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FOREIGN INVESTMENT IN

AFRICA

A LOOK INTO FDI DETERMINANTS

Bachelor’s thesis within Economics

Author: Kufamuyeke Indopu, 880820-T035 Joseph Tagne Talla, 8306200596 Tutor: Börje Johansson, James Dzansi Jönköping June 2010

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Acknowledgments

We would like to thank our supervisors Professor Börje Johansson and Ph.D. candidate James Dzansi, for their invaluable contributions.

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Bachelor’s Thesis in Economics

Title: Foreign Investment in Africa; a Look into FDI Determinants Author: Kufamuyeke Indopu, Joseph Tagne Talla

Tutor: Börje Johansson, James Dzansi

Abstract

Foreign Direct Investment is seen as a critical source of capital inflow and a stimulant of economic growth in many developing nations. It brings with it benefits such as job creation, technology and knowledge transfers just to mention a few. Thus many African countries are keen in finding ways of attracting FDI.

The main objective of this paper is to empirically examine the determinants of foreign direct investment (FDI) by incorporating an econometric method based on cross-sectional data from 41 African countries over the period 2002-2007. More precisely, this research intends to answer the following question: what are the relevant determinants that promote FDI inflows in Africa? Among the several determinants of FDI, the finding suggests that market size and natural resource predominance are the main determinants of FDI into Africa.

Keywords: FDI, OLI paradigm, regional economic community (REC), location specific determinants.

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ABBREVIATIONS

CSA………Country Specific Advantages.

EBRD………. European Bank for Reconstruction and Development. EIA………..Energy Information Administration.

BIT ……….Bilateral investment treaty.

ECCAS………Economic community of central African states. ECOWAS………Economic community of West African states. FDI………...Foreign direct investment.

IGAD………Inter-governmental authority on development. IMF………...International monetary fund.

M&As………...Mergers and acquisitions. MDG………....Millennium development goals. MNE………Multi national enterprise.

REC………..Regional economic community.

SADC……….. Southern African development community UMA………Union of Arab Maghreb.

UNCTAD……… United Nations conference on trade and development. WIR………..World investment report.

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Table of Contents

1

Introduction

... Error! Bookmark not defined.

1.1 Purpose...2

1.2 Limitation………2

1.3 Outline……….2

2. Background...3

2.1 FDI flow by region...7

3 Theoretical framework...9

3.1 OLI theory...9

3.2 Location theory……….10

3.3 FDI types and determinants...10

4 Literature review...12 5 Data &Methodology...16 5.1 Variables ...16 5.2 Data...17 5.3 Methodology...19 5.4 Results………..20

6. FDI and RECs...22

7. Discussion and conclusion...23

7.1 Further research………24

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Figures

Figure 1Effects of FDI on host country ... 3

Figure 2 Africa, top 8 recipients of FDI inflows ………..………6

Figure 3 Major determinants in SADC ...8

Tables

Table 1 Africa, country distribution of FDI inflow……….…………6

Table 2 Host country determinants ...11

Table 3 Effect of selected variables on FDI ...14

Table 4 Regression varaible ...17

Table 5 Descriptive statistics ...18

Table 6 Cross sectional analysis 2002-2007...20

Table 7 FDI inflow in regional economic communities...22

Appendix

Appendix 1 African region……….30

Appendix 2 List of countries in each "REC"...31

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1

INTRODUCTION

The main challenge faced in African economies is the task of having to reduce poverty levels. The eradication of poverty in Africa has become an issue of major concern globally, and thus the set up of the Millennium Development Goals (MDGs). The 2000 United Nation´s Millennium Development Goals, outlined commitments intended to be reached by 2015 by developing countries. The main aim of MDGs is the eradication of poverty and the general improvement of human wellbeing. The achievement of these Goals depends a great deal on Foreign Direct Invest (FDI). This according to bodies such as IMF and the World Bank is perceived as being pivotal to solving Africa’s economic problems. This is due to its ability to overcome such difficulties as shortages of financial resources, technology and skills. Hence, many countries not only African countries are actively seeking to attract FDI. There are many definitions of FDI, but the general consensus in many empirical works is that the investments should be long term and the foreign company providing the investment should own and control more than 10% of the shares in the domestic company (Lipsey, 2001).

Until the recent economic crisis, private capital flows, especially FDI, reached record levels in both developed and developing nations. However, the financial crisis lead to changes in global FDI flows. Up until the year 2007, the year in which global FDI inflows reached a record level of USD 1.9 trillion, developed countries received the bulk of FDI inflows, while transition countries came in second with developing countries receiving the least amount of FDI (UNCTAD). However these trends were changed during the course of the financial crisis. In 2008 global FDI flows to developing nations rose by 43%, with Africa reaching record levels. FDI inflows in Africa rose by 27%, with West Africa experiencing the fastest increase with a 63% rise over its 20071 levels (WIR, 2009). However, it should be noted that Africa´s share in global FDI inflows is still the lowest and weakest when compared to other regions of the world. Thus the question arises as to what the main determinants of FDI are?

Applying cross sectional data on 41 countries, this paper investigates the factors attracting FDI in Africa. Many studies have been conducted to find the major determinants of FDI using a number of explanatory variables. A paper by Asiedu Elizabeth (2006) among many others found market size and natural resources to be the major determinants of FDI. Thus included in the paper are variables for natural resources and market size, we also look at government policies in host countries in order to see how these affect the direction of FDI. We include a corruption variable, openness to trade variable and inflation variable to look at host country institutional policies, trade policies and macro economic policies respectively. Having noted that previous studies find market size and natural resources to be major determinants of FDI worldwide, we set out to see if these results are the same in the African region. We realize that the predominance of small economies in Africa, given the significance of market size in attracting FDI is a potential deterrent to FDI inflows into the region. So in this paper we consider both national economies and regional economies in Africa. Thus, we study the difference in FDI inflows in Africa’s five Regional Economic Communities, in the pursuit of finding which one attracts the most FDI and the reasons behind its success. The five regions looked at are; Southern African Development Community (SADC),

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Economic Community of West African States (ECOWAS), Economic Community of Central African States (ECCAS), Intergovernmental Authority on Development (IGAD), and Union of Arab Maghreb (UMA). In the paper, UMA is found to attract more FDI and this is attributed to its large endowment in natural resources and its large market size. The result of our analysis is that market size and natural resources are the main determinants of FDI into Africa. It should be noted that the determinants attracting FDI vary depending on the type of FDI, being that FDI can take the form of resource seeking, market seeking or efficiency seeking FDI.

