Foreign Direct Investment Theories And Motives

Published Date: 02 Nov 2017

CHAPTER 2

Investing in foreign countries is risky business. The unfamiliarity with rules and regulations, but also a different culture can cause problems in the interaction with the new country during the outflow of FDI. Those problems will exist as long as the world has different nations and cultures; it is part of the game. However, many elements are changeable and shape the economic landscape of a country. In this chapter theories and determinants for foreign direct investments, will be discussed. Important to note is that the literature about determinants of foreign direct investment is too general for Sub Saharan Africa countries. In Africa more factors play a role in the choice of firms to start business in Africa (Asiedu, 2006) than the current literature suggests. Literature has also classified the determinants into various classes which are explored in the following sections. The last section reviews empirical studies on the determinants of FDI in emerging or developing countries and on Sub Saharan Africa in particular.

2.4 FDI THEORIES

A number of theories have been developed in FDI literature. These have subsequently been grouped into micro and macroeconomic approaches. The microeconomic theories focus on firm specific characteristics that influence the decision making of firms, for instance, market imperfections theories. Macroeconomic theories seek to analyse country characteristics that explain FDI flows within and across countries, that is, internalization and product cycle theories. FDI literature has also tended to review another set of theories in terms of FDI motives, that is, natural resource seeking, market seeking and efficiency seeking FDI. In explaining FDI theories, the aim is to identify determinants of FDI and how each of the factors impacts on FDI.

Hymer (1976) developed the market imperfections theories which aim at explaining behaviour of firms in non-perfect competitive environments, that is, oligoplistic or monopolistic environment. For firms to undertake FDI they need some unique advantage such as technology to compete abroad with local firms who already have locations pecific advantages. Considering the market disequlibrium hypotheses, FDI will be transitory as it acts as an equilibrating force among segmented markets, which will be eliminated through the re-establishing of equilibrium. The disequlibrium is usually found in factor markets i.e. labour markets where FDI flows from high labour cost countries to low labour cost countries (Calvet 1981:45). Cost of labour emerges as an important determinant of FDI.

Market power theories focus on structural imperfections i.e. deviations from purely market determined prices brought about by the existence of monopolistic or oligopolistic market characteristics. Voutilanen (2005:4) shows that firm specific asset power enable MNCs to create impediments to new entrants and thus increase their own power. Therefore certain types of monopolistically competitive companies undertake foreign investment.

The internalization theory of Buckley and Casson (1976) supports the idea that there is a tendency in the economic system to generate sophisticated information and to transfer this information internationally in the form of FDI (Trevino and Daniels 1995:180). The generation and transfer of such information is because there are time and cost savings associated with transferring information internally. Internalization theories concentrate on identifying transactional market imperfections with a focus on the firm’s choice to directly own the foreign assets (Voutilanen 2005:9). The internalization of markets across the boundaries of national markets creates MNCs. Knowledge and expertise are the important factors in imperfect markets.

Vernon’s (1966) product life-cycle hypothesis postulate that firms engage in FDI at a particular stage in the life-cycle of products that they initially produced as innovations (Moosa 2002:38). Innovation and economies of scale are then used to explain the product cycle. The theory is production oriented, focusing on the production of industrial goods in manufacturing sectors. New products or initial production takes place in a domestic developed country because of high per capita income, easy access to markets and efficient communication process (Kim and Lyn 1987: 54). Other countries are served initially through exports and as a customer base is established, then production would follow. The maturity stage takes place when production methods are standardized and markets are saturated in emerging and less developed countries. According to Moosa (2002:39), FDI takes place as production costs become an important factor and this is the case when a product is standardized and in the maturity stage. From these theories, three factors emerge i.e. market size, cost of labour and openness.

Eclectic theory attempts to answer the question of why a firm would want to produce in a foreign location instead of exporting or entering into a licensing arrangement with a local firm (Lim 2001:10). According to Dunning (1988) three conditions must be satisfied for a firm to engage in FDI and these are ownership, firm specific assets or internalisation and locational advantages which subsequently came to be known as the eclectic theory or OLI paradigm.

