Effects of Remittances and

Market Size on Foreign

Direct Investment to Sub-

Sahara Africa

William A. Amponsah and

Pablo A. Garcia-Fuentes Second Annual Conference on Regional

Integration in Africa July 7-8, 2011

Outline of Presentation

Introduction

Background of the Problem

Motivation

FDI and Remittances in SSA

Literature

Research Objective

Theoretical Framework and Model

Data

Results

Conclusions and Policy Implications

Introduction

Foreign direct investment (FDI) viewed as one of the

most critical external sources of development finance.

• For stimulating economic growth and employment as

nations compete to attract transnational corporations

(TNCs) to augment own production (Kumo, 2009).

• Studies report positive relationship between FDI and

economic growth (for example Bengoa & Sanchez-Robles,

2003; Campos & Kinoshita, 2002; Hansen & Rand, 2006;

Li & Liu, 2005)

• Those studies provide the impetus for many developing

countries in adopting policies targeted at attracting FDI.

Background

Global FDI inflows projected to reach $1.2 trillion in

2010, and to rise further to $1.3-1.5 trillion in 2011,

and head towards $1.6-2 trillion in 2012 (UNCTAD).

• However, FDI fell plagued by risks and uncertainties

associated with the ongoing global economic recession.

• FDI to Africa rose to historical high of $88 billion in 2008

(UNCTAD, 2009) but fell to $59 billion in 2009 due to

global economic recession (UNCTAD, 2010).

• Of the 2008 total, West Africa attracted $27 billion,

Southern Africa received $27 billion, Central Africa got $4

billion, East Africa got $6 billion and North Africa got $24

billion.

Background

But Africa’s share of global FDI is very low (5%) and

has not grown despite economic and political reforms

and recent upsurges along with those in developing

countries.

Much of African FDI has gone toward prospecting

for petroleum and precious metals.

• Recently, attention has turned to telecommunications,

agricultural lands, etc.

By 2005, remittances entering developing countries

were $188 billion (twice the ODA).

• SSA received $7 billion, only 4% of total global

remittances (Gupta et al., 2007).

Motivation

With regional integration, growth in the size of the African

market becomes important in attracting FDI.

Market size is a good and positive predictor of FDI inflows

(Bajo-Rubio & Sosvilla-Rivero, 1994; Barrel & Pain, 1996;

Billington, 1999; Gopinath et al., 1999)

Augmenting market size is also a good strategy in attracting

FDI flows to S. Africa (Fedderke & Romm, 2006).

Also, a country’s level of output (per capita GDP) and money

available for spending are related to consumption demand

(Dornbusch & Fischer, 1994).

Remittances augment recipients’ incomes, provide working

capital and other resources, and smooth consumption (Gupta et

al. (2007).

FIGURE 1

Figure 1. Net FDI Inflows, ODA Inflows, and Total Remittances Inflows

as Percent of GDP to SSA, 1970-2008

Source: Own calculations using data from the World Development

Indicators, 2010.

Figure (1) includes SSA countries as grouped by the World Bank.

FIGURE 2

Figure 2. Net FDI Inflows, ODA Inflows, and Total Remittances

Inflows in Current U.S. Dollars to SSA, 1970-2008.

Source: Own calculations using data from the World Development

Indicators, 2010.

Figure (2) includes SSA countries as grouped by the World Bank.

Literature Review

Many studies on FDI flows to SSA are descriptive, explaining

factors appealing for TNCs in locating to the region

(Dupasquier & Osakwe, 2005; Mwilima, 2003)

Empirical studies find that political instability, institutional

and macroeconomic uncertainties, and poor regulatory

frameworks negatively and significantly impact FDI flows to

Africa (Asiedu, 2002; Lemi & Asefa, 2003; Onyeiwu &

Shrestha, 2004). Have led to reforms.

