FDI in southern Africa: Microeconomic consequences and macro causes

Daniel Lederman, Lixin Colin Xu, 17 October 2010

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Foreign direct investment has been an important component of development success stories around the world. Africa, however, and particularly southern African economies, has not been part of this story (see Table 1).

Even though African economies belonging to the Southern African Development Community (SADC) are poor on average, per capita FDI inflows are a meagre $37 per year. This is roughly 18% of the average, and 58% of the average for countries with a similar income.

Country differences within southern Africa are huge. FDI per capita ranges from single digits in countries such as Malawi1 to $10-$30 in Mozambique2 to $50-$100 in South Africa3 to $167 in the outlier in this region, middle-income Botswana. Even within this region there is a positive relationship between average income and FDI per capita, a pattern that holds for the world as a whole. Thus, any hope of relying on FDI as a supply-side remedy to catapult poor countries onto a development fast track is not likely to materialise anytime soon. Policymakers and development agencies are right to be concerned.

Table 1. The southern African development community and the rest of the world: Selected indicators

Notes: "Similar income countries" are economies with less than $4,600 GDP per capita.
ICRG is the acronym of the International Country Risk Guide, a private assessor of country risk. ICRG data is proprietary. Higher values reflect better rule of law and less corruption. Source: World Bank.

Does FDI help? Horizontal and vertical spillovers

Although officials may hope that FDI can play a positive role in local economic development, this is not a foregone conclusion either. Multinational corporations might merely capture rents and create jobs at the expense of existing jobs. Further, technological spillovers may not materialise but instead foreign firms might steal domestic markets away from national firms. The potential benefits of FDI may also differ across economic contexts. This combination of wishful thinking and hard-nosed theoretical predictions puts empirical research on centre stage.

Thus, the horizontal spillover effects tend to be ambiguous. Indeed, many recent studies find insignificant and even negative horizontal spillover effects – sometimes dubbed the “market-stealing” effect. The reference along this line includes Haddad and Harrison (1993) on Morocco, Aitken and Harrison (1999) on Venezuela, Djankov and Hoekman (2000) on the Czech Republic, and Konings (2001) on Bulgaria, Romania, and Poland.

The evidence appears to be more positive for the horizontal effects of FDI in developed countries (Haskel et al. 2002, Keller and Yeaple 2003) based on evidence from the UK and the US. In contrast, Kee (2010) finds positive horizontal FDI spillover effects due to the cultivating of and the stronger demand for local input suppliers based on a sample of Bangladeshi garment firms.

Vertical spillover effects refer to the potential benefits to input suppliers or clients of foreign companies, such as the offering of technological help, stronger quality control, and so on. Since there are no conflicts of interests between foreign firms and their clients and suppliers in technology and managerial know-how spillovers, vertical spillover effects are more likely. This is indeed what Javorcik (2004) finds for Lithuania.

It is safe to say that the evidence has been at most mixed. In surveying related evidence, Rodrik (1999) stated that “today’s policy literature is filled with extravagant claims about positive spillover effects from FDI but the evidence is sobering.” The understanding of the spillover effects is further complicated by the idea that the effects of policies tend to differ across contexts due to differences in complementary institutions, regulatory environments, and even skill levels of local employees (Kremer 1993; Xu, forthcoming).

Missing evidence for Africa

Until now, the literature had not addressed these issues for African economies, partly due to a lack of reliable and comparable micro data. But new data is now available. The World Bank’s investment climate surveys in this region offer comparable cross-country, firm-level data with information that allows us to link foreign ownership to firm performance in thirteen southern African economies.

In a paper we coauthored with Taye Mengistae, an Africa specialist at the World Bank (Lederman et al. 2010), we find that FDI has significantly facilitated development in southern Africa.

  • Foreign firms tend to perform better, as measured by both sales growth rates and total factor productivity. An increase of foreign ownership by 10 percentage points is associated with higher sales growth of about 2 percentage points and productivity gains of about 1.4 percentage points.
  • Foreign-owned firms tend to be larger, located in richer and better-governed countries with more competitive financial intermediaries.
  • They are also more likely to export than domestic firms. The probability of exporting for a foreign-owned firm relative to a domestic firm is about 5.5 percentage points higher. This effect is quite large since the average probability of exporting for domestic firms is only 6.3%.

More importantly, domestic firms tend to benefit from the presence of foreign firms operating in the same industry, thus suggesting that positive spillovers might be important.

  • An increase in the percentage of foreign-owned firms in an industry by 10 percentage points appears to be associated with an increase in the productivity of domestic firms by about 2 percentage points.

Hence FDI does have the potential to help southern African economies escape under-development. But, are the obstacles to FDI insurmountable?

Obstacles to FDI in southern Africa

The literature on FDI points towards a relatively simple generic set of variables that appear correlated with FDI success (e.g. Fan et al. 2009). The literature views prospective multinational firms as possessing information-based firm-specific capabilities that they could profitably apply in foreign countries. Indeed, these capabilities allow them to overcome the “difficulties of being foreign” to generate returns to justify the investment.

