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Impact Foreign Direct Investment on Domestic Private Investment in Ethiopia

Master's Thesis 2014 32 Pages

Business economics - Economic Policy

Excerpt

Inhaltsverzeichnis

1. Introduction

2. History and Trend of Foreign Direct Investment

3. History and Trend of Domestic Private Investment

4. Link between Foreign Direct Investment and Domestic Investment

5. Rationale to see Nexus between Foreign Direct Investment and Domestic Private Investment

6. Empirical Literatures
6.1 Does Foreign Direct Investment Crowd-in/out Domestic Private Investment?
6.1.1 Foreign Direct Investment Crowds-out Domestic Private Investment
6.1.2 Foreign Direct Investment Crowds-in Domestic Private Investment
6.1.3 The Relationship between Foreign Direct Investment and Domestic Private Investment depends on Sectorial Distribution

7. Data and Methodology
7.1 Source and Nature of Data

8. Data Analysis and Interpretation
8.1 Descriptive Analysis
8.1.1 Foreign Direct Investment and Domestic Private Investment: Trend and Interrelationship
8.1.2 Sectorial Distribution of Foreign Direct Investment and Domestic Private Investment
8.1.3 Regional Distribution of Foreign Direct Investment and Domestic Private Investment
8.2 Econometrics Analysis
8.2.1 Stationarity Tests
8.2.2 Estimation of VAR Model
8.2.3 VAR Diagnostic Test
8.2.4 Granger Causality/Block Exogeneity Test
8.2.5 The Johansen Co-integration Test Result
8.2.6 Vector Error Correction Model (VECM)
8.2.7 Impulse response and variance decomposition
8.7.2 Variance Decomposition

9. Conclusion and policy implication
9.1 Conclusion
9.2 Policy Implications

References

1. Introduction

Investment is, one of the primary engines of growth in all economies. Countries that devote high proportion of output to investment may sustain more rapid growth than countries that invest less. Domestic savings mainly finance investment. However, developing countries short of domestic savings find it difficult to contribute towards high investment rates. To maintain strong capital accumulation and economic growth saving is vital and considered as determinant of growth in economic literature.

Kojo et’al (2012), states that a sustained level of investment engendered by sufficient domestic investment is a pre-request for sustainable growth of the country. However, in the case of developing countries: where insufficient domestic investment and outdated technologies has greatly endangered sustainable economic growth: foreign direct investment considered as shortcut to achieving sustainable growth.

In addition, efficient utilization of productive resources, including capital and labour is crucial for Economic growth of the country. In the context of a labour-surplus developing country, efficient policy regime for maintaining steady investment stream holds a crucial step for ensuring growth. Internally, gross domestic capital formation plays a major role in shaping future growth trajectory and on the external front, foreign capital in the form of foreign direct investment not only ensures current gross domestic product growth by boosting production and employment, but also might contribute to future growth potential by bringing better technological expertise and management practices in the country.

According to Borensztein et’al (1998), De Mello (1999) and Lipsey (2000), foreign direct investment enables developing countries to fill the gap between saving and investment by bringing non-debt creating inflows of foreign capital and thereby stimulate economic growth. In addition, foreign direct investments are sources of finance, which may facilitate the transfer of the modern technology and innovations of industrialized countries to developing countries, thus helping them to accelerate the speed of their economic development.

The effectiveness of foreign direct investment depends on its relation with other determinant of growth: most notably technological progress, domestic private investment and the development of innovative capability. The link between foreign direct investment and these other determinants of growth, however, is not an automatic process. It requires a favorable macro policy environment and specific policies and institutions aimed at attracting and directing foreign direct investment to key sectors in the economy thereby enhancing the contributions of investment of skills formation, technological change, competitiveness, and economic growth. A clear understanding of how such a synergy between investment policy on the one hand and technological progress on the other can be created is an essential prerequisite for designing an effective national investment policy and investment promoting strategy (UNCTAD, 2011).

Foreign direct investment directly contributes to gross investment level. If foreign direct investment complements domestic private investment, gross investment ought to increase by more than the increase in foreign direct investment. contrary to that if foreign direct investment substitutes domestic private investment, gross investment ought to increase by less than the increase in foreign direct investment; finally if foreign direct investment has no effect on domestic private investment the increase in foreign direct investment is equal to increment of total investment. Therefore, the existence of positive relationship between foreign direct investment and domestic private investment is necessary to get positive effect from inflow of foreign direct investment on economic growth as a whole.

