MEKELLE UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN ETHIOPIA

BY

MR. MEGBARU MISIKIR TASHU

ID.NO.: CBE/PR021/02

A THESIS

SUBMITTED IN PARTIAL FULFILLMENT OF

THE REQUIREMENTS FOR THE MASTER OF SCIENCE DEGREE

IN

FINANCE AND INVESTMENT

PRINCIPAL ADVISOR: CO-ADVISOR:

DR. TESFATSION SAHLU DESTA (PhD) MR. GIZACHEW YIRTAW

MAY 2011

MEKELLE, ETHIOPIA
 TABLE OF CONTENTS
CONTENTS PAGES
Table of Contents i
Declaration iii
Certification v
Acknowledgment vii
Abstract ix
Acronyms xi
List of Tables xiii
CHAPTER I: INTRODUCTION 1
1.1 Background of the Study 1
1.2 Statement of the Problem 4
1.3 Objectives of the Study 6
1.4 Research Questions 6
1.5 Research Hypothesis 7
1.6 Scope of the Study 7
1.7 Significance of the Study 8
1.8 Limitations of the Study 8
1.9 Organization of the Paper 8
CHAPTER II: LITERATURE REVIEW 9
2.1 Empirical Studies on the Determinants of Foreign Direct Investment 9
2.1.1 Previous Studies in Industrialized and Emerging Market Countries 9
2.1.2 Previous Studies in OECD Countries 11
2.1.3 Previous Studies in Transition Economies Countries 12
2.1.4 Previous Studies in Developing Economies Countries 13
2.1.5 Previous Studies in African Countries 15

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2.1.6 Previous Studies in Specific Countries 18
2.1.7 Previous Studies on Pull and Push Factor Approach 20
2.2 Conceptual Framework 25
CHAPTER III: RESEARCH METHODOLOGY 27
3.1 Study Design 27
3.2 Data Source and Collection Methods 27
3.3 Data Analysis 27
3.4 Description of Variables 28
3.4 Model Specification 30
CHAPTER IV: DATA ANALYSIS AND INTERPRETATION 33
Summary of Descriptive Statistics 33
Goodness of Test 36
4.2.1 Tests for Stationary 36
4.2.2 Test for Co-integration 38
4.2.3 Test for Heteroskedasticity 39
4.2.4 Test for Multicollinearity 40
4.2. 5 Test of Autocorrelation 40
4.2.6 Test of Model Specification 41
4.3 Hypotheses Testing 42
4.3.1 Correlation Analysis 42
4.3.2 Regression Analysis 46
CHAPTER V: CONCLUSION AND RECOMMENDATION 55
Conclusion 55
5.2 Recommendation 60
References 63
Appendix 71

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 DECLARATION

I, Mr. Megbaru Misikir, have been a bona fide student of Master of Finance and Investment
(MFI) in the Department of Accounting & Finance (AcFn), College of Business and
Economics (CBE), Mekelle University (MU), Mekelle since September, 2009.

I do here by declare that the thesis entitled, “DETERMINANTS OF FOREIGN DIRECT

INVESTMENT IN ETHIOPIA” for the Master’s Degree of this University, is my own piece
of original research work.

This thesis is submitted for the Master of Science (MSc.) Degree in Finance and Investment
in the Department of Accounting & Finance, CBE, under the direct supervision and guidance
of Dr. Tesfatsion Sahlu (Principal Advisor) and Mr. Gizachew Yirtaw (Co-Advisor),
CBE, MU, Mekelle. The manuscript of the thesis has been thoroughly scrutinized by them. I
also assert that this thesis has not been submitted earlier for the award of any other degree or
diploma anywhere else.

With high regards,

Candidate

Name: Megbaru Misikir

ID. No.: CBE/PR021/02

Sig.: _____________________

Date: _____________________

AcFn, CBE, MU, Mekelle.

iii
 CERTIFICATION

This is to certify that Mr. Megbaru Misikir has been a bona fide student of Master of
Finance and Investment (MFI) in the Department of Accounting & Finance (AcFn), College
of Business and Economics (CBE), Mekelle University (MU), Mekelle since September,
2009.

With regard to the thesis entitled, “Determinants of Foreign Direct Investment in Ethiopia”
for the Master of Science (MSc.) Degree in Finance and Investment in the Department of
Accounting & Finance, CBE, We certify that he has carried out the research work under our
direct supervision and guidance. The manuscript of the thesis has been thoroughly scrutinized
by in view of the requirements of the regulations of the University.

This thesis does not contain any conjoint research work with us or with any one else. The
final copy of the thesis which is being submitted to the university office has been carefully
read for its material and language and he has completed his research work to our entire
satisfaction.

To the best of our knowledge, the entire thesis comprises the candidate’s own piece of
original research work.

Thus, the thesis is worthy of consideration for the award of MSc. Degree in Finance and
Investment.

With high regards,

Principal Advisor Co-Advisor

Name: ________________________ Name: ________________________

Sig.: ______________ Sig.: _________________

Date: _______________ Date: __________________

AcFn, CBE, MU, Mekelle AcFn, CBE, MU, Mekelle

v
 ACKNOWLEDGEMENTS

First and foremost, I would like to thank The God Almighty for every blessing that He enrich
me with in all my life. I would also like to thank St. Mary for Her precious intersection and
for helping me realize my prayers.

Next I am deeply grateful to my principal advisor, Dr. Tesfatsion Sahlu and to my co- advisor
Mr Gizachew Yirtaw for their persistent helps in all the steps of completing the thesis, from
title selection to writing the final report, my debts are innumerable. Besides, their fascinating
guide, good advice, constructive criticism, support, and flexibility are learnable.

My heartfelt thanks also go to my former advisor G.Egziabher H.Selasie (Assistant Professor)

for his constructive advice and guidance while I was writing the proposal of the thesis. I am
grateful to his invaluable comments and suggestions from which I have benefited a lot. May
God rest his soul in heaven.

Most important, this project would not have been possible without the support of the
exceptional people who are employees of Ethiopian Investment Agency, World Bank, and
NBE in giving me the necessary data of the sample period of the study.

Finally, it would not be justified if I do not mention the support of Abel Birku (PhD
Candidate). I thank you for taking your precious time to read my thesis and provide me with
valuable comments.

MEGBARU MISIKIR

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viii
 ABSTRACT

This study entitled “determinants of foreign direct investment in Ethiopia” found on the key
factors that determines the inflows of foreign direct investment in a country during the period
of 1992-2010. This study was developed with the objective of investigating the major
determinants of foreign direct investment in Ethiopia for the period of 1992-2010. To achieve
the aim of the study, seven explanatory variables: market size and growth, openness,
macroeconomic stability infrastructure, human capital, growth of domestic investment and
lagged FDI was regressed against the flow of foreign direct investment. In this study both
primary and secondary data collection methods were used. The secondary sources of data for
the study were collected from the Ethiopian Investment agency, World Bank, IMF, and NBE.
Moreover, in order to support the secondary data, additional information was obtained by
primary data gathering tool through conducting unstructured interview with macroeconomic
experts. Finally, the gathered information was analyzed by descriptive, correlation and
ordinary least squared analysis methods. The major findings of the study indicated that
market size, openness, government expenditure, employment level, foreign debt, human
capital, telephone line, gross fixed capital formation, growth of domestic investment and
lagged FDI were major significant determinants of FDI inflows in to Ethiopia. From these
variables market size, government expenditure, employment level, human capital, overall
infrastructure development, and growth of domestic investment were motivating factors while
openness, foreign debt and telephone line were constraints for the inflows of FDI. However,
market growth and inflation found to be insignificant determinant for the inflows of FDI in to
Ethiopia. The study also recommended that the country is supposed to formulate appropriate
policies that can exploit emergent and undiscovered market of the country, develop job
training programs, formulate policies that highly promotes internal source of government
revenue and also increasing the capacity of secondary schools and higher institutions
enrollments so as to attract more FDI than the past. Finally, this study was limited to time
series regression analysis of a country. Thus, further researchers are suggested to investigate
on similar topic at country level or major economic sector specifically by considering cross
sectional or panel data regression analysis techniques.

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 ACRONYMS
BRIMC Brazil, Russia, India, Mexico and China
CPI Consumer Price Index
EL Employment Level
EU European Union
EXIM Exports and Import
FD Foreign Debt
FDI Foreign Direct Investment
GAFTA Greater Arab Free Trade Area Agreement
GDI Growth of Domestic Investment
GDP Gross Domestic Product
GFCF Gross Fixed Capital Formation
GE Government Expenditure
GRRGDP Growth Rate of Real Gross Domestic Product
ICT Information and Communication Technology
IMF International Monetary Fund
INF Annual Rate of Inflation
LFDI Lagged FDI
MENA Middle East and North Africa
MOFED Ministry of Finance and Economic Development
MNCs Multinational Companies
NBE National Bank of Ethiopia
OECD Organization for Economic Cooperation and
Development
OLS Ordinary Least Squares
RGDPC Real Gross Domestic Product per capita
SEER Secondary Education Enrollment Rate
TELE Telephone Lines
UNCTD United Nation Conference on Trade and Development
WTO World Trade Organization

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 LIST OF TABLES

Tables Description Page

Table 4.1 Summary of Descriptive Statistics 34
Table 4.2. Unit Root Test on Variables 37
Table 4.3 The Unit Root Tests on Residuals 39
Table 4.4 Breusch-Pagan / Cook-Weisberg Test for Heteroskedasticity 39
Table 4.5 Variance Inflation Factor 40

Table 4.6 Durbin–Watson d statistic 41

Table 4.7 Link Test on Variables 41
Table 4.8 Ramsey RESET Test Using Powers of the Fitted Values of ∆FDI 42
Table 4.9 Correlation Matrix 45
Table 4.10 OLS Estimation FDI Inflows as Percent of GDP Using Time Series 47
Data From Ethiopia, 1992-2010

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xiv
 CHAPTER ONE

INTRODUCTION

The objective of this study was to identify the determinants of foreign direct investment in
Ethiopia. Accordingly, this chapter provides a bird’s eye view of the overall study. It starts
with the presentation of the brief background of the study followed by statement of the
problem and general and specific objectives of the study. It then gives the hypothesis to be
tested. Moreover, there is a section that discusses the significance of the study and a section
that sets out the scope of the study with the range of limitations faced while conducting the
research. Lastly, organization of the report is outlined, which enables to picture the general
structural organization of the whole paper.

1.1 BACKGROUND OF THE STUDY

Mossa (2002) defined Foreign Direct Investment as the process whereby residents of one a
country (the source country) acquire ownership of assets for the purpose of controlling the
production, distribution and other activities of a firm in another country (the host country). It
involves the transfer of financial capital, technology and other skills such as managerial skill.

Foreign direct investment is defined as an investment involving a long-term relationship and

control of a resident entity in one economy. It further implies that the investor exerts a
significant degree of influence of the management of the enterprise resident in the other
economy. FDI may be undertaken by individuals and business entities as well (OECD, 1996).

IMF defines foreign direct investment as investment that is made to acquire a lasting interest
in an enterprise operating in an economy other than that of the investor, the investor’s purpose
being to have an effective voice in the management of the enterprise (IMF, 1977).

Frankel and Romer stated that FDI is often seen as one of the important catalysts for
economic growth in the developing countries (Frankel & Romer, 1999). FDI is acting as a
very important vehicle for developed countries to transfer technology to developing countries.
FDI also encourages investment of domestic firms so as to check with foreign investors and
improve human capital, also as establishments within the host countries. Moreover, in
comparing with alternative capital inflows of a nation, FDI is anticipated to possess stronger

1
effects on economic growth of a nation as FDI provides more than simply capital.
Furthermore, FDI offers access to internationally out there technologies and management
know-how and should render it easier to penetrate world markets (Nunnenkamp, 2001).

FDI is one of many approaches that foreign investor will use to enter foreign market. Mossa
(2002) declared that there are three common ways in which companies use to develop foreign
markets for their products:

• Export of the products created within the supply country.

• Licensing an overseas company to use method or product technology

• Foreign distribution of merchandise through an affiliate entity.

Mabey and McNally (1998) indicated that the potential contribution of foreign direct
investment to economic development and integration into the global economy is currently
widely known. It assumed prime importance within the wake of declining concessional aid
that has created a preference for long-term and more stable monetary inflows. In addition to
providing capital inflows, FDI can boost economic development of a country by “crowding
in” alternative investments with an overall increase in total investment, in addition as
hopefully making positive “spillover effects” from the transfer of technology, skills and
information to domestic companies. It can also stimulate economic growth by spurring
competition, innovation and enhancements to a country’s export performance. The indirect
impacts of FDI on the domestic economy are reasons for the intense political focus in FDI in
most countries that has led to unprecedented levels of public subsidies, diplomatic efforts and
promotional activities to draw in investors.

Ikiara (2003) showed that quick growth in FDI over the last few decades has encouraged a
large body of empirical literatures to scrutinize the determinants and the growth enhancing
effects of FDI. The effects of FDI can be wide ranging since FDI typically encompasses
packages of capital as well as technical, managerial and organizational know-how. FDI is
particularly important for developing countries since it provides access to resources that
would otherwise be unavailable to these countries. Its contribution to economic development
and therefore poverty reduction comes through its role as a conduit. FDI will go to countries

2
that have a favorable investment environment, better stability of economy, larger market
share, higher degree of openness of the economy, attractive infrastructure access, skilled labor
and adequate natural resources.

According to OECD (2005), FDI can bring many advantages to host countries like bringing
technology transfer, raising foreign funds, creating employment opportunities, producing
competitive business environment, helping human capital formation and so on. As a result of
these advantages of FDI, several developing countries are currently actively seeking foreign
investment by taking measures that embody economic and political reforms designed to
enhance their investment environments. Most African countries have undertaken varied policy
measures to form hospitable investment climate for FDI. The main policy measures are:
liberalizing controls on foreign exchange &price, liberalizing investment laws & privatization
of public enterprises and making stable macroeconomic environment. The policy frameworks
for FDI of African countries are on average no more restrictive than alternative developing
nations.

