Do Foreign Direct Investment and Foreign Aid Promote Good Governance in Africa?

The literature on the roles that governance/political and economic stability play to attract capital flows into African economies has been burgeoning. Good governance, liberalization, infrastructure, incentive packages have been regarded as cures to break the deadlock to reverse the economic plight, to attract inflow of capital and, in some cases, to reverse outflows of African economies. The flow of capital, however, has undesirable side effects on host economies’ working conditions, environmental standard, inequality, and culture, among others. These economic and social external or negative spillover effects are due to the phenomenon of “race-to-the-bottom” where companies invest in economies with lax regulations and generous incentive packages. Given the highly expected significant economic impacts of Foreign Direct Investment (FDI) and foreign aid in Africa,, it is becoming clear that the increased inflow of FDI and foreign aid may also have impacts on the political institutions and governance of a nation, especially for the case of economically low income African economies. However, these effects of capital flow on democratic institutions and governance of host economies have not been formally addressed. Using data on governance indicators, FDI, and foreign aid recently made available and other control variables, the present study explores whether FDI and foreign aid promotes or retards governance in African economies. Appropriate estimation techniques that take into account endogeniety in the data as well as heterogeneity of the sample countries are employed. The results of the study show that foreign aid (official development aid) has had immediate and persistent positive effects during the study period. Flow of FDI also has positive, though weak, effects on governance but with no persistent effect. Other forms of official flow, with less grant component, have both immediate and lag negative effects on governance in African economies