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Assessing the Impacts of Capital Inflows

on Domestic Economy across the Sub-
Saharan Africa Countries
a b
Jian Zhang & Thomas Ward
a
World Bank Group, Washington, DC, USA
b
TWConsult, 8115 Gale Street, Annandale, VA 22003
Published online: 19 Mar 2015.

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 International Economic Journal, 2015
http://dx.doi.org/10.1080/10168737.2015.1020325

Assessing the Impacts of Capital

Inflows on Domestic Economy across
the Sub-Saharan Africa Countries
Downloaded by [Mangalore University Library] at 22:11 19 March 2015

JIAN ZHANGa∗ & THOMAS WARDb

a World Bank Group, Washington, DC, USA; b TWConsult, 8115 Gale Street, Annandale,
VA 22003

(Received 11 March 2014; in final form 27 December 2014)

ABSTRACT Using GMM models, this paper analyzes the impacts of capital inflows on
domestic investment in 44 Sub-Saharan Africa (SSA) countries from 2003–2012. It is
found that foreign direct investment across the SSA remains to be the largest percentage
share, accounting for 35% of the total capital inflows. FDI inflows have significant pos-
itive impacts on domestic investment across the SSA in both short term and long term.
Other key macroeconomic factors such as age dependency ratio, domestic economic
growth, terms of trade, real effective exchange rate and trade openness also play vital
roles in determining domestic investment.

KEY WORDS: Capital flow, foreign direct investment, Sub-Saharan Africa

1. Introduction
The motivation of this paper is to examine the economic impacts of capi-
tal flows across the Sub-Saharan Africa (SSA) region. Theoretically, capital
inflows generally promote economic growth; but they also can generate
counter domestic macroeconomic instability. This includes empirical lessons
from a series of crises such as: the Latin American debt crises of the 1980s,
the Mexican crisis of 1994–95; the Asian crisis of 1997–98, the Russian crisis
of 1998, the Brazilian crisis of 1999, and the Argentine crisis of 2001–2002,

*Correspondence Address: Jian Zhang, World Bank Group, Washington, DC, USA.
Email: zhjiangator@gmail.com
© 2015 Korea International Economic Association
 2 Jian Zhang & Thomas Ward

suggesting that capital inflows can become a significant output losses and
economic instability. Massive capital inflows generate a potential upward
pressure on exchange rate and domestic price levels and lead to real exchange
rate appreciation; as a result, a current account deteriorates due to a decline
in international competitiveness. If a country’s macroeconomic environment,
such as financial system, inflation pressures, exchange rate regimes, mone-
tary and/or fiscal balance, is unable to adjust a sudden surge of large capital
inflows, the country is likely to be subject to unexpected liquidity constraints,
economic shocks, and if severe, it may trigger and result in internal financial
economic crisis.
The determinants of capital inflows have been analyzed in many studies
(Calvo, Leiderman, & Reinhart, 1992, 1993, 1996; Campion & Neumann,
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2004), the causes of the movement of international capital flows can be

divided into country-specific factors (the pull effect) and global factors (the
push effect). For example, good domestic investment climate, rules of law,
institution and an increase of economic growth have a pull effect; and uncer-
tain debt crisis in the Euro zone and recession in the US may have a push
effect. There is ample literature that analyzes the capital flows in advanced
economies (Krugman, 1998; Warnock & Warnock, 2006) and in the emerg-
ing market (Bosworth & Collins, 1999; Calvo et al. 1993, 1996, 2003;

30

25

20

15

10

-5

-10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Total investment Gross national saving

Current account balance Resource gap

Figure 1. (a) Gross government debt, current account and net investment to GDP Ratio in the
Sub-Saharan Africa countries, 2000–2011.
Note: Resource Gaps = Gross National Savings –Total InvestmentSource: Author’s calcula-
tions based on International Monetary Fund, World Economic Outlook (2013)
 Capital Inflows and Domestic Economy across SSA Countries 3

1
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-1

-2
1970 1975 1980 1985 1990 1995 2000 2005 2010

SSA Northern Africa (exc. Sudan) ECCAS

ECOWAS COMESA

Figure 1. (b) The percentage share of FDI inflows in World’s Total FDI Inflows by region
(%, 1970–2011).
Source: author’s calculation based on UNCTAD (2012); Note: ECCAS (Economic Commu-
nity of Central African States); ECOWAS (Economic Community of West African States);
COMESA (Common Market for Eastern and Southern Africa)

Dooley, Fernandez-Arias, & Kletzer, 1994; Mileva, 2008; Mody & Murshid,
2005; Serven, 2002; Sompornserm, 2010). However, the extensive scholarly
literature on impacts of capital inflows for least developed countries, espe-
cially the fragile SSA region, has been silent on this point. This paper aims
to fill in the gap.
Many SSA countries remain on the fringes of international capital mar-
kets and they are dependent on financing from official (and unofficial) credit
sources as the cost of financing from the capital markets is far too high due
to the pricing of such risk. On average, according to Global Development
Finance (2012), foreign direct investment (FDI) of the Sub-Saharan Africa
(SSA) region accounts for two-thirds of net capital flows during 2001–2010.
Among all the developing regions, except the Middle East and North Africa,
considering the share of net capital flows to developing regions, the SSA
countries remain the smallest share with around just 5% of GDP from 2005–
2010.1 Although capital inflows to the Sub-Saharan Africa (SSA) region had
not immediately dropped significantly after the financial crisis in 2008, they
continuously fell far short of the resources needed to fund their develop-
ment. The average value of the resource gap in the past decade for the 44