A report released by the UNCTD (2005) showed that FDI into Ethiopia has increased. The
report indicates that FDI inflows to Ethiopia increased from US $255 million in 2002, to $465
and $545 million in 2003 and 2004 respectively. Furthermore, while the total FDI inflows
around the world have actually decreased since 2002, and in particular flows into developed
countries, the total FDI inflows into developing economies have increased, with Africa
benefiting from a marked increase from $12,994 million in 2002 to $18,090 million in 2004.

Since 1991, the Ethiopian economic system shifted from command economy to a market
oriented economy. Ever since, the government has created a broad range of policy reforms, as
well as liberalization of foreign trade regime, decentralization of economic & political power,
and deregulation of domestic price and devaluation of the national currency. Additionally, the
investment code has been amended many times so as to fulfill the demand of each domestic
and foreign investor (Solomon, 2008).

A FDI determinant has adopted either the pull factor approach or the push factor approach, or
a combination of both. The push factor approach examines the key factors that could
influence or motivate multinational corporations (MNCs) to want to expand their operations

3
overseas. They try to clarify why national firms involve into MNCs, and why they come to a
decision to locate production in another country rather than licensing or exporting. Push
factors illustrate the relationship between host-country specific conditions and the inflow of
FDI that is, the factors that attract FDI when the decision to invest out of the home country is
prepared by the multinational firms. A number of political and socio-economic factors exist in
the host country that determine available business opportunities and potential political risk
and thus influence the decision of MNCs to locate in a specific country (Singh & Jun, 1995).
Among these factors, this study focus on those regularly cited in the FDI literature:
infrastructure, market size and growth, human capital development, government expenditure,
employment level, openness of the economy to international trade, inflation rate, foreign debt,
infrastructure development, and the lagged FDI were used.

1.2 STATEMENT OF THE PROBLEM

Agosin and Mayer (2000) argued that foreign capital inflow, significantly FDI has been
enjoying an important role in developing economies. The question of whether or not FDI
generates positive welfare effects for the host countries has been a topic of bigger discussion.
Most scholars believe that FDI tends to be useful. The presumption that FDI is nice is
predicated on the concept that FDI could generate positive spillovers for the rest of the
economy. The spillovers could flow through a range of channels. If the foreign firm is
technologically more advanced than most domestic corporations, the interaction of its
technician, engineers and managers with domestic corporations likely result in information
spillovers. Positive spillovers might also arise if the foreign firm trains employees who could
eventually be employed by domestic corporations. FDI will bring many edges to host
countries like bringing technology transfer, raising foreign funds, making employment and so
on.

The FDI advantages to host countries may rely on the manner in which the investment is
attracted into the country. A substantial volume of literatures includes a robust consensus
within the literature why multinational corporations invest in specific locations (Globerman &
Shapiro, 2001). Multinational firms are mainly attracted due to robust economic fundamentals
like market size, skilled labor, trade policies and macro-economic environments. There’s a

4
highlight within the importance of physical infrastructure and investment climate as a
determinant for foreign direct investment (Kumar, 2001).

Ajay (2006) has identified that FDI flows are influenced in Africa by both pull and push
factors. The push factors are mainly size of the market growth, openness of an economy,
profitability of investment and clustering result, whereas the pull factors consist mainly of
host country characteristics and policies. It is important to note that while the list of factors is
fairly long, not all determinants are equally important to every investor in every location at all
times. While Steve and Hemanta (2004) in his study pointed out that inflation, economic
growth, international reserves, openness of the economy, and natural resource accessibility
are important determinates of foreign direct inflows in Africa.

Getinet and Hirut (2005) in their study used variables such as rate of real GDP, export
orientation, liberalization, macroeconomic stability and infrastructure in order to identify
determinants of foreign direct investment in Ethiopia. The finding shows that economic
growth, export orientation and liberalization have a major positive impact on FDI, whereas
macroeconomic instability and low level physical infrastructure have a negative impact on the
flow of FDI.

This study was conducted to analyze the determinants of foreign direct investment in Ethiopia
by taking seven explanatory variables representing market size and growth, openness,
macroeconomic stability, infrastructure, human capital, growth of domestic investment and
lagged FDI and one dependent variable represented by foreign direct investment which are
used in studies by Getinet and Hirut (2005); Steve and Hemanta (2004); Ajay (2006); Oludele
et al. (2006); Khan and Bamou (2006). The study on determinants of foreign direct
investment in Ethiopian case was unique from the previously studies in Ethiopia by Getinet
and Hirut (2005). Because this study incorporated additional appropriate variables that
determine the inflows of foreign direct investment which are used by Steve and Hemanta
(2004); Ajay (2006); Oludele et al. (2006); Khan and Bamou (2006). Variables incorporated
are openness measured by imports + exports to GDP, macroeconomic stability represented by
inflation, foreign debt, employment level and government expenditure, human capital
measured by secondary school enrolment, growth of domestic investment and lagged FDI.

5
In view of the above evidences, this study was conducted to identify the determinants of FDI
in Ethiopia owing to the following additional rationale: First, as to the knowledge and
capacity of the researcher, there is no published empirical study that focuses in testing the
determinants of foreign direct investment in Ethiopia during the period of 1992-2010 and thus
the area of foreign direct investment in Ethiopia is under researched. Second, since FDI
contributes to growth, it is important to know the factors that affect the flow of FDI in the
country, and third, according to UNCTD, FDI into Ethiopia has rapidly increased during the
period of 2002 still now (UNCTD, 2005). Thus, the study also tried to examine the reasons
behind for the rapid rise of FDI in Ethiopia.

1. 3. OBJECTIVES OF THE STUDY

1.3.1 GENERAL OBJECTIVE

The general objective of this study was to identify the determinants of foreign direct
investment in Ethiopia for the period of 1992-2010.

1.3.2 SPECIFIC OBJECTIVES

The specific objectives of this study are:

1. To identify the major driven for the inflows of foreign direct investment in to Ethiopia.

2. To identify the major factors that constraint FDI inflow in to Ethiopia.

3. To examine the relationship between independent variables and dependent variable.

1.4 RESEARCH QUESTIONS

The study was conducted with the aim of providing answers to the following basic research
questions:

1. What are the major factors that driven foreign direct investment inflows in to
Ethiopia?

2. What are the factors that constraint flows of foreign direct investment in to Ethiopia?

3. To what extent the independent variables are related to dependent variable?

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1.5 RESEARCH HYPOTHESIS

The following three hypotheses are tested throughout the study:

Ho1= FDI determinant factors (macroeconomic stability, human capital, growth of domestic
investment, lagged FDI, market size and growth, openness, and infrastructure) are not
the major driven of FDI flows in to Ethiopia.

Ha1= FDI determinant factors are the major driven of FDI flows in to Ethiopia.

Ho2= FDI determinant factors are not constraints for the flows FDI in to Ethiopia.

Ha2= FDI determinant factors are constraints for the flows FDI in to Ethiopia.

Ho3= There is no significant positive relationship between FDI and independent variables.

Ha3= There is significant positive relationship between FDI and independent variables.

1.6 SCOPE OF THE STUDY

This study was delimited to:

Topic: The topic of this study was delimited to examining determinants of foreign direct
investment in Ethiopia.

Variables Used: The variables used were delimited to one dependent and seven independent
variables i.e. the dependent variable representing FDI and seven explanatory variables
representing market size and growth, openness, macroeconomic stability, infrastructure,
human capital , growth of domestic investment and lagged FDI.

Study Area and Study Duration: The geographical scope of this study was delimited in to
the boundary of Ethiopia for the period of 1992-2010.

Methodology Used: the methodology is delimited only to descriptive, correlation and OLS
regression analysis.

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1.7 SIGNIFICANCE OF THE STUDY

The study will have a great contribution to the body of knowledge by identifying the potential
determinants of foreign direct investment inflows in Ethiopia as well as it will serve as a good
base for the forthcoming researchers who want to do a further research on this topic in
Ethiopia or elsewhere. Thus, by developing a conceptual framework regarding the
relationship between foreign direct investment and explanatory variables this research will
contribute to the current literature. Moreover, the study will benefit stakeholders such as
researchers, policy makers, and professionals using the research as guide for future research,
reappraise current economic practices, and provide basic guidelines for encouraging foreign
direct investment inflows in Ethiopia in a dynamic macro-economic environment.

1.8 LIMITATIONS OF THE STUDY

The sample periods for this study may not be large enough, for the very reason that, there are
problem of getting complete information for the period before 1992 and also data before 1992
shows the former Ethiopia i.e. before Eretria declared its independence. Furthermore, this
study limited to study determinants of foreign direct investment in country level on basis of
time series ordinary least square regression analysis without considering the issue on the
major economic sector specifically on the basis of cross sectional or panel data regression
analysis. Finally, this study limited to study the issues only on the supply side without taking
in to consideration the demand side factors that motivates or constraints the FDI inflows in to
Ethiopia. These might limit the findings of the research.

1.9 ORGANIZATION OF THE PAPER

This study consists of five chapters, including the first introductory chapter just discussed.
The second chapter discusses the works of previous researchers from which the conceptual
framework for analysis and the hypotheses are derived. The third chapter provides the
methodology pursued in answering the research questions. The fourth chapter deals with data
analysis and interpretation. Finally, the fifth chapter discusses about findings of the study, and
provides possible recommendations.

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 CHAPTER TWO

LITERATURE REVIEW

Currently several empirical studies were conducted to identify the factors that influence the
inflow of FDI in the world. Nevertheless, the variables that were identified as determinants of
FDI vary from study to study and from country to country. Thus, this chapter of the study
builds an empirical frame of FDI, which provides facts regarding major driven for FDI,
constraints of FDI and relationships with various variables in numerous countries in different
period of time. Finally, conceptual framework drawn from the empirical literature reviewed
was outlined.

2.1 EMPIRICAL STUDIES ON THE DETERMINANTS OF FOREIGN DIRECT

INVESTMENT

2.1.1 PREVIOUS STUDIES IN INDUSTRIALIZED AND EMERGING MARKET

COUNTRIES

Lim (2001) has conducted a study on determinants of foreign direct investment in

industrialized and emerging market countries. The study summaries findings on two aspects
of foreign direct investment i.e. its correlation with economic growth and its determinants.
He argued that the flow of foreign direct is principally rely positively upon market size,
quality of the infrastructure, economical as well as political stability and free trade zones.
While results are diverse regarding the importance of fiscal incentives, business or investment
climate as well as labor cost.

Wilhelm and Morgan (1998) have conducted a study that analyzes determinants of net foreign
direct investment inflows in emerging economies between 1978 -1995 and based on the
concept of Institutional FDI Fitness. The institutional FDI Fitness theory stipulates that FDI is
determined less by intransigent fundamentals than by institutional variables amenable to
change, policies, laws, and their implementation. There are four institution contributing to
FDI Fitness are markets, government, socio-culture, and education. Thus, the FDI Fitness
concept is tested in an econometric cross-section across 67 emerging economies. The
econometric regression analysis shows market and government variables as the most

9
significant determinants of FDI inflows. Governmental fitness is showed in economic
openness with only minimal trade and exchange rate controls. Government fitness also
indicates a strong rule of law and low corruption, based on administrative and legal equity and
transparency. Market fitness is characterized by high urbanization, low taxes, high trade
volume, and ready availability of credit and energy. The regression analysis hence confirms
the institutional FDI Fitness hypothesis. The way in which policy-makers handle institutions,
laws, policies, and their implementation is significantly more important to foreign direct
investors than relatively intransigent factors such as population size and socio-culture. The
FDI institutional Fitness theory suggests that every nation has the opportunity to identify and
expand its competitive strengths to increase its share of global foreign direct investment.

Devrim et al. (2007) have investigated a study on the relationship among foreign direct
investment and institutions in emerging markets with main the aim of investigating the
relationship among foreign direct investment and institutions in emerging markets. The study
applied panel data regressions on 6 selected countries. The results point out institutional
variables as a major determinant of inward FDI. This includes low level of social, economic
and political risks, government stability, democratic accountability, stable and reliable
functioning of bureaucracy, transparent legal and regulatory framework, easiness to create a
company, transparency, lack of corruption, security of property rights, enforcement of
contract law, efficiency of justice and prudential standards. The study suggests that these
results are encouraging in the sense that efforts towards raising the quality of institutions may
help developing countries to obtain more FDI, hence help them to enjoy of higher GDP per
capita.

Carlos (2010) has explored determinants of foreign direct investment in an Emerging market
economy evidence from India. The paper examines the relationship between foreign direct
investment and domestic investment, while using the ordinary least squared technique, and a
time series analysis from the period 1979‐2008. The paper also provides an empirical analysis
of domestic determinants of FDI such as size of market, openness to trade, infrastructure,
attractiveness to domestic market, and exchange rate instability. In addition, the study
includes technology growth and specific variables to examine local determinates of FDI in
India. The paper finds the size of domestic market, attractiveness of domestic market, and

10
technology growths are statistically significant and positively affect foreign direct investment
inflows

2.1.2 PREVIOUS STUDIES IN OECD COUNTRIES

Agiomirgianakis et al. (1998) have concentrated on assessing the relative significance of the
factors that may attract FDI via a panel data regression analysis for a sample consisting of
twenty OECD countries for twenty three years. Their findings suggest that variables such as
trade regime and human capital, as well as, the density of infrastructure appear to be robust
under diverse condition. Positive implication of the clustering factor is also observed,
confirming the significant hypothetical propositions. However certain deferential variables,
such as the governmental policy causes, could not be fully captured due to the statistical
homogeneity of the sample.

Using a fixed-effects panel data approach, Michael (2005) has conducted a study on
determinants of foreign direct investment of OECD countries 1991-2001 the study FDI flows
of 22 OECD countries a by gravity equations. It is distinguished between all available
observations, Intra-EU observations only, and observations not belonging to the EU area in
order to control for European Union particular effects. Regressions are frequently repeated
with exports as dependent variable in order to capture diverging influences for trade inflows.
Change in total amount of relative market size and market size are important factors that lead
both FDI and exports in the same direction. But, relative market size is only significant in the
FDI equation when variation between the EU area and other investment is taken into account,
thus indicating a concentration of FDI within Western and middle Europe. Stock market
booms enhance FDI but not exports. Dissimilarity in significance levels/signs of coefficients
of political indicators and exchange rate changes indicate that exports are demand driven
while FDI is supply driven. Time dummies interacted with country distance show that,
overall, FDI and exports tended to flow less to distant countries over the period under
contemplation. Nevertheless, this trend is reversed for exports within the EU area.

