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7 Policy Reform and Foreign Direct Investment in Africa: Absolute Progress but Relative Decline

Author(s):
Saleh Nsouli
Published Date:
September 2004
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Author(s)
Elizabeth Asiedu

Foreign direct investment (FDI) in Sub-Saharan Africa increased substantially in the 1990s. However, the rate of increase was meager compared with that in other regions. As shown in Table 7.1, for example, between the 1980s and 1990s, FDI in the region grew by about 218 percent. This compares with an increase of 993 percent for East Asia and the Pacific, 556 percent for Latin America and the Caribbean, 789 percent for South Asia, and 755 percent for all developing countries. As a consequence, Africa’s share of FDI to developing countries has declined over time, from about 19 percent in the 1970s to 9 percent in the 1980s and to about 3 percent in the 1990s. This is in spite of the policy reforms implemented by countries in the region. Thus, with regard to FDI, Africa’s experience compared with that of other developing countries can be characterized as one of “absolute progress but relative decline.”

Table 7.1.Annual Averages of Net FDI Inflows to Developing Countries and Selected Regions, 1970–99
FDI Net Inflows

(In millions of dollars)
Growth

(In percent)
Region1970s1980s1990s1970s-80s1980s-90s
East Asia and Pacific7493,96743,347430993
Latin America and Caribbean2,4985,71437,480129556
Middle East and North America1298063,836-725376
South Asia612562,278323789
Sub-Saharan Africa7731,1023,50943218
All developing countries4,01312,059103,075201755
Sub-Saharan Africa’s share (%)1993
Source: World Bank (2003b).
Source: World Bank (2003b).

The ineffectiveness of policy reform and the deterioration in Africa’s global FDI position are frustrating to policymakers in the region. Indeed, African leaders and the international community have grappled, and continue to grapple, with ways to increase FDI flows to the region. For example, one of the main objectives of the New Partnership for Africa’s Development (NEPAD) is to increase Africa’s share of global FDI. Also, in March 2002 the United Nations Conference on Trade and Development (UNCTAD) for the first time organized a meeting that brought together policymakers and international business leaders to draw up strategies on how to increase FDI flows to Africa.

This chapter contributes to this important discussion by examining the underlying factors behind the deterioration of Africa’s global FDI position. Drawing on the empirical literature on FDI, the article addresses three questions: Why does Africa’s share of FDI continue to decline despite improvements in the policy environment? How can policymakers reverse this trend? And how can Africa attract more FDI in a globally competitive economy?

Finding answers to these questions is important to both policymakers and academics for at least two reasons. First, FDI is crucial to Sub-Saharan Africa. FDI serves as a source of capital, stimulates domestic investment, creates employment, promotes the transfer of technology, and enhances economic growth.1 The role of FDI as a source of capital has become increasingly important to the region. The reason is that, in order for the continent to achieve its Millennium Development Goal of reducing its poverty rate by half,2 the region needs to fill an annual resource gap of $64 billion, or about 12 percent of GDP.3 Since incomes and domestic saving in the region are low, the bulk of the finance will have to come from abroad: from official finance (such as aid from the World Bank) or from private foreign investment. However, official assistance to the region has been declining. For example, net official development assistance (ODA) to Sub-Saharan Africa declined from $17.8 billion in 1995 to $12.2 billion in 2000, a decrease of about 31 percent (World Bank, 2003). Moreover, FDI, including bond finance and portfolio investment, is unavailable to most African countries because of their thin financial markets. In addition, most are unable to raise capital from international capital markets. For example, in 1998 almost all the portfolio investment in the region ($8.6 billion) went to South Africa. From 1995 to 2001, annual FDI flows to Sub-Saharan Africa averaged about $7 billion. This average falls to $2.9 billion when Angola, Nigeria, and South Africa are excluded. (Angola and Nigeria are oil-exporting countries.) Thus, filling the annual resource gap of $64 billion needed for poverty alleviation would require a substantial increase in FDI.

