FDI Components in Selected MEFMI Countries: The Role of Institutional Quality

By Wilson C.K. Phiri
April 2015
Foreign Direct Investment (FDI) inflows in most Macroeconomic and Financial Management Institute of Eastern and Southern Africa (MEFMI) countries continue to be low relative to other regions of the world, despite notable progress made towards achieving relative macroeconomic growth and stability. Controlling for macroeconomic and other major drivers, this study bridges the gap in the literature by distinguishing the role of institutional quality (property rights, political stability, and economic and investment freedom) in driving the equity and debt components of FDI in selected MEFMI member countries (Kenya, Lesotho, Malawi, Mozambique, Tanzania, Uganda, and Zambia) for the period 1995-2012. The study employs Fedderke (2002) portfolio theoretical model, via a panel Vector Error Correction framework.

The findings show that there is a clear distinction of macroeconomic and institutional factors that drive equity and debt components of FDI and their degrees of elasticity. While both real GDP and political stability have a positive effect on both components of FDI, the impact on intercompany debt is generally more than twice higher than on equity. The real effective exchange rate, the degree of openness and investment freedom have a positive and significant effect on equity but insignificant on the intercompany debt component. Property rights, however, were found to have a significant effect on intercompany debt component but insignificant effect on equity. The role of economic freedom is direct, positive and significant on intercompany debt, while its impact on equity is indirect, positive but significant via its effect on real GDP.

In terms of impact on growth, a one percent rise in the equity component contributes up to 3.8 percent increase in real GDP compared with 0.6 percent contribution of the inter-company debt component. To stimulate the equity component which is highly desirable, priority should be given to maintaining robust real GDP growth, exchange rate competitiveness, political stability, and fostering investment and economic freedom. In order to enhance and ensure stability of overall FDI inflows in the region, member countries should improve the investment climate by strengthening institutional quality. Focus should be laid on reducing uncertainty and transaction costs associated with weak institutions. This entails enhancing the rule of law, regulatory efficiency and open markets through credible institutional and policy reforms.

Key words: FDI Equity, FDI Debt, Institutional Quality, MEFMI Countries