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2.1.3 PREVIOUS STUDIES IN ECONOMIC TRANSITION COUNTRIES

Campos and Kinoshita (2003) have used panel data to analyze the determinants of foreign
direct investment of twenty five transition economies over 1990 -1998. They arrived on the
conclusion that FDI is positively influenced by market size, economy clusters, low cost of
labor, and abundant natural resources. Besides all trade openness, sound institutions, and
lagged FDI variables are significant negative influence on FDI inflows.

Using a panel dataset containing information on FDI flows in transition economies, Alan and
Saul (2002) have sought to identify determinants of FDI in transition economies. The analysis
presented in the paper has enabled identification of several key determinants of FDI inflows
to the transition economies of Central and Eastern Europe, and highlighted the Implications of
announcements of progress in EU accession for FDI inflows to the applicant Countries. By
utilizing an extremely detailed dataset which permit to identify FDI inflows to sample of
transition economies and the source country of these inflows, the study have found that FDI
inflows are significantly influenced by risk, unit labor costs, host market size and gravity
factors. Moreover, at the second stage of the analysis, the study have identified that private
sector development, industrial development, gross reserves, corruption and the government
balance are significant determinants of perceived country risk in the sample.

Empirically, Campos and Kinoshita (2002) have investigated the determinants of foreign
direct investment inflows in the transition economies during the period 1990 and 1998. The
study obtains two innovations. The first is the attention to the effect of agglomeration, an idea
that has been highlighted recently in the works of economic topography. The next innovation
is that looking all transition countries instead of focusing on, for instance, EU candidates. The
finding shows that the main determinants of FDI in transition are agglomeration, the degree of
external liberalization, and the quality of the bureaucracy. The study also finds an important
difference commonwealth of independent country. The agglomeration effect is greater for
commonwealth of independent states countries than in non-commonwealth of independent
countries. For non commonwealth of independent states, the more liberalized the trade regime
is, the more FDI they attract. For commonwealth of independent countries, availability of
skilled labor and the rule of law are the main factors influencing FDI flows.

12
2.1.4 PREVIOUS STUDIES IN DEVELOPING COUNTRIES

Nonnemberg and Mendonça (2002) have investigated the determinants foreign direct
investment based mostly on econometric model based in panel data analysis for thirty eight
developing countries including transition economies for the 1975-2000 periods. Their findings
suggest that size of the economy, and the average rate of growth affected the inflows of FDI,
being strongly positive significant. The level of schooling and degree of openness also proved
to be a positive effect on FDI. But, inflation was proved to be insignificant effect on FDI.

Khondoker and Kaliappa (2010) have investigated the determinants of foreign direct
investment and its impact on economic growth in developing countries by using panel data
from 60 low-income and lower-middle income countries, this study initially identifies the
dominant factors that determine FDI inflow in the developing countries and secondly
empirically demonstrates the relationship between FDI and economic growth. It is found that
countries with larger GDP and high GDP growth rate and maintain business friendly
environment with abundant modern infrastructural services, for instance internet can
successfully attract FDI and FDI on the other hand significantly affected by economic growth
of a country.

Using cross sectional data, Diaram et al. (2006) have sought to identify some of the factors
that increase the inflows of FDI into 29 developing countries. The study attempted to include
variables such as the Tourism, infrastructure, economic growth and openness and market size
in model of the regression to identify the factors that influences inflows of FDI in developing
countries. Therefore, the variable Tourism, infrastructure, economic growth and openness
were found to be the principal variables that attract FDI to these countries. Contrasting to the
expectation the role of market growth as a determinant was found to be insignificant.

Razafimahefa and Shigeyuki (2005) have analyzed the FDI determinants in Sub Saharan
African economies and selected economies of Asia and Latin America. The study used
variables such as total factor productivity, exchange rate measured with the host country’s
currency per US money, inflation measured with by the consumer price index, volatility of
CPI measured with the variance, trade share measured with the ratio of the sum of exports and
imports in proportion to GDP, capital return or rental measured with the inverse of gross

13
domestic product, and the market Size measured with GDP. The study used annual data
covering 1980 to 2001 and selects variables based on availability of data and estimating was
by using ordinary least squares. The results of study suggest that both productivity-related
policy and exchange rate policy can be effective in sharpening FDI competitiveness, which
attracting foreign investments. While the level and volatility of CPI can both discourage
inflows of FDI but, trade share weakly determines FDI inflows.

Tony and Almas (2003) have investigated the determinants of FDI inflows in to developing
countries, in a particular focus on the impact of the ‘third wave of democratization’ that
started in the early 1980s and the spread of information and communication technology that
began in the near the end of 1980s. These two global developments must now be taken into
account in any explanation of what determines FDI flows. Using a large sample of 207
countries observed for 1960 to 1999, together with panel data method, the study investigates
the determinants of FDI. The causal association between FDI, trade openness, ICT and GDP
growth was investigated. The main findings of the study are that democratization and ICT
increase FDI inflows to developing countries. Additional, the paper suggests that there is a
positive relationship between the flow of FDI and economic growth and openness to trade.
But, level of risk affects FDI negatively.

Abimbola (2010) has investigated the relationship between FDI and economic growth in
Brazil, Russia, and India, Mexico and China and select SSA countries for the period 1985-
2006. In particular, the study employed the panel data random effect technique to test whether
trade openness and human capital has helped in the attraction of FDI, and also whether the
extent to which FDI affects growth depends on trade openness and the quality of human
capital. The results indicated that FDI is mainly determined by trade, Economic growth,
.literacy and infrastructural development. In addition, the stud noticed that trade openness
interacts positively with human capital insofar as the attraction of FDI is concerned. One
interesting result is that inflation has a positive but insignificant relationship with FDI in the
SSA sample countries. Although FDI has a positive impact on economic growth, its impact is
more pronounced with its interaction with trade in the BRIMC countries. In the SSA countries
however, FDI interacts positively with human capital that promote economic growth.

14
2.1.5 PREVIOUS STUDIES IN AFRICAN COUNTRIES

Ajayi (2006) has analyzed determinants of foreign direct investment on top twenty African
countries which attracts foreign direct investment over 2000-2003. His analysis focuses on
testing the significance of size of the market and growth, cost of labor, good infrastructure,
openness of an economy, institutional environment, clustering effect and Return of investment
variables in explaining the determinants of FDI. He conclude that the size of the market and
growth, cost of labor, good infrastructure, openness of an economy, institutional environment,
clustering effect and return of investment are important determinates of foreign direct inflows
in Africa but, not all determinants are equally important to every investor in every location at
all times.

Based on a panel dataset for twenty nine African countries over the period 1975 to 1999,
Steve and Hemanta (2004) have sought to identify determinants of foreign direct investment
inflow. They explored the following factors are positive and significant effect on FDI flows
to Africa such as economic growth, international reserves, and natural resource accessibility.
On the contrary foreign debt, inflation and openness, has negative impact on FDI. Opposite to
conventional insight, political rights and infrastructures were found to be unimportant for FDI
flows to Africa.

Using panel- data for 71 developing countries, which is thirty two Sub-Saharan African
countries and thirty-nine non Sub-Saharan African countries, Asiedu (2001) has sought to
identify whether determinants of FDI differs in Sub-Saharan African and non Sub-Saharan
African countries. The results indicate that A higher return on investment and better
infrastructure have a positive impact on FDI to non Sub-Saharan African countries, but have
no significant impact on FDI to Sub-Saharan African. Openness to trade promotes FDI to
Sub-Saharan African and non Sub-Saharan African countries. However, the marginal
advantage from increased openness is less for Sub-Saharan African. These results imply that
Africa is different suggesting that policies that have been successful in other regions may not
be equally successful in Africa.

Using panel data from twenty two Sub-Saharan African nations, Bennett (2005) has employed
three separate regression processes to explain FDI inflows over the period 1982-2000, of the

15
three regression analyses, one utilizes regional dummies to correct for country fixed effects,
one ignores country heterogeneity and the last regression uses country dummies. Using such
indicators as lag of FDI, GDP, total trade, population, inflation, a political rights index,
production of oil, and an infrastructure proxy, his findings suggest that GDP, trade and crude
oil production are statistically important in explaining FDI inflows to the host country. While
the infrastructure proxy of telephone line, and lag of FDI has negative and significant effect
on FDI.

Rojid et al. (2008) have investigated determinants of FDI in 20 African countries. They
argued that the volume of FDI that flows to Africa is not only very low as a share of total
global FDI flows or even as a share of FDI flows to developing countries, but also it share
inflows of FDI is on a steady downward trend for three decades. Their study aim to analyze
the various potential determinants of FDI for a sample of African economies and a panel data
analysis has been used in the study. The period of the study for analysis is a fifteen year
period, 1990-2005 and 20 African countries. Their finding shows that the abundance of
natural resources is reported to be positive and significant. Openness had a positive impact on
FDI as well and is in line with the fact that an efficient environment that comes with more
openness to trade is likely to attract foreign investors. The domestic market size, stock of
human capital, though to a large extent as witnessed by the size of their respective
coefficients, played a significant positive role while political instability and labor cost a
negative role in attracting FDI.

Sufian and Moise (2010) have concerned with the analysis of the main determinants of
foreign direct investment in Middle East and North Africa countries. The regression is run on
the determinants of FDI in the sample which consist of thirty-six countries. Twelve of these
countries were in MENA countries and another 24 were the major recipients of FDI in their
respective regions in developing countries. By using a panel data methodology the study
investigates whether the determinants of FDI are similar to the other FDI receiving
developing countries. The study discloses that the key determinants of FDI inflows in MENA
countries are natural resources, the size of the host economy, the government size and the
institutional variables. The study also reveals that, countries that are receiving less foreign
investments could make themselves more attractive to potential foreign investors. The study

16
suggests that policy makers in the MENA region should remove all barriers to trade, build
appropriate institutions and develop their financial system.

Using a cross-country econometric approach to identify the determinants for FDI in Africa,
Naudé and Krugell (2003) have contributed for the paper was threefold. Firstly, the study
recognizes that the estimation techniques used elsewhere in the literature, such as OLS, may
be flawed. The study therefore uses a dynamic one-step generalized method of moments
estimator. They also argue that significant outliers mark FDI inflows to Africa and therefore
use a non-parametric estimator, the least absolute deviation estimator. Secondly, the paper
contributes by critically reviewing the claims for the dominance of economic policies – such
as policies to foster openness, in attraction of FDI. Thirdly, in the light of progress in
economic growth literature that underlines the importance of institutions and geography, they
focus on quantifying the significance of institutions and geography for FDI flows to Africa.
From the various results they conclude that geography does not seem to have a direct
influence on FDI flows in to Africa, but not direct through its influence of institutions. Also
they find that neither market-seeking nor re-exporting motives of FDI look like to dominate,
with different policy tool being significant in the different specifications. This does not reduce
the importance of good policies, but most likely indicates the importance of good policies
made by good institutions. All through, institutions, in the form of political stability showed
up as a significant determinant of FDI.

The study by, Beatrice and Adolf (2004) examined the key determinants of FDI inflows in to
African countries. One of the key determinants investigated is related to the stance of
governance in the African countries. To identify the determinants the study used a panel data
estimation approach is used. The study reveals that governance has a positive effect to FDI
inflows, even though the coefficient is insignificant. The political regimes stability is also a
significant determinant of FDI inflows to African countries. Other significant determinants
are; level of industrialization, population size and aid received per capita. Even if the level of
infrastructure as measured by the number of telephones has positively effect to FDI inflows,
the coefficient is statistically insignificant. Additionally, the level government involvement in
the economy as proxy by government expenditure in proportion to GDP has positively effect
to FDI inflows.

17
2.1.6 PREVIOUS STUDIES IN SPECIFIC COUNTRIES

Hoang (2006) has used time series data to explore factors determinants of foreign direct
investment in Vietnam over 1988 to 2005. His study shows that higher market size, GDP
growth, openness to trade and better infrastructure development are main factors attracting
FDI inflows into Vietnam. However, at this stage of research, he has not found a strong
relationship between FDI and human capital quality.

Micah and Thula (2009) have explored the determinants of foreign direct investment inflows
in Swaziland through time series regression. The study examined the location determinants of
FDI inflows in Swaziland over the period of 1980 to 2001. The study uses the co-integration
and stationary tests before identifying factors influencing FDI inflows. The study tests
variables such as internal and external economic stability, size and attractiveness of the
domestic market, infrastructure as well as economic openness to foreign trade whether or not
they are determinates of foreign direct investment in Swaziland. Finally, the finding shows
that FDI inflows is positively influenced by economic stability, infrastructure, internal
economic stability, and openness of the economy, but, negatively influenced by attractiveness
of the domestic market, and the size of the domestic market respectively.

Empirically, Boopen and Sawkut (2011) have come across the on determinants of FDI in
Mauritius through a dynamic time series investigation. The purpose of the paper was to
supplement the literature on the determinants of foreign direct investment by bringing new
evidences for the case of a successful FDI recipient country in Africa, namely Mauritius. The
study was examined by specifying a reduced-form specification for a demand for inward
direct investment function, and used a dynamic framework. In the absence of co-integration, a
differenced vector autoregressive model is used to capture the short-run dynamics of the
growth rate of the different specified variables. The most important factors applied in the
model to be trade openness, wages and the quality of labor in the country. Thus, the finding
reported to have of the size market is a relatively lesser impact on FDI, likely related to the
limited size of the population and the domestic market on the one hand and the good export
opportunities from Mauritius on the other. The coefficient of the lagged dependent variable
suggests the presence of significant negative relation.

18
Dauti (2009) has conducted a study on determinants of foreign direct investment in
Macedonia Evidence from time series 1994 – 2008. The study aim to provide some more
robust evidence on the tested hypothesis related allocation over time of gross aggregate FDI
inflows in the Macedonian economy. For this purpose, the study used quarterly data for the
period 1994 – 2008. The study employed stationary, co-integration analysis and applied
dynamic econometric methodology empirically to investigate the determinants affecting
foreign direct investment inflow in Macedonia. Finally, the finding shows that openness level
of economy, measured by exports plus imports over GDP, employment level, average
monthly wages and exchange rate is shown to be positive, and statistically significant. While
government expenditures as a share of GDP are found to be significant factor determining
FDI, laying on a negative relationship with foreign direct investment.

