The African Financial Review July-August 2014 | Page 42

FDI - Economic nexus: foreign direct
investment financial sector development
and economic growth
By Ibrahim Dolapo Raheem and Mutiu Abimbola Oyinlola

This study examines the relationship between foreign direct investment (FDI) and economic growth
considering the influence of financial sector development (FSD). We empirically determine the threshold
level of three FSD indicators that would ensure the positive association between FDI and growth
once these threshold levels are exceeded. The policy implication of this study is that policies directed
towards attracting FDI should go along with and not precede policies that aim at promoting FSD.
Introduction

In recent times, developing countries, especially in Africa, see
the role of foreign direct investment (FDI) as crucial to their
economic growth and development. FDI is viewed as an engine
of growth as it provides the much needed capital for investment,
increases competition in the host country industries, and aids
local firms to become more productive by adopting more efficient
technology or by investing in human and/or physical capital.

In absolute terms, the global flow of FDI in 2007 was
estimated to be about $1.9 trillion which was the highest the
world ever recorded. The reason for this is not farfetched as it was
due to the financial crisis which led to global disinvestment. This
assertion can be backed by the fact that as at 2010, the flow was
estimated to be about $1.2 trillion after a drastic decline in the
global flow in 2009. After a 16 per cent decline in 2008, global
flow fell further by 37 per cent to $1.114 trillion. FDI flows to
the Sub-Saharan Africa (SSA) region have increased since the
beginning of the 1990s. The value of FDI to the region rose from
US$36.7 billion in 1990 to US$108.5 billion in 2000, and stood
at US$336.8 billion as at 2008. In terms of the contribution
to the region’s gross domestic product, available data also show
some noticeable improvement. The FDI/GDP ratio progressively
increased from 12.4 percent in 1990 to 36.2 percent in 2008. It
is also interesting to note that the distribution of FDI flows in
the region is getting even, with 29 out of the 47 countries in the
region recording increase in FDI inflows in 2008 (UNCTAD,
2009).

Despite the increased flow of investment to developing
countries, SSA countries are still characterized by low per capita
income, high unemployment rates as well as low and falling
growth rates of GDP. These are developmental problems that FDI
is supposed to ameliorate to a great extent. An overall evaluation
of the economic performances of African continent and of SSA
in particular has not been impressive over the period under study.
The SSA countries are putting so much effort into attracting
foreign investors and yet the economy is still dwindling in terms
of economic growth. The reason attributed to this fact goes beyond
the major determinants of FDI. This concern is exacerbated by
the conclusion of Asiedu (2002) that what constitutes the drivers
of FDI in other developing regions do not necessarily match
well with the case of SSA countries. Zeng et al. (2002) also
find that policies that have been successful in other regions may
not be so in Africa. Several studies have argued that the non

42 | The African Financial Review

performance of FDI in enhancing growth in Africa can be linked
to the inability of government to develop their financial markets
(Alfaro et al., 2009; Levine et al., 2000; Hermes and Lensink,
2003; Demetriades and Hussein, 1996; Cattaneo and Eheoha,
2011) as the financial position of a country plays a crucial role
in the growth of an economy[1].

Studies like that of Kabalyk (2009), Zadeh and Madini
(2012), Azman-Sain et al. (2010) all argued that there must be a
certain “level” of financial sector development (FSD) compared
to previous argument which advocated for FSD without recourse
to value specification. The condition at which break-even effect(s)
of FDI can be felt on economic growth is a situation where an
economy at least reaches a certain threshold of FSD and once this
level is exceeded, the positive effects of FDI starts to kick-in until
then the benefits cease to exist. Despite this flow, questions that
need to be asked are: why does FDI have positive impact on the
growth process of the Asian Tigers[2] while the case is different
in the African context? What are the reasons attributed to the
fact that non Asian Tiger countries (Brazil, Malaysia, and India)
record positive effect of FDI on growth and countries in most
SSA do not? Could the answer to these questions be linked to a
well-developed financial market? These questions become crucial
following the findings of previous studies like that of Levine
(2000) and Alfaro et al. (200 3).

It is the objective of this study to determine the level of
FSD that will ensure positive effect(s) of FDI on growth once
this threshold level is reached. Hence, we adopted Threshold
Auto Regressive (TAR) developed by Hansen (2000). The scope

Despite the increased flow of investment to
developing countries, SSA countries are still
characterized by low per capita income, high
unemployment rates as well as low and falling
growth rates of GDP.
of this study which is dictated by availability of data is based on
time series data for fifteen countries in SSA and the time frame
of 1970-2010. To the best of our knowledge, this will be the first
attempt to capture this relationship in SSA countries. Studies like
that of Azman-Saini et al. (2010), Liao and Huang (2009) and
Girma (2003) all extracted data from both set of countries thus
violating what can be called “empirical principle”. Besides, since