Significance of Foreign Direct Investment on Developing Countries

Posted: Jan 23, 2012 |Comments: 0 |

It has been increasingly recognized that growing foreign direct investment inflows can contribute to economic development and promise a variety of potential benefits to poor country recipients. Due to the potential role foreign direct investment can play in accelerating growth and economic transformation, many developing countries seek such investment to accelerate their development efforts. Consequently, foreign direct investment has become an important source of private external finance for developing countries.

The foreign direct investment can increase growth in two ways. The investment increases total investment by attracting higher levels of domestic investment. Also, through interaction of the more advanced technology with the host country's human capital, foreign direct investment is more productive than domestic investment.

Indeed, the most significant channel through which foreign direct investment contributes to productivity growth is perhaps increased access to technology, through market transactions such as joint ventures, licensing, and goods trade.

While foreign direct investment represents investment in production facilities, its significance for developing countries is much greater. Not only can foreign direct investment add to investible resources and capital formation, but, perhaps more important, it is also a means of transferring production technology, skills, innovative capacity, and organizational and managerial practices between locations, as well as of accessing international marketing networks. In addition, the foreign direct investment can improve overall growth by promoting competition in the domestic input market.

In particular, the foreign investment could increase competition in the host-country industry, and hence force local firms to become more productive by adopting more efficient methods or by investing in human and/or physical capital. Multinational firms' large size, advanced technology, and advertising expertise often enable them to invest in industries in which barriers to entry, such as large capital requirements coupled with trade restrictions, reduce the access of potential local competitors.

Multinational corporations can promote the transfer of technology, with possible spillovers to the rest of the host economy or domestic firms. Technology spillover is a channel through which capital account liberalization can have a positive impact. These spillovers are most clear in the case of foreign direct investment, especially through foreign firms incorporating new technologies in their subsidiaries. As new technologies are generally developed and adapted by firms in industrial countries, foreign direct investment may be the most efficient way for developing economies to gain access to them. In addition, this knowledge may become more widely available in the country over time, as employees with experience in the techniques used in foreign companies switch to other firms.

Furthermore, foreign direct investment can help boost host country exports. Multinational enterprises may help developing host countries process and export locally produced raw materials, using their marketing skills, superior technology, and general know-how. They facilitate the export of local production through their distribution networks, and they often account for a significant share of host country exports.

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Questions and Answers Ask our experts your Economics related questions here... Ask 200 Characters left Why has most foreign direct investment gone into acquiring existing companies rather than establishing new ones? How many countries are developing countries ? What are the developing countries in the world ? Rate this Article 1 2 3 4 5 vote(s) 0 vote(s) Feedback RSS Print Email Re-Publish Source:  http://www.articlesbase.com/economics-articles/significance-of-foreign-direct-investment-on-developing-countries-5595798.html Article Tags: foreign direct investment Related Articles Latest Economics Articles More from Abey Francis Foreign Direct Investment

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Investment Efficiency, Savings and Economic Growth in Sub Saharan Africa Posted By : Wolassa L. Kumo

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Investment Efficiency, Savings and Economic Growth in Sub Saharan AfricaBy: Wolassa L. Kumo

    

[ Posted On: 2011-08-27 ]  
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Dr. Wolassa KumoIntroduction

Fixed capital has long been considered as an engine of growth both as a factor of production and as an embodiment of technological progress. Countries that had made sustained accumulation of fixed capital were able to achieve higher and sustained economic growth and development while those who had not lagged behind. For instance, economic development in Sub-Saharan Africa has been severely constrained by inadequate saving and investment, among other things. The average annual gross domestic saving rate by 41 sub Saharan African countries during the period 1980-2010 was as little as 14.3% of GDP while the average fixed investment was 20% of GDP for the same period. Therefore, sub-Saharan Africa's burgeoning debt was not primarily meant to finance investment as the saving- investment gap was only about 6% of GDP during the past three decades.

Sub Saharan Africa's dismal average economic growth of about 3.8% during the past three decades was therefore a direct consequence of low saving and low investment. The Sub Saharan Africa average saving and investment rates pale in comparison to the saving and investment rates of the newly industrialized and emerging Asian economies, such as China, whose saving and investment rates of over 40% of GDP ensured real economic growth rates of over 10% during the same period, i.e. 1980-2010.

Average annual growth in Africa reached above 5% during the past decade following the commodity price boom since the early 2000s but was dampened by the global economic and financial crises during 2008-2009. Growth rebounded in 2010 and is projected to reach 5.5% in 2011 making sub Saharan Africa the second fastest growing region in the world following Asia.

