FEATURE ARTICLE 429

FDI and Economic

Activity in Africa:
The Role of Local
Financial Markets
By
Charles. K. D. Adjasi
Joshua Abor
Kofi A. Osei
Ernestine E. Nyavor-Foli

This article examines the role local financial markets play in the link between foreign direct investment
(FDI) and economic activity. The article uses panel data methods on 32 African countries over the
period 1997 to 2008. Our results show that FDI only has a significant effect on economic activity when
interacted with financial market variables, namely, private-sector credit and savings. The results of this
study imply that FDI is more productive in the presence of well-functioning local financial markets. Af-
rican governments must therefore pay particular attention to developing further local financial markets
to ensure full economic benefits of FDI inflows. © 2012 Wiley Periodicals, Inc.

Introduction FDI as a source of capital has become increasingly crucial,

especially to sub-Saharan African countries. This is mainly

F
oreign direct investment (FDI) is considered an
important source of economic growth in many
countries. While financing flows often proved
volatile and prone to recurrent misallocation, FDIs are
sought by many countries because of the large, positive
externalities with which they are associated. The role of
because of the low levels of income and domestic savings
in the region. External capital is therefore necessary to
supplement domestic savings in order to spur investment
and growth (Asiedu, 2002). Governments of host coun-
tries are now adopting policies aimed at attracting FDI
inflows. These policy moves are motivated by the benefits

Correspondence to: Charles. K. D. Adjasi, Associate Professor of Development Finance, University of Stellenbosch Business School, P.O. Box 610, Bellville 7530,
Cape Town, South Africa, +27 21 918 4284, +27 21 918 4468, charles.adjasi@usb.ac.za

Published online in Wiley Online Library (wileyonlinelibrary.com)