1 Global Development Finance 2012, Table 4, p.5.

 4 Jian Zhang & Thomas Ward

6
.1

5.5
.075
GDP growth rate
5
.05

GDP growth
4.5
.025

4
0
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-.025 3.5

-.05 3
2003 2004 2005 2006 2007 2008 2009 2010

Portfolio to GDP ratio Loan to GDP ratio

FDI to GDP ratio GDP growth

Figure 1. (c) Average share of capital flows ratio to GDP in Sub-Saharan Africa
(2003–2010, %).
Source: Author’s calculations based on International Monetary Fund, World Economic
Outlook (2014); World Development Indicator , World Bank

120

100

80

60

40

20
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

GFCF Government Debt

M2

Figure 1. (d) Average value of GFCF, government debt and broad money (M2) of Sub-Saharan
Africa (% of GDP, 2003–2012).
Source: Author’s calculations based on International Monetary Fund, World Economic
Outlook (2014); World Development Indicator, World Bank
 Capital Inflows and Domestic Economy across SSA Countries 5

Sub-Saharan Africa (SSA) countries is substantial (Figure 1(a)). Owing to low

domestic private savings and continued government budget deficits and/or a
current account deficit, many of these African countries face a grave short-
age of capital to meet their investment needs and sustainable development
goals. The impact of the global financial turmoil and Euro zone crisis have
further hit the most vulnerable nations worldwide, particularly those in Sub-
Saharan Africa, which are heavily depended on foreign direct investment and
other types of foreign capital. The total SSA share of FDI inflows in global
FDI inflows has dropped significantly from 6.2% in 1970 to just 2.4% in
2011 (Figure 1(b)); although intriguingly the net capital inflows in SSA is
increasing in recent years (Table 1).
Although many previous studies have assessed the impact of FDI inflows
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on the economy of the host country, only a few have examined the interre-
lationship between capital inflows and domestic investment (Bosworth &
Collins, 1999; Mileva, 2008; Mody & Murshid, 2005). Furthermore, it
is found that very few studies have addressed these issues facing the SSA
countries. This is mainly due to the unavailability of the data set for many
countries across the SSA countries and lack of attention on this issue.
The key contributions of this study are as follows: first, it analyzes the
main characteristic of capital inflows and the composition of capital flows
of the SSA region. It is found that FDI inflow is the one of the key types
of capital inflows in this region in the past decade. Second, the impact of
capital flows (mainly FDI) on domestic investment are positive, the impact
of capital flows (mainly FDI) on domestic investment is positive, the mag-
nitude of the effects of FDI inflows on domestic investment is close to that
of other developing countries. Finally, we have found that economic growth,
trade openness, age dependency ratio, real effective exchange rate, real inter-
est rate, terms of trade and other key macroeconomic variables are strong
correlated with capital flows.
This paper is organized as follows: Section 2 presents stylized facts of
capital inflows across the SSA. Section 3 provides an empirical methodology,
and a model description and data source are discussed. Section 4 analyzes
the empirical results. Section 5 is the conclusion.

Table 1. Net Capital Inflows to Sub-Saharan Africa, 2001–10 ($ Billion)

Inflows 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Net private & 10.9 10.4 15 24.2 33.6 38.7 53.4 42.6 46.4 53.4
official inflows
Percent of GNI 3.5 3.2 3.6 4.7 5.6 5.4 6.6 4.6 5.2 5.2
Net equity inflows 13.0 10.7 14.3 17.8 26.6 33 38.4 31.8 43 36.8
–Net FDI inflows 13.9 11.1 13.6 11.2 18.6 16.2 28.3 37.5 32.8 28.8
–Net portfolio –0.9 –0.4 0.7 6.7 8.1 16.8 10.1 –5.7 10.2 8.0
equity inflows
Net Debt flows –2.1 –0.4 0.7 6.4 7.0 5.7 14.9 10.9 3.4 16.6

Source: World Bank, Global Development Finance (2012)

 6 Jian Zhang & Thomas Ward

2. Stylized Facts of Capital Inflows in Sub-Saharan Africa

In the past decade, the net capital inflows in terms of gross national income
(GNI) have slightly increased, growing from 3.5% in 2001 to 5.2% in 2010.
Table 1 shows the broad picture of net capital inflows to the SSA countries
during the period 2001 to 2010. In 2008, there was a significant drop in
the net capital flows to the SSA countries, declining from $53.4 billion in
2007 to $42.6 billion in 2008, reflecting the immediate and direct impact of
the global financial crisis on these countries. Among various components of
capital flows, net portfolio flows have shown the biggest decline, showing
the pro-cyclical nature of this kind of flows. Interestingly, their FDI values
remained stable with a rising trend from 2007 to 2009. However, in 2010,
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net debt inflows on loans from official creditors and a resumption of short
term debt inflows jumped to $16 billion from $3.5 billion in 2009. Our study
shows how the composition of capital flows across the SSA region varies by
type and changes by region over time. Specifically, Tables 2(a)–(c) demon-
strates a diverse composition of capital flows across the SSA region. FDI
remains the largest share of GDP for all four sub-regions of the SSA. Among

Table 2. (a) Key macroeconomic indicators as percentage of GDP by region (2003–2010)

Eastern Central West Southern

Indicator Africa Africa Africa Africa SSA

GDP growth (%) 5.0 6.2 4.4 2.8 4.7

Quasi Money (M2) 42.2 16.5 28.6 37.4 31.5
Private capital flows (% GDP) 3.1 6.7 5.3 2.7 4.4
Gross national savings (% GDP) 14.1 21.4 13.8 22.2 16.7
Total investment (% of GDP) 21.0 23.2 21.1 23.5 21.8
Gross fixed capital formation (% GDP) 18.3 17.3 13.2 19.8 16.6
FDI net inflow(% GDP) 3.9 7.0 5.9 3.6 5.2
Portfolio investment (% GDP) 0.0 0.0 0.0 0.0 0.0
Loan investment (% GDP) 0.0 0.0 0.0 0.0 0.0
FDI (% GDP) 0.99 0.12 0.14 0.18 0.35

Source: Author’s calculation based on compiled data sets, Global Development Finance and World
Economic Outlook and international Financial Statistics. International Monetary Fund.

