FOREIGN CAPITAL FLOWS, FINANCIAL DEVELOPMENT AND GROWTH IN SUB-SAHARAN AFRICA

Abstract

1. INTRODUCTIONOrthodox development perspective quite apparently delineates an important role for capital flows from richer countries as a critical component of the much-needed development finance requirement in the developing world. This North-South capital kinesis paradigm, while encompassing diverse categories of capital - portfolio investment, remittances, foreign direct investment (FDI), and official development assistance (ODA) among others - recognises the prominence of foreign direct investment, relative to other sources, as a key predictor of economic growth. In 2004, for example, FDI accounted for one half of total resource flows to developing countries, while remittances, ODA and portfolio equity split, albeit not equiproportionally, the remaining half (World Bank, 2011). This seems particularly apposite since foreign direct investment both in its conception and composition examplifies the necessary long term ingredients required to nurture growth which in itself is a phenomenon observable chiefly over comparably long horizons.However, there are conflicting opinions not only on the importance of foreign direct investment (FDI) on economic growth but also on the channels. FDI can positively affect growth by an outward shiftin the economy's production possibilities frontier through technology transfer and the attendant spillovers (Blomstrom et al, 1994; Kokko and Blomstrom, 1995). The former underscores the importance of all categories of investment, particularly FDI, in maintaining the economy on a sustainable growth trajectory. For instance, most sub-Saharan Africa (SSA) countries witnessed systematic declines in investment rates from the early 1980s with corresponding negative growth rates in real output till around 1990 in some cases (Oshikoya, 1994). Therefore, since FDI flows to these countries ranked amongst the lowest to developing countries, it suggests close ties between low investment and the observed economic downturn in SSA during this decade that has been tagged lost.While the positive influence of FDI on growth remains in large part an empirical regularity, a crucial issue that is by far less clear regards the channels through which the positive impact of FDI on economic growth works (Lemi and Asefa, 2003). A prominent view that has emerged in this discourse is that the absorptive capacity of the FDI-receiving country matters. Interestingly though, this absorptive capacity has been looked at under different prisms. For instance, Balasubramanyam et al, (1996) and Borensztein et al, (1998) see the domestic economy's trade as well as human capital policies as the prerequisite for FDI's growth-promoting effects, while De Mello (1997) focused on the importance of physical capital accumulation. Likewise, there are equally a number of other somewhat complimentary opinions along the lines of market size, natural resource endowment amid a host of other factors.In more recent studies, however, research focus appears to have shifted to the role of the recipient economy's financial sector in the FDI-Growth nexus (see Hermes and Lensink, 2003; Alfaro et al, 2004 for elaborate narratives). There are at least three distinct merits to emphasize this shift. First, deeper and broader based financial institutions through more efficient delivery of financial services serve to promote growth directly (Levine, 1997; Errunza, 2001). Second, advanced financial systems by construction are better positioned to attract foreign direct investment which is a vital predictor of growth (Albuquerque, 2003). Third, increased financial sector efficiency should lower transaction costs which are chiefly related to perceived risks arising from information asymmetries (Reisen and Soto, 2001).While this study is similar in spirit to this latter strand of evidences, we tread a distinct path on a number of fronts. First, the link between FDI and economic growth and the influence of financial development is delved into within a SSA-specific panel context. …