Dterminants of FDI in developing countries

Determinants of Foreign Direct
Investment in Developing
Countries
A Focus on Sub Saharan Africa Countries and the Role of Public Governance
International Master in Public Finance – 2019/2020
Alessia DE SANTO, Camilla FIORINA

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Table of contents
1. INTRODUCTION AND LITERATURE REVIEW 3
2. PUBLIC GOVERNANCE AND FDI 5
3. DATA AND METHODOLOGY 6
4. DESCRIPTIVE STATISTICS 9
5. MODEL SPECIFICATION 14
6. RESULTS 16
6.1 Sub Saharan countries 18
7. CONCLUSION 21
APPENDIX A 23
REFERENCES 25

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1. Introduction and literature review
Foreign Direct Investments are a global phenomenon which has displayed remarkably constant
growth over the last decades. As reported by Buchanan et al. (2012) the worldwide flow of FDI has
grown by 19% between 1996 and 2006, which is more than double than the 8% growth in the
international trade of goods and services.
Developing countries have been increasing recipient of FDI. While multinational companies benefit
from lower production costs, developing countries are eager to attract FDI inflows, as they play an
important role in nourishing their growth. First, they represent a vital source of funds which creates
job opportunities and increases income. Moreover, productive activity from multinational
enterprises often brings technical and managerial expertise, boost R&D activity and facilitate the
spread of new technologies, contributing in the reduction of the technological gap between
developed and developing economies.
This has led most of developing country to undertake steps to attract high FDI inflows. However,
developing countries differ widely in their ability to attract FDI.
The favorite destination for FDI in the latest decades has been BRIC countries (Brazil, Russia, China
and India) which are very dynamic economies and have been displaying very high growth rates since
the 1990s. In particular, China has been the major FDI recipient in the last 30 years, followed by
India, which according to UNCTAD (2007) is the second most preferred FDI destination.
Countries from Sub Saharan Africa, which are traditionally at the bottom of investors’ preferences
according to the UNCTAD, have registered a more than six-fold increase in FDI inflow since 1996
(Buchanan et al., 2012). The region’s FDI to GDP ratio has improved significantly in the current
century: Azemar and Desbordes (2009) report that, between 1984 and 2004, the median FDI to GDP
ratio was less than 1% in the SSA region, compared to almost 2% in South East Asia and Latin
America. In contrast, we find that over the period 1999-2014, median FDI values represented
around 3,8% of GDP, overcoming the median value for Asian economies – of about 3,2%.
Despite this substantial growth, the SSA region still lags behind in terms of quantity of FDI received
compared to the rest of the world (Figure 1).
While many scholars have been investigating on the basic determinants of FDI, no consensus seems
to have been reached, meaning that there is not a universally accepted set of variables which can
be considered as the true determinants of FDI, especially for developing countries.
As reported by Kumari and Sharma (2017), the existing literature has considered as the
determinants of FDI volumes mainly the following set of variables: market size, trade openness,
infrastructure, return on investment, real labor cost, human capital, exchange rate, inflation,
political risk and government incentives. Most of the studies have found that market size, trade
openness and infrastructure play a positive role in attracting flows of FDI (Na and Lightfoot (2006);
Quazi (2007); Hoang and Goujon (2014)). Others, as Buchanan et al. (2012), find evidences in
support of the centrality of quality of institutions in attracting FDI, concluding that the traditional
policy recommendation of “offering the correct macroeconomic environment” would be ineffective
without adequate institutional reforms.

