The impact of the investment climate on foreign direct investment in Africa
Written By: Parfait Bihkongnyuy Beri
Economic literature widely appreciates the crucial role of foreign direct investment (FDI) in economic development, particularly in low-income developing countries. Its benefits cut across creating employment opportunities, technology spillovers, productivity enhancement, knowledge spillovers and competition. Perhaps more important is the fact that FDI inflows are non-debt-creating. This can be a preferred method of financing external current account deficits, especially in African countries, where such deficits are often large, persistent, and unsustainable.
Over the years, many African countries have invested enormous resources to attract foreign investments to accelerate social and economic development using several channels like participating in bilateral investment treaties, trade liberalisations and other domestic policy initiatives. While several studies in the literature on the effectiveness of these initiatives continue to arrive at mixed and contested results, the role of the investment climate has received less attention than expected despite the advantage that it takes a shorter period to make and implement reforms that can improve it to attract FDI. Besides that, a few studies that have ventured into this area often treat African countries as a uniform entity, and the results may mask differences across countries.
The investment climate refers to the policy, governance, institutional or regulatory environment that determine investors’ willingness to operate businesses in a country. In Africa, the investment climate seems to be characterised by recurrent conflicts, widespread coups d'état, lack of respect for the rule of law, poor human rights records and most importantly, the poor and sometimes biased reporting from the mainstream media. For instance, 2010 to 2021 witnessed a groundswell in coups d'état, coup attempts and coup plots in Africa. These challenges tarnish the investment climate and could potentially hamper the much needed inflow of FDI for social and economic development.
Against this backdrop, African governments should be concerned about the quality of their investment climates for three main reasons. It provides the bedrock upon which most economies can transition from underdevelopment to economic prosperity through new investments, innovations and entrepreneurship; it ensures the long term sustainability of the economy and also facilitates equality of opportunities among market agents. These qualities imply that the extent to which a country can attract new investments and accelerate the creation of new firms and decent jobs to foster inclusive development is determined significantly by the host government’s policies which can either make a good or bad investment climate.
In a research paper authored with Dr Nubong, we rigorously investigated the role that investment climate plays on FDI attraction in selected African countries by combining several standard noneconomic variables to measure the investment climate. Secondly, we examined the impact of the investment climate on FDI in the 15 landlocked nations, 33 least developed countries (LDCs), 23 countries with developed financial markets, and 19 countries with abundant natural resources. Finally, we performed regressions using the generalised method of moment and the fixed-effect models with Driscoll-Kraay standard errors. The two approaches enabled us to arrive at robust and conclusive results about the average impact of the investment climate on FDI. Unlike the use of FDI inflows in some studies, FDI is measured as stocks to account for the value of additional investments in host countries often financed from domestic banks through loans, which FDI inflows tend to underestimate.
The empirical results showed that investment climate is a critical determinant of FDI in the pooled sample, resource-rich countries, and those with well-developed financial markets. Conversely, this effect was not significant in landlocked countries when considering both methods for the analysis. After obtaining these results, we turned to the moderating role of the investment climate on foreign direct investment in Africa. The moderator variable demonstrated the complementarity of the investment climate and gross domestic product in enhancing FDI in Africa and across various sub-samples. Therefore, countries with a good investment climate experience higher economic growth and attract more investments.
These results suggest a need for least developed and landlocked countries in Africa to strengthen their domestic investment climates by adopting policies that enhance the rule of law, fights corruption and build more robust institutions that can facilitate governments’ effectiveness. Similarly, policies that catalyse economic growth can also attract FDI, especially across landlocked and least developed countries. Finally, the research re-echoes the importance of accounting for country and region-specific differences in large panels to arrive at generalisable results.
Conclusively, a good investment climate increases the return on investments; allows foreign investors to reinvest or repatriate their returns without difficulties, and these are the very reasons most businesses consider before investing more capital in developing countries. Therefore, African governments should make necessary reforms to enhance their investment climates and leverage them to attract FDI for social and economic development.
Parfait Bihkongnyuy Beri
Socio-economic Research Applications and Projects
|Delegates in the Business and Innovation Hub at the UK-Africa Investment Summit, which took place in London on 20 January 2020|