The millennium goal of halving poverty rates is particularly important to sub-Saharan Africa because the poverty rate for the region is very high. About 48 percent of the population lives on less than $1 a day, compared with 4 percent for Eastern and Central Europe, 15 percent for East Asia, 12 percent for Latin America, 2 percent for the Middle East and North Africa, 40 percent for South Asia, and 24 percent for all developing countries. Furthermore, in several countries in the region, more than half the population live in abject poverty. For example, the poverty rate for Burkina Faso is 62 percent, 66 percent for the Central African Republic, 73 percent for Mali, 70 percent for Nigeria, and 64 percent for Zambia. For such countries, the role of FDI as a source of capital is critical. Indeed, the importance of private foreign investment as a source of capital is reflected in the declaration of the NEPAD agreement, which notes that “NEPAD seeks to increase private capital flows to Africa, as an essential component of a sustainable long–term approach to filling the resource gap.”

This paper provides a plausible explanation for the deterioration in Africa’s global FDI position and proposes policies that will enhance FDI flows to the region. The analysis focuses on three key policy-related variables that affect FDI flows: infrastructure development, openness to trade and investment, and institutional quality. Measures of these variables indicate that Sub-Saharan Africa’s policy environment has improved over time—the region has made absolute progress. However, compared with other developing countries, policy reform in the region has shown relative decline. As a consequence, the region has become increasingly less attractive as other developing countries have become more attractive for FDI. Thus the ineffectiveness of policy reform and the deterioration in Africa’s global FDI position may be explained by the fact that sweeping reform in other developing countries and mediocre reform in Africa have made Africa less attractive for FDI.

The following section describes how Sub-Saharan Africa’s infrastructure, institutions, and FDI policy have changed over time compared with other regions.

Description of the Variables and Data

According to the “eclectic” theory of FDI, countries that have a locational advantage will attract more FDI (Dunning, 1988). Location-specific advantage covers any characteristic (economic, institutional, or political) that makes a country attractive to FDI. This includes large domestic markets, the availability of natural resources, an educated labor force, good infrastructure, low labor costs, and reliable institutions, to mention but a few. The empirical literature on the determinants of FDI to developing countries has generally focused on identifying the location-specific factors and the relevant government policies.4 As pointed out earlier, the objective of this chapter is to prescribe policies that will improve Sub-Saharan Africa’s global (relative) FDI position. It therefore focuses on policy-related variables (variables that can be altered by policymakers) that have been found to have an impact on FDI. It considers three policy variables: openness to foreign investment, infrastructure development, and the institutional setup. The next subsection describes the trends in FDI flows and such variables for Sub-Saharan Africa and other developing countries.

FDI Flows to Developing Countries

Table 7.1 indicates that FDI to Sub-Saharan Africa has increased over time. However, the growth rate is substantially lower than that for developing countries as a whole, causing the region’s share of global FDI to decline over time.

Openness to Foreign Investment

Several studies have found that countries that are open will attract more FDI (Asiedu, 2002; Noorbakhsh, Paloni, and Yousseff, 2001; Morrisset, 2000). In the FDI empirical literature, the most widely used measure of openness is the share of trade in GDP. Thus the positive relationship between trade volumes and FDI implies that countries that wish to attract more FDI should increase their trade. However, as pointed out by Rodriguez and Rodrik (2000), this type of policy recommendation is not constructive because policymakers do not directly control the volume of trade. Since the objective of this chapter is to prescribe policies that will enhance FDI flows to Africa, it considers three measures of openness that can be altered by policymakers. The variables and their sources are described below (data are presented in Table 7.2):