• Also, incidence of wars, high inflation, distortions from capital controls

in foreign exchange market negatively and significantly impact FDI

flows to Africa (Reinhart & Rogoff, 2002).

However, none has studied the effects of market size and

remittances on attracting FDI to SSA.

Research Objective

Empirically study the effects of market size and

remittances on net FDI inflows to Sub-Sahara African

(SSA) countries.

• The study uses a panel data set for 34 SSA countries (based

on World Bank classification) from 1980 to 2009.

• The study follows Bajo-Rubio & Sosvilla-Rivero’s (1994)

cost minimization approach to derive the TNC’s optimal

level of capital at the foreign plant.

• Has found application in other studies on FDI (Love &

Lage-Hidalgo, 2000; Marchant et al., 2002; Pain, 1993).

Model Description

The model assumes the TNC decides whether or not to

undertake FDI based on output level in the country.

Total costs for the TNC defined by cost of production at home

and foreign plants.

TNC’s cost minimization s.t. total output demand => derive

equilm output production in foreign plant related to total

demand and relative unit costs.

TNC then decides on levels of inputs for producing in foreign

country => determines necessary capital stock.

Estimate demand for remittances on consumption, investment

and imports => based on disposable income (Glytsos, 2005).

Model Description

Prior studies show that TNCs consider foreign exchange rates

in location decisions (Aliber).

Trade (imports) as substitute for FDI (Mundell, 1957).

Macroeconomic stability using inflation as proxy (Romer,

2006; Barro & Sala-i-Martin, 2004; Bruno & Easterly, 1998).

Empirical model:

• FDI a function of (lnGDPP. lnREM, lnGDPP*lnREM, lnER, IM,

lnINF, lnK, ln relwages)

MODEL

MODEL continued

Equation (19): net FDI inflows depend on the factors

that determine desired capital stock (equation (17)) and

the lagged value of capital stock at the foreign plant.

MODEL continued

Variables Definition & Sources Variable name Variable definitions Source

Net FDI inflows Net FDI inflows as a share

of total GDP.

World Development

Indicators (WDI), online

version, World Bank 2010.

Per capita GDP Host country real per

capita GDP.

WDI, online version,

World Bank 2010.

Remittances/GDP Workers’ remittances,

compensation of

employees and migrants’

transfers as a share of GDP.

WDI, online version,

World Bank 2010.

Remittances/GDP* per

capita GDP

Interaction of the log of

Remittances/GDP and the

log of host country per

capita GDP.

Own calculations.

Variables Definition & Sources Real exchange rate Real exchange rate.

Dollars per unit of

foreign currency. It is

defined as in Waldkirch

(2003). It is computed by

multiplying the nominal

exchange rate by the

ratio of the host country

CPI to the U.S. CPI.

Own calculations.

First lag of imports/GDP First lag of host country

imports as share of GDP.

WDI, online version,

World Bank 2010.

Inflation Natural log of 1 plus the

annual percentage

change of GDP deflator.

GDP from WDI, online

version, World Bank

2010.

Variables Definition & Sources Lag foreign capital stock/GDP

First lag of host country foreign capital stock.

Key Data from WIR (World Investment Report) Annex Tables, UNCTAD (United Nations Conference on Trade and Development), www.unctad.org/fdistatistics.

U.S. CPI U.S. consumer price index.

International Financial Statistics CD-ROM, IMF 2010.

GDP deflator GDP deflator WID, online version, World Bank 2010.

Host country CPI Host country consumer price index

International Financial Statistics CD-ROM, IMF 2010.