Table 2. (b) Average value of private capital flows in Sub-Saharan Africa (% of GDP)

Eastern Africa Central Africa Western Africa Southern Africa

2003 4.23 2.42 10.96 4.03

2004 3.69 4.23 5.64 4.89
2005 0.10 14.33 6.94 3.59
2006 4.96 11.68 5.99 3.03
2007 5.30 10.38 5.37 1.91
2008 2.27 0.76 4.51 1.46
2009 1.94 3.10 3.95 1.85
2010 2.62 8.61 2.05 0.52

Source: Author’s calculation based on World Bank, Global Development Finance

Downloaded by [Mangalore University Library] at 22:11 19 March 2015

Capital Inflows and Domestic Economy across SSA Countries 7

Table 2. (c) Key macroeconomic indicators in Sub-Saharan African Countries (as a percentage of GDP, 2003–2012)
Indicator 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

GDP growth rate (%) 2.98 5.83 5.26 5.21 5.68 4.44 3.05 5.04 4.81 5.21
quasi money 32.24 30.7 30.59 31.19 30.33 31.12 32.97 33.02 38.58 36.69
private capital flows 5.85 4.81 4.99 5.84 5.33 2.84 2.92 2.89 N/A N/A
gross national savings 15.48 15.35 17.87 18.19 18.58 16.76 15.43 16.16 N/A N/A
total investment 21.85 20.86 22.03 20.76 22.19 22.43 23.26 24.63 24.62 25.57
GFCF 18.16 17.71 17.72 16.44 16.57 16.05 17.6 12.43 25.05 25.69
FDI net inflow 6.22 3.36 3.49 4.5 5.58 6.15 4.52 6.07 7.94 7.16
portfolio 0 0 0 0.01 0.01 0 0 0 N/A N/A
loan − 0.03 − 0.01 − 0.01 − 0.03 − 0.02 − 0.01 0.02 0.01 N/A N/A
FDI 0.21 0.22 0.18 0.19 0.22 0.18 0.21 0.19 N/A N/A
Real interest rate 14.48 17.08 14.51 7.91 10.27 5.61 10.37 9.11 8.94 9.79
trade openness 0.57 0.59 0.69 0.71 0.70 0.74 0.65 0.69 0.79 0.78
REER (2005 = 100) 98.84 97.29 100 101.86 102.53 108.83 123.73 134.31 108.98 109.64

Source: Author’s calculation based on compiled data sources from World Development Indicators (WDI), World Economic Outlook (WEO, 2013); Note: GFCF
represents gross fixed capital formation (% of GDP); Real interest rate is the annual average value of real interest rate of SSA countries. REER is the annual average
value of REER of SSA countries.
 8 Jian Zhang & Thomas Ward

which, on average, Southern Africa and Central Africa countries have both
had the higher total investment to GDP ratios of 23.5% and 23.2% respec-
tively, compared with other SSA regions. For most of the SSA countries their
portfolio to GDP ratios are less than 1% of their GDP. Meanwhile, their loan
to GDP ratios are also extremely small.
As a resource rich and capital poor continent, as represented by the SSA
countries, capital inflows may play a significant role for the development
of their economies. Figure 1(b) shows that for the SSA region, on average,
during 2003–2010, gross fixed capital formation takes account of 18% of
GDP, and it declined to about 14% of GDP in 2010. GDP annual growth
rate in SSA bounced back to 5% after the financial crisis and is one of the
fastest growing economies. However, this region still has many challenges,
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such as high inflation, high food prices, debt reduction and political stability.
Figure 1(c) shows the average share of capital flows ratio to GDP in SSA and
the GDP growth rate. FDI remains the largest share among capital inflows,
portfolio investment is very close to zero and loans flows increased in 2008–
2009 and started to drop moderately in 2010, on average, in 2010, loans
accounted for 2% of the GDP in SSA. Figure 1(d) further demonstrates the
average value of gross domestic investment to GDP ratio, domestic invest-
ment and broad money remain relatively stable in the past decade, while the
government debt dropped significantly from 118% of GDP in 2003 to about
40% in 2012.
Table 2(a) demonstrates the key macroeconomic indicators across the SSA
by region over 2003–2010. On average, GDP growth of SSA was around
5%, private capital flows took account for 5% of GDP, gross national sav-
ings, total investment and gross fixed capital formation is around 16% and
22% and 17% of GDP respectively. On average, for the countries in SSA,
FDI accounts for 4% of GDP, and loan and portfolio investment are closer
to zero. In terms of private capital flows, central Africa attracted the largest
share of private capital flows in the past decade (Table 2(b)). Table 2C shows
the key macroeconomic indicators in SSA by year. The main conclusion from
this table is very similar to Table 2(a).

3. Modeling Methodology and Data Source

We design both a static and dynamic Generalized Method of Moments
(GMM) model. Here we mainly explain the static model. The effects of
gross short-term capital inflows and macroeconomic growth on domestic
investment are modeled as follows:
GFCFit = α0 Kit + α1 Xit + εit (1a)
GFCFit = α0 GFCFi,t−1 + α1 Kit + α2 Xit + εit (1b)
Equation (1a) is a static GMM model and equation (1b) is a dynamic
GMM model, where i refers to each of 44 SSA countries in our sample
and t is time index. GFCFit refers to gross fixed capital formation mea-
sured in percentage of GDP at time t. GFCFi, t−1 is one year of GFCF, Kit is
 Capital Inflows and Domestic Economy across SSA Countries 9