However, heavy dependence on growth driven by improved commodity terms of trade subjects the sub continent to vagaries of global demand uncertainty. Unless improved commodity terms of trade translates into higher saving and investment, the sustainability of the current improved growth performance will be at stake. Equally important is the continuation of economic and political reforms that are required to enhance the participation of the private sector in economic development, and also improve productivity and investment efficiency.

This brief paper presents an overview of investment efficiency, savings and economic growth in 41 sub Saharan African countries for the past three decades using data from the IMF, World Economic Outlook Data Base, April 2011. Six countries have been excluded from the analysis for lack of consistent time series data. These are Djibouti, Liberia, Mauritania, Sao Tome and Principe, Sudan and Zimbabwe.

Investment Efficiency in Sub Saharan Africa

There are two broad concepts of efficiency: allocative efficiency and technical or production efficiency usually measured by total factor productivity. Some empirical analysts use these broad concepts of efficiency to assess inefficiency in aggregate investment in terms of excess investment demand that captures the deviations of actual investment from the desired investment. These approaches usually use nonparametric methods, such as Data Envelopment Analysis (DEA), as well as, parametric methods including multiple linear or non- linear regression models.

In this brief article, we use a simple approach based on marginal productivity of capital, known commonly as the Incremental Capital Output Ratio (ICOR) to measure investment efficiency in 41 sub Saharan African countries for the period 1980-2010. ICOR is the ratio of investments in some previous period or periods and growth in output in subsequent period or periods measured at constant prices.

Growth in output is not attributed only to investment in fixed capital. It could be due to growth in productivity (partial or total factor productivity), increased use of labour input or improvement in the level of education of the labour force (growth in human capital), and/or improvements in productive capacity utilization. However, changes in fixed investment still explain a significant portion of growth in output particularly in developing countries with limited fixed capital stock and therefore the efficiency with which this input is utilized provides a useful clue about the correlation between the later and economic growth.

The higher the ICOR, the lower is the implied investment efficiency. That is fixed investment is more efficient if fewer dollars are required to generate a unit growth in output. The average ICOR for sub Saharan Africa for the period 1980-2010 was 5.23 and was comparable with the ICOR for of about 5 during the 1980-2003 period. This implies that fixed investment in sub Saharan Africa is pretty efficient and the level of investment efficiency in the sub region is comparable with that of China during the early two decades of its rapid industrialization. This is not only because the sub region is capital scarce but also because there have been marked improvements in business climate and political environment during the past two decades. Therefore, no wonder that foreign direct investment surged in Africa from less than US$15 billion in early 2000s to over US$80 billion in 2007 before the inflow was hit by the global financial and economic crises of 2008-2009.

While average investment efficiency in sub Saharan Africa is high, performance varies from country to country. The 41 countries in sub Saharan Africa can be classified into three groups based on their ICOR performance for the period 1980-2010: (a) those with ICOR value of 1-5, (b) those with 6-9, and (c)) those with ICOR values of above 10.

The majority of the 41 counties (i.e. 25 countries) in the sub region recorded higher investment efficiency during the past three decades. These countries include both the least developed countries with very low fixed capital stock base, as well as, some middle income economies with higher level of capital stock. These best performing countries with ICOR value of 1-5 are: Botswana, Cameroon, Central African Republic, Comoros, DRC, Republic of Congo, Equatorial Guinea, Ethiopia, Gabon, The Gambia, Ghana, Guinea, Guinean Bissau, Kenya, Malawi, Mali, Mozambique, Namibia, Niger, Nigeria, Rwanda, Seychelles, Togo, Uganda, and Zambia. Most of these countries are not only face extreme capital scarcity but have also shown some progress in opening up their economies during the past 3 decades.

The countries with medium investment efficiency level of ICOR 6-9 include: Benin, Burundi, Cape Verde, Eritrea, Mauritius, Sierra Leone, and Swaziland. Mauritius is among the Upper Middle income countries and top reformers in the sub region. Lower investment efficiency may imply an over investment in the economy where marginal investment needed to generate a unit output was greater during the past three decades than during the earlier years of its economic expansion.

Investment efficiency was the lowest in the following countries during the past three decades: Angola, Chad, Cote d'Ivoire, South Africa and Tanzania. All of these four countries have experienced some form of economic and political upheavals during the past three decades. Preliminary data analyses showed that South Africa's ICOR was comparable with that of China for the post-Apartheid period, but the number was very high for the pre 1994 period, i.e. 1980-1994 pulling the country's overall performance significantly down. Investment efficiency was very low during the Apartheid rule in South Africa, due to global isolation and heavy state control over the economy. Thus if we exclude the pre 1994 period South Africa's investment efficiency will fall within the first group of best performers. Poor performance by Angola, Cote d'Ivoire and Tanzania reflects the continued impacts of civil war and socialist mode of production in the case of the later which contributed to wasteful investment.