Amir and Torki (2009) have explored the determinants of foreign direct investment in Jordan.
The study aims to identify the determinants of foreign direct investments in Jordan during the
past decade. The sample focuses on Arab countries only during the years 1996-2007. Also the
paper tries to verify whether the greater Arab free trade area agreement had an effect on FDI
or not. The model assumes that FDI depends on variables such as GDP, per capita GDP,
distance, integration agreements, border countries and immigration (Jordanians working
abroad). The estimation is for a panel data over the same countries and time period. The paper
concludes that country size in terms of GDP and per capita are the major determinants of FDI.
Distance, common borders and the presence of Jordanian workers plays no significant role in
determining FDI. Also, the paper showed that the GAFTA factor was insignificant in
influencing FDI.

Empirically, Fedderke and Romm (2004) have analyzed the growth impact and determinants
of foreign direct investment into South Africa, 1956-2003. Estimation is in terms of a
standard spill-over model of investment, and in terms of a new model of location choice in
FDI between domestic and foreign alternatives. The study finds complementarities of foreign
and domestic capital in the long run, implying a positive technological spill-over from foreign
to domestic capital. While there is a crowd-out of domestic investment from foreign direct
investment, this impact is restricted to the short run. Further the study finds that foreign direct
investment in South Africa has tended to be capital intensive, suggesting that foreign direct

19
investment has been horizontal rather than vertical. Determinants of foreign direct investment
in South Africa lie in the net rate of return, as well as the risk profile of the foreign direct
investment liabilities. Additionally, market size and openness of the economy carries a strong
positive elasticity while a wage cost carries a strong negative impact on foreign direct
investment.

The study by, Dinda (2010) has empirically investigated the determinants of foreign direct
investment to Nigeria during 1970-2006. The study suggests that the endowment of natural
resources, trade intensity, macroeconomic risk factors like inflation and exchange rates are
significant determinants of FDI flow to Nigeria. The findings also suggest that in long run
market growth is not the significant factor for attracting FDI to Nigeria. The results indicate
that FDI flow to Nigeria is resource-seeking FDI.

Khan and Bamou (2006) have explored the determinants of foreign direct investment in
Cameroon. Thus, the regression analysis showed that the level of infrastructure development
appears as the most significant and robust determinant of FDI in Cameroon. The market size,
human capital development, growth of domestic investment, the rate of economic growth and
openness of the economy to international trade are also positive impact on FDI but to a lesser
extent. The level of political risk, the rate of inflation, the exchange rate, the debt burden and
the creation of an export-processing zone do not seem to have any influence on FDI in
Cameroon. Agglomeration effects or lagged FDI was shown unexpected negative sign.

Empirically, Getinet and Hirut (2005) have investigated determinants of foreign direct
investment in Ethiopia. The study used variables such as rate of real GDP, export orientation,
liberalization, macroeconomic stability and infrastructure in order to identify determinants of
foreign direct investment in Ethiopia. The findings show that growth rate of real GDP, export
orientation, and liberalization, among others, have positive impact on FDI. On the other hand,
macroeconomic instability and poor infrastructure have negative impact on FDI.

2.1.7 PREVIOUS STUDIES ON PULL AND PUSH FACTOR APPROACH

The literature on FDI determinants has adopted either the pull factor approach or the push
factor approach, or a combination of both. The push factor approach examines the key factors
that could influence or motivate multinational corporations to expand their operations

20
overseas. They try to explain why domestic firms involve into MNCs, and why they decide to
place production in a different country rather than licensing or exporting (Singh & Jun, 1995).
The implication is that while push factors affects the overall size of FDI. While, pull factors
determine which country obtain what share of the FDI (Hernandez & Carlson, 2002).

The relative significance of the pull factors in attracting foreign direct investment depends on
the type of FDI. The literature generally discovers two main types of FDI, resource-seeking
and market-seeking FDI. Market-seeking FDI is planned to serve the local market. It is also
called horizontal foreign direct investment, as it involves the replication of production
facilities in the host country. The reason might be to reduce the cost of supplying the market
such as tariffs and transport costs or to become more competitive by responding at the
appointed time to local situations and preferences. Horizontal foreign direct investment is
therefore expected to replace exports if the cost of market access through exports is higher
than the net cost of setting up a plant and producing in a foreign country. Market-seeking
foreign direct investment is motivated essentially by market size and market growth of the
host economy, as it intends to better serve the local market by local production. Impediments
to accessing local markets, such as tariffs and transport costs, encourage this type of FDI
(Lim, 2001; Campos & Kinoshita, 2003).

Resource-seeking foreign direct investment, on the other hand, is motivated by factor cost
differences. It goes for low-cost inputs such as natural resources, raw materials and labor. It is
called export-oriented, vertical or still raw material-seeking FDI because it involves slicing
the vertical chain of production and relocating part of this chain in a low-cost location.
Usually, vertical FDI will be enthused when different parts of the production process have
different input requirements and input prices differ across countries (Campos & Kinoshita,
2003). According to Shatz and Venables (2000), international differences in factor, raw
material prices and refinements in production technology will tend to motivate vertical
foreign direct investment. This type of FDI is usually trade creating, as products at different
stages of production are shipped between diverse locations, and especially back to the MNC’s
home market. It is important to note, though, that vertical l and horizontal FDI are not
mutually exclusive, even though the distinction between them is useful.

21
In the literature Gastanaga et al (1998) has indicated that the ratio of trade (imports + exports)
to GDP is often used as a measure of openness of an economy. Asiedu indicated that this ratio
is also often interpreted as a measure of trade barriers. The brunt of openness on FDI depends
on the type of investment. When investments are market-seeking, trade barriers can have a
positive impact on FDI. The rationale stems from the tariff jumping hypothesis, which argues
that foreign firms that seek to serve local markets may decide to set up subsidiaries in the host
country if it is difficult to import their products to the country. On the contrary, international
firms engaged in export-oriented investments may prefer to locate in a more open economy
since increased imperfections that accompany trade protection generally imply higher
transaction costs associated with exporting. Thus most literature, hypothesize a positive
relationship between openness and FDI. The empirical literature has generally focused on the
impact of trade openness on FDI. However, one would expect capital account openness of
also affect FDI (Asiedu, 2001).

Foreign investors may be attracted to countries with an existing concentration of other foreign
investors. Thus, the investment decision made by others is seen as a good signal of favorable
conditions. The term agglomeration economies are often applied to this situation. The
clustering of investors leads to positive externalities. Three types of such externalities have
been identified in the literature. The first is that technological spillovers can be shared among
foreign investors. Second, they can draw on a shared pool of skilled labor and specialized
input suppliers. Third, users and suppliers of inputs cluster near each other because of the
greater demand for a good and the supply of inputs, which is provided by the large market.
(Campos & Kinoshita, 2003).

According to Morriset (2000) infrastructure covers many dimensions such as roads, ports,
railways and telecommunication systems to the level of institutional development.
Infrastructure development has high importance for the expansion of FDI because efficient
and adequate infrastructure implies better access to natural resources and potential market.
The availability of well-developed infrastructure will reduce the cost of doing business for
foreign investors and enable them to maximize the rate of return on investment Therefore
countries with good infrastructures are expected to attract more FDI.

22
Inflation increases the user cost in a negative way, a high rate of inflation results from capital,
and as a result affects the profitability irresponsible monetary and fiscal policies, such as too
much money supply, budget deficits, and a weakly managed exchange rate regime. It may
also reflect weak economic conditions in the country conditions that discourage the flow of
FDI (Steve & Hemanta, 2004).

Goldberg and Klien (1997) argued that frequent and erratic changes in exchange rate of the
domestic currency have an effect on the inflow of FDI. Exchange rate devaluations have a
twofold role in explaining variations in FDI. Primarily, the real value of foreign investors’
capital will increase when the host country’s currency is devalued. On the opposite hand,
frequent and continuous declines within the value of host country’s currency would decrease
FDI inflow, because it creates high uncertainty.

Excessive foreign debt is one source of instability and uncertainty in macroeconomic

environment of developing countries and hence this foreign debt is probably going to have an
effect on adversely the inflow of FDI. Too much foreign debt may signal imminent fiscal
crises and foreshadow the long run economic scenario in a county (Serven & Solimano,
1992).

Oludele et al (2006) argued that private sector was said to be awaiting its cue from increased
government spending on infrastructure and a shift within the balance of state spending
faraway from consumption. The domestic Private investment has tended to move within the
same direction as public fixed investment it was argued that for to win the confidence of
foreign investors as an investment viable market, domestic companies have to be compelled
to lead the method and show trust within the economy. This may involve addressing the
underlying confidence problems within the economy.

Dauti (2009) indicated that the role of policy measure is captured by government expenditure
which denotes government expenditures as a share of GDP. It is expect a positive relationship
between these two variables, due to the fact that FDI are more likely to go to countries that do
government expenditures for various purposes of national economy, like fighting
unemployment, decrease taxes, and investing in infrastructure

23
Dauti (2009) indicated that employment level is expected to indicate the plentiful degree of
labor forces. Thus, the higher employment means that the plentiful workers and staffs with
skill and knowledge may satisfy the demand of foreign enterprises, which make benefits from
foreign enterprises to promote labor productivity through the process of learning by doing.
Thus, employment variable is expected to have a positive effect on FDI inflows.

Hoang (2006) argued that foreign direct investors are highly attracted with the quality of the
labor force as well as to its cost. In fact the cost advantages accrued by lower wages in
developing nations can well be mitigated by lowly skilled workers. Since a more educated
labor force is likely to assume new technologies faster and at a lower training cost. Higher
level of human capital is a good indicator of the availability of skilled workers, which can
significantly boost the location advantage of a country. He argued that secondary education
enrollment rate is a proxy of human capital.

Among the many theories trying to explain FDI, Dunning (1993) proposes a framework that
synthesizes the explanations and suggests that three conditions are required to motivate a firm
to undertake FDI. This has become known in the FDI literature as the OLI paradigm because
it explains the activities of MNCs in terms of ownership (O), location (L) and internalization
advantages (I). When selling its products abroad, a firm is at least initially disadvantaged
relative to local producers. Thus, in order to compete effectively with indigenous firms, a
foreign producer must possess some ownership advantages. They can take the form of a
superior production technology or improved organizational and marketing systems, capacity
to innovate, trademarks, reputation, or other assets. Ownership advantages assure a firm’s
ability to enter the host country’s market, but do not explain why the foreign presence should
be established through production rather than exports. This issue is, in turn, addressed by
location advantages that arise due to differences in factor quality, costs and endowments,
international transport and communication costs, overcoming trade restrictions, and host
government policies. The last advantage, internalization, explains why a foreign firm prefers
to retain full control over the production process instead of licensing its intangible assets to
local firms. This decision may be attributable to high transaction costs involved in regulating
and enforcing licensing contracts.

24
 2.2 CONCEPTUAL FRAMEWORK

The study was conducted based on the conceptual framework drawn from the empirical
literature reviewed which is explained above. This research focused on studying the major
determinants that are critical to foreign direct investment in Ethiopia. From the literature
review mentioned above, the study has developed the following schematic representation of
the conceptual framework/ model for this study.

Figure 2.1: Conceptual framework of FDI

Market Size Openness

and Growth

Macroeconomic
Stability

Lagged
FOREIGN
FDI
DIRECT
INVESTMENT
Infrastructure

Growth of Human Capital

Domestic
Investment

25
27
 CHAPTER THREE

METHODOLOGY OF THE STUDY

This part of the study gives details on how the research activities were carried out. Therefore,
the methodology used in this study is discussed as follows:

3.1 STUDY DESIGN

The study design was employed an explanatory research design. It is the most appropriate
design for identifying the relationships between the level of FDI and seven explanatory
variables representing market size and growth, openness, macroeconomic stability,
infrastructure, human capital, growth of domestic investment and lagged FDI.

3.2 DATA SOURCE AND COLLECTION METHODS

The study used both primary and secondary data. The secondary data were collected from
published reports and official web pages of Ethiopian Investment Agency, World Bank, IMF,
and NBE regarding the inflow of FDI and seven explanatory variables representing market
size and growth, openness, macroeconomic stability, infrastructure, human capital, growth of
domestic investment and lagged FDI for the period of 1992-2010.The researcher considered
data after 1992 because data before 1992 showed the former Ethiopia i.e. before Eretria
declared its independence. In order to support the secondary data, primary data were obtained
through unstructured interview with 9 macroeconomic experts working in National Bank of
Ethiopia, MOFED and Ethiopian Investment Agency selected through convenience sampling
method.

3.3 DATA ANALYSIS

Both the qualitative and the quantitative data were analyzed by using descriptive, correlation
and OLS analysis methods. The study used time series regressions of OLS method of analysis
in order to identifying the major determinants (driven or constraints) of foreign direct
investments from those independent variables, which is the first and the second objectives of
the study. Likewise to test the third hypothesis, the study used correlation analysis in order to
examine the relationship between the dependent and independent variables. To analyze the

27
data, statistical package for STATA software version 10 was employed. Further STATA
software was used and tests of stationary, co-integration, model accuracy and other
econometric problems like test for multicollinearity, heteroscedasticity, and autocorrelation
were also employed.

3.4 DESCRIPTION OF VARIABLES

In order to analyze the determinants of foreign direct investment in Ethiopia, the study
identified seven key factors that influence FDI. The chosen independent variables were:

1. Market size and growth

Market size and growth have proved to be the most prominent determinants of FDI. The
market size hypothesis states that multinational firms are attracted to a larger market in order
to utilize resources efficiently and exploit economies of scale. Market size has been
represented by real per capita GDP and growth rate of real GDP as market growth potential.
Real GDP per capita and Real GDP growth rates are measures of market attractiveness
(Chakrabarti, 2001).

2. Openness

The ratio of trade (imports + exports) to GDP is usually used as a measure of openness of an
economy. This ratio is additionally usually interpreted as measure of trade restrictions. The
impact of openness on FDI depends on the kind of investment. When investments are market-
seeking, trade restrictions will have a positive impact on FDI (Gastanaga et al., 1998).