FDI inflows, measured in percentage of GDP. The control variables in Xit

include: age dependency ratio to address the demography factor that may
affect public finance and government budget, GDP growth rate to account
for macroeconomic growth effect, real interest rate to reflect the rate of
return, terms of trade to reflect the competitiveness of a country’s trading
sector, and, real effective exchange rate to account for the relative prices
changes of nominal exchange rate as well as trade openness to measure the
weight of merchandise trade in GDP. Besides these core/baseline variables,
the other three explanatory variables note: international reserve, oil price
and government debt, inflation, broad money. Finally, the third term is an
error term.
There are several econometric problems in the model of these equations:
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first, there exists the endogenity issue: the variables in capital flows Kit vector
are assumed to be endogenous. These variables may be correlated with error
terms. Second, the fixed effect model is included in the Arellano-Bond GMM
model, which is used to analyze time-invariant country characteristics. The
fixed effects are included the error term in equation (1), which contains
of the unobserved country-specific effects σi and the observation specific
error eit :
εit = σi + eit (2)
In order to analyze this panel data with only 10 year time dimension
(T = 10) and a large country dimension (N = 44), we utilized the Arellano-
Bond GMM model (Roodman, 2006) to address these problems. First, to
solve this autocorrelation issue, the first-difference lagged dependent vari-
able is instrumented with its past levels. Second, to solve endogenity and
fixed effects issue, we apply Mileva’s (2008) method,2 in which, instead
of using only the exogenous instruments listed above, lagged levels of the
endogenous regressors in Kit such as GFCF are included, which would makes
the endogenous variables pre-determined and not correlated with the error
term εit . Third, to solve the fixed effect problem, the difference GMM uses
first-difference to transform equation (1a) into equation (3)
GFCFit = α0 Kit + α1 Xit + εit (3)
By using the first differencing factor, the fixed country-specific effect is
erased, because it no longer varies with time. And equation (2) also
transforms to
εit = σit + eit (4)
Finally, the Arellano-Bond estimator is designed for small time dimension
and N panels according to Roodman (2006) and Mileva (2008). Arezki and
Hasanov (2009) also use the static and dynamic GMM model to analyze the
impacts of fiscal policy on current account for the Middle East countries. The
Arellano and Bond (1991) difference GMM panel estimator is used in our
model. There are two lists of variables in the model, gmm() (or gmmstyle())

2 We used the xtabond2 method to analyze the AB estimator.

 10 Jian Zhang & Thomas Ward

lists the endogenous variables, which are instrumented with a GMM-style

instrument, With lag (2 2) we have instructed Stata (xtabond2) to use only
the second lag of the endogenous variables as instruments, which include
domestic investment and FDI inflows in static GMM model specification,
and we add the first lag of FDI inflow in dynamic GMM model specification.
The second list of explanatory variables listed in the iv () are all strictly
exogenous variables, including Inflation, economic growth and governance
index.
Table 2(d) provides the basic summary of the key variables. All of the
data are in annual form. The data on capital flows are from the Global
Development Finance database, and other data sets are from the World
Development Indicators (WDI) and World Economic Outlook (WEO), Inter-
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national Finance Statistics (IFS) from International Monetary Fund (IMF).

Detailed information about the source of data can be found in Appendix 1B.
The exogenous instruments in the models include in different models: GDP
growth, real interest rate, real effective exchange rate, terms of trade. How-
ever, it is difficult to find variables that are orthogonal to errors term or have
no correlation with error terms. Below is a brief discussion of the variables
used in the analysis.
Gross fixed capital formation (% of GDP). In this study, we refer to gross
fixed capital formation as domestic investment, which is a big component
of total investment, which includes both gross fixed capital formation and
foreign investment.
Foreign direct investment net inflows (% of GDP). Theoretically there
is no consensus that net FDI inflow would promote domestic investment.

Table 2. (d) Statistic summary of key variables

Variable Obs Mean Std. Dev. Min Max

GFCF (% of GDP) 407 21.98742 12.1408 2.000441 114.7254

FDI inflow (% of 440 5.588756 8.080574 –5.98721 78.09112
GDP)
age dependency 440 84.28848 14.08739 39.95668 110.957
ratio (%)
GDP growth rate 440 4.911399 5.459011 –32.8321 37.99873
real interest rate 284 11.05007 21.59085 –17.5116 252.1153
terms of trade 440 116.7357 42.09405 21.21808 260.7406
REER 337 108.598 58.11373 79.006 1025.263
trade openness 440 0.691911 0.76436 0.030394 6.464037
population (log 440 1.862801 1.611374 –2.50104 5.104441
form)
Intl reserves (% of 421 0.158663 0.11845 0.006704 0.894694
GDP)
oil price (log 440 4.143268 0.44418 3.286908 4.690614
form)
government debt 438 68.96303 89.43214 0.778 931.661
(% of GDP)
Inflation 412 72.1834 1203.566 –8.97474 24411
broad money 421 34.83357 24.5198 3.160745 146.1444
 Capital Inflows and Domestic Economy across SSA Countries 11

However, a large portion of empirical studies show that there exists a

positive relationship between net FDI inflows and domestic investment.
Age dependency ratio. The dependency ratio is an important determinant
of domestic investment and national savings; the higher age dependency ratio
(an increase in the share of the young and the old) is likely to be associ-
ated with lower domestic investment. However, there is no consensus on the
theoretical effect of demographics on domestic investment.
Economic growth (real GDP growth, %). Economic growth is measured
by GDP growth in this study. Conventional economic theory generally sup-
ports that higher economic growth is always associated with higher gross
fixed capital formation.
Real interest rate (%). An increase in real interest rate is likely to increase
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the cost of borrowing from the financial sector; therefore higher costs
would reduce demand for domestic investment. We would expect a negative
relationship between real interest rate and domestic investment.
Terms of trade. Terms of trade is measured by the ratio of price of
exportable goods to price of importable goods. An improvement of terms of
trade (increase of terms of trade) will allow a country to buy more imports
for any given level of exports. Therefore, it may result in a current account
deficit, reduce demand for domestic goods and therefore lower domestic
investment. A deterioration of terms of trade would have the opposite effect
on trade balance. There is no clear relationship between terms of trade and
gross domestic investment since it depends on various factors in the domestic
market and international market.
Real effective exchange rate (REER). An increase in the REER is likely
to increase the value of domestic currency per dollar in the global market.
Currency appreciation tends to drive up domestic interest rate and cause
a decline in domestic investment. In sum, the overall effect on domestic
investment depends on the relative size of the import and export volume
elasticities, if we assume full pass-through of the exchange rate to relative
prices.
Trade openness (% of GDP). Trade openness implies relatively less con-
trols of trade restrictions. It is likely to be positively associated with gross
fixed capital formation.
International reserves (million USD). There is no consensus that more
international reserves would lead to more domestic investment. It really
depends on how policy makers allocate and spend its international reserve.

