Determinants of foreign direct investment inflows to COMESA member countries: An integration of institutional and socio-economic factors

Meressa, Hayelom Abrha Article Determinants of foreign direct investment inflows to COMESA member countries: An integration of institutional and socio-economic factors Journal of Innovation and Entrepreneurship Provided in Cooperation with: Springer Nature Suggested Citation: Meressa, Hayelom Abrha (2022) : Determinants of foreign direct investment inflows to COMESA member countries: An integration of institutional and socio-economic factors, Journal of Innovation and Entrepreneurship, ISSN 2192-5372, Springer, Heidelberg, Vol. 11, Iss. 1, pp. 1-16, https://doi.org/10.1186/s13731-022-00262-z This Version is available at: https://hdl.handle.net/10419/290227 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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RESEARCH Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 https://doi.org/10.1186/s13731-022-00262-z Journal of Innovation and Entrepreneurship Determinants offoreign direct investment inflows toCOMESA member countries: anintegration ofinstitutional andsocio-economic factors Hayelom Abrha Meressa* Abstract In developing economies, stable foreign direct investment inflow is used as a means of realization of private sector growth and sustainable development goals. However, there is variability in inflows to African region in general and its economic bloc groupings in particular overtime across countries. In this regard, numerous empirical studies have been carried out on the determinants of investment inflow variability using different datasets on developing countries despite the studies have produced paradoxical findings. The aim of this study is, therefore, to empirically identify factors that determine variability of foreign direct investment inflows to COMESA member countries using panel data estimators. The study used explanatory research design with arrangement of secondary data, ex post control over variables, unbalanced short panel inclined with quantitative approach. The data were acquired from world development and governance indicators of World Bank for a period of 15 years ranging from 2002 to 2016 for 17 countries. Econometric model estimation procedures and diagnostic tests for classical linear regression model assumptions were carried out before making valid analysis. Accordingly, empirical evidence of the study revealed that infrastructure, government effectiveness, economic growth, control over corruption, trade openness, political stability, human capital and financial development have statistically positive effect on the inflow. However, external debt, inflation and regulatory quality failed to show significant effect. Therefore, member countries should take measures to narrow-up bottlenecks of financial development, improve infrastructure, scale-up trade integration, improve human capital quality, work to bring better political stability and to control corruption in order to boost-up stable inflows. Keywords: COMESA, Foreign direct investment, Panel estimators Introduction In developing economies, inflow of foreign direct investment (FDI, hereafter) has been recognized as secure element of capital inflows capable of producing economic expansion as long as foreign direct investors usually place a long-term commitment to host countries (Esew & Yaroson, 2014; Mugambi & Murunga, 2017). Moreover, it is *Correspondence: hayelommer[email protected] Accounting and Finance Department, College of Business and Economics, Assosa University, Assosa, Ethiopia Page 2 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 considered as external source of financing that could be used as a means of private sector growth implementation and sustainable development goals (Alla etal., 2015; Hassan, 2017). In this regard, most developing countries have implemented various economic reforms to increase foreign direct investment inflow and to take its advantage (Vinesh etal., 2014). In the same fashion, some African countries introduced policy measures for the promotion of FDI inflows by improving their general investment policy environment (Suleman etal., 2015). As economic bloc and regional integration, COMESA has clear investment provisions such as the COMESA common investment agreement and regional investment agency of COMESA to attract foreign investors. However, there is variability in the inflow of FDI across to the member countries over time as of world development indicators dataset (UNCTAD, 2017). Despite the fact that numerous empirical and theoretical studies have been carried out on the determinants of FDI inflows using different datasets on developing countries, empirical results obtained so far, however, are riddling that have produced conflicting results (Alla etal., 2015; Anyanwu, 2012; Basemera etal., 2012; Buthe & Milner, 2008; Dlamini etal., 2015; Hailu, 2010; Sichei & Kinyondo, 2012; Workneh, 2014; Yasmin etal., 2003). To mention few findings, for instance; empirical