Ownership advantage entails technological advantages, size and access to raw materials as well as comparative advantage over other firms arising from the ownership of some intangible assets (Moosa 2002:37). Location advantage applies where expansion by a firm is best accomplished either at home or in a foreign country. Countries might have advantages such as size of local market, availability of resources, government incentives and other location variables. Voutilanen (2005:7) emphasizes the importance of superior production processes, cheap labour and nearness to customers as factors that make production by MNCs preferable in host countries. Focusing on internalisation advantages multinationals choose between accomplishing expansion internally or alternatively selling the rights to means of expansion to other firms (Moosa 2002:37). The eclectic theory brings out a number of determinants of FDI and these include market size, cost of

labour, government incentives, and access to raw materials.

2.4.2 FDI motives

Some authors such as Narula and Dunning (2000) identify the motives of FDI in foreign countries to be natural resource seeking, market seeking and/ or efficiency seeking, Determinants of FDI are discussed using this framework. Resource seeking FDI is related to the presence of natural resources. Loots (2000:12) suggests that resource or factor driven FDI includes the availability of low cost unskilled labour, skilled labour and quality of physical infrastructure as determinants of FDI. Given the abundance of natural resources in Africa, a greater amount of FDI would be expected to be in the primary sector. For instance, FDI to less developed countries such as Chad, Equatorial Guinea, Angola and Sudan which are resource abundant is manly in petroleum exploration (Moolman et al 2006:5).

The main objective of market seeking FDI is to serve domestic markets, which means that goods are produced in the host country, and sold in the local market. As a result this type of FDI is driven by domestic demand such as large markets and high income in the host country (Asiedu 2002:109). Market size, wage levels and growth become essential characteristics for countries which host market-seeking FDI. Market seeking FDI is also referred to as horizontal FDI since it usually involves building similar plants in a foreign location to supply that market (Lim 2001:11).

Hawkins and Lockwood (2001:21) assert that efficiency seeking or cost reducing investment is undertaken by MNCs to provide more favourable cost bases for their operations. Efficiency seeking FDI aims to minimise costs in the use of factors of production at an international level. The focus is on the prospect of lowering costs through utilizing government-induced structural imperfections, such as tax differentials, or reducing risks through diversification of production. The focus is on the productivity of labour, the cost of resources, input costs and the participation of regional integration frameworks. Efficiency-seeking FDI tends to be located in countries with skilled, disciplined workforces and good technological and physical infrastructure (Hawkins and

Lockwood 2001:21).

Both market seeking and efficiency seeking may tend to cluster in a certain location, also known as the agglomeration effect. It could be as a result of linkages among projects, which then creates incentives to locate close to other firms. In another way, as Lim (2001:11) points out, clustering may occur if MNCs exhibit "herding behaviour", i.e. when firms are uncertain whether a country is a good location, they may wait for the success of the first firm (as a signal for the suitability of underlying national conditions) before entering the market. This could also suggest that one of the determinants of FDI could be in the form of past FDI.

It should, however, be noted that FDI is not always good for the host country, particularly resource seeking FDI, because it could imply low value adding activity and low capital expenditure on plant and equipment with the exception of extractive industries (Narula and Dunning 2000:151). Furthermore, the kind of FDI a country might want to attract depends much on its stage in the investment development path. MNEs should thus be encouraged to invest in higher value adding activities which could come in the form of market seeking and other asset exploiting activities (Narula and Dunning 2000:160).

The theoretical framework above suggests a list of factors that may be important in affecting FDI such as distance/transport cost, market size, agglomeration effects, factor costs, fiscal incentives, business/investment climate, political and economic stability, trade barriers/openness and infrastructure quality.

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2.1 Foreign direct investment theories and motives

FDI is an important factor in the growth in international flows of goods and capital. It also steps up the interaction between states, regions, firms and also pushes interconnected economic activity across boundaries. According to IMF Balance of Payments Manual (paragraph 359, fifth edition, 1993) and Benchmark Definition of foreign direct investment (page 7, third edition, 1999), FDI is defined as "the category of international investment that reflects the objective of a

resident entity in one economy obtaining a lasting interest in an enterprise resident in another economy". The notion of "lasting interest" contained two criteria:

- The existence of a long-term relationship between the direct investor and the enterprise.