4. Analysis of the Modeling Results and Robustness Tests

As shown in Table 3, FDI inflows, GDP growth rate and trade openness have
statistically significant positive impacts on domestic investment for all SSA
countries; on average, the OLS model estimates a one percentage increase
of FDI inflows, and economic growth and trade openness lead to around
1.3, 0.29 and 3.2 percentage points increase of gross fixed capital formation
(as a percentage of GDP) in the short run (Table 3, column 1) respectively.
 12 Jian Zhang & Thomas Ward

Table 3. Gross fixed capital formation estimation in SSA–OLS Model (annual, 2003–2012)

(1) (2) (3) (4) (5) (6) (7)

Variables OLS 1 OLS 2 OLS 3 OLS 4 OLS 5 OLS 6 OLS 7

FDI inflow 1.311** 1.303** 1.284** 1.345** 1.246** 1.496** 1.316**

(0.142) (0.139) (0.143) (0.144) (0.141) (0.163) (0.144)
Age depen- –0.096* –0.061 –0.059 –0.104* –0.057 –0.083 + –0.125 +
dency
ratio
(0.046) (0.047) (0.050) (0.047) (0.047) (0.048) (0.068)
GDP Growth 0.296* 0.345** 0.308* 0.274* 0.258* 0.266* 0.293*
rate
(0.125) (0.124) (0.126) (0.126) (0.123) (0.125) (0.127)
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Real interest –0.249** –0.265** –0.243** –0.263** –0.185* –0.305** –0.252**

rate
(0.083) (0.081) (0.084) (0.083) (0.084) (0.088) (0.084)
Terms of trade 0.015 0.026 0.015 0.021 –0.005 0.013 0.009
(0.019) (0.019) (0.020) (0.020) (0.020) (0.020) (0.021)
REER –0.011 –0.003 –0.009 –0.008 –0.005 –0.005 –0.011
(0.018) (0.017) (0.018) (0.018) (0.017) (0.049) (0.018)
Trade openness 3.207** 2.447** 3.212** 3.266** 3.355** 2.886** 3.299**
(0.736) (0.767) (0.741) (0.736) (0.724) (0.748) (0.755)
Population –1.392**
(0.474)
International 10.166*
reserves
(4.900)
Oil price –1.928
(1.571)
Government –0.056**
debt
(0.019)
Inflation –0.173
(0.123)
Broad Money –0.031
(0.047)
Constant 22.735** 21.122** 17.660** 30.412** 23.842** 22.870** 26.770**
(4.289) (4.246) (5.018) (7.582) (4.231) (6.346) (7.200)
Observations 211 211 205 211 211 207 206
R-squared 0.443 0.466 0.454 0.447 0.465 0.446 0.445
Number of 26 26 26 26 26 26 26
countries

Robust standard errors in parentheses; ** p < 0.01, * p < 0.05, + p < 0.1
Note: Dependent variable is gross fixed capital formation (% of GDP)

Of the other control variables, real interest rate has a negative impact on
gross fixed capital formation. Regarding the fixed effect model, as shown in
Table 4, FDI inflow and trade openness have statistically significant positive
impacts on gross fixed capital formation in all models. On the contrary, eco-
nomic growth has no effects in a fixed effect model. The differences in OLS
and fixed effect model reflect the factors between cross country and within
country.
 Capital Inflows and Domestic Economy across SSA Countries 13

Table 4. Gross fixed capital formation estimation in SSA-fixed effect model (annual,
2003–2012)

(1) (2) (3) (4) (5) (6) (7)

Variables FE 1 FE 2 FE 3 FE 4 FE 5 FE 6 FE 7

FDI inflow 0.986** 0.926** 0.999** 0.963** 0.935** 1.016** 0.956**

(0.086) (0.088) (0.085) (0.090) (0.086) (0.101) (0.090)
Age depen- –0.245 –0.143 –0.256 –0.162 –0.113 –0.212 –0.228
dency
ratio
(0.155) (0.159) (0.169) (0.186) (0.160) (0.162) (0.161)
GDP Growth 0.002 0.010 –0.039 0.002 –0.009 0.003 –0.006
rate
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(0.070) (0.069) (0.070) (0.070) (0.069) (0.071) (0.072)

Real interest 0.022 0.035 0.038 0.032 0.038 0.047 0.006
rate
(0.057) (0.057) (0.057) (0.059) (0.056) (0.061) (0.059)
Terms of trade 0.004 –0.019 0.016 –0.003 –0.011 0.008 –0.013
(0.017) (0.020) (0.017) (0.020) (0.018) (0.019) (0.020)
REER 0.015 0.008 0.016 0.014 0.013 0.015 0.013
(0.010) (0.010) (0.010) (0.010) (0.010) (0.033) (0.010)
Trade openness 10.153** 8.449** 9.668** 9.761** 9.471** 9.806** 10.053**
(2.354) (2.426) (2.342) (2.403) (2.324) (2.392) (2.379)
Population 17.090*
(7.048)
International –21.374**
reserves
(7.076)
Oil price 0.869
(1.054)
Government –0.040**
debt
(0.015)
Inflation 0.110
(0.080)
Broad Money 0.053
(0.082)
Constant 29.010* –10.288 32.805* 19.705 22.606 + 24.826 + 27.983 +
(13.175) (20.776) (14.727) (17.352) (13.140) (14.569) (14.262)
Observations 211 211 205 211 211 207 206
R-squared 0.505 0.521 0.534 0.507 0.525 0.461 0.508
Number of 26 26 26 26 26 26 26
countries

Robust standard errors in parentheses; ** p < 0.01, * p < 0.05, + p < 0.1
Note: The dependent variable is gross fixed capital formation (% of GDP).

