FDI and domestic investment in Africa: Evidence on the role of local conditions

Abstract

This paper investigates the impact of foreign direct investment on domestic investment and the role of local conditions. Local conditions determine the extent to which host countries can absorb and hence benefit from FDI. We assess conditions under which FDI is likely to be beneficial or inimical to development in Africa. We apply the fixed effects and the two-step system GMM estimation techniques for 48 African economies from 1980 to 2016. We use gross fixed capital formation (GFCF) as a percentage of GDP as a proxy for domestic investment (DI) as our dependent variable. We use the following control variables: growth rate in real GDP (RGDP); savings as a percentage of GDP; and inflation. We also control for openness, financial sector development and institutional quality. We use annual data from the World Bank's World Development Indicators (WDI), the International Monetary Fund's (IMF) International Financial Statistics, the UNCTAD database and the Freedom House database. We find that there is a negative relationship between FDI and domestic investment, suggesting that FDI has a crowding-out effect. The negative association may also imply that countries with lower domestic investment attract more FDI because there are more domestically unsatisfied opportunities for foreign investors. However, the negative relationship between FDI and domestic investment does not necessarily imply that FDI has no benefits. It could as well be that the positive benefits from FDI in Africa may be as a result of an increase in total factor productivity (TFP) which more than compensates for the decline in domestic investment. The study also finds that improved institutions and trade openness mitigate the negative effect of FDI on domestic investment while financial market development exacerbates the negative effect. Policy efforts aimed at attracting FDI should be balanced with the imperative of strengthening institutions and domestic firms. A number of scholars have shown that that even in those countries where FDI has been more productive, domestic investment is more effective than FDI in promoting growth. Investment incentives should therefore not discriminate against domestic investors. Market regulations to dismantle the monopolistic tendencies of some foreign investors must be strengthened.