No country is self-sufficient. There is mutual interdependence among countries. The less developed countries particularly depend on the developed countries for finance, technology, and even technical work force while the advanced countries depend on the less developed countries especially for their raw materials.

Over the past decades, there has been a rapid increase in Ethiopia’s needs for resources to finance the development of infrastructure and productive capacity. However, the gap between investment and saving in is wide due to low level of income and domestic savings (EIA, 2012). Realizing the inadequacy of the domestic capital to finance investment needs, the country has opened several economic sectors to foreign investors especially after 1992 to have sustainable economic growth. However the impact of foreign direct investment on economic growth of host country, determined further by whether it crowd-in or crowd-out domestic investments (Agosin,R and mayor, 2000).

Some studies found foreign direct investment discourages the host country’s domestic private investment others found it stimulates the rate of domestic private investment. The realistic impact of foreign direct investment on domestic private investment is still imprecise.

According to assumptions of cournot oligopolistic model, as explained by Teanravisitsagool (1998) foreign direct investment would completely crowd-out domestic investment if foreign and domestic firms are identical; and there is no spillover effect on domestic firms. It would also crowd-out domestic private investment if they employ superior technology in the production process

The neoclassical theory states that there are a certain number of investment opportunities available in the economy, which can be exploited either by domestic or foreign firms. If foreign firms take up some of these Opportunities through foreign direct investment then domestic firms left with fewer investment opportunities. In such a setting, the question of who invests is irrelevant, thus, foreign direct investment has no role in altering the capital formation of the host country (Teanravisitsagool, 1998). In addition, Industrial organization theory states that foreign direct investment is global strategy of MNEs to advance monopoly power over each host country. Ownership advantage leads to monopoly power then eventually domestic firms forced to exit, which in turn creates adverse effect on economic growth (Selvanathan, E. A., and Selvanathan S., 2008).

The empirical evidence varies from country to country because of differences in national policies, response of domestic enterprises, and the type of foreign direct investment inflow in the recipient country. Firms, sectors, or countries that are below certain thresholds (in terms of human capital, financial development, or institutional quality) are less likely to benefit from foreign direct investment. Unfortunately, Ethiopia is not in good in this regard. Therefore answering the basic question that: Does the inflow of foreign direct investment in Ethiopia crowd-out domestic private investment or complement it? - is important.

On the other way, not only foreign direct investment can cause domestic private investment, but also domestic private investment can cause the inflow of foreign direct investment depend on the domestic policy and level of domestic private investment. Domestic investors tend to have better knowledge of the investment climate and so their action is a signal to foreign investors on the state of the economy. Secondly, in an environment where there is information asymmetry between domestic and foreign investors in favor of domestic private investment, domestic private investment will drive out foreign investment. The effect of domestic private investment on foreign direct investment flows is more intricate.

Therefore, relationship between foreign direct investment and domestic private investment needs to be study but not yet in Ethiopia. Not surprisingly, these issues call for an empirical study on the issue.

2. History and Trend of Foreign Direct Investment

The emergence of foreign direct investment as a force for integration in the global economy dates back to the 19th century. Following a slowdown of international capital flows in the first half of the 20th century, foreign direct investment started to grow in the post-war period due to the need for reconstruction of countries around the world. At the beginning of world war second foreign capital inflow from developed countries to developing countries, in search of higher return for their investment was widely argued and it helps developing countries to “take off” in to self-sustaining growth level (Rostow, 1960).

The world has increasingly recognized that private capital has a vital role to play in economic development. African countries have moved to liberalize the investment environment, yet have not received large amount of foreign direct investment. At least part of this poor performance is because of lingering skepticism toward foreign investment, owing to historical, ideological, and political reasons (Moss,J et’al ,2004).

Over the years, the world superpowers have called on the less developed countries such as Ethiopia to embrace globalization. The call made in order to improve on their predicament as they aspire to be like one of the developed economies. This of course implies liberalization whereby the openness of the Ethiopian economy to the world economy would bring about the needed economic development through the stimulation of some variables i.e. trade and investment. UNCTAD (2008) reports that the presence of major socio-economic and political transformations in Ethiopia in the past decades.