Table 5 shows the static GMM estimation of gross fixed capital formation
in SSA. The FDI inflow has a statistically positive effect on fixed capital
formation in GMM models 2, 4, 5 and model 7. On average, the GMM
estimate implies that a one percentage point increase in FDI net inflow (as
a percentage of GDP) leads to a 0.56 to 0.72 percentage point increase in
gross fixed capital formation (as a percentage of GDP) in the short run,
the result is closer to that of Mileva (2008), which is 0.70, and Mody and
 Table 5. Gross fixed capital formation estimation in SSA-static GMM (annual, 2003–2012)

14
(1) (2) (3) (4) (5) (6) (7)
Variables STGMM1 STGMM2 STGMM3 STGMM4 STGMM5 STGMM6 STGMM7

Jian Zhang & Thomas Ward

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FDI inflow 0.465 0.565 + 0.574 0.720 + 0.623 + 0.579 0.620 +

(0.356) (0.338) (0.354) (0.390) (0.371) (0.386) (0.339)
Age dependency ratio 0.053 0.064 0.106 + 0.040 –0.154 0.041 0.147*
(0.050) (0.047) (0.056) (0.051) (0.134) (0.053) (0.065)
GDP Growth rate 0.194* 0.178* 0.177* 0.147 0.229* 0.130 0.158 +
(0.087) (0.081) (0.081) (0.091) (0.090) (0.108) (0.081)
Real interest rate –0.337 + –0.303 + –0.338* –0.313 + –0.255 –0.403* –0.306 +
(0.171) (0.161) (0.160) (0.171) (0.179) (0.189) (0.160)
Terms of trade –0.042 –0.019 –0.026 0.011 0.037 –0.085 –0.015
(0.051) (0.050) (0.047) (0.061) (0.070) (0.067) (0.050)
REER 0.157* 0.056 0.069 0.231** 0.178* 0.227* 0.035
(0.073) (0.098) (0.075) (0.087) (0.075) (0.100) (0.089)
Trade openness 7.908 + 4.147 8.400* 11.986* 6.565 10.110* 4.684
(4.018) (4.562) (3.911) (4.774) (4.132) (4.662) (4.279)
Population 3.733
(2.598)
International reserves 14.628
(10.477)
Oil price –3.969
(2.540)
Government debt 0.113 +
(0.068)
Inflation –0.189
(0.175)
Broad Money 0.105
(0.065)
Arellano-Bond AR(1) test: (P-value) 0.472 0.563 0.677 0.335 0.886 0.261 0.539
Arellano-Bond AR(2) test: (P-value) 0.544 0.611 0.605 0.712 0.949 0.586 0.570
Sargan Test (P value) 0.136 0.081 0.058 0.179 0.219 0.191 0.063
Observations 207 207 201 207 207 207 202
Number of countries 26 26 26 26 26 26 26

Arellano-Bond (1991) difference GMM panel estimator

Robust standard errors in parentheses; ** p < 0.01, * p < 0.05, + p < 0.1
Note: The dependent variable is gross fixed capital formation (% of GDP).
 Capital Inflows and Domestic Economy across SSA Countries 15

Murshid (2005), which is 0.72, and it is closer that of Bosworth and Collins
(1999), 0.81 for developing countries, and 0.90 for an emerging market. As
expected, economic growth rate, real interest rate and real effective exchange
rate have statistically significant impacts on gross fixed capital formation.
In the dynamic GMM models (Table 6), long-term FDI inflows and
short-term FDI inflows both have significant impacts on domestic invest-
ment. Long-term FDI inflows have much higher impacts than that of
short-term FDI inflows on domestic investment. The lag effects of domes-
tic investment (GFCF) are also statistically significant in most model
specifications.
The Arellano–Bond test for autocorrelation has a null hypothesis of no
autocorrelation and is applied to the differenced residuals. The results in
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AR(1) and AR(2) of Table 5 show that we cannot reject null hypothesis.
Although AR(1) in Table 5 cannot reject null hypothesis, the test for the
AR(1) process in first differences usually rejects the null hypothesis, but this
is expected. Since equations (5) and (6) both have ei,t−1
eit = eit − ei, t−1 (5)

ei,t−1 = ei,t−1 − ei,t−2 (6)

The AR(1) test results in Table 6 reject the null hypothesis. The test for
AR(2) in first differences is more important because it will detect autocorre-
lation in levels. The Sargan test has a null hypothesis of ‘the instruments as a
group are exogenous’. Therefore, the higher the p-value of the Sargan statis-
tic, the better result we can get. Sargan test results in Table 5 also cannot
reject null hypothesis.
Table 7 demonstrates the comparison of empirical results of capital inflows
on domestic investment in developing countries. In the static GMM model
(Table 5), FDI inflow has no significant effects in the baseline model; but
it is significant in other static GMM models with coefficients around 0.62.
In the dynamic GMM model, the short-term coefficients of FDI inflow are
significant and range from 0.5 to 0.7, the long-term coefficients of FDI range
from 1.2 to 1.8, implying that SSA countries experienced the ‘crowding in’
effect of FDI, which is consistent with Agosin and Mayer’s (2000) finding
about FDI. The coefficients of lagged domestic investment (lag of GFCF)
range from 0.5 to 0.6, which is very close to the values estimated by previous
empirical studies.
It is worth discussing several key control variables before we move to
robustness test discussion. The real interest rate is statistically significant and
negatively associated with GFCF in OLS, static GMM and Dynamic GMM
and statistically insignificant in the fixed effect model, which is consistent
with theory.
Terms of trade are only statistically significant and positively associated
with GFCF in dynamic GMM (Table 6). By considering long-term FDI inflow
in dynamic GMM, terms of trade increases to respond to capital inflow.
REER is only statistically significant and positively associated with GFCF
in a fixed effect model. Table 2(c) shows that REER increased to its peak level
 16
Jian Zhang & Thomas Ward
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Table 6. Gross fixed capital formation estimation in SSA-dynamic GMM (annual, 2003–2012)
(1) (2) (3) (4) (5) (6) (7)
Variables DYGMM1 DYGMM2 DYGMM3 DYGMM4 DYGMM5 DYGMM6 DYGMM7