- The significant degree of influence on the management of the enterprise.

As two criteria mention, direct investment is the foreign direct investor owns 10 percent or more of shares or voting power of a firm located in a foreign economy. And it gives him or her right to take a part in management or control. Two main modes of FDI were mentioned by Johnson (2005): Greenfield and Brownfield FDI. The term of Greenfield refers to the case when multinational enterprises (MNEs) build new facilities in the host country. However, Brownfield FDI involves merging with or acquisition an existing firm in the host country to reconstruct by

MNE.

Three main theories of FDI are noted by Morgan and Katsikeas (1997). There are market imperfections theory, international production theory, and internalization theory. The market imperfections theory implies that firms seek for market opportunities and their decision to invest overseas is explained as a strategy to capitalize on certain capabilities not shared by competitors in foreign countries (Hymer, 1970). Nevertheless, this theory does not mention why firms produce products or services in particular countries for world markets. Hence, Dunning (1980) and Fayerweather (1982) presented the international production theory.

Two indicators are taken to be considered to international production theory; there are the particular attractions of its home country compared with resource implications and advantages of locating in another country. As Markusen andVenables (1999) mentioned, international economic activity implies foreign production and intra-firm trade by multinational firms. With

low transportation costs and widely available communication technology, firms tend to increasingly use low cost production locations to supply raw materials and final goods or services. In addition, nations which are near to the markets are more attractive for firms to invest in and concentrate on their production. Moreover, overseas investment activities are not only determined by resource differentials and the advantages of the firm, but also host government actions may effect to attractiveness and entry conditions.

The third FDI theory was introduced by Morgan and Katsikeas (1997), which was internalization theory. Internalization states expanding the direct operations of a firm and brings under common ownership and control the activities lead by intermediate markets that connect the firm to customers. It is the ultimate form of FDI. Besides producing internationally, this theory implies that sales, marketing and other activities of the firms should be shifted to an exporting country.

According to the life cycle theory which was presented by Vernon (1966), there is a strong connection between international comparative advantage and FDI. The characteristics of the product change as a product moves through the product-life cycle. It implies that optimal location for production also changes over time. When innovations are turned to actual products, the product-life cycle begins. In consequence of the high level of income and demand, increasing rivals finally pushes production to move from the high income economies or developed countries to lower income economics in order to minimize production costs. Exporting the product from low income, in other words, from developing countries to the rest of the world is an efficient way to satisfy the demand.

Dunning (1979 and 1981) introduced the theoretical background on FDI which is "eclectic (OLI) paradigm". Based on this theory, before deciding to undertake FDI, three conditions that needs to be fulfilled: (1) Ownership advantages, what firm should have in the host country over its competitors. Ownership advantages are usually concerned about intangible assets such as patents, brand name, know-how, etc. (2) Internalization advantages: the case when a firm seeks more benefits to internalize its advantages instead of exchanging them through licensing, alliances or other contracts. (3) Locational advantages that make a firm decide to have production oversea rather than exporting. If ownership and internalization advantages give a firm opportunities to move to different regions, locational advantages belongs to country particular. For that reason, this study concentrates on identifying the host country characteristics that promote FDI inflows.

Every multinational corporation before undertaking FDI considers different locations with various factor endowments. The decision of specific location choice is based on the motives for FDI. According to Dunning, there are three motives for MNEs to invest into foreign country. They are: market-seeking, resource-seeking and efficiency-seeking.

The motive behind market-seeking FDI is to exploit the new markets. A market-seeking company invests in a host country in order to serve its demand for goods. In this case the same production activities are replicated in several locations to satisfy the local de-mand, resulting in horizontal FDI. The main factors that encourage this type of FDI are market size and market growth of the host country; the access to regional and global markets, the market structure.

A firm with the resource-seeking FDI invests in the foreign country order take advan-tage of its natural resources or agricultural production. While market-seeking FDI is de-signed to serve only the local market, resource-seeking type of FDI is intended to serve the local, home and third country markets. The main determinants of resource-seeking FDI include natural resources, raw materials and complementary factors of production.