Investment is the strategic factor in the process of economic development and as such, the need for capital inflow into an import dependent country like Ethiopia is crucial. Ethiopia with a population of over 80 million people; characterized by vicious circle of poverty- and very low level of domestic savings, which cannot facilitate adequate domestic investment. In recognition of these problems, the government of Ethiopia is obliged to see foreign capital inflow.

The above scenario becomes more pathetic when it realized that Ethiopia endowed with vast, substantial, and large untapped natural resources. Despite these however, the country lack the basic technology to exploit these resources. This also therefore pushes the country to open some sector of the economy to foreign investors. Consequently, many efforts have been exerted to increase the inflow of foreign direct investment and thereby achieving the very dream of economic development. Teshome (2012) writes

The government in the Monarchy regime (from 1963-1974) has provided incentives for foreign investors who involved in agricultural sector in the country. Unlike the Monarchy, the Derg regime has invited foreign investors to involve in the economy though joint venture started in 1983 to increase foreign direct investment. However, due to misguided nationalized policy measures, the Military regime failed to attract more foreign direct investment in the country. Before 1991, the low foreign investment in the national economy hindered the capital accumulation and technology transfer into the country.

By realizing the importance of foreign direct investment to the development of Ethiopian economy and the short comes of previous governments, FDRE introduced new foreign direct investment policy framework by designing various policies and reforms activities, and implemented to attract the foreign direct investment in the country. In addition to the involvement of foreign direct investment in the country, various macroeconomic reforms that includes the liberalization of trade policy; privatization of some public sector enterprises; financial sector reforms; and deregulation of prices and exchange rate controls. In line with market-oriented economic policy, the investment regime also liberalized through a series of government proclamations and many activities are taking place to improve the investment environment for the foreign investors (Teshome, 2012).

Due to the investment-friendly environment created in the country, the inflow of foreign direct investment has been increasing over the last twenty years.

Foreign direct investment considered as a key ingredient for economic growth in developing countries and since a host should clean the house before inviting guests, many countries are trying to create a hospitable environment for foreign direct investment. Ethiopia also creates hospitable environment to foreign direct investors in order to benefit from the inflow of foreign capital with the prior assumption that it will not crowd-out domestic private investment. It seems because of this hospitable environment that the inflow of foreign direct investment is increasing from time to time especially for last two decades.

3. History and Trend of Domestic Private Investment

In history of economics it is accepted capital accumulation is one of the most important props for healthy and sustainable growth and the main source of capital accumulation is investment. Private sector has a vital and important place in investment and production based growth. In contemporary economic thinking: development of private investment helps to improve employment opportunity, capital accumulation, production improvement, and thereby economic development in general.

Despite Private Investment is a key to long-term economic growth (Khan & Reinhart, 1990) private investment, in levels and as a percentage of GDP in Ethiopia has shown an inconsistent trend for some periods during 1970-2012. This is a problem, firstly because private investment matters for growth, and secondly because low private investment increase vulnerability in the economy.

The importance of domestic private investment could not be undermining. Normally the history of private sector in Ethiopia dates back to the reign of emperor Menelik II with acquisition of land, however it starts to develop during emperor Haile sillasie. Even during that time, much of the private sector clustered around land and related activities. Contrary to the previous governments, the military government denies the role of private sector. FDRE gives high emphasis to the development of domestic private investors in cognizant of the role of private sector in general and the role of domestic private investment in particular to engendering growth trajectory (Solomon, 2001).

Unfortunately, however the level of private sector in general and domestic private investment in particular, is still at its embryonic stage…it have not any remarkable growth and initiation because of different obstacles.

4. Link between Foreign Direct Investment and Domestic Investment

It is a plain fact that one thing might have a positive or negative impact on the other thing. Foreign direct investment is also lie in this fact: it has a positive or a negative impact on hosting country. Foreign direct investment does not go without risk and disadvantages (Feldstein, 2002).

Since foreign direct investment affects growth through augmentation of the existing capital stock, it is also necessary to look to the interaction between foreign direct investment and its equivalent, domestic private investments. Opponents of foreign direct investment see inflow to developing countries as one of the method used by rich countries to exploit their less developed neighbors.

