no serial correlation in our

regression model.
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d. Heteroscedasticity

This test is done to ensure that we do not violate the classical assumption number 5

where the error term in our regression equation should have a constant variance. In order

to do this, we have performed White test where we will regress the squared residuals on

all the explanatory variables, the squared of the explanatory variables, and the cross

terms. We want to test if the explanatory variables, the squared and the cross terms

jointly have an effect on the residuals squared.

i. White test
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H0: 𝑒𝑟𝑟𝑜𝑟𝑠 𝑎𝑟𝑒 ℎ𝑜𝑚𝑜𝑠𝑐𝑒𝑑𝑎𝑠𝑡𝑖𝑐; Ha: 𝑒𝑟𝑟𝑜𝑟𝑠 𝑎𝑟𝑒 ℎ𝑒𝑡𝑒𝑟𝑜𝑠𝑐𝑒𝑑𝑎𝑠𝑡𝑖𝑐

Level of significance, α = 0.05

TS = χ2 = nR2 = 15.72008

CV = χ2 (14) = 23.685

The test statistic value for this hypothesis testing is obtained from the EViews result

which is 15.72008. The critical value is the product of test statistic value and the number

of explanatory variables incorporated to do the White test which resulted to 23.685. From

this hypothesis testing, we fail to reject the null hypothesis. In conclusion, the errors in

our model are homoscedastic.

7. Final model

After conducting four diagnostic tests above, we find out that our model does not

violate any of the classical assumptions. Hence, our estimated regression model is similar

as stated above which is as followed:

𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i = β0 + β1𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i + β2𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i + β3𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i +

β4𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i + εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1 ,..., 76

𝐿𝑁𝐹𝐷𝐼𝐼𝑁𝐹𝐿𝑂𝑊i = − 2. 650738 − 0. 019081𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇𝑅i − 0. 030347𝐼𝑁𝐹𝐿𝐴𝑇𝐼𝑂𝑁𝑅i +

0.881503𝐿𝑁𝑀𝐴𝑅𝐾𝐸𝑇𝑆𝐼𝑍𝐸i + 0.493264𝐿𝑁𝐸𝑋𝐶𝐻𝐴𝑁𝐺𝐸𝑅i + εi 𝑤ℎ𝑒𝑟𝑒 𝑖 = 1 ,..., 76

For the next section, we will continue with two significant tests which are individual

significance and overall significance of our variables to the regression model.

Appropriate hypothesis testing has been conducted in order to check for the significance.
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Individual Significance

Test statistic and Critical value

a. Interest rate on FDI inflows

1. H0 ：β1=0， H1：β1≠0
2. α=0.05
3. Test statistic value: t = -1.089108
4. Critical value: t0.05, 69-1-1 = ±1.671, -1.671 < -1.089108 < 1.671
5. Accept H0
6. The Interest rate has an insignificant effect on the FDI inflows.
b. Inflation rate on FDI inflows
1. H0: β2=0, H1: β2≠0
2. α=0.05
3. Test statistic value: t = -0.819404
4. Critical value: t0.05, 69-1-1 = ±1.671, -1.671 < -0.819404 < 1.671
5. Accept H0
6. The Inflation rate has an insignificant effect on the FDI inflows.
c. Market size on FDI inflows
1. H0: β3=0, H1: β3≠0
2. α=0.05
3. Test statistic value: t = 15.47654
4. Critical value: t0.05, 69-1-1 = 1.671, TS > CV(15.47654 > 1.671)
5. Reject H0
6. The Market size has a significant effect on the FDI inflows.
d. Exchange rate on FDI inflows
1) H0：β4=0， H1：β4≠0
2) α=0.05
3) Test statistic value: t = 0.639611
4) Critical value: t0.05, 69-1-1 = ±1.671, -1.671 < 0.639611< 1.671
5) Accept H0
6) The Exchange rate has an insignificant effect on the FDI inflows
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P-value and α

Interest rate Inflation rate Market size Exchange rate

H0：β1=0, H1:β1≠0 H0: β2=0, H1: β2≠0 H0: β3=0, H1: β3≠0 H0：β4=0, H1:β4≠0

α = 0.05 α = 0.05 α = 0.05 α = 0.05

P-value = 0.2802 P-value = 0.4158 P-value = 0.0 P-value = 0.5247

0.2802 > 0.05 0.4158 > 0.05 0.0 < 0.05 0.5247 > 0.05

Accept H0 Accept H0 Reject H0 Accept H0

Overall significance

8. H0: β1 = β2 = β3 = β4 = 0
H1: β1 , β2 , β3 , β4 not all zero
9. Level of significance, α=0.05
10. Test statistic: F=(0. 796195/4)/[(1 − 0. 796195)/(69 − 4 − 1)]= 62.50629
11. Critical value at numerator 4, and denominator 64, F0.05,4,64 = 2.514
62.50629>2.514
12. Reject H0
13. Conclusion: Exchange rate, inflation rate, interest rate and market size jointly have a
significant effect on FDI inflows. Alternatively, there is an overall significance of the
model.
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8. Overall findings and conclusion

The study conducted on FDI has allowed us to observe the effects of the

determinants chosen which are inflation rate, interest rate, exchange rate, and market size

on it. In this study, we are looking at how our regression result will support the theories

for the variables. Among the tests conducted include misspecification, multicollinearity,

serial correlation and heteroscedasticity, we found out that our regression equation

agreed to the classical assumptions and the Gauss Markov, no specification error, no

perfect multicollinearity, no serial correlation and no heteroscedasticity.

We also found out that interest rate and inflation rate are negatively related to the

FDI inflows and the market size and exchange rate are positively related to the FDI

inflows. In addition, the results from our individual significance test revealed that

Interest Rate, Inflation Rate, and Exchange Rate are having statistically insignificant

effects on the FDI Inflows. However, the overall 4 explanatory variables jointly have a

significant effect on FDI inflows, which is empirically supported by both theory and

hypothesis tests. Alternatively, there is an overall significance of the model.

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FDI India (2019, October 3). What is FDI Inflow and Outflow?. Retrieved from

https://www.fdi.finance/blog/what-is-fdi-inflow-and-outflow/.

Ghahroudi, M.R., Hoshino, Y. and Turnbull, S. (2019). Foreign Direct Investment Ownership

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