Efficiency-seeking FDI is described by investments undertaken in order to minimize production costs. It takes place when market-seeking investments as well as resource-seeking investments have been already realized. This type of FDI is considered to be a vertical investment and include: sufficiently skilled labor, business related policies, trade policies and physical infrastructure (Dunning, 1997).

Although Dunning’s OLI Paradigm provides rather clear explanation of motives behind multinationals’ decisions to undertake FDI, the theory however lacks the discussion of strategic behavior by MNEs and especially location strategy. In the present economy, where the competitive advantage is the crucial element for a strong position in the market, it is recognized that the main source of advantage comes from the management of the firm’s dynamic capabilities (R&D and design), making knowledge activities increasingly important for firms. Therefore, according to Le Bas (2007), the choice of location is the key element for understanding how MNEs build and maintain their knowledge activities and hence, competition in the market (Le Bas, 2007).

2.2 FACTORS INFLUENCING FDI FLOWS

The history of African countries in general has formed a negative image for investors (Bartels, 2012), which is a direct influence on FDI flows. Unstable situations in the countries do not stimulate the investment climate. Indirectly the history of Africa has shaped the determinants of FDI, such as productivity, infrastructure, human capital, economic stability, more on. The history has also caused some specific determinants of FDI for Sub Saharan Africa. Investors are aware for poverty, unsafety, low productivity and risks. However, countries try with FDI policies to stimulate investments and also some macroeconomic factors can influence FDI inflow positively, for example the abundant resources of Africa.

2.2.1 Market Size and Growth Potential

Market  size (measured by GDP) and  growth  have  proved  to  be  one  of  the  most  important  determinants of  FDI  (Krugell,  2005) and for the most dominant long-run determinants of FDI in SSA Bende-Nabende  (2002).  The argument goes that an increased market size is therefore expected to attract increased levels of FDI. (Pentecost & Rascuite, 2008:3). Thus FDI could be an explanatory variable for GDP growth (Chowdhury and Mavrotas, 2006 ,Wahid et al., 2009:5) . MNCs choose to invest into markets with high GDP to substitute for exports. They produce final goods in the local market for the local demand. Such affiliates require high fixed costs and to make the production worthy, the market has to be big enough to bring the production costs down through economies of scale (Lim 2001). Bhattacharya  et  al.  (1996),  Elbadawi and  Mwega  (1997),  Morisset  (2000)  and  Onyeiwu  and  Shrestha  (2004)  find  evidence  for  the importance  of  economic  growth  in  attracting  FDI  flows  to  Africa. Banga (2009) found a relationship between FDI and market size for both developed and developing countries and it is also an important determinant for the strategy of market-seeking firms. However in the case of the selected Sub Saharan Africa countries real GDP will be used to approximate the potential size of the market.

2.2.2 Exchange Rate Valuation

Before any further argument it is important to name that expected exchange rate is the one affecting firms’ decisions. The instability of exchange rates is also an indicator considered in assessing the riskiness of a country (Ajayi, 2006:37). However, it is not always the truth for frequent and continuous declines in the value of host currency (Accolley et al, 1997), because we know that capital is more like to arrive in a stable environment (Bussea & Carsten, 2005). The empirical work done on the effect of exchange rates on FDI is disputed. There is some evidence that FDI is more stable over time than the other forms of capital flows despite the volatility of exchange rates (Blonigen, 2005). It certainly depends on the engagement and long-term goals that foreign direct investment involves. However, there are researches that have proved the exchange rate being important for FDI flows and especially the timing of investments (Blonigen, 2005).

2.2.3 Labour Cost

One of the highest costs in the production of goods tends to be labour. It therefore stands to reason that if a corporation has the opportunity to produce goods in a country at cheaper labour rates it would serve as motivation to invest in such a country (Wang and Swain (1995), Pentecost & Rascuite, 2008:3). That is why Labour costs is a major determinant for resource-seeking multinationals. Since resource seeking FDI aims at reducing production costs it is obvious that higher labour costs should affect FDI negatively. However it is a complex variable that depends on several factors. Bellak et al (2008) make an informative review of the research on labour costs as a determinant of FDI. The majority of the papers prove labour costs to be negatively significant on FDI while others find the variable to have a positive effect. The explanation given for the positive effect of labour costs on FDI is either flawed data or underlying factors that affect labour costs. Golub (1995) discusses labour costs and uses similar analysis. Empirical studies performed shows that an increased flexibility in the labour market results in improved FDI inflows (Javorcik & Spatareanu in Pajunen, 2008:654) and for this reason considered an applicable determinant to compare. This is not only the case for developing countries, also developed countries with high labour costs have more and more difficulties to attract FDI, largely depending on the motive of foreign direct investment.

