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The impact of FDI inflows on economic growth in Sub-Saharan Africa

Introduction:

The present paper focuses on the impact of FDI inflows on economic growth. FDI net inflows are defined as the inward direct investment value in the reporting economies made by the non-resident investors (WorldBank, 2015). This paper is dedicated to understanding its impact on the economic growth specifically in Sub-Saharan Africa with the help of different theories. The theories selected to analyse the situation is Solow-Swan Theory of Economic Growth and the Endogenous Growth Theories. In addition, the paper also projects the viewpoints of Findley, 1978 and Gerschenkron, 1952, which would explain why theoretically it is expected that FDI inflows contribute positively to the growth rate of the host country and why it might have a negative impact on the host country’s growth rate. Following the theoretical part, a pragmatic analysis was conducted on the empirical tests of the theories to analyse the theoretical perspective and its precision.

Theoretical Perspective: 

Solow-Swan Theory of Economic Growth:

Solow-Swan theory of economic growth given by Robert Solow and Trevor Swan  is an exogenous model that evaluated the long-term problem with the general short-run classical analysis (Knight et al., 1993). The theory proposes that the per capita output growth culminates from the capital accumulation and/or technological progress. According to Solow and Swan, the growth of per-capita output is only achievable through the technological progress immediately as the economy reaches its steady state. It is a simple neoclassical growth model and considered as the benchmark for the neoclassical theory of growth, which intends to offer a theoretical framework to comprehend the idea of worldwide growth output and the perseverance of the geographical dissimilarity in the per capita output.

The Solow-Swan theory is generally a criticism on the Harrod-Domar model that supposed fixed-coefficient production technologies provided model knife-edge equilibria through an unlikely insinuation that the model would be diverged far away from equilibrium if any deviation occurred from equilibrium (Guerrini, 2006). Solow used all the suppositions made in Harrod-Domar model excluding the fixed proportion of input assumption and broadened the model by including labour as the production factor. With the necessity of constant returns to scale and deteriorating returns to labour and capital individually for both factors cohesively, he introduced a time changing technology variable discrete from the labour and capital. Through these assumptions, per capita output in the long-run converges to a stabilised state separately of the primary conditions. With this assumption, the solely possible growth sources maintain the exogenous rise in the primary factors such as exogenously given technological change and population growth.

Endogenous Growth Theories:

The endogenous growth theory given by Paul Romer (1994) was a reaction to the deficiencies and errors of the Solow-Swan theory of economic growth. This theory describes the growth rate of an economy in the end through endogenous factors in contrast to the exogenous factors opposing the Solow-Swan theory. The neoclassical growth model based its long-run output growth rate on the exogenous variables of technological progress rate and population growth rate while being independent of the savings rate. This results in fewer policy implications, however; the endogenous growth theory extends the Solow-Swan theory by introducing the endogenous progress at a rate ascertained by the internal forces of the economic system (Dohse& Ott, 2014). These endogenous factors specifically include those forces that lead towards the opportunities to produce technological knowledge such as policy. Romer (1994) considered three chief constituents in the model defined as externalities. These externalities increased the returns in the output production and diminished the returns in the new knowledge production. He explains that this is spill over from the efforts of research by the firm, which generates new knowledge from other firms’ (Ha& Howitt, 2007). Consequently, the research technology spills over instantaneously around the complete economy.

In contrast, Gerschenkron (1952) claimed that more the country lag in the technology frontier, the average innovation size increases because the gap between the World Technology Frontier (WTF) ideas integrated into an innovation of the country and the ideas ingrained in the old technologies being replaced is larger. This convergence is called the advantage of backwardness because the enhancement in the innovation quantity raises the laggard country’s growth rate until the frontier is eventually stabilised through the separation of the gap. This determines that follower receiving FDIs or importing capital goods makes an investment that represents the generation of latest technical progress. This results in the higher ratio of new to old capital stock in the followers’ economy compared to the leaders, which gradually increases the per person growth of output. With time, the follower than catches up with the leader and the gap declines between incomes per capita while the two rates of growth converge (Dohse& Ott, 2014).

Alternatively, Findlay (1978) proposed that the technology diffusion growth rate is the increasing function of FDI. Findlay characterised the inputs into domestic capital (a developing country) and foreign capital (a developed country) and argued that a rise in the foreign capital elevates the domestic capital. In addition, he pointed out that technological transfer rate is a decreasing function of the FDI share and technology gap in the entire capital stock of a developed country.

Summary:

As a whole, the Solow-Swan model is based on exogenous factors while the endogenous growth model focuses on the internal elements of the economy. However, there are two different perspectives related to the endogenous model whereby Gerschenkron focuses on the advantage of backwardness through WTF, Findlay suggests that technology diffusion growth rate is the increasing function of FDI.

