The effect of financial deepening on FDI inflows to some selected African economies

Abstract

There are copious research studies that attest to the fact that foreign direct investment inflows through MNCs and portfolio investments, among others, lead to positive externalities and economic augmentation in destination countries, especially for developing countries of which Africa features prominently. Even in the face of abundant resource, which the continent can leverage to attract FDIs, Africa still attracts far fewer inflows compared to other countries in the global FDI offerings. To understand the reasons for which less developed, developing, and emerging economies receive less foreign direct investment inflows, numerous empirical studies have been conducted. Some studies have uncovered lack of absorptive capacity and strong macroeconomic stance as the mitigating factors interrupting developing economies from achieving high FDI levels. However, having identified some countries as suffering from these defects but still attract FDI inflows thus brings to the fore, the suitability of these hypotheses. This consideration sets the tone in searching for several alternative indicators that can influence foreign direct investment inflows to Africa and largely, developing economies. The current study seeks to uncover the impact of financial deepening on inflows of foreign direct investment to African economies. As several studies have revealed, the inflows of FDIs to destination economies present positive externalities, which include economic augmentation, technological advancement, labour skill set enhancement, better product offerings and influences the growth of domestic enterprises, among others. For this, we undertake this study to uncover the role of financial deepening in moderating foreign direct investment to Africa. Thus, the study utilises variables on financial deepening and nuances reasons for foreign direct investment inflows in the sampled countries. Several studies suggest that foreign direct investment goes to economies endowed with developed infrastructure, abound with natural resources and skilled labour force. The effect of financial sector deepening on foreign direct investment inflows is seldom researched. Furthermore, there is little research that undertakes a comparative analysis of effect of financial deepening on foreign direct investment and institutional adequacy in a way that combines threshold analysis to uncover threshold level for which FDI is triggered. This study also combines pooled and sub-regional level dataset in various panel analyses. Additionally, none of the literature reviewed is a study in which extended institutional environment variables are incorporated in single research to examine foreign direct investment attractiveness to Africa on sub-regional levels. This study fills that lacuna in the literature. This panel study is based on a dataset from several academic, institutional and policy sources and spans the period 1980 to iii 2018. This study further employed VECM, GMM and threshold analysis using Stata and EVIEWS 10 statistical packages as deemed situationally appropriate. This study found that financial sector depth is an important consideration for foreign direct investment reaching the shores of Africa. Importantly, credit allocation to the private sector from the financial system as a percentage of gross domestic product (PCrBank), monetary aggregates (M2), financial system deposits to GDP (FSD), and stock market variables (EQTYcp) and (STOVR) are significant factors to FDI inflows to the continent of Africa as a whole and the sub-regional levels. Additionally, we ascertain the significant contribution of the institutional environment to the financial deepening process in Africa, specifically, inflation, regulatory efficiency, legal framework and human capital development. In our impulse response function analysis, we observe that a unit deviation disturbance on financial deepening variables triggers movement on foreign direct investment positively to the Africa sub-regional economies under consideration in the short to medium term. But as time elapses, the inflows become greater in the longer term. The results are seen in the sub-regional groupings as well. On the other hand, we record the lower-level effect of the impulse response for some institutional environment variables in the considered Africa economies under review. There is an indication that innovation disturbance on inflation is negative and needs to be managed. Also, improving inflation, law, voice, and political stability proves to be important for financial deepening and foreign investment inflows to the region. We further undertook the granger causality test to examine the impact with which institutional environment could influence the deepening of the financial sector in Africa. Also, private sector credit allocation to GDP (PCrBank) and monetary aggregates to GDP (M2) are observed to granger cause foreign direct investment inflows to the continent. Press freedom and civil liberties (VOIC), law and efficient regulation are found to help in FDI attractiveness. In this study, we find that it is important for African countries to reform their institutions, build absorptive capacity and deepen their financial markets to make them attractive to the inflow of foreign direct investment.