Impact of Foreign Investment in a Country

This chapter forms our bases of our study which is on the impact of foreign direct investment on economic growth in Kenya. Literature that relates to the study is viewed to identify the gaps in the knowledge. Theoretical and empirical literature is viewed through assessment of the various theories on foreign direct investment on the economic growth in Kenya. Besides, it outlines some of the gaps that have been identified from the review of historic as well as current state of research in the field.

This section shades light on the various theoretical theories that have been advanced in the previous studies by different scholars. Theories identified are; the economic theory, Solow type growth theory and the neoclassical theory. These theories are well explained below:

The standard economic theory holds that foreign capital inflows into a recipient country increases its stock of capital and level of technology and lead to better economic performance. Theory provides conflicting predictions concerning the growth effects of FDI. FDI affects economic growth positively through improved technology, efficiency and increased productivity (Lim, 2001). However, the potential contribution of FDI to growth is strictly dependent on the circumstances in the recipient or host country.

Economists tend to favor the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several other advantages (Barry and Collins,1999). First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies.

The role of foreign direct investment (FDI) in stimulating economic growth is one of the controversial issues in the development literature. In the standard Solow type growth model, FDI enables host countries to achieve investment that exceeds their own domestic saving and enhances capital formation. According to this theory, the potential beneficial impact of FDI on output growth is confined to the short run. In the long run, given the diminishing marginal returns to physical capital, the recipient economy could converge to the steady state growth rate as if FDI had never taken place leaving no permanent impact on the growth of the economy (De Mello, 14). Mankiw (2003) applying the Solow growth model argues that private businesses invest in traditional types of capital such as bulldozers and steel plants and newer types of capital such as computers and robots. On the other hand, government invests in various forms of public capital, called infrastructure, such as roads, bridges and sewer systems. Mankiw further argues that policy makers trying to stimulate growth must confront the issue of what kinds of capital the economy needs most.

According to neoclassical theory, FDI influences income growth by increasing the amount of capital per person (Nair, 2010). It spurs long-run growth through such variables as research and development (R&D) and human capital. Through technology transfer to their affiliates and technological spillovers to unaffiliated firms in the host economy, MNCs can speed up the development of new intermediate product varieties, raise product quality, facilitate international collaboration on R&D, and introduce new forms of human capital (Ikiara, 2003). Bajonaand Kehoe (2010) discussed explanations of multinational production based on neoclassical theories of capital movement and trade within the Hecksher-Ohlin framework.

However, they criticize these theories on the basis that they were founded on the assumption of existence of perfect factor and goods markets and were therefore unable to provide satisfactory explanation of the nature and pattern of FDI. In the absence of market imperfections, these theories presumed that FDI would not take place (Bajona and Kehoe, 2010). Nevertheless, they argue that the presence of risks in investing abroad implies that there must be distinct advantages to locating in a particular host country.

This section describes the various determinants of FDI. The exact determinants discussed here include: infrastructure, market size, labour costs and productivity, political risk, economic growth and taxation.

Infrastructure covers many dimensions ranging from roads, ports, railways and telecommunication systems to institutional development like accounting, legal services. According to ODI (1997), poor infrastructure can be seen, however, as both an obstacle and an opportunity for foreign investment. For the majority of low-income countries, it is often cited as one of the major constraints. But foreign investors also point to the potential for attracting significant FDI if host governments permit more substantial foreign participation in the infrastructure sector.

Jordan (2004) claims that good quality and well-developed infrastructure increases the productivity potential of investments in a country and therefore stimulates FDI flows towards the country. According to Asiedu (2002) and Ancharaz (2003), the number of telephones per 1,000 inhabitants is a standard measurement in the literature for infrastructure development. However, according to Asiedu (2002), this measure falls short, because it only captures the availability and not the reliability of the infrastructure. Furthermore, it only includes fixed-line infrastructure and not cellular (mobile) telephones.

According to Artige and Nicolini (2005) market size as measured by GDP or GDP per capita seems to be the most robust FDI determinant. This is the main determinant for horizontal FDI and it is irrelevant for vertical FDI. Bakir & Alfawwaz (2009) mention that FDI will move to countries with larger and expanding markets and greater purchasing power, where firms can potentially receive a higher return on their capital and by implication receive higher profit from their investments.

According to Charkrabarti (2001), the market-size hypothesis supports an idea that a large market is required for efficient utilization of resources and exploitation of economies of scale: as the market-size grows to some critical value, FDI will start to increase thereafter with its further expansion. This hypothesis has been quite popular and a variable representing the size of the host country market has come out as an explanatory variable in nearly all empirical studies on the determinants of FDI. In ODI (1997), it is stated that econometric studies comparing a cross section of countries point to a well-established correlation between FDI and the size of the market, which is a proxy for the size of GDP, as well as some of its characteristics, such as average income levels and growth rates. Some studies found GDP growth rate to be a significant explanatory variable, whereas GDP was not, probably indicating that where the current size of national income is very small, increases may have less relevance to FDI decisions than growth performance, as an indicator of market potential.

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Wage as an indicator of labour cost has been the most contentious of all the potential determinants of FDI. Theoretically, the importance of cheap labour in attracting multinationals is agreed upon by the proponents of the dependency hypothesis as well as those of the modernization hypothesis, though with very different implications (Charkrabarti, 2001). There is, however, no unanimity even among the comparatively small number of studies that have explored the role of wage in affecting FDI: results range from higher host country wages discouraging inbound FDI to having no significant effect or even a positive association.