3. Macroeconomic stability

A widespread perception of macroeconomic stability shows the strength of an economy and

provides a degree of certainty of being able to operate profitably (Balasubramanyam, 2001).
Inflation rates, government expenditure, employment level and foreign debt are used as proxy
variables for macroeconomic stability. Low inflation, higher Employment level and low
foreign debt and stable government expenditure have a positive impact on FDI (Asiedu,
2001); Goldberg & Klien, 1997). As a result, the rate of inflation (based on consumer price
index), government expenditures as a share of GDP, Employment level as percentage of the

28
population and foreign debt in proportion to GDP are included to capture the effect of
macroeconomic stability on FDI.

4. Infrastructure:

According to Morriset (2000), infrastructure covers many dimensions ranging from roads,
ports, railways and telecommunication systems to the level of institutional development. The
availability of well-developed infrastructure will reduce the cost of doing business for foreign
investors and enable them to maximize the rate of return on investment. Therefore, countries
with good infrastructures are expected to attract more FDI. It is a standard practice to measure
infrastructure by the number of telephone lines per 1000 people in a country. In line with this
Asiedu (2004) explains that this measure does not include mobile phones. Moreover, it only
captures existing infrastructure and fails to take into account potential infrastructure. Taking
this into account, gross fixed capital formation (percent of GDP) has been included to proxy
infrastructure development in addition to number of telephones. .

5 .Human capital

Foreign investors are highly attracted with the quality of the labor force as well as to its cost.
In fact, the cost advantages accrued by lower wages in developing nations can well be
mitigated by lowly skilled workers. Since a more educated labor force is likely to assume new
technologies faster and at a lower training cost. Higher level of human capital is a good
indicator of the availability of skilled workers, which can significantly boost the location
advantage of a country. The secondary education enrollment rate was a proxy of human
capital (Khan & Bamou, 2006; Rojid, et al., 2007).

6. Growth of Domestic Investment

The private sector was said to be awaiting its cue from increased government spending on
infrastructure and a shift within the balance of state spending faraway from consumption.
Private fixed investment has tended to move within the same direction as public fixed
investment it was argued that to win the confidence of foreign investors as an investment
viable market, domestic companies have to be compelled to lead the method and show trust

29
within the economy. This may involve addressing the underlying confidence problems within
the economy (Oludele et al., 2006).

7. Lagged FDI

Foreign investors are also interested in countries with an existing concentration of different
foreign investors. In this case, the investment decision by others is seen as a good signal of
favorable conditions to cut back uncertainty. That is, high levels of FDI within the past might
signal to potential foreign investors the soundness and potential of an economy (Campos &
Kinoshita, 2003).

3.5 MODEL SPECIFICATION

There are many variables that are essential in explaining FDI inflows in developing countries
(Dunning, 1993). However, it is not possible to include all of them. The variables in this study
were chosen because of their significance and availability of data. The economic model is
specified as:

FDI =f (GRRGDP, RGDPC, EXIM, FD, GE, EL, INF, GFCF, TELE, SEER, GDI, LFDI)--(1)

Since the study covered the period from 1992 – 2010, using annual data and the variables
discussed in the hypothesis section constitute time series information, the appropriate
modeling strategy is using time series analysis. The specified model was:

FDI = β1 + β2GRRGDP +β3RGDPC + β4EXIM + β5FD + β6INF + β7GE + β8EL +

β9GFCF + β10TELE + β11SEER+ β12GDI + + β13LFDI +ε −−−−−−−− (2)

Where,

GRRGDP = Growth Rate of Real Gross Domestic Product

RGDPC = Real Gross Domestic Product per capita

EXIM = Exports and import as percentage of GDP (measures openness)

INF = Annual rate of inflation based on consumer price index

FD= Foreign debt

30
GE=government expenditure (as percentage of GDP)

EL= employment level

GFCF = Gross Fixed Capital Formation (as percent of GDP)

TELE = Telephone lines per 1000 people

SEER= secondary education enrollment rate

GDI= growth of domestic investment (as percent of GDP)

LFDI= lagged FDI

β1 =Coefficient of Intercept

β2-β13= Coefficient of Independent variables

ε = Error Term

Based on the short run model suggested after test of stationary, two regressions have been
carried out to examine the determinants of FDI.

31
32
 CHAPTER FOUR

DATA ANALYSIS AND INTERPRETATION

This study aimed to identify the determinants of foreign direct investment in Ethiopia for the
period of 1992-2010. Accordingly, in this chapter the data set is presented and analyzed.
Besides, in each sub-section, brief interpretations are made to the results obtained. This
chapter, therefore, deals about; firstly, the interpretation of the summary of descriptive
statistics results of key variables; secondly, interpretations of basic time series tests of
stationary, co-integration, heteroscedasticity, autocorrelation, multicollinearity, and model
specification; thirdly, illustration and interpretations of the correlation analysis among basic
variables; and Finally, a detail interpretation was made based on the regression results of
determinant factors of foreign direct investment in Ethiopia.

4.1 SUMMARY OF DESCRIPTIVE STATISTICS

The following summary of descriptive statistics of all dependent and independent variables
gives the general distribution of the data set and used in order to get insight into the trend of
foreign direct investment flow in Ethiopia and for those variables incorporated in this study
over a period of time.

Table 4.1 below shows descriptive statistics which includes the mean distribution, the
standard deviations, minimum and maximum values of the study variables for the study
period, i.e., 1992 to 2010. The study has used eight key variables for the analysis purpose
including seven independent variables and one dependent variable. Those are foreign direct
investment (FDI) as a dependent variable and market size and growth measured by real GDP
per capital (RGDPC) and growth rate of real GDP (GRRGDP) respectively, openness which
used export and import in proportion to GDP (EXIM) as a proxy, macroeconomic stability
represented by inflation (INF), government expenditure (GE), employment level (EL) and
foreign debt (FD), infrastructure represented by gross fixed capital formation(GFCF) and
telephone line (TELE), human capital measured by secondary education enrollment rate
(SEER), growth of domestic investment( GDI), and lagged FDI(LFDI) as an independent
variable.

33
 As indicated in Table 4.1 below, the average net inflows of foreign direct investment is 17.32
percent in proportion to GDP. However, the standard deviation of inflows of foreign direct
investment accounts 25.7 percent. This deviation shows that the inflow of FDI in Ethiopia
fluctuates from year to year. The minimum inflows of foreign direct investment in proportion
to GDP over the sample period were 0.17 percent and the maximum of 83.43 percent.

Table 4.1: Summary of descriptive Statistics

VARIABLE OBS MEAN STD. DEV. MIN MAX

FDI 19 17.32292 25.70474 .174973 83.42621

GRRGDP 19 6.752715 5.377863 -3.45816 13.57243
RGDPC 19 1106.308 221.1805 871.4637 1636.679
EXIM 19 35.0753 10.70285 10.83072 50.57914
INF 19 8.251428 10.99995 -8.237844 44.39128
GE 19 20.41632 4.033916 13.472 27.018
EL 19 76.36311 3.485862 71.8 81.96534
GFCF 19 20.44728 3.546645 10.7136 25.46706
TELE 19 5.734124 3.598552 2.457953 11.95784
SEER 19 19.85074 9.076773 10.63729 36.1466
GDI 18 38.73951 84.63924 43.67299 345.0322
LFDI 18 16.07432 25.85028 .174973 83.42621
FD 19 85.66668 37.81219 28.048 147.213

The average real growth rate of gross domestic product of Ethiopia over the sample period
was 6.75 percent with standard deviation of 5.38 percent. It means that on average the real
Ethiopian economy or market increased by 6.75 percent but the growth of economy may
deviated by 5.38 percent from its mean. The minimum real GDP growth rate during the
sample period was -3.46 percent and the maximum was 13.57 percent. On the other hand, the
average real GDP per capital of Ethiopia or the size of market over sample the period
accounts 1106.3 birr with the standard deviation of 221.18 birr.

34
In the same way, the descriptive statistics for openness is also presented in the same table 4.1
which is measured by export and import in proportion to GDP. The mean value of export and
import in proportion to GDP is 35.07 percent and a standard deviation of 10.7 percent. This
deviation shows that the EXIM fluctuates by 10.7 percent from its mean. The minimum
proportion of export and import to GDP is 10.83 percent and the maximum is 50.53 percent.

To study the effect of macroeconomic stability on foreign direct investment, this study has
used four variables that measure the stability of macro economy such as INF, GE, EL and FD.
The inflation or average price of goods and service on the basis of consumer price index in the
country over the sample period was recorded an average of 8.25 percent and shows slightly a
big gap of percentage between the highest inflation rate of 44.39 percent and the smallest
inflation rate of -8.23 percent. Regarding to government expenditure, the mean value is
20.42 percent in proportion to GDP with the standard deviation of 4.03 percent. It means on
average the government spends 20.42 percent as compared to the total GDP of the country
which is fluctuated by 4.03 percent from its mean over the sample period. Regarding
employment level the mean value 76.36 percent in proportion to population with standard
deviation 3.49 percent. On the other hand the average foreign debt over sample period
recorded to be 85.67 percent in proportion to GDP with the deviation 37.81 percent. The
minimum foreign debt over sample period is 28.084 percent and the maximum of 147.213. A
gap between the highest and the smallest percent may be due to the decline of foreign debt
from year to year. However, this slightly higher deviation and gab between minimum and
maximum value may indicated that the country borrows too much foreign debt as compared
to its GDP.

Telephone line per 1000 people and gross fixed capital formation were used as a proxy of
measuring infrastructure development. The average telephone line per 1000 people the over
sample period is 5.73 peoples. It means that on average out of 1000 people of country only
5.73 peoples get access of telephone line. On the other hand, the mean of gross fixed capital
formation was 20.44 percent in proportion to GDP with the standard deviation of 3.54
percent. The minimum proportion gross fixed capital formation to GDP was 10.71 percent
and the maximum of 25.47 percent.

35
The other variable used in this study was secondary education enrollment rate as a proxy to
measure human capital effect on foreign direct investment. On average the secondary
education enrollment rate over sample period was 19.85 percent of total population with the
dispersion of 9.07 percent. The minimum enrollment rate over sample period was 10.64
percent and the maximum was 36.14 percent. A gap between the highest and the smallest
enrollment rate may be due to rapid growth of enrollment rate in all over the country.

In addition to the above specific variables, growth of domestic investment was also used as a
one determinant factor. The average growth rate of domestic investment was 38.74 percent
with the standard deviation of 84.64 percent. The minimum growth of domestic investment
over sample the period is 43.63 percent and the maximum is 345.03 percent. A gap between
the highest and the smallest growth rate of domestic investment may be due to that rise of
domestic investment from year to year.

4.2 GOODNESS OF TEST

4.2.1 TESTS FOR STATIONARY

Stationary in a time series means that if mean, variance, and auto-covariance remain the same
no matter at what point we measure them; that is, they are time invariant. Such a time series
will tend to return to its mean and fluctuations around this mean will have broadly constant
amplitude. If a time series is non stationary, we can study its behavior only for the time period
under consideration. Consequently, it is not possible to generalize it to other time periods.
Therefore, for the purpose of forecasting, such non stationary time series may be of little
practical value. If the time-series is non-stationary, the mean, variance or covariance will not
be constant and one is likely to end up with spurious regression where statistical inference on
the basis of the classical regression model will be invalid. It is essential to test for stationary
to confirm that the process by which data could have been generated is a stochastic one. This
is done by using Augmented Dickey–Fuller Test. The null hypothesis in the Augmented
Dickey-Fuller test is that the underlying process which generated the time series is non-
stationary. If the null hypothesis is rejected, it means that the series is stationary i.e. it is
integrated to order zero. If, on the other hand, the series is non-stationary, it is integrated to a
higher order and must be differenced till it becomes stationary. A variable is stationary if the

36
absolute term ADF statistic is greater than the absolute term of critical value for rejection of
hypothesis for unit root. Otherwise it is non stationary (Gujarati, 2003).

Table 4.2: Unit root test on variables

Levels First difference Second difference

ADF ADF ADF
Without With Without With Without With trend
trend trend trend trend trend
FDI -1.495 -2.730 -6.668 -6.471
(-3.000) (-3.600) (-3.000) (-3.600)
GRRGDP -3.559 -4.082 - -
(-3.000) (-3.600)
RGDPC 2.298 -0.354 -3.341 -4.101
(-3.000) (-3.600) (-3.000) (-3.600)
EXIM -3.162 -0.944 -3.372 -3.622
(-3.000) (-3.600) (-3.000) (-3.600)
INF -3.060 -3.696 - -
(-3.000) (-3.600)
GE -1.792 -1.135 -3.675 -4.517
(-3.000) (-3.600) (-3.000) (-3.600)
EL 0.658 -1.996 -3.968 -4.118
(-3.000) (-3.600) (-3.000) (-3.600)
GFCF -3.534 -3.264 -7.280 -8.026
(-3.000) (-3.600) (-3.000) (-3.600)
TELE 1.545 -1.834 -2.202 -2.545 -4.215 -4.039
(-3.000) (-3.600) (-3.000) (-3.600) (-3.000) (-3.600)
SEER 2.246 -2.872 -2.202 -2.872 -4.023 -3.903
(-3.000) (-3.600) (-3.000) (-3.600) (-3.000) (-3.600)
GDI -9.837 -9.227 - -
(-3.000) (-3.600)
LFDI -1.173 -2.574 -8.346 -10.302
-3.000 -3.600 (-3.000) (-3.600)
FD -0.684 -3.165 -4.007 -3.567
(-3.000) (-3.600) (-3.000) (-3.600)

95 % critical values in brackets

37
Table 4.2 shows that all the variables, except GRRGDP, INF and GDI are non stationery. For
GRRGDP, INF and GDI the null hypothesis for unit root is rejected. The other variables are
not stationary because the absolute value ADF statistic is less than the absolute value critical
value for rejection of hypothesis for unit roots and therefore they had to be differenced to
make them stationery. This means that the null hypothesis for unit root is not rejected for
these variables, as shown in table 4.2. As can be seen from the test results on the first
difference given in Table 4.2, the null hypothesis has been rejected for RGDPC, EXIM, GE,
EL, FD, GFCF, and LFDI Variables indicating that variables become stationary at their first
difference. On the other hand, test results on the second difference given in Table 4.2, the null
hypothesis has been rejected for TELE and SEER variables indicating that variables become
stationary at their second difference.
Thus, the stationary that the study conducted, suggest that the model (3) should be estimated,
using the differenced variables. The model estimated has the following form:

∆FDI = β1 + β2GRRGDP + β3∆RGDPC + β4∆EXIM + β5∆FD + β6INF + β7∆GE+β8∆EL

+ β9∆GFCF + β10∆TELE + β11∆SEER + β12GDI + β13∆LFDI +ε---------------------- (3)

4.2.2 TEST FOR CO-INTEGRATION

After determining the order of integration of the variables, the study followed the two-step
estimation procedure for dynamic modeling suggested by Engle and Granger (1987). In a first
step, the so-called "co-integrating regression", in which all the variables would be in levels
and no dynamics included, would be estimated by ordinary least squares, and the residuals
from this regression will be tested for the presence of a unit root (Rubio and Rivero, 1994). If
the residuals were found to be stationary, the co-integrating regression might be taken as a
long-run relationship and we could then proceed to the second step, where an Error Correction
Model, including those lagged residuals as an error-correction term would be postulated in
order to consider the short-run dynamics (Dauti, 2009). When the study test for the presence
of unit root on the residuals obtained, after OLS estimation of the Equation 2 (FDI = β1 + β2
GRRGDP +β3 RGDPC + β4 EXIM + β5 FD + β6 INF + β7GE+β8EL + β9GFCF +
β10TELE + β11SEER+ β12GDI + + β13LFDI +ε ) , the study find that the residuals are non
stationary. This suggests that the variables in equation (2) are not co-integrated. In other
words an error correction model is not required.