Empirical Evidence:

The aim of this paper is to evaluate the impact of Foreign Direct Investment inflows (FDI Inflows) in the Sub-Saharan Africa in terms of the economic growth in the region. It is evident that FDI inflows within the region have increased potentially as observed through the trends of last three decades, however; the overall performance has been disappointing in terms of attracting FDI and increasing economic growth. According to Juma (2012) the exchange rate and current prices of the FDI inflows have increased significantly in the last 30 years. It has been observed that the average annual FDI inflows in the region were US$1.31 billion in the 1980s, while it elevated to US$4.78 billion in the 1990s, and reached to US$27.47 billion in 2000-2010. It is interesting to note that inflows of FDI were highest in 2008 and exceeded US$50 billion, however; the global economic crises brought them down to US$44.4 billion in 2009 and US$39.7 billion in 2010. Consecutively, average FDI inflows were observed to be 0.50% in 1980 in Sub-Saharan Africa since ratios of the region's GDP raised in 1.46% in the 1990s, and 3.94% in 2000s until 2010 (Asiedu, 2006).

The Sub-Saharan Africa’s FDI inflow disseminate all around the region unevenly demonstrating an increased degree of concentration in fewer countries than remaining countries. There has been a mixed evidence in relation to the FDI inflows’ impact on the economic growth of the region because the activities of potential FDI activities are happening in the mining sector of the region majorly whereas the forward and backward linkages and spill over effects are restricted (Pole et al., 2014). Another researcher Adam (2009) cited the work of Alfaro (2003), which analysed the data from primary, manufacturing, and services sectors of Sub-Saharan African countries from 1981– 1999 to analyse the impact of FDI inflows on growth and highlighted that the impact of FDI is subjective to different factors that include sectors as well. FDI was observed to have a positive effect on economic growth in the manufacturing sector while had the negative effect on the growth of the primary sector. The results of FDI’s effect on economic growth for service sector were observed to be ambiguous.

Focusing on the endogenous growth theory it has been observed that policies, which enhance the changes, competition, innovation, and openness, promote growth. Alternatively, those policies that have an effect of slowing the change or limiting it by favouring limited countries, industries, or firm would have low growth compared to others and disadvantage the community (Herzer et al., 2008). Following this theory, it has been observed that within the Sub-Saharan Africa the FDI inflow was considerable more in mining sector compared to other, which brought mixed results of the impact of the inflow. In addition, the distribution of the FDI inflows is also observed to be unevenly disseminated. This highlights the fact that when regions like Sub-Saharan Africa favours limited countries, industries, or firm the impact of FDI inflow is rather negative because compared to theoretical perspective countries do not have ideal situations (Dohse& Ott, 2014). 

This responds to the difference between the positive estimation made in the theory and the reality whereby the negative effect is evident. Concentrating on this perspective, the government has the major role to play since it is responsible to provide the fundamental infrastructures especially technological and design policies for the foreign investors that are ready to invest in the region to grow the economy (Hojjati Moghaddam, 2015). It has been apparent that there have been numerous changes in the initiatives taken by the region, however; there is still need for more suitable policies for foreigners. This is necessary because most of the investors demand availability of natural resources, economical, and political stability and growing market as these are the major requirements for investments.

However, according to Ndambendia and Njoupouognigni (2010), besides formation of direct capital, FDI inflows have a positive effect on the economic growth of a nation based on the technological/knowledge spill over channel. Emphasising the role of FDI inflows as technology and knowledge diffusion in terms of endogenous growth theory by Findlay (1978), FDI inflows have a direct positive impact on the growth. The results from the study conducted by Juma (2012) indicated the same aspect whereby FDI has been observed to be associated with higher growth in the Sub-Saharan African region. The researcher used ordinary least squares regressions to test the differences in the FDI effect between the mineral-rich against mineral-poor countries and find out that there was no statistically significant variation between the two types of countries. The analysis of the 5 years averaged data was repeated and was found to be consistent with the data demonstrating that the effect of FDI inflows on the economic growth of Sub-Saharan Africa is positive.

 

According to the growth model that has been developed by Solow, with an increase in the available capital stock in the economy drives to the production increase, which leads to elevation of the rate in growth output. As it is recognised that FDI is a source of financial and physical capital to the host country, it is estimated that complete available capital stock level for production is increased because of a rise in the FDI. Therefore, focusing on this neoclassical theory higher growth is achieved with an escalation in foreign-owned capital stock since FDI is considered the additional capital (Pole et al., 2014). However, focusing on the declining capital returns any raise in the rate of growth identified past the increase in the stock of FDI is not maintained in the end. This highlights the fact that FDI acts as a growth-driving agent in the short run. The results of Moghaddam (2015) demonstrated that the analysis of 41 Sub-Saharan African countries for the year 2005-2013 using panel data indicated the same results that FDI has a positive effect on economic growth in the host countries for short time period.