According to ODI (1997), where the host country owns rich natural resources, no further incentive may be required, as it is seen in politically unstable countries. In general, as long as the foreign company is confident of being able to operate profitably without excessive risk to its capital and personnel, it will continue to invest. For example, large mining companies overcome some of the political risks by investing in their own infrastructure maintenance and their own security forces. Moreover, these companies are limited neither by small local markets nor by exchange-rate risks since they tend to sell almost exclusively on the international market at hard currency prices.

The role of growth in attracting FDI has also been the subject of controversy. Charkrabarti (2001) states that the growth hypothesis developed by Lim (2001) maintains that a rapidly growing economy provides relatively better opportunities for making profits than the ones growing slowly or not growing at all. Lunn (1980), Schneider and Frey (1985) and find a significantly positive effect of growth on FDI, while Culem (1988) obtains a strong support for the hypothesis over the period 1983 to 1986, but only a weak link from 1975 to 1978.

On the other hand, Nigh (1985) reports a weak positive correlation for the less developed economies and a weak negative correlation for the developed countries. Ancharaz (2003) finds a positive effect with lagged growth for the full sample and for the non-Sub- Saharan African countries, but an insignificant effect for the Sub-Saharan Africa sample. Gastanaga et al. (1998) and Schneider and Frey (1985) found positive significant effects of growth on FDI.

The literature remains fairly indecisive regarding whether FDI may be sensitive to tax incentives. Some studies have shown that host country corporate taxes have a significant negative effect on FDI flows. Others have reported that taxes do not have a significant effect on FDI.

The direction of the effects of above-mentioned determinants on FDI may be different. A variable may affect FDI both positively and negatively. For example, factors, such as labour costs, trade barriers, trade balance, exchange rate and tax have been found to have both negative and positive effects on FDI. In the empirical studies a various combination of these determinants as explanatory variables have been used. Ahmed (2012) states that due to the absence of a consensus on a theoretical framework to guide empirical work on FDI, there is no widely accepted set of explanatory variables that can be regarded as the true determinants of FDI.

Nair (2010) studied the relationship between Foreign Direct Investment and Economic Growth using a case study of India from 1970 to 2007. The study applied regression analysis. The main regression results show that FDI has a positive and highly significant effect on overall growth for India. The stock of human capital is also significant in the growth process, and the magnitude of the effect of FDI does depend to some extent on the interaction between these two variables. The study further notes that the nature of the interaction of FDI with human capital is such that for countries with very low levels of human capital, the direct effect of FDI is negative. The large positive value of the dummy variable, and its high level of significance, reflect that the opening up of the Indian economy in 1991 saw the effect of FDI on economic growth increase tremendously.

Wan (2010) conducted a literature review on the relationship between foreign direct investment and economic growth. This study sums up the literature as well as empirical studies on the relationship between foreign direct investment and economic growth, trying to arrive at a meaning revelation eventually. Theories and existing literature provide conflicting results concerning this relationship. On one hand, some scholars argue that foreign direct investment could stimulate technological change through the adoption of foreign technology and know-how and technological spillovers, thus boosting host country economies. On the other hand, other pessimists believe that FDI may bring about crowding out effect on domestic investment, external vulnerability and dependence, destructive competition of foreign affiliates with domestic firms and market-stealing effect as a result of poor absorptive capacity.

Chakraborty (2012) sought to establish whether there was any relationship between foreign direct investment, domestic investment and economic growth in India using a time series analysis. The findings show that while the long-run co-integrating relationship between FDI, gross fixed capital formation (GFCF) and gross domestic product (GDP) in India is confirmed by the empirical analysis, the findings that there is a unidirectional causality from India’s economic growth to FDI and from FDI to domestic investment raises important policy implications. Higher FDI inflow in India could be argued to be facilitated by the relatively stable GDP growth rate, which in turn acted as a major boost towards a sustainable high domestic investment. The growth effects of the FDI on GDP in the short run were, however, less pronounced.

Njeru (2013) examined the impact of foreign direct investment on economic growth in Kenya using FDI and GDP inflow data series from 1982 to 2012. The findings show that FDI contributes to development in three major ways: capital inflows such as FDI enable countries to import more than they export, which enables them to invest more than they save and thus accumulate capital faster, boosting labor productivity and wages. FDI has the potential to absorb some of the surplus literate labor in the rural and urban informal sectors; and employment creation in industries with good productivity growth prospects is an important aspect of poverty alleviation strategies, which is good for local entrepreneurs.

Abala (2014) conducted an empirical analysis of Kenyan data on foreign direct investment and economic growth. The view suggests that FDI is important for economic growth as it provides much needed capital, increases competition in host countries and helps local firms to become more productive by adopting more efficient technology. The study findings show that FDIs in Kenya are mainly market-seeking and these require

growing GDPs, political stability and good infrastructure, market size as well as reduction in corruption levels. The prevalence of crime and insecurity would be impediments to FDI inflow.

The empirical review above has shown the relationship between foreign direct investment and economic development of a country. However, the studies have not concentrated on the impact of economic growth on FDI or the intervening effects of inflation on the impact of economic growth on FDI with the exception of Chaudhry et al (2013) who established that FDI has a positive effect on economic growth. All the local studies have not considered the effect of economic growth on FDI mixing other macroeconomic variables except the inflation as done by Wanjiru (2013). This study therefore seeks to fill this research gap in literature where the only dependent variable being economic growth.