study made by Basemera etal. (2012) found corruption, inflation, openness of economy and GDP per capita as determining factors of invetment inflows to East African countries. Besides, Suleman etal. (2015) found market size, availaility of natural resource and trade openness as positive determinants in southern Africa customs union countries using pooled OLS, considering foreign companies as resource seeking. In addition, a study conducted by Kaliappan etal. (2015) in ASEAN countries using static panel revealed that human capital, infrastructure,trade openess and market size affects investment inflow positively with negative effect of inflation. Further, Yasmin etal. (2003) found standard of living, urbanization, current account, inflation, and wages as determinants of FDI in low income countries. Moreover, Sichei and Kinyondo (2012) found natural resources, economic growth and international investment agreements as determining factors of FDI in african countries using dynamic panel estimators. Not only the above, a study carried out by Vinesh etal. (2014) on determinants of foreign direct investment for Southern African Development Community found gross domestic product, trade openness, secondary school enrollment rate and natural resources as influencing factors of the inflows. Further more, Jadhav (2012) found that market size, trade openness, availablity of natural resource and rule of law as determinants in attracting foreign investment in BRICS. Despite the efforts made, previous empirical studies on the determinants of foreign direct investment in different countries have largely aimed at testing Dunning’s (1981) eclectic paradigm of ownership, location and internalization advantages of investors from host countries. Surprisingly, to the best of the researcher’s knowledge, the impact of institutional and governance qualities on inflows of foreign direct investment, however, have been missed by many studies. Considering this, there is a need of study on determinants of FDI inflows in African countries by incorporating socio-economic, institutional and governance factors to attract foreign investors. This paper, therefore, seeks to identify empirically the determinants of FDI inflows by integrating economic and institutional factors using data set that covers 17 COMESA member countries over Page 3 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 the period 2002–2016 based on previous studies’ empirical results and theoretical considerations with central research question of “what factors determine inflows of FDI to COMESA member countries?”. The grounds to conduct this study are three folds. First, empirical results available in the literature of foreign direct invstmet determinants are mixed that have produced conflicting results. In some empirical evidences some factors seem to be more significant than others where as the same factors in other empirical evidences are not important factors in determining FDI inflows (Kingu, 2016). Among others, the puzzling results may depend on the researchers’ choice of countries, time-periods and applied methodologies while conducting their study. Second, studies on African region in general and its economic bloc groupings in particular are still limited in addition to the paradoxical result of empirical evidences which needs empirical invetigation (Suleman etal., 2015). Third, as economic bloc, there is uneven distribution of inflows in FDI to the member countries of COMESA over the study period as discussed in the introduction and there is no evidence about the causal factors for the variability of inflow across the member countries overtime. The remainder of this paper is structured as follows: Section two discusses about literature review followed by section three research methodology. Section four presents empirical results and discussion. Finally, section five provides the conclusion thereafter forwards recommendation. Literature review This section describes empirical evidences on the determinants of foreign direct investment inflows and develops hypotheses to narrow the gap between what is now in the literature about the influencing factors and what factors determine FDI inflows to COMESA member countries. In this regard, the study reviewed economic and institutional factors affecting inflows of FDI. Socio‑economic factors nexus foreign direct investment inflows As economic factor, this section starts with the effect of market size on FDI. Market size emphasizes the importance of a large market for efficient utilization of resources and exploitation of economies of scale that could play an important role in attracting inflows of foreign direct investment (Chaliapin etal., 2015). In this vein, it is believed that the larger the market size indicated by GDP of host countries may have greater inflow of foreign direct investment (Wyk & Lal, 2008). This is for the fact that growth rate in economy creates vast opportunities to invest (Wyk & Lal, 2008); whereas, unstable economic environment, characterized by high inflation