Table 7.2.Measures of Openness for Selected Regions, 1980–99
Capital ControlsRestrictions on Trade and InvestmentHost Country’s Investment Climate
Region1980s1990sPercent change1980s1990sPercent change1980s1990sPercent change
East Asia and Pacific3.44.945.76.26.67.16.66.3-4.7
Latin America and Caribbean2.44.174.63.95.644.34.76.434.2
Middle East and North Africa1.72.335.35.05.510.35.86.13.7
South Asia0.40.650.03.13.617.75.75.4-3.1
Sub-Saharan Africa0.61.176.14.95.818.55.15.46.9
All developing countries1.22.386.84.15.230.15.15.813.3
  • Capital controls. This measures restrictions on capital market transactions. The rating is computed based on the index of capital controls from among 13 IMF categories. It ranges from 0 to 10, with a higher rating implying fewer restrictions.
  • Restrictions on trade and investment. This is a composite measure of variables that limit trade and investment. It includes taxes on international trade, regulatory trade barriers (tariffs, quotas, license fees), and exchange controls. It ranges from 0 to 10, with a higher rating implying fewer restrictions. Data for this and for capital controls are published by the Fraser Institute and are available at www.freetheworld.com.
  • Host country investment climate. This measures the host country’s attitude toward inward investment. The rating ranges from 0 to 12 (a higher score implies a better investment climate) and is determined by four components: risk to operations, taxation, repatriation of profits, and labor costs.

The data for all three measures of openness show that Sub-Saharan Africa has become more open in the 1990s. However, the pace of liberalization was slow compared with most other developing countries. For example, with regard to restrictions on trade and investment, the average rating for Sub-Saharan Africa improved by about 19 percent. This compares with an increase of 30 percent for all developing countries.

Infrastructure Development

Good infrastructure facilitates production, reduces operating costs, and thereby promotes FDI (Wheeler and Mody, 1992; Asiedu and Lien, 2004). In the literature, the number of telephone main lines per 1,000 people is often used as a proxy for infrastructure development. This form of measurement has two caveats. First, the data do not include mobile phones. Hence, with the rise in the number of mobile phones, this traditional variable may not be a good proxy for infrastructure. Second, the variable measures only infrastructure availability and does not take into account the reliability of the infrastructure. To take account of these shortcomings, three other measures of infrastructure development are used here (the data are from World Bank, 2003):

  • Telephones per 1,000 people. This is the sum of telephone main lines and of mobile phones per 1,000 people. This variable captures the availability of infrastructure.
  • Electric power transmission and distribution losses as a share of output. This includes losses in transmission between sources of supply and points of distribution. This variable measures the reliability of infrastructure.
  • Gross fixed capital formation as a share of GDP. This includes land improvements and construction of roads, railways, schools, and industrial and commercial buildings. This variable measures infrastructure development in host countries.

Table 7.3 shows that infrastructure availability in Sub-Saharan Africa, defined as the number of telephones per 1,000 people, improved in the 1990s. However, the rate of increase was less than the rate for all developing countries. From the beginning of the 1980s through the end of the 1990s, the number of telephones per people increased by about 71 percent. This compares with an increase of 490 percent for East Asia and the Pacific and 158 percent for all developing countries. With regard to infrastructure reliability, the data suggest that, as in most developing countries, the quality of infrastructure in Sub-Saharan Africa declined in the 1990s. However, the rate of deterioration was higher in Sub-Saharan Africa. For example, electric transmission losses as a percentage of total output increased by 11 percent in the region, as compared with an increase of about 9 percent for all developing countries. Table 7.3 also shows that countries in the region on average spent less on infrastructure in the 1990s than in the 1980s. Gross fixed capital formation as a share of total output declined by 13 percent over the two decades. This compares with an increase of about 3 percent for all developing countries.