© 2012 Wiley Periodicals, Inc. • DOI: 10.1002/tie.21474
430 feature article
associated with inward FDI, including productivity gains,
technology transfers, the introduction of new processes,
managerial skills and know-how in the domestic market,
employee training, international production networks
and access to markets (Alfaro, Chanda, Kalemli-Ozcan, &
Sayek, 2004; Caves, 1996).
However, empirical evidence on the contribution of
FDI at both the micro and macro levels remains unclear.
Prior studies on the spillover effects of FDI on domestic
firms have produced inconclusive results (see Aitken &
Harrison, 1999; Damijan, Knell, Majcen, & Rojec, 2003;
Djankov & Hoekman, 2000; Girma, Greenway, & Wake-
lin, 2001; Kathuria, 2000; Kokko, Tansini, & Zejan, 1996;
Konings, 2001; Liu, Siler, Wang & Wei, 2000; Ruane &
Uğur, 2004; Sjöholm, 1999; Yudaeva, Kozlov, Melentieva,
& Ponomareva, 2003). At the macro level, Borensztein,
De Gregogio, and Lee (1998) and Carkovic and Levine
(2003) find little support for a positive relationship be-
tween FDI on economic growth.
The link between FDI and economic growth appears
to be mixed empirically. There is, however, a general
theoretical consensus among development economists
that FDI inflow is likely to play a critical role in explaining
growth of recipient countries (see Akinlo, 2004; Buckley,
Clegg, Wang, & Cross, 2002; De Mello, 1997, 1999). Bo-
rensztein et al. (1998) assert that FDI is particularly a key
ingredient of successful economic growth in developing
countries. This is because the very essence of economic
development is the rapid and efficient transfer and cross
border adoption of best practices, be it managerial and
technical, or deployment of technology from abroad.
FDI also helps to increase local market competition,
create modern job opportunities, and increase market
access of the developed world (Noorbakhsh, Paloni, &
Yousseff, 2001), all of which should ultimately contribute
to economic growth in recipient countries. Balasubra-
manayam, Salisu, Sapsford, (1996) found that in develop-
ing countries pursuing outward-oriented trade policies,
FDI flows were associated with faster growth than in those
developing countries that pursued inward oriented trade
policies. Other studies cover only transition economies or
industrialized countries covering different periods. Alfaro
(2003), distinguishing among different sectors, found
little support for FDI spillovers in the primary sector, a
positive effect of FDI in manufacturing on growth, and
inconclusive evidence from the service sector. Sharma
and Abekah (2007) found FDI to have a positive effect
on the gross domestic product (GDP) growth of 47 Afri-
can countries during the period 1990 to 2003. Mutenyo
(2008), using panel regressions, assessed the impact
of FDI on economic growth in 32 sub-Saharan African
Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
countries and found a consistent positive impact of FDI
on economic growth.
However, Ayanwale (2007), in a study conducted over
the period 1970 to 2002 in Nigeria, found mixed results
for the effect of FDI on growth. He also found that the
components of FDI have a positive impact on economic
growth, while the manufacturing sector FDI had a nega-
tive impact on economic growth. Other studies (Boyd &
Smith, 1992; Brecher, 1983; Brecher & Diaz-Alejandro,
1977) all predict that in the presence of price and financial
distortion, FDI can hurt resource allocation and growth.
Mansfield and Romeo (1980) find that FDI inflow does
not exert an independent influence on economic growth.
Again at the macroeconomic level, Borensztein et al.
(1998) and Carkorvic and Levine (2003) find little support
that FDI has an exogenous positive effect on economic
growth. Kholdy and Sohrabian (2005), using a panel of
25 countries, suggest that FDI does not induce economic
growth. Hanson (2001) also concludes that evidence that
FDI generates positive spillovers for host countries is weak.
In a review of micro data on spillovers from foreign-owned
to domestically owned firms, Görg and Greenaway (2002)
also conclude that the effects are mostly negative. Further,
Aitken and Harrison (1999) suggest that foreign firm pres-
ence can steal the market away from the domestic firms
and thereby reduce their productivity. They infer that if
the productivity decline from having a lower market share
is large enough, the net productivity of domestic firms can
reduce even if the technology transfer occurs from the
foreign firms to domestic firms.
The extant empirical literature on FDI growth link-
age is therefore mixed. The issue of absorptive capacity
centering on human capital development, financial mar-
kets, and other markets is important in order to derive
the growth linkage of FDI.
Financial markets have generally been credited for
contributing to economic growth. Undoubtedly, stock
markets are expected to increase economic growth by
increasing the liquidity of financial assets, making global
and domestic risk diversification possible, promoting
better investment decisions, and influencing corporate
governance-solving institutional problems by increasing
shareholders interest or value. The theoretical framework
for finance-growth nexus has been well established in the
literature with supporting evidence at the country level
reported in the empirical studies such as those of King
and Levine (1993a, 1993b); Beck, Levine, and Loayza
(2000a, 2000b); and Levine, Loayza, and Beck (2000),
suggesting that financial systems are important for pro-
ductivity, growth, and development. At the industry level,
Rajan and Zingales (1998) find that the state of financial
DOI: 10.1002/tie
 FDI and Economic Activity in Africa: The Role of Local Financial Markets   431
development reduces cost of external finance to firms,
thereby promoting growth.
Alfaro et al. (2004) have also shown that there are dif-
ferent ways in which financial markets matter in the effect
of FDI on economic growth. The inflow of FDI requires
a reorganization of domestic firm structure, inputs, and
skills to take advantage of the new knowledge. Such reor-
ganization requires access to external financing from the
domestic financial systems. Indeed, the greater the tech-
nological-knowledge gap between domestic practices and
new FDI-induced technologies, the greater the need for
external finance. Finally, the development of potential
entrepreneurs from FDI deals is likely to be hampered by
the lack of appropriate financial markets. This is consis-
tent with the results of Carkovic and Levine (2003) and
Hermes and Lensink (2000). This is to say that the extent
of the development of domestic financial markets is very
crucial in translating FDI inflows to economic growth.
The lack of development of local financial markets can
limit the economy’s ability to take advantage of potential
FDI spillovers. Well-developed financial markets are said
to enhance technological innovation, capital accumula-
tion, and economic growth.
Alfaro, Chanda, Kalemli-Ozcan, and Sayek (2007),
using a buildup on Grossman and Helpman’s (1990,
1991) small, open-economy setup of endogenous techno-
logical progress resulting from product innovation, tested
for linkages between foreign and domestic financial mar-
kets and FDI. They found that financial markets allow the
backward linkages between foreign and domestic firms
to turn into FDI spillovers. Hermes and Lensink (2003)
argue that the development of the financial system of the
recipient country is an important precondition for FDI to
have a positive impact on economic growth. Their find-
ings revealed that 37 of the 67 countries examined had
sufficiently developed financial systems in order to let
FDI contribute positively to economic growth. King and
Levine (1993a, 1993b) and Beck et al. (2000b) conclude
that financial markets improve productivity growth and
development. Rajan and Zingales (1998) indicate that de-
