UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The impact of foreign direct investment and
economic growth on CO2 emissions:
Empirical study in ASIA
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By
DO DANG NGOC GIAU

Academic Supervisor:

Dr. PHAM KHANH NAM

HO CHI MINH CITY, NOVEMBER 2015
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ABSTRACT
This paper is to investigate the effects of foreign direct investment (FDI) inflows
and economic growth on CO2 emissions in Asian countries over period from 1991 to
2013. Under the complexity between these variables, this paper applied panel analysis
method and structural equation model (SEM) to explore the influence of FDI, economic
growth on CO2 emissions. The result indicates that FDI inflows contribute to reduce CO2
emission (improve environmental quality) while economic growth make CO2 emissions
level increase. Moreover, the result shows the two-way linkages occur between CO2
emissions and FDI inflows, CO2 emissions and economic growth. In addition, the
unidirectional nexus exists from economic growth to FDI inflows.
Keywords: Foreign direct investment; economic growth; CO2 emissions; SEM;
Asian countries.

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ABBREVIATIONS
GDP:

Gross Domestic Product

FDI:

Foreign Direct Investment

CO2:

TABLE OF CONTENTS
CHAPTER 1 INTRODUCTION...................................................................................... 8
1.1. Problem statement .................................................................................................. 8
1.2. Research Objectives ............................................................................................. 10
1.3. Research Questions .............................................................................................. 10
1.4. Research Scope and Methodology ....................................................................... 10
1.5. Thesis Structure .................................................................................................... 11
CHAPTER 2 LITERATURE REVIEW ....................................................................... 12
2.1. Pollution Haven Hypothesis. ................................................................................ 12
2.2. Pollution Halos Hypothesis. ................................................................................. 14
2.3. Environmental Kuznets Curve Hypothesis (Theory of economic growth –
environmental quality) ......................................................................................... 15
2.4. Empirical studies related to Pollution Haven Hypothesis .................................... 16
2.5. Empirical studies related to Pollution Halos Hypothesis ..................................... 18
2.6. Empirical studies on the impact of FDI, economic growth on CO2 emissions .... 19
2.7. Empirical studies on the three-way linkages between FDI-economic growth-CO2
emissions.............................................................................................................. 22
CHAPTER 3 RESEARCH METHODOLOGY ........................................................... 25
3.1. Analytical framework ........................................................................................... 25
3.2. Model specification .............................................................................................. 27
3.3. Data and Defining Variables ................................................................................ 32
3.3.1.

Data ............................................................................................................... 32

3.3.2.

Defining Variables ........................................................................................ 34

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CHAPTER 1
INTRODUCTION
1.1.

Problem statement
In recent years, climate change and environmental degradation are the major

concerns toward many countries all over the world, especially in ASIA. These problems
cause many difficulties in poverty reduction and economic development (World Bank,
2015). Moreover, human health is threatened as well as cost for health-care sector is
increased by environmental degradation. Neria (2014) suggested that approximately 3
million people worldwide die every year by environmental pollution. Many researchers
found that one of major factors, which causes the climate change and environmental
degradation is carbon dioxide (CO2 emissions) (Pittock, 2003; Solomon et al., 2007).
They has pointed out that the surge of CO2 emissions level pushes greenhouse gases in
atmosphere and leads to climate change threats to socio-economic systems.
As a matter of fact, environmental degradation is caused by human activities such
as industrialization, burning of fossils fuel and deforestation. Human activities are
operated to develop economy and improve life quality. Under enormous pressure of
sustainable economic development goal, many countries increase extraction, production
and especially industrialization. Consequently, these activities cause high pollution level.
It goes to show that economic growth is one of the main reasons of environmental
degradation (Dell et al. 2008). The effects of economic growth on environmental quality
(CO2 emissions) are analyzed by many previous studies. The link of emissions and
economic growth is closely related to the context of Environment Kuznets Curve
(EKC) hypothesis. The EKC theory suggests that the emission level increases with a
rising in per capita growth of GDP, and it declines after reaching at ―turning point‖
(sustainable income level). From above discussions, this thesis will emphasize on
analyzing the impact of economic growth on CO2 emissions.

The finding from this thesis will provide evidence support the current literature
related to the impact of FDI, economic growth on CO2 emissions. Moreover, this study

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gives several suggestions for policy maker in order to achieve the goal of reducing CO2
emissions as well as improving environmental quality in Asian countries.
1.2.