Investment required to achieve a minimum growth threshold of 7 percent

While Africa's growth performance is the second best in the world at present, the continent still lags behind other regions in terms of socioeconomic development. Over 380 million people in Africa today live below poverty line, while youth unemployment is as high as 70% in some countries. Most economies are still heavily dependent on rain fed subsistence agriculture with extremely limited investment on irrigation. Weak economic structure reinforces poverty and poses a major risk to the sustainability of the current growth fuelled by commodity price boom.

African countries will not be able to address this fundamental economic challenge with current growth rates of 5% or less. They should achieve a minimum of 7% annual growth rate individually or collectively for the coming two decades to make a dent on poverty and unemployment. With an average ICOR of 5.23, the sub Saharan Africa region therefore requires a minimum fixed investment of 35% of GDP over the coming two decades collectively or by each country. Given the current actual average regional fixed investment rate of 20% of GDP, the desired investment rate of 35% over the coming two decades seems insurmountable, but not unrealistic. China's economic growth during the past three decades was fuelled by fixed investment of over 40% of GDP. China's massive investment was financed by extraordinarily high household and public savings which at times reached 50% of GDP. The major challenge for Africa, in this respect, is a culture of low savings, which we expound in the following section.

Saving-investment gap in Sub Saharan Africa

When domestic household and public savings fall short of the fixed investment needs of a country, this leads to a saving-investment gap. This gap is exacerbated when export earnings of a country fall short of import demand leading to a second, foreign exchange gap. Most developing countries in Sub Saharan Africa are often characterized by both gaps. Except five countries, i.e. Botswana, DRC, Gabon, The Gambia, Namibia, and South Africa, the rest of 41 sub Saharan African countries had an average saving -investment gap ranging from 1% to nearly 30% of GDP during the past three decades.

The saving-investment gap, however, significantly varies across the countries in the sub region. Countries that faced relatively lower saving-investment gaps ranging between 1-5% in the sub region during the period under review include Angola, Cameroon, Central African Republic, Comoros, Republic of Congo, Cote d'Ivoire, Eritrea, Ghana, Kenya, Mali, Nigeria, Swaziland and Uganda. The lower gap by some countries reflects increased savings from oil revenues, while lower gap by others simply mean lower level of investment.

Countries in the sub region with the average saving investment-gap of 6-10% during the stated period include Benin, Burkina Faso, Burundi, Central African republic, Ethiopia, Guinea, Guinea Bissau, Madagascar, Malawi, Mauritius. Niger, Rwanda, Senegal, Sierra Leone, Tanzania and Zambia, while those with average saving-investment gap of above 11% include Cape Verde, Chad, Equatorial Guinea, Lesotho, Mozambique, Seychelles and Togo.

The poor performance of the sub region in terms of the saving-investment gap reflects two major challenges: First, most countries are characterized by low saving and low investment and hence are at the risk of being trapped in vicious circle of poverty if the they do not raise their saving and investment rates immediately; and second if they raise their investment levels without a concomitant increase in domestic savings they may be trapped in vicious cycle of debt which could undermine the value of their investments, provided money borrowed is invested in economic development. Since the recent economic crisis proved that most of the aid pledged by non-African donors is unlikely to be delivered, the only sustainable solution to Africa's development challenge is aggressive domestic resource mobilization for development. This could be supplemented by foreign direct investments, if the countries in the sub region speed up the current economic and political reforms.

Concluding remarks

Africa is rising. After 5 decades of civil strife and economic stagnation, the first decade of the 21st century shone a new light on the continent. Africa is no more a hopeless dark continent. Like its diamonds in the West, South and at the center, the continent is shining.

It is also shining as a second fastest growing continent in the world. However, there is no time for complacence as Africa is still the least developed continent in the world plagued with high level of poverty, unemployment, political instability and corruption. To sustainably address these fundamental socio economic challenges the region should at least grow by 7% per annum for the coming two decades. However, this is unlikely to be achieved with the current investment rate of 20% and the saving rate of 14% of GDP.

While the return to investment in Africa is high, it is such low levels of investment and saving that are holding the continent back. Given higher returns to investment, Africa's economic transformation will depend on radical shift in the saving culture of its people, further economic and political reforms, and accelerated fixed investment.

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About The Author: Dr. Wolassa L. Kumo -- is a development practitioner and researcher. His research interests include risk and uncertainty, productivity and efficiency, finance and investment, currency substitution and development problems of Africa. Currently, he is working as a researcher in a public institution with a primary responsibility in econometric modelling. Previously, he taught Principles of Economics in an academic institution. FaceBook: www.facebook.com/people/Wolassa-Kumo/100000140891395 before and after the --> | View Profile & All Articles By: Wolassa L. Kumo |

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