Table 7.3.Infrastructure Development for Selected Regions, 1980–99
Gross Fixed Capital

Formation

(In percent of GDP)
Electric Transmission

Losses

(In percent of output)
Telephones per

1,000 People
Region1980s1990sPercent change1980s1990sPercent change1980s1990sPercent change
East Asia and Pacific25.232.615.88.17.6-6.8951490
Latin America and Caribbean20.219.3-4.413.115.719.850109119
Middle East and North Africa24.221.8-9.710.410.94.82761125
South Asia19.621.49.319.419.40.1413228
Sub-Saharan Africa19.917.3-13.18.19.610.681371
All developing countries23.424.02.710.811.79.22155158

Quality of Institutions

Institutional inefficiency, as measured by corruption, weak enforcement of contracts, and a large bureaucracy, deter foreign investment (Asiedu and Villamil, 2000; Gastanaga, Nugent, and Pashamova, 1998; Campos, Lien, and Pradhan, 1999). For the present analysis, three measures of institutional quality are used in Table 7.4:

  • Corruption. This variable measures the degree of corruption within the political system. It covers actual or potential corruption in the form of nepotism, excessive patronage, and bribery. The ratings range from 0 to 6, with a high rating indicating less corruption.
  • Rule of law. The variable measures the impartiality of the legal system and the extent to which the rule of law is enforced. The ratings range from 0 to 6, with a high rating implying an impartial court system.
  • Bureaucratic quality. The ratings range from 0 to 6; a high score implies that the bureaucracy has the strength and expertise to govern without drastic changes in policy and interruptions in government services.
Table 7.4.Measures of Institutional Quality for Selected Regions, 1980–99
CorruptionRule of LawBureaucratic Quality
Region1980s1990sPercent change1980s1990sPercent change1980s1990sPercent change
East Asia and Pacific3.63.6-0.83.54.324.62.42.66.7
Latin America and Caribbean2.52.917.02.43.127.11.31.730.1
Middle East and North Africa3.03.12.32.43.857.61.92.111.8
South Asia1.92.527.81.52.675.51.72.017.2
Sub-Saharan Africa2.72.7-2.42.52.810.81.51.5-1.6
All developing countries2.72.97.32.53.329.11.51.716.1
Source: International Country Risk Guide.
Source: International Country Risk Guide.

Data for the measures of institutional quality were obtained from the International Country Risk Guide (Political Risk Services, 2003). They indicate that, with regard to corruption and bureaucratic quality, Sub-Saharan Africa’s institutions deteriorated in the 1990s. In contrast, corruption declined in developing countries as a whole, and the quality of bureaucracy improved. The rule of law strengthened in Sub-Saharan Africa in the 1990s. However, compared with other developing countries, improvements were meager. For example, the extent to which the rule of law is enforced improved by about 11 percent for Sub-Saharan Africa, as compared with 58 percent for the Middle East and North Africa, 76 percent for South Asia, and 29 percent for all developing countries. Thus, despite improvements in institutional quality in the 1990s, Sub-Saharan Africa seemed less attractive (relative to other developing countries) for FDI in the 1990s than in the 1980s.

Conclusion

This chapter has provided a plausible explanation for the continuing decline in Africa’s global FDI position despite improvements in the policy environment. It has argued that although Sub-Saharan Africa improved its infrastructure, liberalized its investment framework, and reformed its institutions, the degree of reform was mediocre compared with the reform implemented in other developing countries. As a consequence, relative to other regions, Sub-Saharan Africa has become less attractive to FDI over time. With regard to policy, the results indicate that the region needs to keep pace with the rest of the world, the reason being that the world has become more competitive and more integrated. It is therefore not enough just to improve one’s policy environment: improvements need to be made in both absolute and relative terms.

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1See Mody and Murshid (2002) for a discussion on the relationship between FDI and domestic investment, De Mello (1997) for a survey on FDI and economic growth, and Blomstrom and Kokko (1998) for a survey on FDI and technology spillovers to host countries.
2The Millennium Declaration was adopted by the United Nations in September 2000. One of the main objectives is to reduce the number of people living in poverty by 50 percent by 2015.
3It is estimated that reducing the number of Africans living on less than $1 a day by 50 percent would require a 7 percent annual growth rate. For more on this issue, see the NEPAD declaration document, available at www.avmedia.at/nepad/indexg.
4For an extensive survey on the determinants of FDI, see Gastanaga, Nugent, and Pashamova (1998); and Chakrabarti (2001).

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