Research Objectives
This thesis is to understand the impact of foreign direct investments (FDI) on

environmental quality in the context of Asian countries, based on argument of Pollution
Haven Hypothesis and Pollution Halos Hypothesis.
In addition, this thesis attempts to investigate the relationship between economic
growth and environment quality. The results would provide research evidences on the
general relationship between FDI, economic growth and environmental quality. This
knowledge would be a contribution to the literature on the linkages between the economy
and environment.
1.3.

Research Questions
In order to achieve the research objectives, this thesis attempt to the answer these

following questions:
 Does foreign direct investment lead to increase CO2 emissions in ASIA?
 Does economic growth cause an increase in CO2 emission in ASIA?
1.4.




CHAPTER 2
LITERATURE REVIEW
This chapter presents both the theoretical and empirical aspects of the relationship
between FDI and CO2 emissions. There are two sections in this chapter. The first section
is to discuss about two of theory: Pollution Haven Hypothesis and Pollution Halos
Hypothesis. The second section is about the empirical studies including previous studies
that have investigate the relationship between FDI and CO2 emissions based on Pollution
Haven Hypothesis and Pollution Halos Hypothesis. Moreover, this chapter will discuss
about the empirical studies related to causal relationship between FDI-CO2 emissions and
economic growth.
2.1.

Pollution Haven Hypothesis.
From the theoretical view, Pollution Haven Hypothesis (PHH) prefers that FDI has

a negative effect on environmental quality. PHH argues based on Heckscher-Ohlin
theorem (Heckscher, (1919) and Ohlin (1933). According to, comparative advantage of
Heckscher-Ohlin theorem, Pollution Haven Hypothesis has considered ―lax‖ of
environmental regulation as a comparative advantage in polluting industries. In addition,
Dasgupta et al. (1999) supposes that the countries with low environmental standards
might be a ―pollution haven‖ for polluting industries. As stated by Hechscher-Ohlin
theorem, a region with an abundant factor such as labor or capital would have a
comparative advantage in producing goods that use abundant locally factor. Therefore,
this region should specialize in producing and exporting these comparable goods.
Accordingly, in developed countries, especially countries have a large of polluting
industries, tightening up environmental policy is synonymous with the high abatement
cost. An increase in production cost together with a high penalty fee will lead to the
relocation in ―dirty‖ industries. In other words, cost of the inputs for pollution-intensive

is answer the question how much the cost from regulation is. In order to
measure level of stringent environmental regulation, environmental taxes or fees,
permitting cost… had been utilized in the earlier research. In addition, some studies have
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also used emission level to present for stringent environmental regulation with argument
that large of number emissions is signal of weaken environment regulation. However,
using cross-section data gets some troubles in estimation. Namely, cross-section date is
considered that it may not control the unobservable heterogeneity and endogeneity
problem. Then estimation result could be biased. Hence, the subsequent studies applied
panel data to handle unobservable problem. In some cases, the stringent and pollution are
determined simultaneously. Then, instrument variable becomes a better way to solve
endogeneity problem. The findings of subsequent studies are better than previous ones
and provide a higher statistical significance for estimators. To sum of, it could be
deduced that FDI has negative effects on environment through the relocation of polluting
industries and movement of capital.
2.2.

Pollution Halos Hypothesis.
In contrast with PHH theory, Pollution Halos Hypothesis (Halos Effects

Hypothesis) suggests that industrial location and capital flow from foreign countries play
an important role in improving environmental quality in host countries by transferring
superior technologies, cleaner production methods and diffusing better environmental
management skills. The Halos theory not only focuses on FDI firm’s decision from
effects of environmental regulation but also concerns about the environmental
performance in recipient countries (Zarsky, 1999). First, in general, multinational firms
may bring the cleaner energies, newer techniques from foreign countries to domestic
countries that may enhance production productivity. It is not surprising as a wealthy and

environmental quality (Stern et al., 1996). The EKC theory posits that in the first stage of
development economic environmental quality reduce, and after reaching at sustainable
development, environmental pollution will be improve. In other words, in low income
level protection of the environment is not first priority since every person tends to make
use of their income to satisfy their individual basic needs. In the broad scale, early stage
of economic growth, entire society focuses on promoting production with all of available
resources. Therefore, environmental damage increase sharply, and furthermore pollution
is created from industrialization. However, subsequent to reach certain level of income,
demand of environmental quality is paid attention. Thence, entire society as well as
government concentrates on improving environmental quality together with economic
growth. Nonetheless, most of examination of the EKC in many studies related to air
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pollution concern (Shafik, 1994; Liu, 2007). As a result, EKC has become the theoretical
base for government in order to control volume of air pollution (such as CO, CO2, SO2
emissions) by increasing economic growth.
2.4.