1.1 PURPOSE

The objective of this paper is to investigate the determinants of FDI inflow in Africa during the period 2002-2007. This paper is a complement to the existing literature. To our knowledge, it is the first one to include regional inequalities in attracting FDI in Africa.

1.2 LIMITATIONS

The lack of consistent data, proved to be a major obstacle in the process of writing this paper. We are constrained to the 2002-2007 time frames and thus generally provide background information that covers the said period.

1.3 OUTLINE

The thesis is organized as follows. Section 2 will give the background information by first explaining the FDI inflow in Africa and the importance of FDI. Section 3 reviews the theoretical framework with respect to both OLI theory and types of FDI and its determinants. Section 4 will provide a literature review and give support to the variables considered in this research. Section 5 describes the data and methodology used in the research which also includes the empirical result. In section 6, we will analyze the FDI inflow in African regions (REC). Section 7 provides a discussion as well as suggestions for further research and concludes our research.

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2. BACKGROUND

This section provides a summary of facts about FDI in Africa that motivated our study.

1. FDI is a major economic stimulant in Africa

A large number of studies have analyzed the relationship between FDI and economic growth, many of which find that FDI leads to economic development. Chowdhury and Mavrotas (2006) find that FDI does indeed increase economic growth. Using the Granger causality test on data from Chile, Malaysia and Thailand, they found that GDP growth causes FDI in the case of Chile, while in both Malaysia and Thailand; they find strong evidence of a bi-directional causality between GDP and FDI. Hansen and Rand (2006) using bivariate vector autoregressive (VAR) models for GDP and FDI ratios, find a strong causal link between FDI and GDP. Apergis, Lyroudia and Vamvakidis (2007) also examine the impact of FDI on economic growth, there findings also show that FDI has a positive impact on economic growth.

There are many reasons why FDI is seen as the key to solving Africa’s economic problems. For one, FDI is an important source of capital formation, and thus would be beneficial to African countries, a majority of whom have a low capital base. Apart from capital formation, FDIs provide host countries with new technology, through spill over effects. Spill over effects of technology are expected, due to foreign companies using new technology in the host country, which in turn are adopted by local enterprise. (Mwilima, 2003) Knowledge spillovers occur in the same way as technology spillovers. Figure 1: Effects of FDI on host country

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Figure 1 illustrates the two major benefits of FDI which are the direct effects of FDI on firm productivity and the indirect effects received through spillovers produced by foreign-owned firms. Spillovers provide an advantageous source as said before of new technology and managerial know how, which ultimately leads to human capital improvement (Stefanović, 2008). Under the direct effects of FDI in the figure, one can observe that employment and higher wages are listed, as well as the direct effects on consumers which can be negative or positive depending on the direction of price and quality. Competition is included as an indirect effect of FDI and with it comes the possibility of positive or negative effects on local firms. This is said because of the danger of MNCs crowding out profits and jobs in local companies.

2. Africa is keen on attracting FDI

In order to improve their image, African countries have undertaken a number of initiatives to attract FDIs. Among the initiatives undertaken are incentives aimed at attracting international investors, such as subsidized infrastructure and tax holidays. Other initiatives taken are the signing of investment treaties. Many countries have entered and concluded bilateral investment treaties2

Apart from the implementation of new policies to attract FDI, African countries also realize the importance of large market sizes and have thus given regional integration top priority. In 2008, FDI inflows rose in four regions of Africa, with IGAD receiving the lowest inflows. North Africa attracted 27% of FDI, while Sub Saharan Africa attracted a total of 73% of FDI inflow (WIR, 2009).

aimed at the protection and promotion of FDI (Mwilima, 2003). In 2008, African countries signed a total of 12 BITs and accounted for 27% of all BITs globally (UNCTAD).

3. Africa attracts the lowest FDI inflow compared to other regions.

Historically, Africa has not been able to attract sufficient flows of FDI. For instance, during the periods 1980-89 and 1990-98, FDI flows to sub Saharan Africa grew by 59%, a relatively small amount when compared to the 5,200% increase experienced in Europe and central Asia, 942% increase in East Asia and the Pacific, 740% for South Asia and a 455% increase in South America and the Caribbean (World Bank, 2000). This is due to the fact that the continent is still seen by many as being unfavorable for investment. A number of reasons have been given as to why Africa is lagging behind in the attraction of FDI. The first reason given is the relatively high degree of uncertainty in the region that manifests itself in three ways, namely, 1) political instability, 2) macro economic instability and 3) lack of transparency. Also Africa´s lack of adequate infrastructure to support investment has hindered FDI inflow in Africa. This is due to the fact that poor infrastructure leads to reduction in productivity from investments. Another factor that deters FDI flows in Africa is the continents low growth rates and the predominance of small market sizes in Africa relative to other regions of the world (Osakwe & Dupasquier, 2005).

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The bilateral treaties contribute to the establishment of favorable investment climate between two countries by providing assurance and guarantees to investors.

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4. Natural resources are a major source of FDI inflow

Table 1: Africa, country distribution of FDI inflow, 2003

Range Economy

More than $6000 Million Nigeria

$2000- 6000 Million Egypt, South Africa

$1000-2 000 Million Morocco, Equatorial Guinea, Tunisia, Algeria, Libya

$300-1000 Million Cameroon, Congo, Egypt, Ghana, Mali,

Mauritania, Mozambique, Uganda, Tanzania, Zambia, Namibia, Ethopia, Botswana, Angola, Chad

Less than $300 Million Ivory coast, Mauritania, Madagascar, Mozambique, Mali, Gabon, Kenya, Burkina Faso, Mauritius, Senegal, Guinea, Cape Verde, Djibouti, Lesotho, Togo, Malawi, Sierra Leon, Gambia, Benin, Niger, Swaziland, Central African Republic.