The influence of foreign direct investment inflows on domestic private investment may vary depending on the domestic investment environment of the host country. Foreign direct investment could crowd-out domestic private investors those who cannot compete with more efficient and technologically more superior MNCs and had operated under a heavily protected trade regime for a long time. On the other hand, foreign direct investment could crowd-in domestic private investment by generating spillovers through the diffusion of new technologies and forward or backward production linkages.

The reverse impact may also exist from domestic investment to foreign direct investment. There are several reasons why domestic private investment can catalyze foreign direct investment flows in developing countries. Domestic investors tend to have better knowledge of the investment climate and so their action is a signal to foreign investors on the state of the economy. Consequently, in an environment where there is information asymmetry between domestic and foreign investors, domestic private investment will drive foreign investment.

Another reason why domestic private investment could affect foreign investment is that factors that done to stimulate domestic private investment also affect foreign direct investment meaning domestic private investment creates spill over to foreign direct investment. For example, public investments in infrastructure lower transaction costs and increase the return on domestic private investment as well as foreign direct investment.

The two-way relationship between foreign direct investment and domestic private investment has different implications for investment promotion. If domestic private investment is a driver of foreign direct investment, then the best way to attract foreign direct investment(in case it is necessary) is to give priority to the promotion of domestic private investment rather than offering special and generous incentives to foreign investors. This, of course, is not to suggest that incentives should not be offer at all for foreign direct investment.

On the contrary, if countries cannot undertake some investments without the involvement of foreign direct investment, therefore, providing incentives and building institutions to attract targeted foreign direct investment should be an essential component of a national investment policy and strategy. Keeping that incentives and supports given to foreign direct investment is should not drive out domestic private investment.

Until the 1960,s, foreign direct investment considered exclusively a form of international movement of capital. The traditional theory of international factor movements assumed that differences in relative endowment of capital among countries and caused differences in the marginal efficiency of capital, and therefore the level of interest rates. This led to flows of foreign direct investment from capital rich to capital poor countries. Take the important message here foreign investors go abroad in search of better return.

5. Rationale to see Nexus between Foreign Direct Investment and Domestic Private Investment

The monopolistic tendencies of foreign subsidiaries may crowd-out domestic private investment (Gardiner, 2000), the reason is not farfetched as domestic firms are incapable of successfully competing with foreign firms, which have superior marketing and advertisement power…further argued that the larger the proportion of the economy of LDCs in the hands of MNEs, the greater the negative externalities.

The extent to which foreign direct investment is growth enhancing depends on the degree of complementarities and substitutability between foreign direct investment and domestic private investment for the host-country. Since the process of technological upgrading and knowledge spillovers will need a sufficient technical level of the domestic production, a substitutable relationship will outweigh complementarily relationship. This indicates again that a technology gap between the home and host-economy will reduce the growth effects of foreign direct investment. Therefore, it is necessary to know the relationship between foreign and domestic investment to know the impact of foreign direct investment on economic growth in addition that knowing the impact of foreign direct investment on domestic private investment is very crucial for incoming foreign investors or push out their promising advertise.

Similarly Dependency theorists argue that the success and failure of developing countries determined by the structure of international economic system. However, the system is unfair; it benefits the industrial countries because of unequal exchange. Foreign direct investment is an important mechanism through which their exploitation is materializing …meaning it de-capitalizes developing economies by extracting their economic surplus (chase-Dunn, 1985).

In line with this, Bosswell and Dixon (1990) observes that foreign direct investment subverts market, increase inequality that often leads to domestic violence instead of stimulating the growth process of host country.

Therefore answering the basic question that: Does the inflow of foreign direct investment in Ethiopia crowd-out domestic investment or complement it? - is important because complementing relationship means a beneficial effect of foreign direct investment on growth irrespective of time horizons. Otherwise, foreign direct investment may be detrimental to economic growth in the long- run, if not in the short run. If foreign direct investment crowds-out domestic private investment the effect becomes back and forth even under the assumption of positive link between foreign direct investment and economic growth because the effect of domestic private investment on economic growth is positive and not questionable.

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Details

Pages
32
Year
2014
ISBN (eBook)
9783656879183
ISBN (Book)
9783656879190
File size
597 KB
Language
English
Catalog Number
v287286
Grade
very good
Tags
impact foreign direct investment domestic private ethiopia

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Title: Impact Foreign Direct Investment on Domestic Private Investment in Ethiopia