The Linkage between FDI and Domestic Factor Markets: Unravelling the Developmental Impact of Foreign Investment

Recent evidence indicates a large increase in FDI to African countries, especially since the 1990s, although in relative terms Africa continues to lag behind other regions. Despite the increase in private capital inflows, these resources have not had meaningful impact on economic development in African countries. This study posits that a key reason for this limited impact of FDI on the host economies is that FDI has had limited effects on domestic factor markets, especially domestic capital accumulation and employment, which are key drivers of economic growth. The study undertakes detailed econometric analysis using a sample of 38 African countries to provide empirical evidence that sheds light on this important issue by exploring the two-way relationship between FDI and domestic factor markets. The results suggest a strong relationship between foreign direct investment and domestic investment that seems to run both ways, but the impact of private investment on FDI is stronger and more robust than the reverse relation. We find no convincing evidence on the linkages between FDI and labour market characteristics and outcomes in this sample of African countries. High wages do not appear to be a deterrent to FDI. Moreover, while high FDI appears to lead to higher wages, the effect does not survive robustness tests. The results have important policy implications. In particular, the evidence suggests that African countries will gain much from measures aimed at improving the domestic investment climate. This will increase private investment, which in turn will attract more foreign capital. The results suggest that repressing wages will not buy much FDI while having adverse social effects. Efforts towards more labour market flexibility also ought to be motivated by other economic and social goals rather than the need to attract more FDI