may raise the cost of investment and affect the return of it in a negative way (Suleiman etal., 2015). Moreover, it is argued that high inflation would deter inflow of FDI because it increases uncertainty and adversely affects long-term investments to the host countries (Kaliappan etal., 2015; Sichei & Kinyondo, 2012). Besides, the availability and quality of supportive infrastructural facilities is essential for the smooth functioning of investment activities (Shah, 2014). In this regard, it is believed that countries with well-developed infrastructures, such as water supply, airports, power supply, telephone, roads, and internet would be able to minimize costs of Page 4 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 doing business for foreign investors (Kaliappan etal., 2015; Sichei & Kinyondo, 2012; Suleiman etal., 2015). In addition, the degree of openness which could be measured in terms of trade ratio is an indicator of the level of global integration of a nation. It is believed that trade openness promotes efficient resource allocation through specialization as well as competition in different markets to take comparative advantage (Shahzad etal., 2012; Vinesh etal., 2014). In addition, there is a documented evidence on the relationship between external debt and FDI. Excessive foreign debt can be a source of instability and uncertainty in macroeconomic environment which in turn reduces inflows of FDI to the host country (Dlamini etal., 2015). In his regard, scholars indicate that external debt is bad as far as it results to increase external debt service which eats profit of foreign investors (Mugambi & Murunga, 2017). As a socio-economic factor, human capital, proxied by skill labor force, is also a relevant determinant that affects the level of productivity in investment. This is for the fact that skilled labor sectors where the level of education improves, productivity increases and facilitates implementation of technological innovations (Sichei & Kinyondo, 2012; Kisto, 2017; Vinesh etal., 2014). The higher the level of education of the host country, the higher its propensity to attract foreign investors and technological spillover is encouraged (Esew & Yaroson, 2014). Moreover, a financial system has great contribution for the smooth functioning of modern economy and is represented by functioning of financial institutions especially banks. Hence, the development of domestic financial system might help foreign firms to raise finance in order to broaden investment activities in host country (Vinesh etal., 2014). An efficient financial system is also indispensable in attracting capital investment, as a secure capital and money market would provide the essential financial assistance (Esew & Yaroson, 2014). Institutional factors andforeign direct investment inflows In this section, the effect of governance and institutional factors on inflow of FDI is discussed. In this regard, the nexus between government effectiveness and FDI inflows is discussed first followed by other governance indicators. A government is said to be effective if the civilians are provided with best quality services and their lives are free from political pressures (Shah & Afridi, 2015). As cited by Basemera etal. (2012), the World Bank (2007) defines governance as the manner in which public officials and institutions acquire and exercise authority to shape their public policy and provide public goods. A study carried out by Jadhav (2012) on determinants of foreign direct investment in BRICS (Brazil, Russia,India, China and South Africa) economies revealed the influence of government effectiveness on foreign direct investment. Besides, the effect of corruption control on FDI inflow is reviewed. Different studies have examined the economic impact of corruption using various theories, such as public choice, rent-seeking, transaction cost, institution and social cost, socio-cultural perspectives and property rights (Quazi, 2014). With regard to nexus of corruption and inflow of foreign direct investment, however, there is mixed evidence. On the one hand, the grabbing hand theory of corruption which is supported by economists such as Shleifer & Vishny (1992, 1993), Bliss & Page 5 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 Di Tella (1997), & Aidt (2003) explained corruption like a grabbing hand that increases costs involved in conducting economic activities in the market that could raise the cost of doing business, distorts the resource allocation, and decreases output-generating capacity of foreign investment. On the other hand, the helping hand theory of corruption which is supported by researchers such as Beck & Maher (1986), Lui (1985) & Saha (2001), claims on corruption as an efficient lubrication against a rigid economic regulation by facilitating transactions in countries with excessive regulations that may in turn increase foreign direct investment inflows (Alemu, 2012). In addition, foreign investors are likely to think about the political stability of a host country