velopment of financial markets reduces the cost of exter-
nal financing and thereby promote the economic growth.
Wurgler (2000) also suggests that financial markets can
speed economic growth by improving the allocation of
existing investment.
It is important to recognize that the effects of FDI on
growth may depend on the role of local institutions. There
is the argument, therefore, that well-functioning financial
markets ensure low transaction costs, efficient allocation
of capital, and therefore enhance economic growth (see
Boyd & Prescott, 1986; Greenwood & Jovanovic, 1990; King
DOI: 10.1002/tie
Well-developed financial
markets are said to enhance
technological innovation,
capital accumulation, and
economic growth.
& Levine, 1993b; McKinnon, 1973; Shaw, 1973). In spite of
the significant role being played by financial markets, the
extant literature on the effect of FDI on economic seems
to disregard this. Empirical studies have tended to focus
on the effect of financial markets on economic growth,
suggesting a positive relationship. These studies establish
that well-developed financial markets enhance economic
growth (see King & Levine, 1993a, 1993b; Beck et al,
2000a, 2000b; Levine et al., 2000).
In summary, theoretical literature suggests a posi-
tive impact of FDI on economic growth, whereas the
empirical literature indicates mixed results. At the same
time, the role of financial markets has been identified
to contribute positively to the FDI effect on growth. It is
therefore expected that economies with well-functioning
financial market tend to experience positive link between
FDI and economic growth rates.
This current study investigates the extent to which
FDI promotes economic growth in Africa, considering
the level of development in the local financial market.
Specifically, we examine whether the presence of fi-
nancial markets in African economies is necessary for
FDI to positively impact economic growth. This study is
motivated by the fact that limited empirical studies exist
on the important role of financial markets in influenc-
ing FDI effect on growth. This study differs from that of
Alfaro et al. (2004), in two ways: First, it focuses exclu-
sively on African countries unlike Alfaro et al. (2004),
who only include selected African countries. Second, it
also uses a panel data framework for empirical analysis
and thereby captures the time series structure and dy-
namics of the role of financial markets in the effect of FDI
on economic growth.
Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
432 feature article
The rest of the article is structured as follows: first,
we provide empirical issues on FDI in Africa. Second, we
describe the data and give an overview of financial mar-
ket developments and FDI in the countries under study.
Next, we include the empirical methods and a discussion
of the results. Conclusions are drawn in the final section.
Empirical Issues on Foreign Direct
Investment to Africa
Many countries, including developing countries, now see
attracting FDI as an important element in their strategy
for economic development. This is probably because
FDI is seen as an amalgamation of capital, technology,
marketing, and management (Ayanwale, 2007). Also, in
relation to the achievement of the Millennium Develop-
ment Goal (MDG), which aims at reducing poverty rates
by half, FDI will be crucial to help create jobs thereby
reducing the poverty levels within African economies.
Indeed, one of the pillars on which the New Partnership
for Africa’s Development (NEPAD) was launched was
to increase available capital to US$64 billion through a
combination of reforms, resource mobilization, and a
conducive environment for FDI (Funke & Nsouli, 2003).
African countries have in the last decade made con-
siderable efforts to improve their investment climate.
Indeed, whereas countries used to list specific sectors
open to foreign investment, the norm is now to assume
a legally open regime, with restricted sectors listed as the
exceptions. There have also been some policies actively
designed to attract investment, such as tax holidays, eas-
ing of import and customs controls, infrastructure invest-
ment, and labor law reforms (Moss, Ramachandran, &
Shah, 2004). The economic performance of the region
has improved in some cases from the mid-1990s as coun-
tries adopted structural adjustment programs that hinged
on pushing down inflation and government expenditures
and establishing a realistic exchange rate regime.
It is, however, alleged that Africa has not benefited
significantly in a way that is commensurate to its policies
and the rate of return on its investments from the flows
of foreign direct investment (United Nations Confer-
ence on Trade and Development [UNCTAD], 1999).
For most of the time since 1970, FDI inflows into Africa
have increased only modestly, from an annual average of
about US$1.0 billion in 1983–1987 to US$3.1 billion in
1988–1992 and US$4.6 billion in 1991–1997 (UNCTAD,
2001). There was a steady decline between 2000 and
2003, totaling about 41% followed by an upward move
in 2004 to US$18.1 billion. It must, however, be noted
that FDI is still concentrated in only few countries for
Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
reasons ranging from negative country image to poor
infrastructure, corruption, foreign exchange shortages,
and an unfriendly macroeconomic policy environment
among others (Ayanwale, 2007). During the period 1998
to 2002, just three countries (South Africa, Angola, and
Nigeria) accounted for 55% of the total FDI inflows to
Africa. The top fifth (10 out of 48 countries) account for
80%, and the bottom half account for less than 5%. This
trend has held for at least the last three decades, with the
top 10 countries accounting for more than 75% of the
continent’s total FDI inflows (Moss et al., 2004).
Africa continues to attract FDI only into sectors
where competitive advantages outweigh the continent’s
negative factors. These include minerals, timber, cof-
fee, and oil (Mills & Oppenheimer, 2002). Nearly all
of the investment going to Angola, Nigeria, Equatorial
Guinea, Sudan, and Chad is oil-related, with the bulk of
the investment in the former three invested in offshore
facilities. Over the five-year period 1998 to 2002, these
five countries accounted for 43.5 percent of Africa’s total
FDI (roughly matching oil concentration in previous
periods). In addition, much of the foreign investment in
Ghana, Zambia, Namibia, Botswana, and South Africa,
and more recently Tanzania, has been in large mining
projects (Moss et al., 2004). However, the structure of
FDI has shifted toward services worldwide in recent times.
In the early 1970s, the sector accounted for only one-
quarter of the world FDI stock; in 1990, this share was
less than one-half; and by 2002, it had risen to about 60%
(UNCTAD, 2003). Contrary to common perception, the
concentration of FDI in Africa is no longer in the min-
eral resources only. Even in the oil-exporting countries,
services and manufacturing are becoming key sectors for
FDI (Ajayi, 2006). Despite these trends on FDI, it remains
unclear whether FDI positively influences economic
growth in Africa. The interest of this study is to find out if
financial markets are instrumental in influencing FDI in
Africa to positively impact economic growth.
Data
The data for this study are unbalanced panel data on
32 African countries over the period 1997 to 2008. FDI
is measured as the net inflows of foreign investment to
acquire a lasting management interest (10% or more of
voting stock) in an enterprise operating in a domestic
economy. It is the sum of equity capital, reinvestment of
earnings, other long-term capital, and short-term capital
as shown in the balance of payments. Investment is meas-
ured as gross domestic investment and consists of outlays
on additions to the fixed assets of the economy plus net
DOI: 10.1002/tie