Source: World Investment Report 2004

As can be seen in table 1, FDI inflows into the continent are unevenly distributed, with a few countries receiving more FDI than others. The countries that do attract FDI attribute their success to their abundant natural resources and domestic market size. For example, Angola and Nigeria have been successful in attracting FDI due to their comparative location advantages, despite their unstable political and economic situations (Morisset, 2000).

Generally, FDI flows to Africa can be put into the following categories (i) intensive investment in natural resources; (ii) investment driven by host country policies that actively target foreign investment3; and (iii) investment made in response to recent economic and structural reforms (Anupam B, 2002) . Africa has experienced a surge of FDI inflows in the extractive industries. Following a rise in commodity prices, many MNEs in the African region expanded their activities in to oil, gas and mining industries. FDI inflow into Africa’s sub-regions was uneven, reflecting the influence of different factors discussed in the next section.

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Targeting can be defined has focusing on promotional resources to attract a defined sub-set of FDI flows, rather than FDI in general. e.g. Countries like Singapore and Ireland have practiced targeting export-oriented FDI for some time, with great success.

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Figure 2; Africa: top 8 recipients of FDI inflows, 2002-2007 Average (millions of dollar)

Source: Adapted from data collected from UNCTAD.

A group of seven countries stand out in terms of relative FDI inflows and their growth during 2002-2007. The countries are listed in the figure 2. Approximately three quarters of this FDI stock is held by France, Japan, the United Kingdom and the United States. These countries direct their investment into African oil-exporting countries (WIR, 2009). 2.1 FDI FLOW BY REGION

This section provides a brief history of FDI inflow into Africa’s sub regions  Union of Arab Maghreb.

North Africa (henceforth, UMA) generally attracts resource seeking FDIs and the intensified search of natural resources by MNEs, lead to the rise of FDI inflow to a total of $24 billion. Apart from the search for resources, privatizations of public companies in the oil industry lead to the increase in the region. All the countries in this region with the exception of Morocco experienced increased inflows in agriculture, communications, construction, manufacturing and tourism. In the past year, Egypt received most of the FDI inflow in the sub region with a total of 43%. The privatization of private enterprise played a major role in this region, for example in Libya, the state owned oil investment group sold 65% of its shares to Colony Capital (US owned). Algeria and Tunisia have seen an increase in FDI inflows in the petroleum and telecommunications industries due to privatization. In 2006, FDI inflows in Morocco declined as a result of fewer

6288 5006 2486 1729 1445 1293 1187 1040 Nigeria Egypt South Africa Morocco Equatorial Guinea Tunisia Algeria Libya

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privatization sales, but saw an increase in 2008 due to the implementation of privatization schemes.

 Economic Community of West African States.

While, West Africa (henceforth, ECOWAS) had an increase of $ 26 billion in 2008. This increase was due mainly to increased investments in the mining industries in Burkina Faso, Mali and Nigeria (WIR, 2009). The region carried out reform changes in its key sectors such as mining to open them up to foreign investors.4 Privatization schemes like in UMA lead to booms in FDI inflows in the primary and telecommunications companies. The increase in the region reflects projects undertaken in Nigeria´s oil industry and upgrades done to MNEs in Burkina Faso, Cote d´Ivoire and Mali.

 Intergovernmental Authority on Development.

East Africa (henceforth, IGAD) received the lowest amount of FDI in 2008, with a total of $ 4 billion (2009WIR). Kenya experienced an increase in FDI inflow, due to large privatization sales in the telecommunications industry and investments made in railways. In Ethiopia FDI inflows recovered from 2006 on wards, due to increased oil exploration activities undertaken in the region.

 Economic Community of Central African States.

Central Africa (henceforth, ECCAS) like ECOWAS is rich in natural resources, but differs in that FDI investments in the region are more diverse (WIR, 2009). Most of the FDI inflows in this sub region are directed into the primary and service sectors, infrastructure development, with funds coming in from the increased spending by MNEs on oil and mining exploration. The major FDI recipients in the region are Equatorial Guinea, Congo DR, Chad and Cameroon, in that order.

.

 Southern Africa Development Community

Southern Africa (SADC) is characterized as having a lot of cross border mergers and acquisitions (M&As). Jenkins and Thomas (Econews) after conducting interviews with 81 foreign firms in the SADC region found that the firms were influenced by market size the most. The results of the survey are listed in the figure 3. The major FDI recipients in this sub region are; South Africa, Angola, Zambia, Namibia, Botswana and Mozambique. Privatization schemes in the region lead to an increase of FDI inflow from Asian countries, China in particular. Mozambique experienced increased inflows as a result of increased investment in the aluminum industry, because of increased demand of alumina in China.

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Figure 3: Major determinants in SADC

Source: Econews. (15 April 2003.). Foreign Investment in SADC 84%

40%

26%

21% 19%

Size of markets Raw materials Personal reasons Strategic reasons Privatization

SADC FDI DETERMINANTS

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3. THEORETICAL FRAMEWORK 3.1 OLI THEORY

Eclectic paradigm formulated by J.H. Dunning and also known at the OLI theory has been widely used as a framework for empirical investigation by many researchers. Dunning noticed however that the theory lacked in some areas due to its generality, in that the model can only explain specific modes of international production, and thus “its configuration will depend a lot on the type of firm, region or country, industry or value-added activity in which the firm operates” (Stefanović, 2008). In other words the different types of FDI require different investment stimulants that attract them to a specific location. According to the OLI paradigm, a firm’s decision to invest in a foreign country is determined by three different advantages, namely ownership, location and internalization advantages (Johnson, 2005).

Ownership advantages are primarily firm specific advantages, which eliminate the disadvantage of operating in a foreign country. These advantages include reducing the firms production cost, which enable the foreign firm to compete with domestic firms. (Johnson, 2005) This advantage entails that capital owned by the MNE can be replicated in several countries without losing its value, and can easily be transferred within the firm without high transaction cost.

Location advantages determine how attractive a location is for production. These advantages are not transferable but can be used simultaneously e.g. natural resources (Johnson, 2005).These advantages arise from assets or resource endowments existing in a specific location. Host country specific advantages (CSAs) can be divided into three classes, namely,

• E - Economic advantages which include factors of production such as transport and telecommunications.5

• P - Political Advantages include government policies that influence inward Foreign Direct Investment flows, intra-firm trade and international production.