Empirical studies related to Pollution Haven Hypothesis
Theory of Pollution Haven Hypothesis has been tested by many empirical

researches. Most of empirical studies investigate the effects of level of stringent
environmental regulation on the competitiveness (net export, net inflow of foreign
investment, new plant birth and so forth) (Copeland, 2013).
Keller and Levinson (2002) carried out the research on 958 new foreign-owned
factories in United State over period from 1977 to 1994. In order to measure level of
stringent environmental regulation, the industries-adjusted index of environmental
abatement cost is used. The higher the industries-adjusted index in a region is more
stringent environmental regulation. Moreover, the unobserved heterogeneity that is

consistent with Pollution haven hypothesis in some countries such as Algeria, Cameroon,
Iran, and Mexico. Moreover, this research also gives evidence about the causality
between FDI inflow and pollution emissions by applying Granger causality test.
Furthermore, some previous studies test PHH theory. However, their results are
ambiguous. Eskeland and Harrison (2003) carried a study to test PHH in three countries
(Co^te d’Ivoire, Venezuela, Morocco). The result implied that regions with high level of
pollution get more foreign investment. Since cleaner energy is used in foreign factories
that operate in high level of pollution region, it is not matter in industrial relocation. In
another work, Elliot and Shimamoto (2008) measured stringent environmental regulation
by firm’s total amount of investment cost for pollution abatement in each of the
manufacturing industries surveyed by the Japanese Ministry of Economy. Assumption of
this research is that high pollution abatement costs in Japan makes company move out of
nation. The study is conducted in three countries: Indonesia, Philippine, Malaysia. These
countries are FDI recipient from Japan. The empirical result indicates that influence of
high environmental regulation on industries relocation is significant. Nonetheless, the
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coefficient has negative sign in Philippine. This means that outbound FDI from Japan is
not affected by stringent environmental regulation in Japan.
2.5.

Empirical studies related to Pollution Halos Hypothesis
Recently, some studies provide evidences supporting The Halos theory. Most

studies examine the spillovers effects from FDI to environment. In addition, while there
are many researches show the negative relations between FDI and environment, some
provide the mixed results.
Several studies have found positive effects of FDI on environmental quality. Cole et
al. (2008) examined whether foreign ownership made domestic firms increase the access

firms which are OECD firms. Moreover, the result indicates that the plants with new
equipment, high technology do not seem to provide a better environmental management
for local firms. This result of study is not in line with Halos Hypothesis.
2.6.

Empirical studies on the impact of FDI, economic growth on CO2 emissions
Reviewing the theories on the relationship between foreign direct investments,

economic growth and environmental quality is very necessary and helpful. Nonetheless,
it is not less of learning from previous empirical evidences since these studies not only
provide the results about the effects of FDI and economic growth on environment but
also investigate other possible determinants which may have effects on environment.
Laing (2006) set up examination to find an answer for the question ―Does foreign
direct investments (FDI) harm to host countries?‖ with the sample of 260 cities in China
between 1996 and 2003. The author expects that FDI may bring benefit and do not
damage environmental quality. Furthermore, this study investigates the relationship
between trade openness, income and environmental quality (measured by SO2 emissions).
In addition, a major concern in this study is the possibility of endogeneity problem due to
omitting variable. Laing then uses two variables ―geography location‖, ―trade policy‖ as
the instruments for foreign direct investments to handle the endogeneity concern. The
analysis is estimated using Fixed Effects method for both with and without instrument
variables scenario. The result presents that the correlation between FDI and SO2
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emissions is negative, suggests that SO2 emissions in a city of China could be reduced
with the increase of FDI. FDI has been proven to improve environment via transferring of
new technology and ―green‖ goods.
Several studies have looked at FDI inward and outward in explaining changes in
environmental quality. Bernauer and Koubi (2009) provided empirical studies about the