changes in the level of inventories. Human capital is cap-
tured via school enrollment rate. There are three enroll-
ment rates: primary school, secondary school, and tertiary
school. Inflation is measured as the percentage change in
the GDP deflator. Government consumption is also meas-
ured as the ratio of government expenditure to GDP.
Institutional stability and quality in the economies
are captured by the following variables: polity index, cor-
ruption control, government effectiveness, and regula-
tory quality. Polity is a measure of the democratic nature
of governance. Control of corruption measures the ex-
tent to which public power is exercised for private gain,
including petty and grand forms of corruption, as well as
“capture” of the state by elites and private interests. The
polity and corruption control indexes are all obtained
from the World Bank’s World Development Indicators.
Government effectiveness measures the quality of public
services, the quality and degree of independence from
political pressures of the civil service, the quality of policy
formulation and implementation, and the credibility of
the government’s commitment to such policies. Regula-
tory quality measures the ability of the government to
formulate and implement sound policies and regulations
that permit and promote private sector development.
We also use the ratio of the sum of exports plus
imports to total output (GDP) to capture openness to
international trade. We use indicators of financial inter-
mediation or development as proposed by (Beck et. al.,
2000b). Domestic credit to private-sector credit as a ratio
of GDP measures the depth of the financial intermedia-
tion. Liquid liabilities of the financial sector measured
as M2/GDP is a measure of the size of the financial sec-
tor. Domestic savings is used to capture the intermittent
effect of financial intermediation on growth. The last
financial intermediation indicator, the stock market, is
table 1 Descriptive Statistics
Mean
1997–2008
GDP USD 15.6 billion
FDI USD 324 million
Gross investment USD 3.33 billion
M2GDP 31.36%
Savings to GDP 12.61%
Private-sector credit to GDP 23.23%
Stock markets indicators—countries with stock markets
Turnover ratio 13.69%
Market capitalization ratio 38.81%
Source: World Bank’s African Development Indicators (2008/2009) and authors’ computations.
DOI: 10.1002/tie
FDI and Economic Activity in Africa: The Role of Local Financial Markets   433
captured via a stock market dummy for countries with
stock markets.1
All data for the empirical analysis are obtained
from World Bank’s African Development Indicators
2008/2009.
The descriptive statistics for selected data for the
sample in Table 1 show the level of FDI inflows into the
32 African countries. In particular, we notice that mean
FDI inflows are low compared to the level of economic
activity (as measured by GDP) and gross investment
formation. The depth and development of the financial
markets are shown by the mean M2 to GDP ratios as well
as the savings and private sector credit to GDP ratios. On
the average, financial-sector activity makes less than half
of economic activity. Clearly, there is room for improve-
ment in the depth and breadth of financial-sector devel-
opment in relation to the economies of these countries.
The last two rows in the bottom part of Table 1 show stock
market indicators for countries with stock markets in the
sample. The stock markets are relatively small (average of
38.81% of GDP) in these markets and with low liquidity as
measured by turnover ratio (13.69%). These figures com-
pare favorably with 30% for Mexico, but unfavorably with
71% for Thailand and 161% for Malaysia within the same
period (World Bank, 2009). These statistics notwithstand-
ing, the financial landscape in Africa has been growing
steadily over the years.
Empirical Analysis
Our model is similar to that of Alfaro et al. (2004); how-
ever, we construct a panel data and estimate this via panel
data methods.
yit = α 0 + α 1 FDI it + α 2 Controlit + ε it (1)
Standard Dev Maximum
31900000000 US$177 billion
916000000 US$10 billion
6370000000 US$36.2 billion
20.4 101.18%
15.44 67.25%
26 160.76%
17.94 126%
52.52 300.29%
Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
 434 feature article