• S - Social, these include language and cultural diversities. They have to do with the attitude of locals to foreigners and how easily foreign investors will be able to assimilate into the host culture.

Internalization advantages help MNEs in choosing the right usage of the ownership advantage, in that an internalization advantage helps firms find the most efficient alternative of using an ownership advantage either through exports or FDI. If

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Follow the link for further information http://www.investmentsandincome.com/investments/oli-paradigm.html. All definitions of the classes are derived from the site.

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internalization advantage is missing, then it becomes more profitable to license out the ownership advantage (Johnson, 2005)

From the above advantages, ownership advantages are a prerequisite of firms to operate in a foreign country, while internalization and location advantages determine how the FDI is to serve the foreign market. Host countries aiming to attract FDI, thus have to have location advantages in order to attract FDI.

In recent times some extensions have been made to the OLI model in attempts to fully develop the conceptual framework and to explain other considerations of MNC during foreign investment decision-making process. For instance, Guisinger formulated the "evolved eclectic paradigm", also known as the OLMA model. In his model, Guisinger replaces internalization factors with mode of entry factors represented by (M). He does this to account for the different determinants that may affect a firm’s decision about the mode of entry to take which may be influenced by factors unique to each location. His model also accounts for a firm’s adaption to the international business environment, represented in the model by (A) (Stefanović, 2008).

3.2 LOCATION THEORY

As mentioned above, ownership advantages are a prerequisite of firms to operate in a foreign country, while internalization and location advantages determine how the FDI is to serve the foreign market. Therefore the key determinant in decision making process is the location advantages of the host country. In regards to location factors, researchers have pointed out that there are different aspects of these factors which depend on specific advantages of the host country and its economic policy objectives.

The location theory has been used by many researchers studying the factors that influence MNE firms from selecting locations for their foreign operations. The theory addresses the questions of what and why economic activities take place in certain locations. It is based on the assumption that MNEs act in their own interest, thus they pick locations that maximize their profits. This theory is relevant to our thesis, due to the fact that it helps explain the patterns of international production and trade. The policy applications addressed by the theory show the ways in which different regions compete to be production locations for trade and FDI (Feinberg, 2001).

The theory looks at various factors that attract and deter FDI in different locations. In terms of political risk, MNEs make location decisions based on expected future profits. Thus countries that are politically risky create uncertainty about expected profits. Therefore, countries with weak institutions and are corrupt receive little to no FDI (Feinberg, 2001).

A country´s economic environment is also an important determinant of FDI location. For instance, oil in Nigeria continues to be a significant influence on FDI location choices. The size of a country´s economy is another important economic influence on FDI location decisions. Market size can be viewed as an indirect measure of transportation costs, since it reflects the ability of a firm to reach many consumers at a relatively low cost. The attractiveness of large countries is particularly true when an economy is both large in terms of absolute size (GDP) and wealthy in terms of GDP per capita (Feinberg, 2001).

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Finally, economic risk is also an important influence on FDI location decisions. Countries that have experienced very high rates of inflation or exchange rate shocks may have difficulty attracting FDI. Similarly, other things equal, highly indebted countries and countries with periodic fiscal crisis are typically not recipients of large FDI inflows (Feinberg, 2001).

3.3 FDI TYPES AND DETERMINANTS

The determinants of FDI depend a great deal on what type of FDI is being attracted. In general countries that offer MNEs what they are looking for will be most conducive to the activities of the MNE. The types of FDI can be categorized by (1) direction i.e. inward and outward FDI, (2) target as is the case of mergers and acquisition. In our case we categorize the type of FDI by (3) motive, thus we consider; market seeking, efficiency seeking and resource seeking FDIs. These are attracted by a large local market demand, low production costs and natural resource abundance, respectively. The host country characteristics therefore affect both the type of FDI and the volume of inflows.

Market seeking FDI are investments made by MNEs in order to serve the host country´s demand for goods resulting in horizontal FDI6, where the same production activities are replicated in several locations to satisfy local market demand. It is influenced by market size, measured by GDP. Second is the quality of demand, measured by GDP per capita. A higher GDP per capita implies a larger host country demand for more advanced types of goods of a higher quality (Johnson, 2005).

Natural resource seeking investments are made in order to exploit natural resources or agricultural production in the host country (Johnson, 2005). A host countries endowment in natural resources is the most important factor that attracts this type of FDI. Resource seeking FDI is attracted by: raw materials, low-cost unskilled labor, skilled labor and lastly physical infrastructure (ports, roads, power, and telecommunication.)

Production costs and efficiency seeking FDI: this is vertical investment.7 The MNE divides the different stages of production process between geographical locations in order to minimize costs (Johnson, 2005). This type of FDI exists after resource or market seeking FDIs are realized, with the expectation that firm profitability will further increase, thus it is widely practiced in developed economies.

6

Horizontal FDI is an investment made by a multinational company in different nations. The investment is made for conducting the similar business operations as already operated by the company.

7

There are two types of vertical direct investment. The first type of foreign investment is called foreign vertical direct investment which is invested in the industry of foreign country. The second type of the foreign direct investment included forward vertical foreign direct investment in which an industry abroad sells the outputs of a firm's domestic production process.

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Table 2; Host country determinants

HOST COUNTRY DETERMINANTS

Policy frame for FDI ↓

Business facilitation ↓

Economic determinants ↓

Economic, political and social stability Rules regarding entry and operations Standards of treatment of foreign

affiliates

Policies on functioning and structure of markets. Privatization policy Trade policies Tax policy Investment promotion Investment incentives

Hassle costs ( related to corruption) Social amenities i.e. quality of life After investment services

Market size and growth Raw materials

Cheap labor

Physical infrastructure Other input costs. E.g.

transport, communications

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4. LITERATURE REVIEW

It should be noted that the literature discussing the determinants of FDI finds different views on which ones are the most important. This is due to factors such as; the lack of accurate data on some of the determinants and the fact that other determinants chosen in different studies vary significantly across models (Ewe G, 2001). Many of the empirical analysis on the determinants of FDI have used cross country regressions in order to indentify host country characteristics that attract the most FDI. Table 3 presents the results of six variables widely used in literature. In regards to the literature review for this paper, it was noticed that most of the literature could be divided into two groups. The first group would include literature that focused more on endogenous determinants and would ask why firms become investors in the first place. The second group, which this paper focused more on, looked more at the factors exogenous to the investors such as location advantages. It is noted that firms pick locations that minimize the cost of production, therefore below are some of the factors found to attract the most FDI in the literature reviewed. The main variables observed in the literature as will be seen; include market size, economic stability, an economy’s degree of openness and finally other institutional variables