Agency problems, information asymmetries, and property rights protection problems that render information-based assets inaccessible prevent these firms from selling or leasing those capabilities to foreign firms. To profitably apply their unique capabilities abroad, multinationals resort to establishing controlled foreign operations to engage in FDI. Still, FDI is an investment like any other in the sense that it seeks profits.

The net present value of a corporate investment project depends on a number of factors. The first is market size, which raises the expected present value of investments with high fixed costs. All else equal, FDI flows pursue large markets. However, all else is seldom “equal”. Potential profits depend on local product and factor market development and growth potential, and they are negatively affected by market risks and the costs of doing business, including taxes, labour costs relative to productivity, and infrastructure.

All these factors hinge on an economy’s institutional environment. This consideration echoes the finance and growth literature which emphasises that sound and well-enforced rules and regulations, like property rights protection and information disclosure, encourage economic development in general and capital market development in particular (La Porta et al. 1997 and 1998, King and Levine 1993).

Empirical results: The usual suspects

We find that basic economic and institutional factors attract FDI, but it is always safe to check whether other unobserved characteristics make certain countries or regions unique. We find no such region-specific effect, suggesting that southern Africa is, in a sense, receiving the FDI that it deserves, given its average income, human capital, demographic structure, institutions, and economic track record.

To shed further light on the drivers of FDI, we compared southern Africa with two groups of developing countries with higher FDI per capita. The factors that account for southern Africa’s lower FDI inflows are economic fundamentals:

  • Previous growth rates,
  • income,
  • phone density, and
  • the adult share of the population.

Moreover, while income and infrastructure do not matter as much in southern Africa as in the rest of the world, openness (as measured by trade over GDP) matters more. This is consistent with the view that FDI to small countries is export-oriented.

Concluding remarks

Why do southern African countries have worse economic fundamentals? There are plenty of analyses shedding light on this question. Some of the potential culprits include ethnic polarisation, political instability, and civil wars among others. To attract FDI to the region, these countries have to build fundamentally sound economies that naturally lure FDI. In addition, our results indicate that openness is especially important for southern Africa. Policies and procedures to encourage openness are therefore especially important for the region.

References

Aitken, Brian J., Ann E. Harrison. 1999. “Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela.” American Economic Review 89, 605-18.

Alfaro, Laura, Sebnem Kalemli-Ozcan, and Vadym Volosovych, 2005. “Why doesn’t capital flow from rich to poor countries? An Empirical investigation,” NBER Working Paper 11901.

Djankov, Simeon, and Bernard Hoekman. 2000. “Foreign Investment and Productivity Growth in Czech Enterprises.” World Bank Economic Review 14, 49-64.

Fan, Joseph, Randall Morck, Bernard Yeung, Lixin Colin Xu. 2009. "Institutions and Foreign Direct Investment: China vs. the Rest of the World", World Development 37 (4), pp. 852-865.

Javorcik, Beata. 2004. “Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers through Backward Linkages,” American Economic Review 94, 605-27.

Haddad, Mona, and Ann E. Harrison. 1993. “Are There Positive Spillovers from Direct Foreign Investment? Evidence from Panel Data for Morocco.” Journal of Development Economics 42, 51-74.

Haskel, Janathan; Sonia Pereira, and Mathew Slaughter. 2002. “Does Inward Foreign Direct Investment Boost the Productivity of Domestic Firms?” NBER Working Paper 8724.

Keller, Wolfgang, and Stephen Yeaple. 2003. “Multinational Enterprises, International Trade and Productivity Growth: Firm Level Evidence from the US.” NBER Working Paper 9504.

Kee, Hiau Looi. 2010. “Uncovering Horizontal Spillovers: When Foreign and Domestic Firms Share Common Local Input Supplier.” Working Paper, World Bank, Washington, D.C.

King, Robert G and Ross Levine. 1993. “Finance, Entrepreneurship, and Growth: Theory and Evidence,” Journal of Monetary Economics 32:3, pp. 513-42.

Konings, J. 2001. "The Effects of Foreign Direct Investment on Domestic Firms: Evidence from Firm-Level Panel Data in Emerging Countries," Economics of Transition 9(3), 619-33.

Kremer, Michael. 1993. “The O-Ring Theory of Economic Development.” Quarterly Journal of Economics 108, 551-575.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny. 1997. “Legal Determinants of External Finance,” Journal of Finance 52:3, pp. 1131 50.

Lederman, Daniel, Taye Mengistae, Lixin Colin Xu. 2010. “Microeconomic Consequences and Macroeconomic Causes of Foreign Direct Investment in Southern African Economies,” World Bank Policy Research Working Paper 5416.

Xu, Lixin Colin. Forthcoming. “The Effects of Business Environments on Development: A Survey of New Firm-Level Evidence,” World Bank Research Observer.


1 This includes Zimbabwe, Madagascar, Democratic Republic of Congo, and Tanzania.
2 Other examples include Zambia, Mauritius, and Swaziland
3 Lesotho and Angola as well.
 

Topics: Development, International trade
Tags: Africa, development, FDI, southern Africa

Daniel Lederman

Senior Economist, Development Economics Research Group, World Bank

Lixin Colin Xu

Lead Economist, Development Research Group, World Bank