GFCF (one lag) 0.573** 0.530** 0.610** 0.599** 0.506** 0.611** 0.526**
(0.132) (0.130) (0.135) (0.139) (0.145) (0.142) (0.129)
FDI inflow 0.578* 0.721* 0.708* 0.507 + 0.706* 0.531 + 0.718*
(0.279) (0.278) (0.300) (0.306) (0.303) (0.292) (0.279)
Age dependency ratio –0.073 –0.032 –0.004 –0.072 –0.156 + –0.069 0.047
(0.046) (0.047) (0.054) (0.046) (0.092) (0.047) (0.065)
GDP Growth rate –0.052 –0.096 –0.080 –0.057 –0.003 –0.033 –0.099
(0.099) (0.098) (0.104) (0.099) (0.109) (0.104) (0.096)
Real interest rate –0.329** –0.293* –0.373** –0.330** –0.305* –0.296* –0.288*
(0.119) (0.117) (0.122) (0.119) (0.120) (0.128) (0.117)
Terms of trade 0.100 + 0.113* 0.108* 0.094 + 0.115* 0.136* 0.106*
(0.051) (0.050) (0.050) (0.052) (0.053) (0.067) (0.051)
REER 0.026 –0.116 –0.077 –0.009 0.057 –0.033 –0.096
(0.062) (0.081) (0.071) (0.088) (0.069) (0.094) (0.072)
Trade openness 3.194 0.363 1.842 2.424 2.679 2.081 0.936
(3.067) (3.179) (3.265) (3.356) (3.074) (3.408) (3.112)
Population 5.012**
(1.873)
International reserves 25.907*
(10.037)
Oil price 1.114
(1.969)
Government debt 0.055
(0.053)
Inflation 0.128
(0.150)
 Broad Money 0.141**
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(0.049)

Capital Inflows and Domestic Economy across SSA Countries 17

FDI inflow (long term) 1.3536** 1.5340** 1.8153** 1.2643** 1.4291** 1.3650** 1.5147**
Arellano-Bond AR(1) 0.005 0.005 0.009 0.004 0.012 0.003 0.007
test: (P-value)
Arellano-Bond AR(2) 0.841 0.593 0.508 0.843 0.646 0.885 0.554
test: (P-value)
Sargan Test (P value) 0.456 0.837 0.866 0.403 0.428 0.498 0.895
Observations 182 182 176 182 182 182 177
Number of countries 26 26 26 26 26 26 26

Arellano-Bond (1991) difference GMM panel estimator

Robust standard errors in parentheses; ** p < 0.01, * p < 0.05, + p < 0.1
Note: The dependent variable is gross fixed capital formation (% of GDP)
 18
Jian Zhang & Thomas Ward
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Table 7. Comparison of empirical studies of domestic investment estimation

Mileva (2008) Mody and Murshid (2005) Bosworth and Collins (1999) This paper

Static GMM Dynamic GMM Static GMM Dynamic GMM OLS (IV) Static GMM Dynamic GMM
FDI 0.74** 0.49* 0.72*** 0.51* 0.72 0.62** 0.57**
Lag FDI 0.30** 0.84*** 0.57***
Country 22 transition economies 60 developing countries 61 developing countries 44 SSA countries
Time Period 1995–2005 1979–1999 1979–1995 2003–2012

Standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1
 Capital Inflows and Domestic Economy across SSA Countries 19

in 2010 and started to drop in 2011 and 2012. This positive relationship may
be consistent with theory, which argues that currency appreciation is always
associated with capital inflows; however, we still cannot conclude this yet,
we may consider this positive relationship only holds within a country rather
than across countries.
We conducted various robustness tests. The baseline model is the first
model in Tables 2 to 3. We obtain similar results by considering other poten-
tial explanatory variables to our baseline model specifications. By adding
population, international reserve, oil price, government debt, inflation and
broad money, we find that population, international reserves and broad
money have produced a positive effect on domestic investment. In sum, the
signs and magnitude of most variables are consistent with economic theory in
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all OLS, fixed effect models and GMM models. In addition, we also consider
an extra robustness test by including time dummies and/or country dummies
in all three types of model specification, and the results with the dummies
are not statistically different from the results without dummy variables.