In Africa, it is generally assumed that market size and access to natural resources are the major determinants attracting FDI to Africa. The role of market size is evident in the positive correlation between FDI inflows and GDP exhibited by a group of 29 African countries during 1996 and 1997 (the correlation coefficient equals 0.99) in a paper by (Morisset, 2000). Morisset finds that in the 1990s, countries like Mali, Mozambique, Namibia and Senegal managed to attract substantial foreign investment, after joining their respective economic communities which inevitably included them in to larger markets. Also noted in his paper, is the large amount of FDI received by African countries which relative to other African countries had larger domestic markets e.g. Cameroon.

Moriset noticed that many African countries relied heavily on natural resources and market size, and thus set out to find out which factors would attract the most FDI when these two factors were taken out of the equation. In order to do this he made a business climate indicator by normalizing the total value of FDI inflows by GDP and the total value of natural resources in each country. He named this indicator the business climate for FDI (FDIBC)

FDIBCj= FDIJ /(GDPj * NRj)a

Besides policy and political variables, this indicator was intended to reflect structural factors such as infrastructure, transport and human capital. With this indicator Morriset found that Mozambique, Namibia, Senegal and Mali had the most attractive investment

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environments, which in turn lead them to attract more FDI compared to countries with bigger local markets such as Kenya, Cameroon and Congo, as well as countries with more natural resources such as Congo and Zimbabwe. Thus in his paper he showed that business climate was an important determinant of FDI, when natural resources and market size were not considered.

Campos and Kinoshita (2008) drawing from their inspiration from previous literature on the determinants of cross country FDI, tested three caterogories of FDI determinants. These categories were namely, the traditional factors such as market size, infrastructure and macroeconomic environment, secondly institutional factors and thirdly host country government structural reforms. Using panel data on 25 transition economies, they found that FDI is influenced by in order, economy clusters, market size, the low cost of labor, and abundant natural resources.

Another author that finds market size to be an important factor in attracting FDI is Pan Long Tsai. He used simultaneous equation models, and found that domestic market size and trade balance are key determinants of FDI, though economic growth and labor costs are also important (Pan L, 1994). His paper brings up the point that the study of the determinants and consequences of FDI usually deals with the two issues as independent issues. He states that a problem exists when treating endogenous variables as exogenous variables. Furthermore other empirical works on the topic have considered economic growth as a factor attracting FDI. This causes a problem when you consider that FDI has been included as an explanatory variable for economic growth. Thus it’s acknowledged that, not only does FDI inflow affect the host country´s economic growth, but that economic growth affects the direction and volume of FDI. Papers by Scaperlanda & Balough (1983) also state the importance of market size in attracting FDI. Other papers that find market size as a significant determinant of FDI, include Wheeler & Mody (1992), Bandera and White (1968). The authors just mentioned mostly considered U.S and other developed nations. While, Abul F. Shamsuddin (1994), studies economic determinants of FDI in less developed countries. Using a single equation econometric model for 36 LDCs, his study found that the most important factors attracting FDI were per capita GDP in the host country (a measure of market size), wage cost, per capita debt, per capita inflow of public aid, volatility of prices, in that order.

Others identify trade openness as the key determinant attracting FDI. From which they feel that Africa’s low level of FDI is explained by governance failures, which close out the region from international participation. Tonia Kandiero and Margaret Chitiga (2003) Conducted an empirical study on trade openness. They conducted a study with cross country data in which the found that FDI to GDP ratio responds well to increased openness in an economy and the service sectors. While Adenutsi E. Deodat (2008) analyzed the importance of trade openness in attracting FDI in Ghana. Using a set of macro econometric models on quarterly data covering the periods 1983-2006, he finds that FDI flows into the country are highly impeded by trade openness.

Baharom, A.H., Habibullah, M.S. and Royfaizal, R. C (2008) study the role of trade openness and foreign direct investment in influencing economic growth in Malaysia during 1975-2005, using the Bounds testing approach. The find that trade openness is positively associated and is a statistically significant determinant of growth, both in the short run and the long run.

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Other studies include location specific advantages such as economic and political stability. Asiedu (2002) explains the low levels of FDI as being due to faulty policies that deter investors. While others find unstable tax regimes as the major determinants (Gastanaga E, 1998). Other determinants are the slow rates of privatization, (Akingube, 2003; Pigatto, 2001) and the lack intellectual property protection (OECD, 2003). Corruption, regulation and political risk are believed to raise costs, adding to the unattractiveness of the African region to investors (Morrisett, 2000; Elbadawi and Mwega, 1997). (Wheeler & Mody, 1992), Mody and Srinivasan (1998) find political instability to be major deterrent to FDI. In Africa some have argued that political stability is one of the most important determinants of foreign investment location in Africa (Sachs and Sievers (1998))

Others find macroeconomic policy failures as deterring FDI flows from the region. From which the point out the irresponsible fiscal and monetary policies as having generated unsustainable budget deficits and inflationary pressures, raising local production costs, generating exchange rate instability, and making the region too risky for long-term investments (Reinhart and Rogoff, 2002; Lyakurwa, 2003). Yet others identify the cost of local labor as significantly important in location considerations, [Wheeler and Mody (1992) and Mody and Srinivasan (1998)

Table 3: Effect of selected variables on FDI.