2.2.4 Human Capital

Human capital plays an important role in the location decision of foreign investors. Usually FDI is viewed as a channel of spreading knowledge and technology into host countries which contributes economic growth positively (Varum, 2011). Human capital and FDI are both drivers of economic growth, but little evidence has shown about the effect of human capital on FDI. This relationship is decisive as human capital is a determinant of FDI. Majeed (2008) argues that higher quality human capital improves the investment climate and attracts FDI. Also other scholars (Noorbaksh et al, 2001; Nunnenkamp, 2002) argued the increased importance of human capital, especially among efficiency-seeking firms (Noorbaksh, 2001). Important to note is that only recent studies have found evidence for this relationship. In the 1960s and 1970s, when FDI inflows were concentrated on market- and resource-seeking motives, no relationship was found (Majeed, 2008). This does not necessarily mean that human capital quality does not have its influence on market- and resource-seeking FDI. However, an important aspect of human capital is that there is a threshold, before the country can benefit from FDI. If companies only come to the countries to use the worst educated people for their production and pay them a paltry amount, the country will not profit from the FDI (Varum, 2011). In a panel data analysis over Chinese provinces Basu and Yao (2009) find that human capital is affected by FDI inflows. It is as well consistent with the theory because MNCs bring spillover effect to host economies in form of new technology, means of production and management. High human capital is however an important incentive for FDI producing advanced goods and is thus going to be included in the empirical model.

2.2.5 Trade Openness

Several studies have established that open economies encourage the inflows of FDI. For example, studies by (Culem (1988), Edwards (19990) and Singh and Jun (1995) have show that a

significant positive relationship exists between openness and FDI inflows. Easterly and Kraay (2000), also, argued that small economies do not have lower growth rates than their larger counterparts because of their openness. In the literature the openness of a country to trade is measured as the ratio of trade (exports + imports) to the country’s GDP.

2.2.6 Corporate Tax Rates

Corporate tax rates allow for ease as well as comparability of analysis across both a range of countries and time periods. The use of lower tax rates as an incentive is also fairly simple from an administrative view (Bolnick, 2004:82). The majority of studies conducted indicate that an inverse relationship exists between corporate income tax rates and FDI inflow. Wijeweera and Mounter (2007:140) assessed the effect that a change in tax rate had on Australia’s FDI inflow over six-year period and found that decreased tax rate lead to increased levels of FDI. The same result was noted in a 207 study performed on the United States (Clark, Dollery & Wijeweera, 2007:116) and confirmed to be applicable to African countries ( Stapper, 2010:61).

2.2.7 Infrastructure

Several scholars have proven the importance of a reasonable physical infrastructure (Velde, 2006; Tran, 2009; Chakrabarti, 2012; Khadaroo, 2009) as a major macroeconomic factor that heavily influences doing business in a country. For doing business in a foreign country it is important that the infrastructural level is high enough to run the company efficiently. Like Khadaroo (2009) stressed on the importance of physical infrastructure in Africa. Theoretical and empirical literatures on the impact of infrastructure are also divided. Ang (2008), Asiedu (2006), and Onyeiwu and Shrestha (2004) find that the relationship between the level of infrastructure development and FDI flows is significantly positive, whereas Marr (1997) argues that the prevalence of poor infrastructure in the areas of road, rail system, electricity and telecommunication, can create an incentive for the flow of foreign investments.

However, the findings of Onyeiwu (2004) put the role of physical infrastructure in perspective. He recognizes the dominance of resource-seeking FDI and explains that this type of investment does not rely on infrastructure, because the resources are often located in remote areas where the

infrastructure is poor anyway. For market-seeking FDI, infrastructure is more important, but not

more in Africa than other continents.