38
Table 4.3 indicates that absolute value t statistic less than the absolute term of critical value
suggest unit root. The residuals are non stationary, thus confirming the series are not co-
integrated and, therefore, the modeling (equation 3) should proceed with the differenced time-
series.

Table 4.3: The Unit Root tests results on Residuals

Levels
ADF
Without trend With trend
Residuals -1.319 -3.165
(-3.000) ( -3.600)

95 % critical values in brackets

4.2.3 TEST FOR HETEROSKEDASTICITY

In Breusch-Pagan / Cook-Weisberg test for heteroskedasticity, if the p-value is sufficiently

small, that is, below the chosen significance level, then heteroskedasticity is a problem for the
model otherwise heteroskedasticity is not a problem for the model (wooldridge, 2005).

Table 4.4: Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

Variables: fitted values of ∆FDI

chi2(1) = 0.29
Prob > chi2 = 0.5918

The insignificant result from the Cook-Weisberg test indicates that the regression of the
residuals on the predicted values reveals insignificant heteroskedasticity which is a P value
greater than 1%, 5% and 10% levels of significance. Thus, there is no heteroskedasticity
problem for the values fitted values of ∆FDI.

39
4.2.4 TEST FOR MULTICOLLINEARITY
The VIF technique
The variance inflation factor, VIF, is a measure of the reciprocal of the complement of the
inter-correlation among the predictor variables: VIF= 1/(1- r2) where r2 is the multiple
correlation between the predictor variable and the other predictors. Multicolinearity is said to
be a problem when the variance inflation factors of predictors becomes large. How large
appears to be a subjective judgment. According to Haan (2002); Robert (2007) VIF values
greater than 10 indicate possible problem of multicollinearity. Thus, in table 4.6 below there
is no VIF score above value 10; i.e., there is no perfect co-linearity among independent
variables.
Table 4.5 variance inflation factor

VARIABLE VIF 1/VIF

∆EXIM 7.43 0.134662
∆LFDI 6.47 0.154464
∆GFCF 6.19 0.161454
∆GE 6.15 0.162542
INF 4.62 0.216332
∆SEER 4.55 0.219811
GDI 4.33 0.230720
∆TELE 4.08 0.244891
∆EL 4.00 0.249792
GRRGDP 3.18 0.314324
∆FD 2.76 0.362914
∆RGDPC 2.29 0.436959
MEAN VIF 4.67

4.2.5 TEST OF AUTOCORRELATION

If Durbin–Watson d statistic is between du and 4-du there is no serial correlation between

members of series of observations ordered in time series data of each variable otherwise serial
correlation may be a problem for the model (Gujarati, 2004).

40
 Table 4.6: Durbin–Watson d statistic

Durbin-Watson d-statistic = (13, 17) 2.066128

For the given sample size and given number of explanatory variables, the critical dL and dU
values at 95 percent are 0.087 and 3.557 respectively and 4-du is 0.443. So, the result
revealed that Durbin–Watson d statistic is between du and 4-du which indicates that there is
no serial correlation.

4.2.6 TEST OF MODEL SPECIFICATION

Link Model Specification Test

Link test creates two new variables, the variable of prediction, _hat, and the variable of
squared prediction, _hatsq. The model is then refitted using these two variables as predictors.
_hat should be significant since it is the predicted value. On the other hand, _hatsq shouldn't.
This is because if our model is specified correctly, the squared predictions should not have
much explanatory power. That is we wouldn't expect _hatsq to be a significant predictor if our
model is specified correct (yesuf, 2009).

Table 4.7: link test on variables

fdid1 Coef. Std. Err. T P>|t| [95% Conf. Interval]

_hat .9951134 .0357214 27.86 0.000 .9184987 1.071728
_hatsq .0002155 .0009892 0.22 0.831 -.0019061 .0023371
_cons -.0652013 .6035395 -0.11 0.916 -1.359665 1.229262

Table 4.7 above reveals that the regression model is correctly specified, since the coefficient
of the predicted dependent variable (_hat) is statistically significant and the coefficient of the
predicted dependent variable square (_hatsq) is statistically insignificant. The Link test
accepts that the model is correctly specified.

41
 Ramsey Omitted Variable Test
The Ramsey omitted variable test runs the Ramsey regression specification error test
(RESET) for omitted variables. If p value is insignificant, say, at the 5 percent level, one can
accept that the model has no omitted variables (Gujarati, 2004); (wooldridge, 2005).
Table 4.8 Ramsey RESET test using powers of the fitted values of ∆FDI

F(3, 1) = 17.96
Prob > F = 0.1714

It is clear from the above table that the p value is insignificant, greater than 5 percent level of
significance, so, the model has no omitted variables using any of the standard significance
levels.

4.3 RESEARCH HYPOTHESIS TESTING

4.3.1 CORRELATION ANALYSIS

The correlation analysis was done to analyze the relationship between foreign direct
investment and RGDPC, GRRGDP, EXIM, INF, GE, EL, FD, GFCF, TELE, SEER, GDI and
LFDI. To examine the relationship among these variables, Pearson correlation coefficients
were calculated. In this section of the study, the analysis and interpretations of the correlation
results between dependent and independent variables are presented.

Hypothesis testing

Ho= There is no significant positive relationship between FDI and independent

variables.

Ha= There is significant positive relationship between FDI and independent variables.

The correlation matrix in Table 4.9 below resulted in a negative correlation between FDI and
government expenditure, employment level, gross fixed capital formation, telephone, lagged
FDI and foreign debt. And thus, these relations are statistically significant at 1 and 5 percent
level except for telephone and foreign debt.

42
But, variable real GDP per capital, real GDP growth, export and import in proportion to GDP,
inflation, secondary education enrollment rate and growth of domestic investment resulted in
a positive relationship with foreign direct investment. These relations are statistically
significant at 1 and 5 percent level except for inflation.

On the other hand, Table 4.9 reveals the extent of relationship between dependent and all
independent variables. The correlation coefficients for market size and growth measured by
RGDPC and GRRGDP respectively with FDI are 10.34 percent and 10.04 percent
respectively. Likewise the correlation coefficients for macroeconomic stability measured by
INF, GE, EL and FD with FDI are 44.34 percent,-11.49 percent, -29.94 percent and -6.89
percent respectively.

In the same way, the correlation matrix shows the extents of relationship between openness,
human capital, lagged FDI and growth of domestic investment with FDI are 9.21 percent,
2.77 percent, -50.93 percent, and 13.15 percent respectively. Likewise correlation coefficients
for infrastructure measured by GFCF and TELE with FDI are -23.46 percent and -66.19
percent respectively.

As a result, the findings of correlation analysis reveals that the null hypothesis is accepted for
the variables of government expenditure, employment level, gross fixed capital formation,
and lagged FDI while alternate hypothesis is rejected. On the contrary, the findings of
correlation analysis reveals that the null hypothesis is rejected for real GDP per capital, real
GDP growth, export and import in proportion to GDP, secondary education enrollment rate
and growth of domestic investment while the alternate hypothesis is accepted for these
variables.

Moreover, pair-wise correlation matrix is one method of detecting multicollinearity among

explanatory variables. If the pair-wise correlation among two regressors is in excess of 0.8,
we suspect that multicollinearity poses serious challenge to our estimates (Gujarati, 2003).
Thus, according to Table 4.9, the maximum correlation coefficient above 60% is correlation
between EXIM and RGDPC which equals to 66.58%. Even that it is not problem for the
study, when compared to the standard which is more than 80% coefficient.

43
To sum up the correlation analysis, although the pair wise correlations give proof of
relationship between two variables; these measures do not allow us to identify causes and
effect relationships between such variables. From the results of correlation analysis, it is
difficult to say whether independent variables are determinants for the inflow of FDI. Simply
the correlation result shows the coefficient and the direction of relationship between two
variables with the level of significance. Another shortcoming of correlation analysis is that it
does not provide reliable indicators or coefficients of association in a manner which control
for additional explanatory variables. However, it should be noted that a complete assurance
about the significance of the relationship between the endogenous and exogenous variables
can be obtained from the regression results which are discussed in the forthcoming section.

44
 Table 4.9: Correlation Matrix

FDI RGDPG RGDPC EXIM INF GE FD EL GFCF TELE SEER GDI LFDI
FD1 1.0000
(0.0389)
GRRGDP 0.1004
1.0000
(0.0000)
RGDPC 0.1034
0.1652 1.0000
(0.0151)
EXIM 0.0921
-0.1721 -0.6658 1.0000
(0.0009)
INF 0.4434 -
0.0755 0.3625 1.0000
(0.7357) 0.3666
GE -0.1149 -
-0.6198 -0.2286 0.1607 1.0000
(0.0001) 0.0886
FD -0.0689 -
-0.1743 -0.5079 0.3532 0.3168 1.0000
(0.1553) 0.1008
EL -0.2994 - - -
0.1202 0.1701 0.0070 1.0000
(0.0000) 0.2304 0.1685 0.0668
GFCF -0.2346 - - -
-0.0107 -0.4451 0.5840 0.3158 1.0000
(0.0000) 0.4989 0.1470 0.2261
TELE -0.6619 - -
0.1269 -0.1593 0.2402 0.1386 0.3482 0.3268 1.0000
(0.7352) 0.6735 0.0679
SEER 0.0277 - - -
0.3212 -0.1617 0.3083 0.0550 0.3047 0.5275 1.0000
(0.0005) 0.6023 0.1996 0.0323
GDI 0.1315 - - - -
0.3090 -0.5107 0.5290 0.5243 0.5419 0.2054 1.0000
(0.0000) 0.0793 0.2783 0.1069 0.0994
LFDI -0.5093 - - - - 1.0000
0.0545 0.1832 1.0000 0.0363 0.3302 0.2313 0.3059
(0.0145) 0.3727 0.1585 0.2204 0.1945

45
4.3.2 REGRESSION ANALYSIS

So far the study established a framework of literature and data analysis including descriptive
statistics and correlation analysis in order to investigate the relationship between foreign
direct investment and explanatory variables so that to answer the research questions, two
regressions have been run in order to examine the relationship between foreign direct
investment and explanatory variables.

This section of the study presents the results and interpretation of the regression/econometrics
analysis. Before running the regressions, the data sets were tested for stationarity, co-
integration, multicollinearity, heteroscedasticity, autocorrelation and for model specification
to test goodness of data collected and where fitness of the model specified were discussed
above. Thus, the regression analysis based on the model is presented here under table 4.10
below.

Table 4.10 below reveals that all the variables determining FDI in Ethiopia are statistically
significant except inflation and growth rate of real GDP. The intercept is statistically
significant at 1 percent. The adjusted R squared values show higher explanatory powers of the
explanatory variables in both regressions. In the first and second regression independent
variables explain the variability of the dependent variable to the extent of 95.70 and 96.61
percent respectively. Only the remaining 4.3 and 3.39 percent of variability in foreign direct
investment is explained by other factors that are not included in the first and second
regression. In addition, the overall significances of both regressions when measured by their
respective F statistics are 30.70 and 41.05 with P-values of 0.0023, and 0.0001 respectively
indicated that the model are well fitted at 1 percent level of significance. Accordingly Table
4.10 gives the main findings of the study on determinant factors affecting foreign direct
investment inflows in Ethiopia over the period of 1992-2010. Thus, its detail interpretation on
each variable based on the findings of regression analysis can be discussed in paragraphs as
follows.

46
 Table 4.10 OLS Estimation FDI inflows as percent of GDP using time series data from
Ethiopia, 1992-2010

Specification (1) specification s(2)

.0866315
GRRGDP
(0. 810)
.0930211** .1053852 ***
∆RGDPC
(0.024) (0.003)
-2.2824* -2.261297**
∆EXIM
(0.066) (0.027)
6.534886*** 6.168154 ***
∆GE
(0.003) (0.000)
15.47002** 13.38581**
∆EL
(0.026) (0.012)
4.440283** 3.977845***
∆GFCF
(0.020) (0.008)
-26.0869*** -25.48916***
∆TELE
(0.002) (0.000)
5.324589* 4.062122 **
∆SEER
(0.056) (0.035)
.4630255*** .4744385 ***
GDI
(0.001) (0.000)
-.8266527 *** -.8653372 ***
∆LFDI
(0.004) (0.000)
.1953016
INF
(0.354)
-.4939988*** -.4863181***
∆FD
(0.008) (0.001)
-22.99045*** -19.75765***
_cons
(0.006) (0.001)
Adj R-squared 0.9570 0.9661
30.70*** 41.05***
F statistics
(0.0023) (0.0001)
N 17 17
Figures in parenthesis denote p-values, ***significant at 1 percent, **significant at 5 percent,
* significant at 10 percent.