before making investment. It is believed that political stability of host countries reduces risks and investment uncertainty that could lead to an increase in FDI inflows (Basemera etal., 2012). Therefore, political risk in a country is an important consideration for foreign investors that may influence foreign direct investment inflows negatively (Kariuki, 2015). Political stability of a country is composed of different sub components like government stability, internal and external conflict, religious and ethnic tensions, democratic accountability and bureaucracy quality. Thus, political instability and frequent occurrence of civil disorder create an unfavorable business climate which seriously erodes the risk-averse foreign investor’s confidence to make investment (Sichei & Kinyondo, 2012). If a country’s political condition is not good, investors will hesitate to bring any investment projects until they are assured that the business environment would to be favorable and conducive (Brada etal., 2005; UNCTAD, 2010; World Bank, 2011 as cited by Shahzad etal., 2012). Moreover, regulatory quality which indicates the governments’ ability of formulating and implementing sound policies as well as regulations that could permit and promote private sector development affects flow of foreign direct investment positively (Fakher, 2014). This is for the fact that some regulations such as price control, high tax loads, stock market limitations can restrict and prevent the development of foreign direct investment inflows. On this basis, government can play a remarkable role for improvement and development of foreign investment through decreeing appropriate regulations and through clarifying the current existing structures, equalizing the opportunities, reducing the rent-seeking costs, and also updating the legal disciplines (Barkhordari etal., 2017). Therefore, regulatory quality is expected to encourage the entry of foreign investors by eleminating market unfriendly policies such as price controls, government intervention, and restrictions on capital movement (Fazio & Talamo, 2008; Shah & Afridi, 2015). Materials andmethods Research paradigm andapproach The study used ex post facto quantitative approach under positivist paradigm that reflects a deterministic philosophy in which causes probably determine outcome and knowledge creation is restricted to what can be observed and measured. Quantitatively, the purpose is to determine factors influencing FDI inflows to COMESA member countries deductively to test formulated hypotheses based on prior theoretical and empirical studies. Page 6 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 Sampling anddata There are 19 member countries in COMESA. These are Ethiopia, Burundi, Djibouti, Comoros, Egypt, Congo, Eritrea, Kenya, Malawi, Libya, Madagascar, Mauritius, Swaziland, Rwanda, Sudan, Seychelles, Uganda, Zimbabwe and Zambia. In this regard, target population of the study comprised all member countries. However, only data of 17 countries were used in the study purposely by excluding countries (Eritrea and Libya) with many missing observations on the variables of the study. The type of data employed was secondary data. Specifically, the study used short and unbalanced panel data that include large cross section and small time with missed values; blending characteristics of both cross-sectional and time-series data. The data were acquired from world development and governance indicators of World Bank for period of 15years ranging from 2002 to 2016 for 17 countries. The rationale to start the time period from 2002 is due to the unavailability of data regarding world governance indicators of World Bank before the year indicated above. Variable measurement Although prior empirical evidences on FDI inflow determinants have suggested numerous possible explanatory variables, it is impracticable to include all of them due to many resource related constraints and/or availability of data. In the current study, unquestionably, the choice and measurement of variables was based on previous empirical studies and availability of data. Therefore, variables incorporated in this study were delimited by accessibility of secondary data of World Bank development and governance indicators. Accordingly, the study incorporated host countries’ economic, social, political and institutional factors that determine inflow of FDI measured by net inflows as percentage of GDP. To be specific, inflation, economic growth, infrastructure, trade openness, government effectiveness, regulatory quality, political stability, control over corruptions, external debt, human capital and financial development were considered as foreign direct investment influencing factors based on their relative importance from previous empirical literature and availability of data in the study period for the member countries. Accordingly, measurement of these variables is dealt here. First, the index of government effectiveness is calculated based on public service quality; effectiveness of the