Where, ε it = υ i + η it cording to endogenous growth models (Romer, 1986),

υ i = individual country effects—32 African countries are a permanent increase in economic growth can be deter-
used, mined by higher savings and capital accumulation.
yit = real GDP in 2000 constant US$ for country i in time
Regression Results
t = 1997–2008,
Results from model 1, which examines the effect of
FDI it = foreign direct investment (US$) for country i in
FDI on economic activity, are shown in Table 2. It is
time t, and
important to note that the effect of FDI is insignificant
Control it = vector of control variables—determinants of
economic growth.
To capture the interactive effect between FDI and local table 2 FDI and Growth-First Stage Regression
financial markets we reestimate model 1 and introduce an
interactive term between FDI and financial market indicators.
Inflation –0.0981
yit = β 0 + β1 FDI it + β 2 ( FDI it × Financeit ) + β 3 Financeit + β 4 Controlit + u it (0.220)
+ β 3 Financeit + β 4 Controlit + u it (2) Government exp 0.4298
(0.000)
Where, u it = φ i + σ it , Investment 0.1652
φ i are individual country effects, (0.042)
Population 0.2990
Finance is the set of financial sector variables, and
(0.000)
β2 captures the interactive effect between FDI and local FDI 0.0099
financial markets. (0.504)
Our choice of the independent variables follows from M2/GDP –0.0006
(0.695)
standard growth literature. In this regard, we dwell on the
Savings 0.0123
importance of investment-capital accumulation, trade,
(0.000)
macroeconomic stability, institutional and governance
Private-sector credit 0.0051
quality and human capital development on growth. Our (0.000)
a priori expectations are therefore based on assumptions Trade openness 0.1519
in the standard growth models. (0.290)
Investment and population growth are significant driv- Corruption control –0.0715
ers of economic growth (Mankiw, Romer, & Weil, 1992). (0.218)
The endogenous growth theory also argues that human Gov effectiveness –0.0381
capital is a significant predictor of growth. We expect the (0.603)
contribution of tertiary school enrolment to growth to Polity 0.0828
(0.018)
be more significant.2 A priori, we expect human capital
Regulatory qual –0.0082
to positively predict growth. Inflation and the ratio of
(0.891)
government expenditure to GDP are used as a proxy for
Primary school 0.1938
macroeconomic stability (Barro, 1991; Easterly, Loayza, (0.014)
& Montiel, 1997). Other important growth drivers accord- Secondary school –0.2106
ing to the endogenous growth literature are institutional (0.000)
and governance issues (Acemoglu, Johnson, & Robinson, Tertiary school 0.2732
2004) as well as trade openness (Hausmann, Pritchett & (0.000)
Rodrik, 2005). Strong institutions and good governance Stock market dummy 0.1427
are expected to stimulate growth. Again, increased trade (0.004)
openness would significantly and positively impact growth. Intercept 4.9390
(0.000)
The finance-growth nexus posits that financial inter-
R2 0.996
mediation is a significant determinant of growth. This
occurs through efficient allocation of resources for invest- Obs. 70
ment and reduced external cost of finance among other 2 11384.96
Wald χ
{0.000}
things (Beck et al., 2000b). Traditional theories such as
those suggested by Romer (1986), for example, have also Hausman test results show that random effect is the appropriate estimator.
emphasized the role of savings in economic growth. Ac- Figures in brackets show asymptotic probability values.