Determinants of FDI positive negative insignificant

Real GDP per capita Schneider and

Frey(1985) Tsai(1994)

Edwards (1990)

Jasperen, Aylward, and Knox (2000)

Loree and Guisinger (1995)

Hausmann and Fernandez- Arias

(2000) Infrastructure quality Wheeler and Mody

(1992) Kumar(1994)

Loree and Guisinger (1995)

Labor cost Wheeler and Mody

(1992)

Schneider and Frey (1985)

Tsai (1994)

Loree and Guisinger (1995) Lipsey(1999) Openness Edwards (1990) Gastanaga el al. (1998) Hausmann and Fernandez- Arias (2000)

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Taxes and tariffs Loree and Guisinger (1995)

Gastanaga et al. (1998) Wei (2000)

Wheeler and Mody (1992)

Lipsey(1999)

Political instability Schneider and Frey

(1985)

Edwards (1990)

Loree and Guisinger (1995)

Hausmann and Fernandez- Arias

(2000)

Jaspersen et al (2000)

Source: Elizabeth Asiedu (2002)

5. DATA AND METHODOLOGY

In section 5.3, we run the Ordinary Least squared (OLS) regression to test the main determinants of FDI using inflation, oil, GDP, freedom from corruption and openness to trade as independent variables. We use cross sectional data for the period 2002-2007 for 41 African countries.

5.1 VARIABLES

Dependent variables; flow of FDI inflows (FDI)

For FDI measure, we use as a key variable the FDI per capital net inflows. FDI is measured by FDI net inflows, which is the sum of equity capital, reinvestment of earnings, long term capital and short-term capital as shown in the Balance of Payment. It is measured as US dollars at current price and current exchange rates in millions.

Trade freedom (opent)

Openness to trade is the ratio of trade (imports plus exports) to GDP. This variable can be interpreted as a measure of the economy’s openness or a measure of trade restrictions. It’s included as a policy variable, in that it can be directly altered by policy makers; it’s a proxy to reflect the willingness of a country to accept foreign investment. (Marcelo B).

Freedom from corruption (corrupt)

There is corruption when a government illegitimately makes private profits and this will therefore impose an extra cost to investors. Corruption is expected to have a negative impact on FDI. It is measured on a 0-100 index with 0 as the less corrupt country and 100 the most corrupt country.

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GDP is used as a proxy of market size. Gross Domestic Product is the market value of total goods and service produced in a country for a given year, measured as millions of current US dollars. The market size hypothesis states that FDI is a positive function of the market size of the host country. The market size is usually measured by the GDP of the host country. It is assumed that the higher the GDP in a country, the larger the total share of the FDI.

Natural resources (Oil)

Historically, the most important host country determinant of FDI has been the availability of natural resources. Oil is used as a proxy of natural resources in this paper. It is measured as production of crude oil in thousand barrels per day. Due to Africa’s large endowment in natural resources it’s expected to be a major host country location advantage.

Economic stability (Inflation)

The rate of inflation (INFLATION) acts as a proxy for the level of economic stability. It is measured as GDP deflator in annual percentage. Economic stability is an important determinant of FDI used in literature, due to the fact that a stable economy implies less risks and transaction costs.

Table 4: Regression Variables

Variables Explanation Data source and period Expected sign of coefficient

FDI Fdi inflows, millions

of dollars World Investment Report (UNCTAD,2009), 2002-2007 na Independent variables

OIL Production of crude oil in thousand barrels per day. Proxy for natural resources in host country. EIA(2010), 2002-2007 + GDP Gross Domestic Product, millions of US current dollars. Proxy for market size.

The World Bank (2010) +

INFLAT Inflation, GDP inflator (annual %)

The World Bank (2010) - CORRUPTION Trade freedom, index

ranges from 0 to 100 where high

rating means low degree of corruption 2009 Index of Economic Freedom, Heritage Foundation (2009), 2002-2007 -

OPENNESS Trade freedom with

high indexed number

2009 Index of Economic Freedom,

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means lower trade barriers

Heritage Foundation (2009), 2002-2007

5.2 Data

Due to lack of data, we will examine the periods 2002-2007. To normalize the data, we calculate and use the mean for every variable (the period 2002-2007) in the regression. The data used is the cross- sectional data for 41 African countries. Due to missing data, we exclude some countries ( Zimbabwe, Congo) to avoid misleading results in the regression. We also excluded war torn countries (Liberia, Sudan) from the countries. In some instances, certain countries did not have data for some years; to account for them we replaced them by inserting the mean value using SPSS.

For the dependent variable, we collected data from the World Investment Report (UNCTAD, 2009). Alternative sources for FDI are available (ERBD), but it is better to use data from WIR since it focuses on all economies while ERBD focuses only on European transition economies.

Data for natural resources are collected from Information Administration (EIA) while data for market size and inflation are collected from Word Bank (2010). Data from the World Bank was obtained from the data catalog, which is a listing of available World Bank data sources. This listing is continuously updated as additional data resources are added. Thus inflation data collected from the World Bank in actuality comes from IMF. The index of economic freedom from the Heritage Foundation (2009) gives information on almost all African countries concerning trade freedom and freedom from corruption. The measures in the index go from 0 to 100, and a country with high rating (80-100) is considered free while one with a low rating is not consider free.

Table 5: Descriptive statistics for 2002-2007

Mean Minimum Maximum Std. Deviation

Fdi 6,763,171 16 6288,00 126,382,484 Oil 2,254,931 -,22 2359,79 55,490,232 Lngdp 22, 7270 19, 95 26, 08 1, 41751 Corrupt 281,805 11,50 60,00 1,068,060 Opent 629,363 23,57 157,75 2,940,364 inflat 92,557 1,99 53,09 903,507 N 41

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As shown on the descriptive statistics table, average of FDI in Africa is relatively low (676, 3171 millions). African countries do not attract enough FDI due to the low market size represented by the lnGDP on the table (𝑒22,7270 ≈ 21, 259 billions ). Central African Republic is observed to have the lowest amount of FDI with 16 million, while Nigeria has the highest value with 6, 288 billions. This indicates that Nigeria attracts the most FDI, a fact attributed to its abundance in natural resources (2359, 79 thousands barrel per day). The table above shows that Nigeria is the most abundant country in natural resources (2359, 79 thousands barrel per day).

Market size measured as GDP is determinant for FDI inflow. As we can see on the table, the top countries with the highest market size is South Africa (𝑒26,08 ≈ 212,969 billions) while Gambia has the lowest value (𝑒19,95 ≈ 59, 6620 𝑚𝑖𝑙𝑙𝑖𝑜𝑛𝑠)

It is important to note that inflation matters as regard to FDI inflow, which is a factor deterring investment in Angola (1.99). This might be why although its large abundance is natural resources (oil supply); the country is experiencing an average FDI inflow as compared to the richest countries in natural resources.