urbanization is one of main determinant that affects CO2 emission in high-income
countries.
Grossman and Krueger (1991), Selden and Song (1994), Rothman (1998) estimated
the relationship between economic growth and environmental quality and provide
evidences supporting for EKC. This means pollution tends to increase in the first stage of
economic degradation but beyond the sustainable point of average income, pollution will
be decline. Following the empirical findings from previous studies, Asghari (2013) uses
the reduced form of econometric model and panel data of six countries in Middle East
and North Africa (MENA) from 1980 to 2011 to estimate the effects of FDI on
environmental quality by applying the Fixed Effects Model. For the dependent variable in
analyzed model, author chooses CO2 emission of industrial pollutants as proxy. To get
some sense of the factors which affect environment, other control variables are
considered that the real Gross domestic product (GDP), share of industry in GDP, trade,
population density and corruption perception index. This paper implies that FDI inflow
transfers cleaner technology to make environment become better. This result again
provides evidence support Halos Hypothesis. In addition, this paper provides evidences
consistent with the conclusion of Blackman and Wu (1998), Cole (2008).
In a related study, Halicioglu (2008) found positive effects of income, foreign trade
and energy use on environmental quality in Turkey. In the same way, Farhani (2013)
carried out the research about the impact of economic growth and other determinants on
CO2 emissions. This research uses panel data in eleven countries of Middle East and
North Africa (MENA) over period 1980-2009. He (Farhani, 2013) estimated regression
in two groups by using Fully Modified Ordinary Least Square (FMOLS) and Dynamic
Ordinary Least Square (DOLS) methods. First, he investigates environmental effects of a
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group of indicators including income, energy consumption, and trade liberalization. The
result of FMOLS and DOLS indicate that the increases in energy use and trade lead to
CO2 emissions go up. In addition, the effect of income on CO2 emissions is in line with

series data. Based on suggestion of Arellano and Bond (1991), authors used GMM
technique to estimate the simultaneous equation. As such, they find the unexpected result
that there is insignificance unidirectional effect from economic growth to foreign
investments. However, the foreign investments have positive and statistically significant
effects on economic growth. In order to find strong evidence for the two-way links
between FDI and economic growth, Anwar and Nguyen (2010) made an investigation for
61 cities in seven regions in Vietnam from 1996 to 2005. By using the simultaneous
equation model and GMM estimation, this paper reports the result that the two-way links
between economic growth and FDI inflow exist in four regions (i.e. Red River Delta,
North East, South East and Mekong River Delta). Specifically, the FDI inflows increase
with economic growth and economic growth is also increase with arise of FDI inflows.
This result is consistent with Tsai (1994).
Second, there are many studies confirm causal links of pollution and economic
growth. Halicioglu (2009) analyzed the relationship among economic growth, energy use,
trade openness and CO2 emission by using time series data in Turkey from 1960 to 2005.
Soytas and Sari (2009) set up an investigation for economic growth, energy use and CO2
emissions in Turkey during 1960-2000. In addition, Ghosh (2010) examined the
economic growth and CO2 emission relation in India over period 1971-2006. Applying
Ganger Causality Test, these studies report a same conclusion that between economic
growth and CO2 emissions (proxy for pollution) have two-way effects. However, some
studies find the mixed results for economic growth and pollution nexus. Take examples,
study in Malaysia of Ang (2008) and study in South Africa of Menyad and Rufael (1995)
confirmed the evidence about the relationship between the CO2 emissions and economic
growth, indicating that arise of CO2 emissions causes economic growth declines and
without feedback effects from economic growth on CO2 emissions.
Third, it is believed that between FDI and pollution are causal nexus. Hoffmann et
al. (2005) used the Granger causality test to test the relationship between FDI inflow and
CO2 emissions (as a proxy for pollution) by using sample of 112 countries in over the
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Analytical framework
On the theory and empirical analysis, this paper show the complex relation of CO2

emissions, economic growth and foreign direct investment through the analytical
framework. Accordingly, the effects of some exogenous variables is also presented in this
graph.
Firgue 1:

Conceptual Framework

FDI
Capital Stock

CO2 Emissions
Economic
Growth

Trade openness

Polity

Activity

Source: Author’s analysis

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