Africa Finance Forum
African countries have experienced a surge in private capital inflows between 2000 and 2008. According to UNCTAD (2009) (1), the inflows of foreign direct investment reached an unprecended level of $88 billion in 2008, representing 29% of Africa’s gross fixed capital formation. Interestingly, African countries differ significantly in terms of their capacity to attract foreign direct investment. The UNCTAD report also shows that the top 10 recipient countries accounted for nearly 82 percent of the total foreign direct investment inflows.
Meanwhile, financial markets in Africa exhibit significant differences in terms of their levels of development. Most of them are characterized by a low liquidity and a lack of transparency and depth. As reported by Beck et al. (2009) (2), the shallowness of finance or the lack of developed financial market in Africa has dampened economic growth on the continent.
In our research paper, we conduct an empirical study on the direct causal relationship between foreign direct investment (hereafter FDI) and financial market development (hereafter FMD) in Africa, and their combined impact on economic growth. This study is even more relevant in the African context for a number of reasons. On the one hand, one can expect FDI to be an impetus for financial market reforms and serve as a mechanism to improve the transparency, liquidity and depth of financial markets in Africa. On the other hand, well-functioning financial markets on the continent can contribute to a more efficient allocation of foreign investments into productive sectors and create more value for foreign investors, hence foster more foreign investments. Therefore, we would expect FDI and FMD to simultaneouslyimpact positively on each other in the African context.
There are several theoretical rationales for expecting a causal relationship between FDI and FMD. First, an increase in FDI net inflows would contribute to the expansion of the economic activities and lead to an increase in funds available in the economy, which in turn would boost financial intermediation through available financial markets or the banking system. Besides, companies involved in FDI are also likely to be listed on local stock markets as they usually originate from industrialised countries where financing through stock market is a tradition and a must-do for any company that wants to enhance its image among investors. Second, using political economic analysis, one can argue that an increase in FDI would reduce the relative power of the elites in the economy and can prompt them to adopt market friendly regulations, thus strengthening the financial sector. Third, a relatively well functioning financial market can attract foreign investors as they will perceive it as a sign of vitality, openness from the countries authorities and market friendly environment, thus inducing them to invest more in the country. In addition, a relatively developed stock market increases the liquidity of listed companies and may eventually reduce the cost of capital, thus making the country attractive to foreign investors. Each of these arguments providesa theoretical rationale for a positive relationship between FDI and financial market development.
Furthermore, the literature on the relationship between FDI, FMD and economic growth has focused primarily on the relationship between FDI and economic growth and the role played by FMD in that linkage. The literature is almost silent on a possible direct causality between FDI and FMD. The few empirical papers that address this issue consider the role played by FMD in the channelling of FDI into economic production or focus on specific regions. Although, it is established that FDI contributes more to growth in countries with more developed financial market, it is not clear how FDI and FMD interact with each other, especially in Africa, where financial markets are still at the very developmental stage.
The extant literature has not clearly established, at least empirically, a direct link between FDI and FMD, especially for African countries where stock markets are at their embryonic stages and these countries rely strongly on foreign investments for economic development programs. The forgoing discussion relating to the link between FDI and FMD clearly suggests that the relationship between FDI and FMD is endogenously determined. We therefore use a system of simultaneous equations involving both FMD and FDI variables as dependent and independent variables in assessing this direct relationship between FDI and FMD, while controlling for other factors that affect the inflows of foreign direct investments and the development of financial markets.
Compared to previous studies, we use a multiple ofvariables to measure FDI and FMD, as suggested by the literature. For FDI, we use the ratio of FDI net inflows as a percentage of GDP and the ratio of FDI net inflows as percentage of gross capital formation (GCF). For FMD, we use stock market and as well as banking sector development variables; namely: (i) stock market capitalisation as a percentage of GDP, (ii) stock market turnover ratio, (iii) stock market value traded as a percentage of GDP, (iv) total credit by financial intermediaries to private sector over GDP, (v) liquid liabilities of the financial system divided by GDP and (vi) ratio of commercial bank assets to commercial bank andcentral bank assets. We also include in our regressions other variables found in the literature to be key determinants of FDI and FMD.
Based on Granger causality tests and multivariate analyses, we document a bidirectional positive relationship between FDI and FMD. We also find that FDI impacts positively and significantly on economic growth in Africa when we control for the simultaneous effects of both FDI and FMD.
Our work provides additional evidence that FMD facilitates the inflows of FDI and significantlycontributes to economic growth. More importantly, the statistical results also support the view that economic growth, FDI and FMD are interconnected. While the surge in private capital inflows in the 2000’s may be facilitated by the combined effects of worldwide excess liquidity and high commodity prices, it arguably reflects the progress made by a number of African countries in financial sector reforms. Yet, for most African countries, FMD is still in its infancy. Despite the policy measures adopted by some countries to make the business environment more attractive to FDI, the financial system remains bank-based rather than market-based. With the exception of a few stock exchanges such Johannesburg Stock Exchange, several African exchanges suffer from a lack of scale and the network economies needed to create the level of liquiditynecessary to make the markets effective channels to mobilize long-term capital resources in general and induce greater inflows of FDI in particular. The extent to which a consolidation of African stock exchanges and a greater integration of financial markets would induce greater inflows of FDI and foster higher economic growth could be an interesting subject for a future study.
Dr. Isaac Otchere is Associate Professor of Finance at Sprott School of Business at Carelton University in Ottawa, Canada. His research interests include valuation, mergers and acquisitions (M&A), and privatization. He taught MBA courses at Universities in Canada, Australia, Singapore and Ukraine, among others and has received a number of awards for excellence in teaching.
Dr. Pierre Yourougou is Clinical Associate Professor of Finance and Kiebach Fellow at Whitman School of Management at Syracuse University in New York, USA. His research interests include emerging markets, corporate finance, and financial markets and institutions.
Dr. Issouf Soumaré is Associate Professor of Finance and Managing Director of the Laboratory for Financial Engineering at Laval University in Canada. He is also responsible for the MBA & MSc Finance and MSc Financial Engineering programs at the same university. His research and teaching interests include risk management, financial engineering and numerical methods in finance. His theoretical and applied financial economic works have been published in leading international economics and finance journals.
(1) UNCTAD, 2009, World Investment Report 2009, Transnational Corporation, Agricultural Production and Development, United Nations, New York and Geneva.
(2) Beck, T., Fuchs, M., and M. Uy, 2009, Finance in Africa: Achievements and Challenges, World Bank Policy Research Working Paper 5020.