Working Paper Series no. 816: Foreign Direct Investment and Domestic Private Investment in Sub-Saharan African Countries: Crowding-In or Out ?

The impact of FDI on domestic private investment is double edged. On the one hand, Foreign Direct Investment (FDI) is acknowledged to a long-run source of capital and investment fostering economic development through agglomeration of economic activities. On the other hand, FDI may lead to rises in prices and exchange rate appreciation, which reduce competitiveness and result in a crowding-out of private domestic investment. In the case of Sub-Saharan African (SSA) countries, the beneficial impact of FDI on private domestic investment may also depend crucially on specific characteristics of developing countries, for instance low institutional quality or financial development.

Our paper aims to clarify this ambiguity and to disentangle possibly contradictory dynamics at play between FDI (as a ratio to GDP) and other private domestic investment determinants in SSA: crowding-out effect of public investment, macroeconomic stability (inflation, public debt and exchange rate), total factor productivity, financial development, the quality of institutions and economic diversification. We rely on a dynamic error-correction model to address possible two-way causality in the relation between FDI and private domestic investment and capture distinct short and long term effects.

Using a panel of 40 Sub-Saharan African countries over the period 1980-2017, we find  FDI inflows have substantial crowding-in effects in the long run: a 1% increase in the ratio of FDI to GDP is associated with a 0.3% increase in the rate of private domestic investment. However, in the short term, competition effects dominate (weak crowding-out effects). The positive benefits of FDI on private investment take time to implement because of low absorption capacity and lags in fully benefiting from FDI positive effects in developing economies.

High fiscal deficits and debts, as well as political instability and corruption, may also undermine long run crowding-in effects of FDI on private domestic investments. Economic diversification in secondary and tertiary sectors have a positive effect on private investment. Our findings are in line with the current literature showing a reduced impact of FDI in enclaved sectors (extractive activities) on economic development.

To be successful, investment promotion policies in SSA should aim at enhancing economic diversification and be tailored to specific country characteristics (natural resources, labor and capital endowments, economic structure and investment needs). Reallocating public spending towards high-yield public investment and fostering private and international investors partnerships are also key.

Further research is needed on the dynamics between FDI, public and private investment. We should also address possible structural changes in FDI and private investment patterns in the wake of rising FDI from China and other emerging countries in SSA, as well as challenges to the globalization process itself, trade relocation and regionalization spurred by digitalization and the current economic crisis.