So, the descriptive statistics table gives an overview of the relationship between FDI inflow, natural resources, market size and macroeconomic stability. However, OLS regression results will give us a better picture of the main determinants of FDI inflow of Africa.

5.3 METHODOLODY

In our research, we run the model below to show how the variables will be regressed. Regression analysis is used to show the empirical findings for this paper. We use Ordinary Least Squares (OLS) as the most fundamental estimation methodology to run our regression. The econometric model is used based on cross-sectional data for the African countries over a period from 2002 to 2007.

FDI = α + β1Oil + β2lnGDP + β3INFLAT + β4CORRUPT + β5OPENT + u

Where lnGDP is the log of GDP used as proxy for market size. OIL as proxy of natural resources

INFLAT = inflation (proxy of market instability) CORRUPT = corruption index

OPENT = trade freedom 𝛽𝑛 = Estimated coefficients

u = error term

We run the above regression to study the impact of market size, natural resources, macroeconomic instability, corruption and trade freed. We include in the model frequently mentioned quantifiable demand side determinants of FDI. To control for political instability and weak institutions, we add the corruption variable. We also use a trade freedom variable, since in previous studies it has been used to control for the effect

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of FDI on economic growth. Inflation is introduced to capture macroeconomic instability, and is expected to have a negative impact on FDI inflow, because a high level of inflation can characterize a more unstable macroeconomic environment.

We hypothesize that market size, natural resources and freedom from trade will have a positive impact on FDI inflow while corruption and macro economic instability are expected to have a negative impact.

5.4 RESULTS

The results found are summarized in Table 6. The R Squared is 0, 575 meaning that 58 % of the total variance in FDI inflows is explained by the regression model. Moreover, the F

value is 9, 456 which indicates that at least one of the variables included in the model is significant. The t-values presented in the table provide information about the significance.

Table 6: Cross-section analysis for 2002-2007

Explanatory Variables Coefficient Estimate t-value

Oil 1, 060 2, 888* lnGDP 392, 016 2, 881* Inflat -21, 918 -1. 196 Opent -1, 634 -0, 323 Corrupt -5, 590 -0, 381 Constant -8008, 829 -2, 687 R. Squared 0, 575 Adj. R. Squared 0, 514 N 41 F. stat 9, 456 Note: *= significant at 5%

We use OLS regression techniques to estimate the relationship between the exogenous variables and FDI in Africa. The results obtained from the regression are presented in table above.

When tested at 5% significance level, the result from the regression shows that natural resource is significantly positive with FDI in Africa. This confirms our expectations and earlier research such as Aseidu (2002) for the African case and Kinoshita and Campos (1998). Shiells (2003) also suggest that the abundance of oil is important in attracting FDI inflows.

Furthermore, there is a strong relationship between FDI and market size as the coefficient estimate indicate. Indeed, a one percent increase in market size will increase FDI by 3, 92 millions U.S dollars. The result shows that market size is positively significant when

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tested at 5 %. In other words, market size is an important determinant of FDI in Africa. Many papers on the determinants of FDI, report that market size is important as determinant of FDI. Barrel and Pain (1996) and Love and Lage-hidalgo (2000) in their research show this positive relationship between host country market size and FDI.

However, Inflation is insignificant as a FDI determinant although its coefficient parameter is negative as expected. This indicates that macroeconomic stability is not important as FDI determinant in Africa. This is not consistent with previous researchers such as Bajo-Rubio and Sosvilla-Rivero (1994), Bengoa and Sanchez-Robles (2003) and Devereux and Engel (1999) who concluded that macroeconomic instability (inflation and exchange rate risk) have a significant negative impact on FDI.

Corruption has been commonly accepted as a barrier of FDI inflow in many papers. However, at 5% significance level, corruption is insignificant while its coefficient parameter in the model; therefore it is not a determinant variable of FDI inflow in Africa. This result is not consistent with earlier research in which corruption has a negatively significant impact on investment and economic growth Mauro (P, 1995). Many researchers have found that corruption has an adverse effect on FDI since the extra costs investors have to pay to start up a business force investors to avoid investing in countries with high levels of corruption. However, our regression result shows that corruption is not a determinant variable of FDI inflows in Africa. One explanation of this result is that the insignificant relationship between FDI inflow and corruption can be attributed to the natural resources abundance. In other words, if a country is abundant in natural resources, it may still be able to attract more FDI inflows despite its level of corruption.

Openness to trade is insignificant as a determinant of FDI inflows in Africa. This result contradicts our expectation. Good trade policies are expected to attract foreign investors. The link between FDI and openness to trade has been supported by (Deichmann J. , 2001), (Janicki & Wunnava, 2004), (Caetano, Galego, Vieira, Costa, & Vaz, 2004). However, our result shows that openness is insignificant related to FDI inflow. This is contrary to the results of Asiedu (2001), who worked on determinants of FDI at the regional level (Africa). There is an explanation behind this result however. As noted above, natural resources abundance is one of the determinants of FDI inflow in Africa. Indeed, oil sectors are usually dominated by large companies with a high technology. So, they have the power to construct their own infrastructure and this power comes from the advanced technology they posses and the bargaining power they have with the local government. Therefore, these companies do not care about the overall degree of openness in Africa.

Summarizing the findings of this section, our results reveal that natural resources and large markets promote FDI inflows in Africa. However, macroeconomic instability does not have any impact on FDI in Africa. Besides, openness to trade and corruption are not FDI inducing as expected. In other words, MNE investing in Africa do not take into consideration the level of corruption and openness. No evidence was found that host country level of corruption and openness to trade affect FDI inflows in Africa.

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6. FDI inflow and Regional Economic Communities (REC)

The second part of our research is to explain the difference between FDI inflow and the five regional economics communities (REC) in Africa. To analyze the regional difference, we just sum up the average FDI inflows in each region for the period 2002-2007. The table below gives us an overview of FDI inflow, natural resources abundance and market size in the five Regional Economic Communities namely: UMA, ECOWAS, SADC, ECCAS and IGAD. The question here is why some regions are attracting FDI inflows more than others?

Table 7: FDI inflow, Oil and GDP in regional economic communities for 2002-2007.

