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Why FDI?


Foreign Direct Investment. Together with the broad pickup in African activity over the last decade or so has been a rise in foreign direct investment inflows to the continent. Examples include a business in country X physically investing (i.e. buying a stake) in a business in another country Y or establishing a new whole new enterprise there (i.e. opening a factory).

Can be positive. From the receiving countries perspective, the key point about FDI is that it has the scope to propel economic activity. There are two main channels. The first is by adding to the capital stock of a nation (dubbed "capital widening" by economists), especially if it involves new facilities or infrastructure which increase potential output. This impact is likely to be particularly acute in markets where existing capacity is limited. The second channel involves the transfer of knowledge, technology and organisational capabilities ("capital deepening") which increase productivity. The resulting boosts to economic growth can then feed through to broader development objectives. For example, it may deliver extra tax revenues to governments which can be used to increase the supply and quality of public goods such as infrastructure, education and healthcare.

But Buyer Beware. Of course, there are some potential downsides. For example, inward flows can displace and denude local entrepreneurial activity, skill formation and employment in several ways. For example, finance-pressed governments may reduce outlays on some elements of tertiary education on the grounds that training offered by the entering multinational companies is suffice. The incoming firms may also be better at securing local bank loans which can restrict broader credit access while their career prospects, say via external secondments, and higher wages, may see them scooping up skilled workers who might otherwise have gone to local companies. An influx of accompanying expatriate labour may encourage the emigration of equally adept local workers.

More caveats. Despite the potential nuances, the plethora of tax breaks, import duty exemptions and even direct subsidies indicate that many African nations see encouraging increasing levels of FDI inflows as a key policy objective. This partly stems from the empirical evidence which tends to show a positive correlation between FDI and economic output. However, there are two key issues to bear in mind. To begin, it is entirely plausible that the positive relationship stems from, say, higher GDP growth rates attracting FDI rather than the reverse. Relatively cheap labour, raw material access, workforce skills and government support are not the only reason why Chinese textile and light manufacturing companies are clustering in Ethiopia. Thus, FDI may simply follow economic development rather than drive it. If so then an undue emphasis on securing it may be misplaced. Second, the early results of our own empirical with African data chime with other studies in indicating that the positive relationship is strongest among least developed markets and weakens as countries become more wealthy - possibly because richer nations are better able to propel their development via internal mechanisms and so the marginal impact of FDI is lower. In sum, the possibility that the FDI inducement packages of many African governments represent a misallocation of precious resources remains live.