Thunderbird International Business Review Vol. 54, No. 4   July/August 2012 DOI: 10.1002/tie
 FDI and Economic Activity in Africa: The Role of Local Financial Markets   435

table 3 FDI and Growth—Role of Local Financial Markets

(1) (2) (3) (4)

M2/GDP SGDP Private-Sector Credit Stock Markets
Inflation –0.0981 –0.1084 –0.08759 –0.1101
(0.214) (0.158) (0.264) (0.167)
Government exp 0.4320 0.4406 0.4308 0.4488
(0.000) (0.000) (0.000) (0.000)
Investment 0.15228 0.1129 0.1569 0.1462
(0.059) (0.162) (0.048) (0.073)
Population 0.3006 0.3325 0.3000 0.3096
(0.000) (0.000) (0.000) (0.000)
FDI –0.0204 –0.0056 –0.0140 –0.0057
(0.403) (0.720) (0.468) (0.753)
FDI*Finance 0.0010 0.0020 0.0011 0.0493
(0.212) (0.016) (0.063) (0.153)
M2/GDP –0.0176 0.0006 0.0021 0.0006
(0.112) (0.701) (0.311) (0.714)
Savings 0.0126 –0.0252 0.0128 0.0130
(0.000) (0.112) (0.000) (0.000)
Private-sector credit 0.0048 0.0050 –0.0184 0.0043
(0.001) (0.000) (0.147) (0.005)
Trade openness 0.1644 0.1723 0.1660 0.2103
(0.247) (0.211) (0.237) (0.155)
Corruption control –0.0790 –0.0698 –0.0826 –0.1039
(0.169) (0.209) (0.147) (0.092)
Gov effectiveness –0.0165 0.01236 –0.0238 –0.0243
(0.601) (0.866) (0.740) (0.740)
Polity 0.0884 0.1005 0.0835 0.0916
(0.011) (0.003) (0.015) (0.009)
Regulatory qual –0.0199 –0.0030 0.0003 –0.0109
(0.738) (0.958) (0.996) (0.854)
Primary school 0.1851 0.1515 0.1703 0.1599
(0.017) (0.050) (0.028) (0.049)
Secondary school –0.2405 –0.2316 –0.237 –0.2233
(0.000) (0.000) (0.000) (0.000)
Tertiary school 0.2843 0.2652 0.2795 0.2783
(0.000) (0.000) (0.000) (0.000)
Stock market dummy 0.1756 0.1824 0.1657 –0.7753
(0.002) (0.001) (0.002) (0.229)
Intercept 5.7540 5.5547 5.5417 5.2969
(0.000) (0.000) (0.000) (0.000)
R2 (overall) 0.995 0.995 0.996 0.996
Obs. 70 70 70 70
Wald χ2 11693.60 12431.82 11927.82 11614.99
{0.000} {0.000} {0.000} {0.000}