5. Conclusion and Discussion

In the past decade, capital inflows to the Sub-Saharan Africa region have
remained stable and small compared with other developing economies. On
average, the FDI to GDP ratio, loans to GDP ratio and portfolio invest-
ment to GDP ratio are around 3.5%, 1% and 0.01% respectively. The SSA
region is still hungry for capital and for funds to meet its investment needs
and development goals. Low savings, a fragile financial system coupled with
a government budget deficit and current account deficit have minimized the
resources for further development. Based on our extensive research, these are
a few research papers that examines the impact of FDI inflows on domestic
investment in the SSA region, specifically from macroeconomic perspectives.
We find that the type of capital inflows are relatively small and the allocation
of the capital flows are distributed unevenly across the regions. FDI inflows
have produced a significant positive spillover on domestic investment in both
the short-term and long-term. Moreover, the long-term effects of FDI inflows
have much higher impacts than short-term FDI inflow. Other key macroeco-
nomic factors, such as age dependency ratio, domestic economic growth,
terms of trade, real effective exchange rate and trade openness also play vital
roles in determining domestic investment.
Further improvements of this paper can be done by finding the missing
data sets to increase the quality of the study, although it is quite difficult
to collect them. There are still lots of questions that need to be answered,
for example, how fiscal policy and monetary policy effect capital inflows
across the SSA region. Capital markets and financial markets in Africa are
still weak, small and have not been well-developed compared with other
developed regions, although trade openness of the SSA region has signifi-
cantly increased from 57% in 2003 to 78% in 2012, implying that the SSA
region has gradually integrated with the global market. How to sustain and
 20 Jian Zhang & Thomas Ward

improve the capital market and attract capital inflow to produce a positive
spillover effect on domestic investment are still open questions for policy
makers.

Acknowledgement
The authors are grateful to the comments from reviewers and for editor’s comments. The authors also
thank many colleagues in the World Bank and IMF for their suggestions and discussions on earlier drafts,
especially deputy director of the Africa Department of IMF, Montfort Mlachila. The views expressed
herein are those of the authors and do not necessary reflect the views of the World Bank or those of
others.
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 Capital Inflows and Domestic Economy across SSA Countries 21

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Appendix 1A. Country Name List in Sub-Saharan Africa

1 Angola** 23 Lesotho
2 Benin 24 Liberia
3 Botswana 25 Madagascar**
4 Burkina Faso 26 Malawi
5 Burundi 27 Mali
6 Cameroon** 28 Mauritius
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7 Cape Verde 29 Mozambique

8 Central African Republic 30 Namibia
9 Chad** 31 Niger
10 Comoros 32 Nigeria**
11 Congo, Dem. Rep.** 33 Rwanda
12 Congo, Rep.** 34 Sao Tome and Principe
13 Cote d’Ivoire** 35 Senegal**
14 Equatorial Guinea** 36 Seychelles
15 Eritrea 37 Sierra Leone
16 Ethiopia 38 South Africa**
17 Gabon** 39 Swaziland
18 Gambia, The 40 Tanzania
19 Ghana 41 Togo
20 Guinea 42 Uganda
21 Guinea-Bissau 43 Zambia
22 Kenya** 44 Zimbabwe
Western Africa(15)
Central Africa (9)
Southern Africa (7)
Eastern Africa(13)

** represents the countries that export oil during the period of 2003–2010 in SSA
 22 Jian Zhang & Thomas Ward
Appendix 1B. Variables and Data Sources
Variable Description
Domestic Investment Gross fixed capital formation
(GFCF) (% of GDP) ; Indicator code:
NE.GDI.FTOT.ZS
FDI Foreign direct invest-
ment, net inflows (% of
PPP GDP) Series Code:
BX.KLT.DINV.WD.GD.ZS
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Loans PPG, commercial banks +
PNG, commercial banks and
other + PPG, other private
creditors (% of PPP GDP)
Series code: DT.NFL.PCBK.CD
and DT.NFL.PNGC.CD.
Portfolio Portfolio investment,
bonds(PPG + PNG)
[DT.NFL.BOND.CD]
+ Portfolio investment,
equity (% of PPP GDP)
[BX.PEF.TOTL.CD.DT}
GDP growth rate GDP growth (annual
%); Indicator code:
NY.GDP.MKTP.KD.ZG
real effective real effective exchange rate
exchange rate (2005 = 1); Indicator Code:
(REER) PX.REX.REER
Real interest rate real interest rate % ; Indicator
Code: FR.INR.RINR
Broad money (M2) “Money and quasi money (M2) as
% of GDP” ; Indicator code for
M2: FM.LBL.MQMY.GD.ZS
Private capital flows Private capital flows (total, %
of GDP); Indicator code:
BN.KLT.PRVT.GD.ZS
Inflation Inflation, (CPI base)
Trade openness Trade openness = (exports +
imports)/GDP
Total investment Expressed as a ratio of total
investment in current local
currency and GDP in current
local currency. (% of GDP)
Indicator Code: NID_NGDP
Data Source
World Development Indicators
(2014); World Bank
Global Development Finance
(2014); UNCTAD.
Global Development Finance
(2014), World Bank; Inter-
national Financial Statistics
International Monetary Fund.
World Development Indica-
tors (2014); World Bank;
International Financial Statis-
tics; Balance of Payment,
International Monetary Fund.
World Development Indicators
(2014); World Bank
Global Development Finance
(2014); World Bank
Global Development Finance
(2014); World Bank
Global Development Finance
(2014), World Bank; Inter-
national Financial Statistics,
International Monetary Fund
Global Development Finance
(2014); World Bank
World Development Indicators
(2014); World Bank
World Development Indicators
(2014); World Bank
World Economic Outlook (2014);
International Monetary Fund
Continued.
 Capital Inflows and Domestic Economy across SSA Countries 23

Appendix 1B. Continued

Variable Description Data Source

Terms of Trade It is measured by the ratio of price United Nation Conference

of exportable goods to price of on Trade and Development
importable goods. (UNCTAD)
General government Gross debt consists of all World Economic Indicator
gross debt liabilities that require payment (2014); World Bank
or payments of interest and/or
principal by the debtor to the
creditor at a date or dates
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in the future. Indicator code:

GGXWDG_NGDP
Oil price Nominal oil price (current USD) Research Group, World Bank
International reserves Total international reserve (Mil International Financial Statis-
USD) tics(IFS), International
Monetary Fund
Population Population World development Indicators
(WDI) (2014); World Bank
Governance index Indicators of governance World Bank (2014)