47
Hypothesis testing

Ho: Market growth is not a determinant (driven or constraint) factor for the inflows
of FDI

Ha: Market growth is a determinant factor for the inflows of FDI

Table 4.10 reveals that Market growth, measured by GRRGDP, has statistically insignificant
but positive effects on the inflows of foreign direct investment. Thus, the null hypothesis
regarding market growth is accepted while its alternate hypothesis is rejected because market
growth has insignificance effect on FDI, which implies that market growth is neither a driven
nor a constraint for FDI inflows in to Ethiopia.

Hypothesis testing

Ho: Market size is not a determinant factor for the inflows of FDI

Ha: Market size is a determinant factor for the inflows of FDI

The other market variable, RGDPC which measures size of market, has a positive and
significant effect on FDI in regressions one and two. It is significant at 5 percent and 1
percent in both regression one and two respectively. The result indicates that, one percent
increase in RGDPC will lead to an average 0.93 percent increase on cumulative FDI. The
explanation for such result could be that the rise of per-capita income from year to year
encouraging a market seeking FDI in to Ethiopia. Thus, this finding is in line with the
alternate hypothesis that market size is a driven for FDI inflows because market size is turned
to be significant and positive. As a result the study rejects the null hypothesis.

In order to the support secondary data analysis regarding the relationship between FDI and
market size and growth, the study conducted an interview with macroeconomic experts.
According to most macroeconomic experts, growth of the economy which is measured by
GRRGDP and the rise of per capital income from year to year together with existence of
emergent and undiscovered market with crowded population, about 82 million in Ethiopia
attracts the inflow foreign direct.

48
Hypothesis testing

Ho: openness is not a determinant factor for the inflows of FDI

Ha: openness is a determinant factor for the inflows of FDI

As concern to openness, measured by import and export as a share of GDP, has negative and
significant effect on FDI in all of the regression, which is in line with the alternate hypothesis
that, openness of an economy is a constraint factor for inflow of FDI. It is significant at 5
percent level of significance in second and at 10 percent in first regression. This result implies
that the openness of Ethiopia economy constraints the inflows of FDI. As a result, the study
rejects the null hypothesis.

In order to support secondary data analysis regarding the relationship between FDI and degree
of openness, the study conducted an interview with macroeconomic experts. According to
most macroeconomic experts, the degree of openness of the Ethiopian economy is a one
factor of influencing inflow of foreign direct investment. According to them, degree of
openness of Ethiopian economy was improved and its openness is increased from year to year
after 1991 measures that have been undertaken by government like liberalization of trade
policy, privatization of public sector enterprises, deregulation of prices and exchange rate
controls and liberalized investment regime through a series of government proclamations and
government incentive to promote exports. However, they reveal that the Ethiopian economy
was still closed in certain investment areas which decrease the inflows FDI. Thus, this finding
implies that openness of the Ethiopian economy is important determinates of FDI inflows.

Hypothesis testing

Ho: macroeconomic stability is not a determinant factor for the inflows of FDI

Ha: macroeconomic stability is a determinant factor for the inflows of FDI

One of the four macro-economic indicators, inflation, is found to yield positive but
insignificant effect on FDI, which is in line with the null hypothesis that is, inflation is neither
a significant driven or constraint factor for inflow of FDI. The coefficient government

49
expenditure, which constitutes the government spending in proportion to GDP, is found to be
positive coefficient and significant at 1 percent level of significance in all regressions. The
result indicates that, one percent increase in GE, will lead to an average 6.5% percent increase
of cumulative FDI. This result may imply that public investments promoted through
government expenditures are contributing to the inflows of foreign investments, which is in
line with the alternate hypothesis that, government expenditure is a significant driven factor
for inflow of FDI. The other macroeconomic variable, EL which measures employment level
in proportion to the population has a positive and significant effect on FDI. It is significant at
5 percent level of significance in all regressions. The results indicate that one percent increase
in employment level, will lead to an average 15.5 percent increase on the cumulative FDI.
This result may implies that attributed to raise high skilled workers and staff with sufficient
knowledge for applying the appropriate performance during their job from year to year satisfy
the demand of foreign enterprises to invest in the country, which is in line with the alternate
hypothesis that employment level is a significant motivational factor for inflow of FDI.

The last variable in model that represents macroeconomic stability, foreign debt in proportion
to GDP has a negative and significant coefficient in all of the regressions, which is in line
with the alternate hypothesis that foreign debt is a significant constraint factor for inflow of
FDI. It is significant at 1 percent level of significance in all regressions. Holding other
variables constant, 1 percent increase in the value of foreign debt will imply, on average 0.49
percent decrease on cumulative FDI.

As a result of the regression analysis regarding to macroeconomic stability represented by

government expenditure, employment level and foreign debt are statistically significant. Thus,
the alternate hypothesis is accepted while null hypothesis is rejected. On the other hand,
macroeconomic stability represented by inflation was statistically insignificant, which is in
with null hypothesis and then alternate hypothesis is rejected.

In order to support the secondary data analysis regarding the relationship between FDI and
macroeconomic stability, the study conducted an interview with macroeconomic experts.
According to most macroeconomic experts, Ethiopia’s broad based economic growth
continued for six years putting the country in higher growth path despite the world economy
melt- down and global financial crisis. According to them, the result of such economic growth

50
is due to the existence of appropriate monetary and fiscal policies that control inflation,
government expenditure, employment level and foreign debts at appropriate level in the
economy. They finally conclude that the visible economic stability of Ethiopia over the past
years was a one main reason for the rise foreign direct investment inflows in to Ethiopia.

Hypothesis testing

Ho: infrastructure development is not a determinant factor for the inflows of FDI

Ha: infrastructure development is a determinant factor for the inflows of FDI

One of the infrastructure variable denoted by telephone line per 1000 people is shown to be
statistically significant and negative coefficient in all regressions. It is significant at 1 percent
level of significance in all regressions. This result may be explained by the poor
telecommunication facility which is negatively affects FDI inflow into the country. On the
contrary the coefficient of GFCF, which constitutes all kinds of infrastructure development,
yields a positive and significant coefficient. It is significant at 5 percent level of significance
in first and at 1 percent in second regression. Holding other variables constant, each
percentage increase in GFCF, will lead to an average 4.44 percentage increase of cumulative
FDI. Thus, this result shows that the overall infrastructure development has positive effect on
FDI and which might indicate that the growing infrastructural facilities in Ethiopia having a
favorable effect on FDI. As a result of the regression analysis regarding to infrastructure
development represented by telephone line per 1000 people and gross fixed capital formation
are statistically significant. Thus, the alternate hypothesis is accepted while null hypothesis is
rejected.

In order to support secondary data analysis about the relationship between FDI and
infrastructure development, the study conducted an interview with macroeconomic experts.
Most of them replied that the improvements shown in recent years on access to basic
infrastructure services of network on roads, telecommunication and availability of sufficient
electricity supply and others are currently contributing for the country to attract foreign
investors.

51
Hypothesis testing

Ho: Human capital is not a determinant factor for the inflows of FDI

Ha: Human capital is a determinant factor for the inflows of FDI

The human capital variable, measured by secondary education enrollment rate has statistically
significant and positive coefficient in all regressions. It is significant at 5 percent level of
significance in second and at 10 percent in first regression. Holding other variables constant,
each percentage increase in SEER will lead to an average 5.32 percentage increase of
cumulative FDI. This result may be further explained that an economy has high fraction of
skilled workers which are likely to be much higher productive and attractive to foreign
investors. Thus, the alternate hypothesis is accepted while null hypothesis is rejected because
the secondary education enrollment rate which is a proxy of human capital is statistically
significant.

In order to support secondary data analysis about the relationship between FDI and human
capital, the study conducted an interview with macroeconomic experts. Most of them replied
that the educational sector has witnessed a great leap forward over the past years both in terms
of coverage as well as quality. Accordingly, they replied that recently secondary education
enrollment stood more than 1.5 million, 126 percent higher than the year 2002 which shows
rise from year to year. Thus, they agreed that availability of skilled workforce in Ethiopia
increases the productivity of investments thereby encouraging inflows of FDI.

Hypothesis testing

Ho: growth of domestic investment is not a determinant factor for the inflows of FDI

Ha: growth of domestic investment is a determinant factor for the inflows of FDI

Table 4.10 shows that the growth of domestic investment has positive and statistically
significant effect on FDI at 1 percent level of significance in all regressions. Holding other
variables constant, each percentage increase in GDI will lead to an average 0.46 percentage
increase of cumulative FDI. As a result the alternate hypothesis is accepted while null

52
hypothesis is rejected because GDI is statistically significant at 1 percent level in all
regressions.

In order to support secondary data analysis concerning the relationship between FDI and
human capital, the study conducted an interview with macroeconomic experts. Most of them
replied that domestic investment in Ethiopia has been steadily increasing over past years
owing to favorable investment climate. According to them, steadily increasing of domestic
investment over past years in Ethiopia highly builds the confidence of foreign investors and
which makes Ethiopia an interesting country for foreign direct investment.

Hypothesis testing

Ho: lagged foreign direct investment is not a determinant factor for the inflows of FDI

Ha: lagged foreign direct investment is a determinant factor for the inflows of FDI

With regard to clustering effect, measured by lagged foreign direct investment, is found to be
a negative and significant effect on FDI at 1 percent level of significance in both regressions.
As a result the alternate hypothesis is accepted while null hypothesis is rejected because the
lagged foreign direct investment is statistically significant at 1 percent level in all regressions.
However, the negative coefficient of lagged FDI is a surprise result of this study.

53
54
 CHAPTER FIVE
CONCLUSION AND RECOMMENDATION
This chapter presents the conclusions and recommendations that were drown from the study
results.

5.1 CONCLUSION

Ethiopia has made a significant progress towards becoming a functioning market economy
and establishing a satisfactory track record of macroeconomic stabilization and performance
and also good progress has been made in the inflows of FDI. Thus, this study investigated the
determinants of foreign direct investment in Ethiopia during 1992-2010. The study was
undertaken based on an ordinary least square (OLS) model based on time series data of 19
years. The study used one dependent and seven independent variables, i.e., the dependent
variable representing foreign direct investment (FDI) and seven explanatory variables
representing market size and growth measured by real GDP per capital (RGDPC) and growth
rate of real GDP (GRRGDP) respectively, openness which used export and import in
proportion to GDP (EXIM) as a proxy, macroeconomic stability represented by inflation
(INF), government expenditure (GE), employment level (EL) and foreign debt (FD),
infrastructure represented by gross fixed capital formation (GFCF) and telephone line
(TELE), human capital measured by secondary education enrollment rate (SEER), growth of
domestic investment (GDI), and lagged FDI (LFDI).

Descriptive statistics was used to examine the trend of the chosen variables over the sample
periods. Both correlation analysis and OLS models of time series data were used to analyze
the relationships among dependent and independent variables and identify major determinates
of FDI. Finally, the study findings are discussed in the subsequent paragraphs as follows:

The third research question of the study was to explore direction of relationships between the
explanatory variables and inflows of FDI which was investigated through correlation analysis.
Thus, the findings of correlation analysis reveals that there exist strong significance negative
relationships between FDI and government expenditure, employment level, gross fixed
capital formation, and lagged FDI. On the contrary, correlation analysis reveals that there
exist strong positive significance relationships between FDI and real GDP per capital, real

55
GDP growth, export and import in proportion to GDP, secondary education enrollment rate
and growth of domestic investment. On the other hand, the correlation analysis reveals that
there exists insignificant relationship between FDI and inflation, foreign debt and telephone
line.

The first and second research questions were to explore whether the explanatory variables are
determinants of FDI inflows in to Ethiopia, which was investigated through the regressions
analyses. Accordingly, the findings of regression analysis are discussed below as follows:

The market growth, measured by GRRGDP, had statistically insignificant but positive effects
on the inflows of FDI in Ethiopia. This insignificant result of GRRGDP in this study may be
due to a low relative purchasing power of the population, i.e., about 85% of the population are
living in rural where poverty is high. Besides, the rural lacks adequate infrastructure that
facilitates market growth. However, the empirical study in developing countries in general
and in Nigeria in particular reveals that market growth has insignificant effect on the flow
FDI. Thus, the insignificant effect of market growth on FDI in Ethiopia is consistent with
prior studies in Nigeria particularly and in developing countries in general.

The other market variable, RGDPC which measures size of market, had a positive and
significant effect on FDI. The positive influence of market size on FDI in Ethiopia may
signify that the growth of the economy with emergent and undiscovered market potentials
coupled with the largest population and a double digit economic growth over the past years in
Ethiopia was stimulating market-seeking investment. Thus, the growing market size in the
country promotes the production more goods and services and then investors are eager to
invest in a growing economy that promotes the production more goods and services where
they can benefit from the economies of scale and efficient utilization of resources from the
large market size, which reduce the cost of supplying. The previous studies in transition
economies, developing countries, and Africa countries revealed that market size measured by
RGDPC is a significant positive effect on the inflows of FDI. Thus, the significant positive
effect of market growth on FDI in Ethiopia is consistent with the empirical studies.

56
The finding on openness, measured by import and export as a share of GDP, indicated that
openness has significant negative effect on FDI inflows. This negative impact of openness on
FDI may signify that still there are restrictions in certain investment areas which are not
allowed for foreign investors to invest. According to the investment Proclamations of 7/1996,
37/1996, 35/1998, 36/1998 and 116/1998 certain areas are reserved for government included
air transport , rail transport services, postal services, and telecommunications and also the
economy reserves certain sectors for domestic investors including banking and insurance,
small-scale electricity, small scale air transportation services, radio and television
broadcasting, retail trade and product brokerage, wholesale trade and distribution, exports of
raw coffee, oil seeds, pulses, hides & skins, and live sheep, goats and cattle, tanning hides and
skins up to crust level, hotels other than star designated, motels, tearooms, coffee shops, bars,
night clubs and restaurants excluding international and specialized restaurant and the printing
sector. Hence, sectors reserved only for government and domestic investors in Ethiopia
implies that the economy is linked to the rest of the world with certain restrictive economic
sector regime and then affects FDI flow negatively. Thus, this finding revealed that FDI flows
in Ethiopia are not only market seeking but also resource-seeking or export-oriented FDI
because the coefficient of openness is significant and negative. This finding is supported by
empirical studies in developing countries in general and in African countries particularly,
which revealed that openness has a significant negative effect on FDI inflows.