2.2.8 Political instability

FDI is a particular form of investing because it binds the investing company to the laws and politics of the host county. A good example of relatively strong rule of law has proven by Barthel (2008) in a study about Ghana, where abundant natural resources are attractive for foreign investors, and the political stability has been key to attracting sustainable investment. They attach value to market size and growth, resources, but political environment in particular. In this study there has also been proved that small entrepreneurs attach more value at political stability and protection than large entrepreneurs like NGOs. Each company planning to invest in a host country has some negotiating power and can affect the conditions of investing. However FDI remains uncertain because MNCs are unable to prevent the political environment from changing later on (Azzimonti and Sarte 2007). The expected role of institutions is to produce public goods that otherwise would not exist (Blonigen, 2005). The World Bank (2010a) performed a study on 213 countries in which they assessed the political stability of countries allowing the countries to be rated from 0 to 100, 0 being perceived as excessively politically unstable.

2.2.9 Corruption

Corruption is the highest constraint for foreign investors according to some scholars. The direct relationship between corruption and FDI is studied by Habib (2002) and he proved that entrepreneurs try to avoid corruption. The reasons are both ethnically and economically. Previous researchers (such as Habib & Zurawicki, 2002 and Al-Sadig, 2009) predict that corruption scares away foreign investors because it is considered illegal, and because it leads to operational inefficiency. However, Egger and Winner (2005) theorize that corruption, acting as a helping hand, can sometimes be an incentive for inward flow of FDI. Habib (2002) also stressed the different impact of corruption depending on the size of the company. Especially small sized companies have difficulties to overcome corruption. Asiedu (2006) emphasized the role of corruption in Africa as major constraint for FDI and therefore is a determinant of FDI in Sub-Saharan Africa. Using 73 developed and less developed countries and for the time period 1995–1999, they find a positive relationship between corruption and FDI, and conclude that corruption can indeed be a stimulus for some kinds of FDI.

2.2.10 Financial Development

Unfortunately, financial systems in the SSA region generally match the description of underdeveloped systems. The systems are characterised by limited financial products and financial innovation, wide interest rate spreads, weak legal systems, and pronounced market fragmentation (Ncube, 2007; Beck and Hesse, 2009). In his study of a group of low income countries, Marr (1997) confirms that the financial systems in SSA economies are characterized by inefficiencies, lack of depth and transparency and absence of regulatory procedures.

Along this line, Zukarnain Zakaria (2007) carries out a systematic study to determine whether a causal relationship exists between FDI and the level of financial development. The author uses data from 37 developing countries for examining this causality in a multivariate framework. The findings from causality tests provide little support for the hypothesis that the inflows of FDI can contribute to the development of the domestic banking sector in developing countries. This study also finds that FDI has no effect on the development of the domestic banking sector. In contrast, the author finds strong support that FDI can affect the development of the domestic stock markets in the developing countries, and vice versa.

2.2.11 Regional Integration (RI)

The effects of trade and economic integration on levels of FDI are going to be considered jointly because they depend on each other and are difficult to separate. The two variables belong however to the different motives of FDI. Market-seeking outsider investors hope to enter the markets with a high level of economic integration so that they can reach several economies from one country. They are not affected by the trade within the union or with a third country because as soon as they make their first horizontal investment in the union they obey the same rules as the insiders and can expand within the region. Resource-seeking outsider investors are more concerned about the outcome of economic integration. Vertical integration is based on transport costs that are low enough not to offset cheap labour costs (Sayek, 2009). Reduced trade with a third part increases trade costs of the intermediate goods and makes the foreign direct investment in the host country less worthy.

2.2.12 Government Policies

The earliest studies by Bond and Samuelson (1986), Black and Hoyt (1989), Haufler and Wooton (1999), and Haaland and Wooton (1999) argued that there are strong links between MNC strategy and government policy in host countries.In Sub-Saharan Africa governmental factors are concerned to be crucial. Often, investors cannot rely on the bad organized governments and the related political instability. Policy factors can be a result of weak governments, but are not specific African problems. However, Asiedu (2006) already argued that Africa in particular has problems with policy determinants and the extent of the fact that an unstable government is a barrier for FDI is not as high as expected.In a 2007 International Monetary Fund piece, published in the Journal of Comparative Economics the authors find that the policy environment (including fiscal policy) does have a significant effect on levels of FDI.