Figures in brackets show asymptotic probability values. In equation (1), FDI is interacted with M2/GDP ratio—a measure of financial depth- ( FDI it × M 2GDP it ) . In
equation (2), FDI is interacted with savings/GDP- ( FDI it × SGDP it ) . In equation (3) FDI is interacted with private sector credit/GDP- ( FDI it × Pr CredGDPit ) .
In equation (4), FDI is interacted with the stock market dummy- ( FDI it × SMDummyit ) . Unlike Alfaro et al. (2004), we are unable to run separate regressions on
countries with stock markets alone due to the smallness of the sample with data (13 countries) as well as the paucity of data within the period under study in the
case of some countries.

in this first stage of analysis. The significant predicators rollment, and the stock market dummy. Specifically, in-
of growth are investment, population growth, financial vestment spurs GDP growth. The importance of finance
depth measured by savings and private-sector credit in growth is reinforced by the significant and positive
corruption control, human capital–secondary school en- relationship observed between savings and GDP changes

DOI: 10.1002/tie Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
436 feature article

table 4 Instrumental Variable Regression for Endogeneity Check—Baltagi IV EC 2SLS

(1) (2) (3) (4)

M2/GDP SGDP Private-Sector Credit Stock Markets
Inflation –0.318 –0.338 –0.336 –0.334
(0.000) (0.000) (0.000) (0.000)
Government exp 0.351 0.360 0.354 0.350
(0.000) (0.000) (0.000) (0.000)
Investment 0.324 0.274 0.329 0.331
(0.000) (0.000) (0.000) (0.000)
Population 0.220 0.271 0.226 0.225
(0.000) (0.000) (0.000) (0.000)
FDI –0.071 –0.030 –0.036 –0.013
(0.040) (0.101) (0.121) (0.602)
FDI*Finance 0.002 0.003 0.001 0.022
(0.035) (0.001) (0.077) (0.586)
M2/GDP –0.033 0.003 0.003 0.001
(0.038) (0.055) (0.155) (0.537)
Savings 0.006 –0.059 0.006 0.006
(0.001) (0.004) (0.000) (0.002)
Private-sector credit 0.002 0.002 –0.017 0.002
(0.115) (0.057) (0.140) (0.131)
Trade –0.196 –0.195 –0.192 –0.216
(0.011) (0.010) (0.015) (0.006)
Corruption –0.021 –0.001 –0.015 –0.017
(0.634) (0.985) (0.738) (0.714)
Government effectiveness –0.003 0.028 –0.023 –0.031
(0.947) (0.579) (0.642) (0.540)
Polity 0.099 0.117 0.093 0.093
(0.002) (0.000) (0.003) (0.004)
Regulatory quality –0.020 0.041 –0.004 –0.008
(0.711) (0.466) (0.945) (0.881)
Primary school 0.181 0.114 0.169 0.181
(0.010) (0.109) (0.017) (0.011)
Secondary school –0.238 –0.198 –0.210 –0.184
(0.000) (0.000) (0.000) (0.000)
Tertiary school 0.282 0.241 0.281 0.271
(0.000) (0.000) (0.000) (0.000)
Stock market 0.246 0.232 0.207 –0.218
(0.000) (0.000) (0.000) (0.767)
Intercept 7.142 6.254 6.294 5.881
(0.000) (0.000) (0.000) (0.000)
R2 (overall) 0.9932 0.9938 0.9933 0.9932
Obs. 70 70 70 70
Wald χ2 11898.05 12987.94 12033.61 11817.42
{0.000} {0.000} {0.000} {0.000}

Figures in brackets show asymptotic probability values.

as well as private-sector credit and GDP changes. The
inability of FDI to significantly predict economic activity
is line with results of studies by Borensztein et al. (1998)
and Carkovic and Levine (2003). These results offer
further motivation into investigating the role financial
markets may play in stimulating FDI to positively im-
pact on economic activity. We therefore reestimate the
model with interactive terms between FDI and financial
market indicators.
Four different regressions (Table 3) are estimated,
with each having a unique FDI financial market interac-
tive term. We observe that the impact of FDI on GDP
becomes significant when interacted with savings and
private-sector credit. Specifically, the interactive terms