FDI OIL GDP ECOWAS 7708 2396.554 1.66E+11 IGAD 931 61, 03 4.03E+10 ECCAS 2662 637.977 3.66E+10 SADC 5893 1672.565 3.08E+11 UMA 10535 4416.621 3.20E+11

Indeed, from the first part of our paper, we concluded that there are two factors that promote FDI inflows in Africa: natural resources and market. The table 7 shows that natural resources as well as FDI inflow is higher in UMA, ECOWAS, SADC, ECCAS and IGAD respectively. This result is confirming our regression result in the sense that high natural resources lead to high FDI inflows in Africa countries. In other words, regions that are rich in oil are attracting more FDI inflows. The table reveals that the gap between IGAD and the four other regions in term of FDI inflows is high. This can be explained by the lack of natural resources in the region. Furthermore, the table reveals that UMA has a larger market size as well as FDI inflows compared to the other region.

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The three first regions with higher FDI inflows have a larger market size. As regard to regional difference on attracting FDI inflows, we can conclude that natural resources as well as market size are the main factors that bring about the difference in attracting FDI at the regional level in Africa.

7. DISSCUSSION AND CONCLUSION

This paper analyses the main demand side determinants of FDI in Africa. So, the empirical part of the paper attempts to determine the factors that are decisive when MNEs decide to invest in Africa. We use Oil as a natural resource measure and GDP as a market size measure and inflation as a market stability measure. To these explanatory variables, we add openness and freedom from corruption. We perform the regression using cross-sectional data analysis on a data set of 41 African countries for the period 2002-2007.

The empirical analysis concludes that oil supply and GDP are the variables positively significant as FDI factors in Africa and this result confirms our expectation. In other

words, FDI inflows in Africa are mainly resource-seeking and market-seeking and this result contributes to the mixed results from earlier research. It’s also noted that natural resources cannot solely attract foreign investors in Africa. A more detailed study of the

data (Appendix 3) reveals that among the top five African countries to receive higher FDI inflows, four of them have larger market size (Nigeria, Egypt, South Africa and Morocco) while only two have large natural resources endowments (Nigeria and Egypt). This gives us an overview of the importance of market size along with natural resources in attracting foreign investment in Africa.

Results support the market size hypothesis; this can be attributed to benefits of being part of a REC, such as the expansion of the size of the market.

This advantage is beneficial to African national economies that are not large enough to attract FDI individually. Thus it requires joining and forming coalitions with other nations, to form a market size sufficient enough to attract FDI. Apart from the benefits of an increase in market size, RECs promote political stability and policy coordination among member states and this

provides better environments in which investment can flourish (Asiedu, 2006). In fact, the

only FDI attraction polices undertaken in Africa, that have the most impact are those that have a direct effect on regional integration.

Market size and natural resources are also confirmed as the main FDI determinants when looking at the regional economic communities in Africa as revealed from the detailed data in table 7. The levels of FDI inflows in the sub-regions correspond with their respective market size, this is because higher GDP does not only indicate domestic market size but better infrastructure as well.

The regression result shows that macroeconomic instability is insignificant as a determinant of FDI inflows in Africa. Although it has a negative coefficient, this result contradicts with earlier research. African countries try to contain inflation by adopting fiscal and monetary policies, which have increased participation of the private sector in economic activities, and at the same time secure significant FDI (Anupam B, 2002). The implication of our finding that macro instability is insignificant is that small economies

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that lack natural resources are unlikely to attract FDI even when the implement policies to improve their environment. We also find out that openness to trade and corruption are not important as FDI determinants. This result can be explained by the fact that abundance in natural resources attracts more foreign natural resource seekers. Indeed, those investors are less sensitive to a country´s level of corruption and openness to trade due to their capacity to build their own infrastructure.

The FDI policy framework, a necessary but not sufficient determinant of FDI Location.

Africa receives less FDI than other regions because openness is globally important for FDI, and African countries are generally less open. Open policies are intended to increase FDI, but from our result we see that they can not guarantee the increase in FDI inflows. We understand that primarily, openness allows for foreign firms to operate in host countries, but openness differs from restrictive polices that effectively close the door. In that changes made in light of greater openness may allow firms to establish themselves in a particular location, but they do not guarantee this. Therefore, we conclude that initiatives made to facilitate a favorable investment climate in Africa are necessary in the long run but not the short run. This is said because the initiatives are not sufficient enough for FDI to take place and because of the lack of transparency foreign investors generally don’t trust policies that have been set up.

Overall the location theory of the OLI theory holds in our thesis. MNEs investment in Africa because of the high returns they receive from investing in natural resources. Africa as a FDI destination is only responsible for its location advantages, such as natural resources and market size. However, the policy frame work of FDI in Africa is not sufficient enough to be a determinant of FDI location, and thus could be an explanation as to why Africa is lagging behind in attracting FDI. From the regional differences in FDI inflow, we conclude that the creation of sound regional integration frameworks will lead to the access of regional markets superseding the national markets as important FDI determinants, and that locational economic determinants are more important than host country policy determinants in Africa because of the lack of transparency in Africa.

We feel that an understanding of the determinants of FDI will help African countries reach the Millennium development goals a lot faster. In terms of policy implementation, an understanding of the policies and knowing their effects on FDI will help African policy makers learn from each other and implement suitable policies (Asiedu, 2006).

Thus as a recommendation to African policy makers, we say the way forward is to continue implementing a competitive incentive framework, while at the same time leveraging their comparative advantage in extractive and natural resource activities,

7.1 FURTHER RESEARCH

We deliberately left out most of the research that addresses the role of mineral resources in our literature review. Because we found counter arguments to the theory that FDI leads to economic growth. Most of the work we reviewed indicated that countries with large natural resource endowments were worse off than less endowed countries in terms of

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their long term economic situations. It is argued that developing natural resources rather than manufacturing may be detrimental for growth. Thus for further studies, we could discuss the role of natural resources on economic growth and question the view that having natural resources is bad for growth and welfare is questioned. (Gregorio, 2003)

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2

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Figure

Figure 1: Effects of FDI on host country
Figure 3:  Major determinants in SADC
Table 3: Effect of selected variables on FDI.
Table 4: Regression Variables
+3

References

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