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Figure 1 - net FDI inflow (1998-2014)
Source: World Bank Development Indicators. See table 1 in Appendix A for the complete list of countries included in the analysis.
Only a limited number of studies has investigated the sources of the high disparity between SSA
countries and the rest of the world.
Asiedu (2002, 2006) analyzed a panel of 34 SSA countries over the period 1980-200 and confirmed
the importance of market size, infrastructure, trade openness and institutional framework.
Azemar and Desbordes (2009) grouped all the previously mentioned variables under four indicators
of public governance; they perform a panel analysis over a sample of 70 developing countries and
conclude that reasons for the gap in FDI inflows between SSA countries and other regions can be
mostly find in market size and low human capital accumulation. To be able to draw this conclusion,
they first estimate a fixed effect panel model over the entire sample and include a second stage of
the analysis where they decompose the sources of the FDI gap between SSA region and the rest of
developing countries.
Following a similar methodology to that of Azemar and Desbordes (2009), this paper provides an
analysis of the main determinants of FDI based on a more recent dataset, covering the period 1998-
2014 for 66 developing countries. While the study is performed over a sample including developing
countries from all regions, the focus will be, as in Azemar and Desbordes, on investigating the main
factors that drive the disparity of SSA countries in inbound FDI volumes. Because of the important
improvement in FDI volumes directed toward SSA countries, we believe that it would be meaningful
to perform an analysis of FDI determinants over a more recent period of time, to investigate for
possible new dynamics compared to those highlighted in Azemar and Desbordes and the previous
literature.
The remainder of this paper will be composed of the following sections. Section 2 details the four
dimensions of public governance and how they can impact the level of FDI inflow into developing
countries. Section 3 presents the database on which the analysis is performed. Section 4 includes a
graphical representation of the data and the related descriptive statistics. Section 5 define the
econometric model and section 6 report the estimation’s results. Section 7 concludes.

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2. Public governance and FDI
The OECD defines public governance as “the formal and informal arrangements that determine how
public decisions are made and how public actions are carried out, from the perspective of
maintaining a country’s constitutional values when facing changing problems and environments”.
Public governance plays and important role in influencing the investment decisions since it is
fundamental in designing the necessary rules that will make a country institution trustworthy.
Azemar and Desbordes (2009) distinguish four dimensions of public governance at a
macroeconomic level: the degree of democracy, provision of public good, macroeconomic policies
and security of property right. The following section is dedicated to detail these different dimensions
and discuss their expected effect on FDI level.
The first dimension which is taken into account is the degree of democracy, a form of government
where, thanks to free and competitive elections and the existence of check and balances
mechanisms, governors are elected by citizen and directly accountable to them. Level of democracy
is expected to have a positive effect in attracting foreign capital.
First, democratic states offer more both political and economic stability – in that, for example, they
allow citizens to express dissatisfaction by denying votes to politicians instead than through the use
of violence. Moreover, from an ethical point of view, multinational corporations prefer to invest in
democratic countries, in order not to compromise their image.
These hypotheses are empirically supported. A number of studies (e.g. Busse (2004) and Jakobsen
& De Soysa (2006)) demonstrate that, since the beginning of 1980s, countries which ensure higher
levels of political and civil freedom to their citizens attract higher FDI flow.
Provision of public good is a central dimension as it includes public supply of infrastructure, which
previous literature proved to be an important determinant of FDI: better infrastructures provide
more investment opportunities for companies and facilitate their operations, making them more
eager to invest in a country which offers a dense network of infrastructures and good telephone or
internet coverage.
Moreover, governments are the main provider of health and education, thus determining the level
of human capital of a country. As previously mentioned, higher average human capital often
corresponds to larger FDI inflows. Indeed, as higher human capital improves productivity, it lowers
unit labor costs, therefore decreasing productions costs for multinationals.
Section 1 mentioned some econometric studies which report evidences of a positive and significant
effect of infrastructure and human capital in determining FDI volume into developing countries.
The ability of governments to maintain a favorable and stable macroeconomic environment - mainly
by the use of efficient and sound macroeconomic policies - can play a major role in attracting the
attention of foreign investors. Indeed, volatile inflation and exchange rates or high debt to GDP
ratios increase uncertainty over the feature and consequently investment cost, making companies
desist from investing. Degree of market openness can as well have an impact on inflow of foreign
funds, as it facilitates exports and imports for companies that delocalize their production process in
different countries – as it is often the case for multinationals.
A number of studies have proven empirically that multinational companies favor stable countries to
direct their FDI. Among others, Cevis and Camurdan, (2007) find a negative and significant impact
of inflation on inbound FDI in developing countries. Asiedu (2002) shows that a positive and
significant relation exists between FDI and degree of market openness.