Inflation (i.e. macroeconomic variable) had a positive but insignificant effect on FDI. The
insignificance effect of a variable inflation may be due to that inflation may correlated with
other factors such as exchange rate and return of investment that also influence investment
decisions which are not included in the model of the study. This conclusion is consistent with
prior studies in developing countries and the studies revealed that inflation has insignificant
positive effect on FDI inflows.

The other macroeconomic variable, i.e., government expenditure, had significant positive
effect on FDI inflows. The positive effect of government expenditure on FDI may signify that
the government allocates more of annual budgets for public investments in order to fighting
unemployment, decrease poverty, increasing infrastructure facility and other developmental
projects. As a result, public investments promoted through government expenditures reduce

57
cost of doing a business that determines the inflows FDI in to Ethiopia. The prior studies in
developing countries revealed that the government expenditure that promotes public
investment has positive effect on FDI inflows. Thus, the conclusion on government
expenditure is supported by empirical studies in developing countries. Likewise, employment
level had a positive and significant impact on FDI inflows in Ethiopia. This finding may
signify that Ethiopia has experienced skilled workers and staff with sufficient knowledge and
appropriate performance that satisfies the demand of foreign enterprises. Thus, the result on
employment level is consistent with empirical studies in Macedonia, which reveals that
employment level has significant positive impact on FDI inflows.

On the contrary, the other macroeconomic variable, foreign debt had significantly negative
effect on the inflows of FDI in Ethiopia. This result is supported by descriptive analysis that
on average the foreign debt over the sample period accounted to be 85.67 percent as
compared to GDP and also it is known that Ethiopia is categorized under highly indebted poor
countries. This may indicate that the country borrows too much, i.e. has too much foreign
debt. This too much foreign debt service burdens often restrict the ability to avoid uncertainty
in macroeconomic environment which concurrently constraints the inflow of FDI in to
Ethiopia. This finding is consistent with prior studies in Africa countries, which revealed that
too much foreign debt in African countries affects the FDI inflows negatively.

Telephone line per 1000 people had significantly negative impact on the inflow of FDI in to
Ethiopia. This result may signify that, there are low telephone line access and poor
telecommunication facility that are detrimental for the inflows of FDI in to Ethiopia. This
finding is consistent with empirical studies in Vietnam, African countries in general and
Ethiopia in particular, which revealed that telephone line is significant negative effect on FDI.
On the contrary the other infrastructure proxy, gross fixed capital formation, had a
significantly positive effect on FDI. The positive impact of overall infrastructure development
signify that the rapid growth of overall basic infrastructure services of network on roads, air
transport, telecommunication and availability of sufficient electricity supply and other facility
in Ethiopia reduces production costs and then encourages the inflows of FDI. The previous
studies in Vietnam and African countries revealed that the overall infrastructure development

58
in the countries encourages FDI inflows. Thus, the conclusion on gross fixed capital
formation is consistent with the empirical studies in Vietnam and African countries.

Human capital had significantly positive effect on the inflows of FDI in to Ethiopia. This
result is consistent with prior studies in developing countries in general and African countries
in particular, which revealed that human capital is necessarily an important determinant for
inflows of FDI. The significant positive effect of human capital on FDI inflows in to Ethiopia
may signify that foreign investors demand for educated labor force. Thus, the increased
secondary education and higher institution enrollment rate in Ethiopia to produce skilled
manpower enhances individual’s knowledge and skills and brings productivity labor in the
country and then encourages FDI inflows in Ethiopia.

Growth of domestic investment had positive effect on FDI inflows in Ethiopia. This positive
effect of domestic investment may be due to the fact that the steadily increasing of domestic
investment over the past years increases the confidence of foreign investors regarding the
existence of favorable investment climate in Ethiopia. Thus, such a friendly favorable
investment climate attracts FDI because a friendly favorable investment climate lowers costs
of doing business, lower judicial obstacles, protects property rights and shows that the
existence of general macroeconomic and political environment stability. This conclusion is
consistent with empirical study in Cameroon, which revealed that the increase of domestic
investment in the economy has a positive effect on FDI inflows.

Lastly, Lagged FDI had a negative effect on FDI inflows in to Ethiopia. Even though this
negative effect in FDI is a surprise result, such situations may be happened when market size
is one of the important determinant of FDI and where market size is narrow. Because of panic
of competitions among existed investors, forthcoming foreign investors may have a
possibility to be discouraged to invest. The result on lagged FDI is consistent with prior
studies in African countries in general and Cameroon and Mauritius in particular, which
revealed that an existing concentration of different foreign investors in the economy
discourages forthcoming foreign investors due to fear of competition of forthcoming foreign
investors with existing foreign investors.

59
To sum up, the findings of regressions analysis showed that market size, openness,
government expenditure, employment level, foreign debt, human capital, telephone line, gross
fixed capital formation, growth of domestic investment and lagged FDI were major
determinants of FDI inflows in to Ethiopia because the coefficients of the variables were
statistically significant. From these variables, market size, government expenditure,
employment level, human capital, overall infrastructure development, and growth of domestic
investment were motivating FDI inflows in Ethiopia because the coefficients of the variables
were positive. While openness, foreign debt, lagged FDI and telephone line were constraints
for the inflows of FDI because the coefficients of the variables were negative. Conversely,
market growth and inflation becomes insignificant determinant for the inflows of FDI in to
Ethiopia because the coefficients of the variables were turned out to be statistically
significant.

5.2 RECOMMENDATION

This study attempted to identify the determinants of foreign direct investment in Ethiopia for
the period of 1992-2010 by using OLS regression. On the basis of the findings and
conclusions reached, the following recommendations were forwarded in order to attract more
FDI inflows in to Ethiopia than the past.

Eventhough, the Ethiopian market size has attracted FDI inflows in to the country over the
sample periods, it is appropriate to formulate policies that can exploit emergent and
undiscovered market of the country and also formulate a polices that advocates the
consumption of locally produced goods and services so that the country would have a strong
and supportive local market, thus attracting more FDI inflows to the country than the past.

The government expenditures was found to be the main driver to the inflows foreign
investments with high extent of attracting FDI in to Ethiopia as compared to other variables
and its contribution in promoting public investment was marvelous. However, the government
institutions of Ethiopia need to work hard and loyal for proper utilization of the government
expenditures allocated by house of peoples representative for fighting unemployment,
decreasing poverty, increasing infrastructure facility and other developmental projects in
order make the contribution of government expenditure continuous in attracting FDI in future.

60
Furthermore, this hard work and commitment of governmental institution for utilizing the
government expenditure which allocated for specific goal by concerned bodies accordingly
contributes for overall basic infrastructure development in roads, air transport,
telecommunication and availability of sufficient electricity supply and social welfare
programs which attracts more FDI flows in to the country than the past.

Employment level was among the main drivers to the inflows of foreign investments in
Ethiopia. Thus, the job training programs should be developed furthermore by the responsible
institutions such as universities, colleges, regional offices and other concerned governmental
and non governmental bodies, in order to contribute to the increase of labor productivity in
the Ethiopian economy thus satisfying the labor demand of multinational firms.

It requires a serious commitment to address the excessive foreign debt, as the increase in this
factor implies that macroeconomic environment may be under uncertain situation along with
the possibility of increasing tax on investors during time of payment of the debt and then
affect the image of the country in the eyes of potential foreign investors. Thus, it may be
better for the country to formulate policies that highly promotes internal source of government
revenue in order to reduce foreign debt to attract more FDI than the past.

Even though the human capital development in Ethiopia encourages FDI flow, the secondary
education and higher institution enrollment rate along with quality education should be
increased furthermore by increasing the capacity of secondary schools and higher institutions
through constructions of class rooms, teaching aids, qualified teachers and by creating
hospitable teaching-learning process which make the contribution of human capital in
attracting FDI better than past.

The growth of domestic investment encourages FDI inflows, the government institutions of
Ethiopia need to work harder for reduction of transaction costs of doing business in the
country, eliminating bureaucracy procedures, involving in the improvements of weak legal &
regulatory frameworks, and struggle for reduction of corruption. These measures may satisfy
domestic investor. Thus a satisfied domestic investor is an important promoter for hospitable
investment environment and then the country attracts more FDI than the past.

61
62
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70
 APPENDIX

MACROECONOMIC, INFRASTRUCTURE AND HUMAN CAPITAL VARIABLE DATA

Year Gross Trade (% secondary Employm Population, Inflation Telephon

Fixed of GDP) School ent level total e lines
Capital enrollment
formation (% gross)
(% of
GDP)
1992 10.7136 10.83072 12.21255 71.8 51685687 10.52744 127041
1993 16.52988 20.1841 10.9264 72.3 53455787 3.543066 132478
1994 16.37967 21.22213 10.63729 72.8 55230033 7.593876 137731
1995 17.95808 25.41511 10.79106 72.4 56982906 10.02217 142452
1996 16.60466 25.54262 11.32758 72.9 58704453 -5.06936 148739
1997 19.75042 29.232 12.03338 73.4 60402030 2.39521 156538
1998 21.15281 33.37795 12.70268 73.8 62089193 2.582846 164140
1999 21.91434 35.76612 13.27331 74 63787720 7.941449 194494
2000 20.27968 36.00442 14.44749 75 65514626 0.662458 231945
2001 21.45325 35.72457 17.43738 76 67272331 -8.23784 283683
2002 23.92655 39.20873 19.47376 76.8 69058616 1.653729 353816
2003 21.84382 40.73144 20.07853 77.6 70880658 17.76228 404790
2004 25.46706 46.48114 22.26852 78.4 72746225 3.256273 484368
2005 22.99424 50.57914 24.93834 79.9 74660901 11.61092 610347
2006 24.22768 50.46853 28.93838 79.7 76627697 12.31 725046
2007 23.45764 44.75452 32.05532 80.3 78646128 17.238 880088
2008 19.84511 42.18763 33.43448 80.6 80713434 44.39128 897287
2009 22.42668 39.40184 34.04102 81.2 82824732 8.468336 915085
2010 21.57322 39.31802 36.1466 81.9 84,799,000 8.125 1014013

Source: World Bank

71
FOREIGN DIRECT INVESTMENT, DOMESTIC INVESTMENT AND MARKET
VARIABLE DATA

Year FDI inflows(birr) Domestic Real GDP(birr)

investment(birr)
1991 48,031,700,000
1992 153,876,100 934,289,000 45,042,200,000
1993 87,657,600 4,157,886,900 50,097,800,000
1994 315,379,400 3,159,422,000 50,478,200,000
1995 73,411,500 4,866,270,890 52,804,000,000
1996 508,646,500 5,616,785,200 59,194,900,000
1997 656,725,000 3,821,530,900 61,888,400,000
1998 635,244,900 4,274,519,170 59,748,200,000
1999 557,547,100 4,067,112,210 62,832,600,000
2000 744,991,600 4,859,640,910 66,648,000,000
2001 1,844,889,300 6,761,584,700 72,181,100,000
2002 514,136,430 7,306,070,356 73,274,400,000
2003 1,362,250,580 8,920,657,300 71,690,900,000
2004 3,148,825,825 16,515,130,764 81,421,100,000
2005 1,498,219,273 23,036,723,733 91,044,100,000
2006 2,005,031,500 46,067,164,636 100,908,400,000
2007 3,087,930,390 62,813,321,741 112,468,500,000
2008 4,369,282,580 69,879,683,190 124,602,500,000
2009 2,478,508,028 80,017,504,466 135,557,500,000
2010 916,854,683 45,071,466,914 152,404,600,000

Source: Ethiopian Investment Agency and National Bank of Ethiopia

72
MACRO ECONOMIC DATA

Year General government General government

total Foreign net debt
expenditure(%GDP) (%GDP)

1992 13.923 83.429

1993 13.472 133.739
1994 17.239 147.213
1995 17.008 139.067
1996 18.377 125.993
1997 17.433 75.652
1998 20.5 84.032
1999 26.028 92.088
2000 25.783 91.479
2001 22.612 93.404
2002 25.06 108.702
2003 27.018 108.268
2004 23.351 99.021
2005 23.078 70.764
2006 22.239 57.095
2007 20.677 30.313
2008 18.871 28.048
2009 17.189 28.102
2010 18.052 31.258

Source: International Monetary Fund, World Economic Outlook

73
Unstructured Interview Schedule

Official Name of the organization: _______________________________________

Position in the organization: ____________________________________________

E-mail address: _____________________________________________________

1. Is Ethiopia a noteworthy country for foreign investors to invest? If so what makes

Ethiopia a noteworthy country in terms of FDI?

2. How do you evaluate the infrastructure development in Ethiopia in relation to the

inflow of foreign direct investment?

3. What is your outlook regarding to the importance quality human capital availability in
Ethiopia to attract foreign direct investment?

4. Do foreign investors consider Ethiopia as a target market or use Ethiopia as a Platform

to export products and services to neighbor countries before they invest in Ethiopia?

5. Are multinational firms attracted to invest in Ethiopia because of large Market Size
and growth in order to utilize resources efficiently and exploit economies of scale?

6. How do you explain the market size and growth in relation to attracting FDI in
Ethiopia?

7. Do you think that foreign investors consider the Openness of an Ethiopian economy
before they invest?

8. How do you measure the extent of the openness of Ethiopian economy to attract
foreign direct investment?

9. How do evaluate Macroeconomic stability trends of Ethiopia since 1992 in relation to

Inflation rates, foreign debt, Government Expenditure, Employment level and
exchange rates?

10. Do you think that the Macroeconomic stability is a potential factor in order to attract
foreign direct investment Ethiopia? How?

11. How do evaluate the contribution of the growth of domestic investment in attracting
FDI?

12. What are the most difficult situations that investors are facing and what are the
constraints that hinder the inflow of FDI in Ethiopia?

13. Anything you want to say_____________________________________________

74