Foreign Finance, FDI-Climate Interaction and Economic Development in Ethiopia: A Time Series Analysis

Abstract

Developing countries such as Ethiopia, over the years particularly after the cold war, starting from early 1990s have adopted neoliberal policies through reforms to attract foreign finance for development needs in view of inadequacy of domestic capital for public and private investment. However, despite the inflow of foreign capital into the economy, it is still grappling with major development challenges. It is in view of this that this study examines the impact of foreign finance on the economy, and whether FDI-climate interaction limits the potential impact of foreign direct investment (FDI) as an important component of foreign capital, on economic development in Ethiopia. The study further reveals the implications of post-cold war adoption of market-oriented policies in Ethiopia. The study uses autoregressive distributed lag (ARDL) model with data spanning from 1981 to 2020. It is found that FDI has positive and significant impact on economic development in the long run, but the positive effect is revealed to be insignificant in the short run. On the other hand, foreign debt is revealed to have long term negative though insignificant impact on economic development of the country. Furthermore, it is revealed that FDI-climate interaction has negative implication on the economy in both the long run and short run. Therefore, the effectiveness and efficiency of foreign finance on growth and development outcome in Ethiopia is conditional on whether it produces long run sustainable environmental outcome. Also, the adoption of neoliberal policies has not resulted in development of Ethiopia. Hence, the study recommends among others, the need for consideration of absorptive capacity of the country as a recipient economy and in its reforms, as well as the need for the government and development partners to ensure assessment of the long run potential environmental impact of foreign capital before they are deployed on the economy.