state apparatus; the degree of independence of civil service from political pressures. Thus, estimate gives country’s score on aggregate indicator and percentile rank reflects rank of a country among others. To be specific, the percentile rank approaches to 0 imply lowest rank and a percentile that approaches to 100 indicates highest rank (Babayan, 2015; Chaib & Siham, 2014; Kaufmann etal., 2008). With regard to trade openness, though few studies measure it using import or export as percentage share of GDP, in the current study it is measured by international trade as percentage share of GDP (Anyanwu, 2012; Fiodendji, 2016; Shahzad etal., 2012; Vinesh etal., 2014). External debt is proxied by external debt stocks of host countries (Dlamini etal., 2015; Mugambi & Murunga, 2017; Yasmin etal., 2003). Besides, political stability measures perceptions of political instability risk and/or violence motivated by politics. In fact, estimate gives score of a country on aggregate indicator, and percentile rank designates rank Page 7 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 of a country among entire countries covered by the indicator, with 0 corresponding to lowest rank and 100 to highest rank. Indeed, political instability risk is proxied by an indicator developed by world governance indicators project of World Bank (Basemera etal., 2012; Chaib & Siham, 2014; Quazi, 2014). Host country’s domestic credit supply to private sector as percentage of it’s GDP is used to measure financial development of the member countries. Infrastructure is measured using number of mobile cellular subscription per hundred persons for country as a proxy of information and communication technologies (Kaliappan etal., 2015; Suleman etal., 2015; Vinesh etal., 2014; Zekarias, 2016). As additional explanatory variable, human capital is measured by secondary school enrollment as percentage of gross enrollment (Anyanwu, 2012; Esew & Yaroson, 2014; Fiodendji, 2016; Kisto, 2017; Vinesh etal., 2014; Yasmin etal., 2003). Moreover, regulatory quality captured the perceptions of governments’ ability to formulate and implement best policies as well as regulations that could permit and promote development of private sector (Babayan, 2015; Chaib & Siham, 2014; Kaufmann etal., 1999). Likewise, the above indicators of good governance, estimate gives a country’s score on the aggregate indicator, and percentile rank indicates a country’s rank among all countries covered by the indicator, with 0 corresponding to lowest rank, and 100 to highest rank. Further, economic growth is measured by GDP growth rate (Anyanwu, 2012; Buthe & Milner, 2008; Vinesh etal., 2014). Inflation is measured by consumer price index. Finally, even if it is possible to measure control over corruption using corruption perceptions index adopted by transparency international which is global coalition against corruption the index developed by world governance indicator is used in the current study due to the data availability (Anyanwu, 2012). Empirical results anddiscussion Empirical models are mostly formulated based on theoretical background and/or previous empirical evidences. In this regard, the current study considers both theoretical and empirical issues related with foreign direct investment while formulating the econometric model. In the existing literature, there is no single superior theory which comprehensively explains foreign direct investment. Therefore, it is important to conduct research from a specific theoretical background (Makoni, 2015). Product cycle theory, industralization theory, ownership advantage theory, internationalization theory, eclectic paradigm are few among many theories of FDI. Iindustrialization theory of FDI states that the flow of foreign direct investment affects host country’s industrial structure by initiation and diffusion of industrialization across countries as long as adopting foreign invented technology is generally beneficial for industrial development (Soreide, 2001). According to product cycle theory of FDI (Vernon, 1966), multinational firms establish their manufacturing facilities in foreign countries when their product reaches maturity stage in the home country. Besides, ownership advantage theory of FDI states that firms with better competitive advantage domestically derived from their valuable assets like brand names, technology and large-scale economics extend their operations to foreign Page 8 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 markets in other countries through FDI to utilize their assets. This theory, however, fails to explain the means of entering to foreign markets in order to exploit the ownership advantages which is solved by internationalization theory. Internationalization theory of FDI, therefore, concerns extending the direct operations of foreign firms and bringing under common ownership and control of the activities conducted by intermediate markets that link the firms to customers through various means like licensing, franchising and exporting by entering a