2.2.13 Natural resource availability

Moolman et al (2006:5) show that a number of African countries i.e. Chad, Equatorial Guinea, Angola and Sudan have received significant FDI flows due to the availability of natural resources. This is because FDI in these countries is usually natural resource seeking. Natural resource seeking FDI also aims at exploiting cheap labour. Therefore, the more abundant are natural resources and access to raw materials the more FDI would flow, signalling a positive relationship.

2.3 Determinants of FDIs – Empirical Literature

There has been an extensive body of empirical studies trying to explain "why some countries were more successful than others in attracting FDI" (Moosa & Cardak 2003). This plethora of empirical studies have tested and explored the effect of a range of macroeconomic determinants including GDP, GDP growth rate, real GDP per capita, exchange rate policy, openness of the economy, financial stability and physical infrastructure among others. There have also been studies dealing with the impact of socio-political factors such as political stability, education, corruption, political freedom etc., on FDI flows (Dar et al., 2004).

Asiedu (2002) assessed the determinants of FDI in developing countries. The main objective of the study was figuring out whether the factors that affect FDI in developing countries affect African countries specifically Sub-Saharan African. There were 71 countries selected for this study (32 were Sub-Saharan African countries and 39 were non Sub-Saharan African countries). Cross sectional data were used for the period from 1988 to 1997. OLS method was employed to analyze the data. The variable FDI was used as dependent variable and return on investment, infrastructure development, openness of the host country, political risk, financial depth, size of government, inflation rate, and GDP growth rate used as explanatory variables. The study result shows that trade openness has positive impact on both Sub-Saharan and non-Sub-Saharan Africa. However, Sub-Saharan Africa received less FDI than non Sub- Saharan African. This is because, as Asiedu (2002) argued, Sub-Saharan Africa countries are less open than other regions. While infrastructure development has positive impact on the FDI inflow in non sub-Saharan Africa, it has no significant effect on sub-Saharan Africa. The study suggests that the same policy cannot be effective in different regions.

Wint and Williams (2002), Thomas et al (2005) and Wijeweera and Mounter (2008) have been using economic factors such as the target country’s market size, income level, market growth rate, inflation rates, interest rate and current account positions to explain the determinants of FDI. They found that a positive interest rate differential assist in attracting FDI inflows as MNCs get the incentive to invest in foreign countries with positive interest rate differential barring the fact that there is no major fluctuation in the exchange rate. In the same vein, Cleeve(2008) using a multivariate regression model for 16 Sub Saharan Countries and trying to capture economic stability through the proxy (nominal exchange rate adjusted deflator), has shown that this variable is statistically effective.  

Rogoff and Reinhart (2002) and Wint and Williams (2002) show that a stable country attracts more FDI implying that a low inflation environment is desirable to promote capital inflows. Ali and Guo (2005) and Choudhury and Mavrotas (2006) have indicated that there is a strong relationship between the money growth acting as a proxy for financial stability in the host country and its effects in attracting FDI. Asiedu (2006) using a panel data for 22 Sub Saharan African countries has also shown that inflation rate depicts a negatively and statistically significant effect. However, under Mhlanga et al (2010) multivariate regression model for 14 SADC countries (Southern African Development Community), the inflation rate independent variable does not have any effect as it is statistically insignificant.

In terms of the importance of capturing human capital development, both Asiedu (2006) and Cleeve (2008) made use of the percentage of adult literacy and secondary school education index respectively. Both indicators have proved to be not only positive (that is higher stock of human capital will increase FDI) but also statistically significant.

 

It goes without saying that in order to attract FDI, economic liberalization is important both internally and externally. This has been translated in several empirical studies even for SADC countries and Sub Saharan African countries from Cleeve (2008) and Mhlanga et al (2010). The famous proxy used for openness of the economy, remains the total value of exports plus imports divided by the level of national income (GDP) although Asiedu (2006) uses an openness index from the International Country Risk Guide which also proved to be positive and statistically significant.