Modeling the Relationship between FDI and Financial Development in Small Island Economies: A PVAR Approach

Abstract

FDI is considered as an important source of capital investment for small island economies and is considered as a crucial tool for attaining economic growth and development. Most studies that have been done relating to foreign direct investment (FDI) are rather on the link between FDI and economic growth or even the link between FD and economic growth. Certainly, there is sufficient theoretical rationale to ascertain that FDI does influence the development of financial market of the recipient countries. Hence, basing on the argument that there is a lack of studies done in this area mainly for the case of small island economies, this paper uses a panel vector autoregressive model (PVAR) which caters for both endogeneity and dynamism, and investigates the relationship between FDI and FD over the time period spanning from 1990 to 2013. Actually, the study shows that FDI can be an important ingredient for developing the financial market in small island econ omies. For instance, a bi-causal relationship between FDI and FD is observed from the results. Also, economic growth has been identified to play a crucial role in boosting financial development in this study. Moreover other interesting relationships have been detected in the PVAR model.