contract with foreign firms (Morgan & Katsikeas, 1997). In the same fashion, internalization theory fails to explain locational advantage. Accordingly, eclectic theory incorporates locational advantage of FDI in addition to the ownership advantages and internalization advantage. According to this theory, foreign companies go abroad get the competitive advantages by consuming resource endowments of host countries and unique strengths of the investing company. Accordingly, this study is based on Dunning’s foreign direct investment eclectic paradigm by incorporating addiional institutional and governance variables. This is for the fact that the framework is influential model for many empirical researches on FDI affecting factors for long time (Alla etal., 2015; Azam, 2010; Basemera etal., 2012). To this effect, based on (Dunning, 1988, 2000): From the OLI, the location advantages could be considered as country specific factors (demand/pull factors) and ownership and internalization advantages are supply side (push side) factors which are company specific. To put it in other way, supply side factors are external to host country, however, demand side are factors internal to host (recipients) countries economic, political and social factors (Alavinasab, 2013; Anyanwu, 2012; Hailu, 2010; Popovici & Călin, 2014). As a result, the dependent variable in the econometric model of this study is foreign direct investment inflow and the regressors are demand side factors including inflation, economic growth, infrastructure, regulatory quality, political stability, government effectiveness, trade openness, external debt, human capital, financial development, and control over corruption. To put it in a functional form: Based on the above functional form, it is better to provide panel econometric models (static and dynamic). In line with this, literature revealed pooled OLS, random effect and fixed-effect estimators as static panel estimators. The OLS estimator assumes homogeneity across study units (Cameron & Trivedi, 2005). In this regard, if there is heterogeneity, the estimator is inconsistent. If we are concerned that the OLS results may be biased due to unobserved individual heterogeneity across unit, either fixed effect or random effect could be used based on some preconditions. Therefore, checking whether there is existence of poolability (homogeneity) or unobserved individual FDI =fownership advantage, location advantage, internalization advantage . Inflow of Foreign Direct Investment =f(inflation, economic growth, infrastructure, trade openness, government effectiveness, political stability, regulatory quality, external debt, human capital, financial development, and control over corruption ) . Page 15 of 16 Meressa Journal of Innovation and Entrepreneurship (2022) 11:68 fashion, with regard to the governance factors, the countries under investigation should bring better government effectiveness, political stability, and control over practice of corruption to boost-up inflow of FDI that could be used as means of achievement of growth of private sector and sustainable development goals. However, policy measures that have been successful in one country should not be blindly replicated in another since these policies might have differential impacts as long as each member country of COMESA has some unique features that might attract or hinder inflows of FDI. Abbreviations COMESA Common Market for Eastern and Southern Africa FDI Foreign direct investment BRICS Brazil, Russia, India, China, and South Africa GDP Gross domestic product UNCTAD United Nations Conference on Trade and Development OLS Ordinary least squares GMM Generalized method of moment Acknowledgements Not applicable. Author contributions The author, HAM, personally undertook this research paper. The author also read and approved the final manuscript. Funding Not applicable. Availability of data and materials The data that support the findings of the study can be obtained from the author based on request. Declarations Ethics approval and consent to participate Not applicable. Consent for publication The author personally approves that the paper should be published in your journal. Competing interests The author declares that there is no competing interest. Received: 20 December 2021 Accepted: 16 November 2022 References Alavinasab, S. M. (2013). Determinants of Foreign Direct Investment in Iran. International Journal of Academic Research in Business and Social Sciences, 3(2). Alemu, A. M. (2012). Effects of corruption on FDI inflow in Asian economies. Seoul Journal of Economics, 25(4). Alla, O. A., Abdelmawla, M. A., Mohame, A. A., & Mudawi, S. K. (2015). Evaluation of Foreign Direct Investment Inflow in Sudan: An empirical investigation (1990–2013. Journal of Business Studies Quarterly, 7(2). Anyanwu, J. C. (2012). Why does foreign direct investment go where it goes?: New evidence from African Countries. Annals of Economics and Finance, 13(2), 425–462. Azam, M. (2010). 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