SUMMARY STATISTICS

Variable Obs. mean S.D. min max

FDI/GDP 1114 0.02 0.04 -0.26 0.46

Ln per capita GDP 1142 7.89 2.19 5.21 16.56

Ln Remittances/GDP 937 -5.01 2.00 -12.35 -1.53

Ln real exchange rate 738 -4.44 2.27 -8.81 3.64

Ln of first lag host

country imports

1099 -1.04 0.48 -3.51 0.32

Inflation 1110 0.12 0.17 -0.34 1.57

Ln first lag foreign

capital stock

940 -15.93 1.34 -21.97 -13.45

RESULTS Table 1. Remittances, Per Capita GDP and Net FDI Inflows as a Share

of GDP to Sub- Sahara Africa, Panel GMM Estimation, 1980-2009

Explanatory variables Model

Constant 0.1498***

(5.16)

Log per capita GDP 0.0052*

(1.79)

Log remittances/GDP -0.0156***

(2.95)

(Log remittances/GDP)*(Log per capita GDP) 0.0010**

(2.26)

Log real exchange rate 0.0064*

(1.84)

First lag of imports/GDP 0.0165***

(2.97)

RESULTS continued

Significance: 10 percent (*), 5 percent (**) and 1 percent (***). Values

in parenthesis are t-values. The J-statistic suggests failure to reject the

null hypothesis so the instruments are valid.

Log inflation 0.0167

(1.18)

Log first lag of foreign capital stock/GDP 0.0118***

(4.78)

Year 0.0012***

(7.72)

R-squared 0.4243

Observations 684

Countries 34

J-statistic 6.223

P-value for J-statistic 0.1831

Important Results

Positive and significant effect of per capita GDP on net FDI

inflows.

• Consistent with the market size hypothesis (Garcia-Fuentes, 2009; Lall

et al., 2003; Love & Lage-Hidalgo, 2000; Tuman & Emmert, 2004).

• Transnational corporations (TNCs) are attracted to larger markets to

exploit economies of scale.

There is a complementary effect between per capita GDP and

remittance to GDP on net FDI inflows to SSA (based on the

interaction term between remittances to GDP and per capita

GDP).

• Suggests that remittances strengthen the impact of market size in

attracting FDI to SSA.

Important Results

Positive and significant effect of real exchange rate on FDI

• Consistent with results of Stevens (1998) and Waldkirch (2003).

Host country imports have a positive and significant effect on

FDI inflows => trade as complement (Mundell, 1957)

• Such complementary relationship between host country imports and

FDI also occur in Billington (1999) and Globerman & Shapiro (1999).

Lagged foreign capital stock has a significant and positive

effect on FDI inflows

• Bajo-Rubio & Sosvilla-Rivero (1994) find relationship between

previous year’s capital stock and FDI inflows can be positive or

negative.

Conclusions and Policy

Implications The key results are that (i) market size helps to attract FDI;

and (ii) remittances complement per capita income in

attracting FDI

The results are consistent with the model on economic

geography in locating economic activities in proximity to large

markets where consumption would likely take place

(Krugman, 1991).

As Africa integrates, it stands to offer a much larger market

and scale economies to attract global FDI and portfolio

investment for enhanced development.

Increase in remittances by SSA immigrants abroad

complement market size in attracting FDI.

Policy Implications

In seeking to compete for increased investment SSA

region faces three key challenges to make region

attractive under regional integration:

• Strike the right policy balance, including shared

responsibility by nations in policy harmonization and

implementing protocols.

• Enhance critical interfaces between investment and

development (eg. FDI and poverty reduction of MDGs).

• Ensure coherence between national/regional and

international investment policies, and between investment

policies and other public policies.

Policy Implications

Trade substitution found to be important in locating FDI.

• Trade liberalization challenges under Doha Development Agenda

(DDA)

• Improving market access for SSA products (AGOA, EU Economic

Partnership Agreements , reduction of trade barriers under DDA) => all

with development implications.

Investment promotion and potential assistance from OECD

countries vs effects of global financial crisis.

• Calls for sustained efforts in coordinating and harmonizing regional

macroeconomic (fiscal and monetary) policies, reducing risks of policy

reversals, good governance, etc.

Technical assistance in capacity building, infrastructure

development, health, education, etc.