On the other hand, Edrees (2015) recognises through his research that FDI inflows negatively affect and harm the economic growth. The study used the 39  Sub-Saharan African countries as the sample for analyses divided into two groups of middle income (18) and low-income countries (21) from 1992 - 2012. For the analysis the effect of FDI inflows on economic growth, the researcher used Pooled Mean Group estimator (PMG). The results clearly demonstrated that FDI inflows were observed to be negative and statistically significant in both the countries without much difference. In addition to this Sukar, Ahmed, and Hassan (2007) examined the FDI inflows effect on the GDP growth using the conditional convergence model over the period of 1975–1999. The results demonstrated that there were positive yet statistically insignificant effects on the economic growth of the FDI inflows. The Adams (2009) also conducted an econometric study whereby the researcher studied 42 Sub-Saharan African countries using panel data in order to determine the effect of FDI inflows on economic growth for the years 1990–2003. The results of this study indicated that there was no positive effect of the FDI on the GDP growth in this region.

The result of these studies highlights two factors whereby the growth of economic in terms of FDI inflows is not positive for long-run effects and that infrastructure and policy is generally significant for the development of economic growth through FDI. It has been observed that the impact of FDI on growth is dependent on certain external factors and the host country would benefit through the positive spill over of the FDI solely if the region improved its infrastructure especially technological elements and policy for doing the business and reducing the cost. This finding is in favour of the endogenous growth theory that focuses on spill over, however, requires technology to be effective. From this perspective, infrastructure is also necessary and on the other hand includes technological aspects as well when it comes to the positive impact of the FDI inflows. However, with a declined and poor control for infrastructure the results of FDI for economic growth declines in the long run (Edrees, 2015).

Kottaridi and Stengos (2010) projected that capital level is responsible for the production of innovation and adopting new production technologies and procedures. This effective environment is responsible for assisting the economy to gain directly from the FDI inflows as per endogenous theory by Gerschenkron (1952). However, due to poor capital production in Sub-Saharan African countries, the results for FDI inflows on the economic growth rate are observed to be negative. Another study conducted by Trevino and Upadhyaya, (2003) demonstrated that FDI inflows do not necessarily have a separate positive effect on the economic growth of a nation, however, the effect is dependent on the initial conditions of the country, which would allow it to exploit spill over. This perspective is in favour of the exogenous theory that highlights the significance of technology for exploiting spill over. Another research conducted by Asiedu (2006) projects that positive impact on FDI is dependent on large markets and natural resources. However, an educated population, good infrastructure, openness to FDI, political stability, lower inflation, a reliable legal system, and less corruption, have similar effects. 

Summary:

The overall analysis of the empirical evidence related to theories and the effect of FDI on economic growth projects ambiguous finding as some of the researches favoured and showed a positive effect on economic growth of FDI however, some of the researches clearly demonstrated that the effect is not satisfactory. 

Conclusion:

The present paper intends to appraise the influence of FDI inflows on economic growth specifically in Sub-Saharan Africa. These are defined as the value of an inward direct investment made by a non-resident investor in the reporting economies. The paper has been analysed using varying theories. The theories selected to analyse the situation is Solow-Swan Theory of Economic Growth, which is considered as the neoclassical approach. According to Solow-Swan model, the exogenous factors are responsible for the growth of economic rate. Another theory used for analysis was Endogenous Growth Theories given by Romer, which focused on endogenous growth factors that are the internal elements affecting the economy.

Findley, 1978 and Gerschenkron, 1952 performed the changes in endogenous growth theory, which had different viewpoints of the internal factors were also included for analysis. Gerschenkron focuses on the advantage of backwardness through WTF, however; Findlay suggests that diffusion of technology growth rate is the increasing function of FDI. The paper also projects the viewpoints of different researches, which described why theoretically it is expected that FDI inflows contribute positively to the growth rate of the host country and why in reality it majorly has a negative impact on the host country’s growth rate. The analysis of the empirical evidence suggests that endogenous theory is more suitable when it comes to predicting the impact of FDI on economic growth.

 

On the other hand, the results project that there are mixed effects of FDI on economic growth, both positive and negative as some of the researches favoured and showed a positive effect on economic growth of FDI however, some of the researches clearly demonstrated that the effects are not satisfactory. In addition, the analyses of past researches also indicate that the effect of FDI is responsible on factors such as technology, infrastructure, population growth, global economic crises, and many other factors favouring the exogenous growth theory majorly. It is also evident that the perspective of Findley is supported more compared to Romer (1994) and Gerschenkron (1952).

 


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