Thunderbird International Business Review Vol. 54, No. 4   July/August 2012 DOI: 10.1002/tie
 FDI and Economic Activity in Africa: The Role of Local Financial Markets   437

between FDI and financial market indicators are signifi-
cant in equations 2 and 3 in Table 3. Our results show
that the FDI interactive term has an incremental effect
beyond the variables it is interacted with. For instance,
FDI interacted with savings to GDP ratio is significant in
equation 2, whilst savings to GDP itself is insignificant in
the regression. Similarly, FDI interacted with private-sec-
tor credit is significant, in equation 3, while private-sector
credit itself is insignificant in the regression. These results
are largely consistent with those of previous studies (see
Alfaro et al., 2004; Alfaro et al., 2007; Carkovic & Levine,
2003; Hermes & Lensink, 2000). With the exception of
M2/GDP and the stock market dummy, other financial
market indicators significantly interact with FDI to pro-
mote GDP changes.
As noted by Alfaro et al. (2004), the significance of
the FDI interactive term may show its ability in capturing
an important allocation function that the financial sec-
tor performs. Therefore, it is not enough to attract FDI
inflows, since their impact would depend on how well the
local financial sector is able to allocate resources. This
implies that the development of local financial markets is
important for FDI to significantly influence growth. FDI
is able to positively influence economic activity if local
financial markets are robust in mobilizing resources and
channeling them for productive uses. Since it is theo-
retically plausible that FDI and financial markets may be
endogenous to economic activity, we reestimate all re-
gressions using instrumental variable (IV) regressions to
check for endogenity. We use the Baltagi IV EC 2SLS to
check for endogenity.
Our instruments for financial market variables in-
clude rule-of-law index, voice and accountability index,
and political and democratic development index. These
variables are obtained from the World Bank World Gov-
ernance Indicators available at www.worldbank.org/wbi/
governance. Following the evidence by Wheeler and
Mody (1992) that FDI is self-reinforcing, we use lagged
FDI as an additional instrument for FDI. Our IV regres-
sion results (Table 4) continue to show a positive and
significant effect of the FDI interacted with financial mar-
kets on economic activity. The validity of our instruments
is proven by the robustness of the regression results in the
instrumental variable modeling.
Conclusion
The attraction of FDI remains important in the develop-
ment agenda of developing countries, especially in Africa.
This is mainly due to the positive effect that FDI has on
economic growth. Empirical studies, however, continue
to be inconclusive on the role of FDI in economic growth.
In this article, we examined the effect of FDI on eco-
nomic activity by determining the role of local financial
markets in helping FDI promote economic activity.
Our results follow that of Alfaro et al. (2004) and
show that local financial markets play an important role in
the link between FDI and economic activity. In particular,
we find that FDI only has a significant effect on economic
activity when interacted with financial market variables,
namely; savings, and private sector credit. FDI inflows
require reorganization of productive activity and to a
large extent reliance on external financing. Local firms
are able to utilize FDI inflows better with good and stable
financial markets. Therefore, for FDI to be effective in
promoting economic activity in Africa, governments must
strengthen and further develop local financial markets to
ensure full economic benefits of FDI inflows.

Charles. K. D. Adjasi is associate professor of Development Finance at the University of Stellenbosch Business
School, Cape Town, South Africa. He is also a researcher with the African Economic Research Consortium, Kenya.

Joshua Abor is an associate professor and the head of the Department of Finance, and vice dean at the University of
Ghana Business School, Legon, Ghana. He is also a researcher with the African Economic Research Consortium, Kenya.

Kofi A. Osei is a senior lecturer and vice dean of the University of Ghana Business School, Legon, Ghana. He is
also a researcher with the African Economic Research Consortium, Kenya.

Ernestine E. Nyavor-Foli is an MPhil student at the Department of Finance at the University of Ghana Business
School, Legon, Ghana.

DOI: 10.1002/tie Thunderbird International Business Review Vol. 54, No. 4   July/August 2012
438 feature article
Notes
This paper has benefited from useful comments from participants at
the African Finance Conference Journal Cape Town 2009 and the July
2009 Economics Seminar at the University of Stellenbosch, Cape Town.
1. The paucity of data on stock market indicators across the countries
with stock markets does not help in running robust regressions when
stock market countries are isolated, hence the use of the dummy.
2. We are grateful to an anonymous reviewer for the suggestion.
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