CHAPTER ONE

Introduction

1.1 Background of the study Sustainable economic growth is highly determined by the rate of investment which in turn is mainly determined by national savings. The national saving level of countries in Africa is quite low (FDI) is an alternative source of capital to bring the gap between saving and the required investment. Nevertheless, the development role of FDI is highly debated. The proponents of FDI point out that FDI fills savings, foreign exchange, national income and local revenue gaps of developing countries. FDI can also provide managerial, entrepreneurial and technological skills and increase exports and integrate the county’s economy in to the global economic network (Solomon M., 2008).

FDI is particularly important for developing countries since it provides access to resources that would otherwise be unavailable to these countries. Its contribution to economic development and therefore poverty reduction come through its role as acoduite for transferring advanced technology and organizational forms to the host country ; triggering ethnological and other spillovers to domestically owned enterprises; assisting human capital formation;cotribing to international trade integration, and helping to create a more competitive business environment as a result these benefits of FDI ,many developing countries are now actively seeking FDI by taking measure that include economic and political reforms designed to improve their investment (wesministeresarch. Wmin.ac.uk).

In1991, Ethiopia s transition to market oriented economy stared. Since then, the government has made a broad range of policy reforms, including liberalization of foreign trade regime decentralization of economic and political power, deregulation of domestic and devaluation of national currency. in addition, the investment code has been amended several times in order to the demands of both domestic and foreign investors(Solomon M,2008)Statement of the problem

The Ethiopian economy has to grow at least at annual growth rate of 10% for more than tow decades so that the country can attain th per capital income level achieved today by average sub- Saharan African countries. However, Ethiopia’s grow domestic saving is as proportion of GDP is quit low ,and it is unlikely to achieve this growth rate by mobilizing the major domestic saving (EEA,2000&2007). The current government of Ethiopia hasrealizeed the inadequacy of the domestic capital and opened several economic sector to foreign investors. The government has also issued several investment incentives, include tax holyday, duty free importation of capital good and export tax exemption to encourage e foreign investment. Furthermore, Ethiopian Investment Authority (EIA) has been established to service investors and streamline the investment procedures. Nevertheless ,Ethiopia’s performance in attracting FDI is very poor compared to many African courtiers besides, Ethiopians per capita inflows were only $5 in 2006 , compared with $39 for African countries as a whole (Solomon

M ,2008).Therefore, this study will attempt to identify main factors that determine the inflows of FDI in Ethiopia.

Objective of the studyGeneral objective The general objective of the study is: to identify the major determinants of FDI in Ethiopia. Specific objective To identify the policies set by Ethiopia’s government to encourage foreign investors. To measure to what extent saving, exchangerate, and government policies affect FDI.

1.4 Methodology of the study

1.4.1 Type and source of data

This study is entirely depending on secondary data source. The major data sources are world investment repots and courts published by the united nations conference on trade and development (Unctad),National bank of Ethiopia and Ethiopian investment agency (EIA) annual report,

1.4.2 Method of Data analysis

In the study, both quantitative and quantitative method will use to analyze the information collect using different instruments from

different sources’. Average annual FDI in flows, percentages, tables and graph will use to analyze this study.

1.4.3 Model Specification

Determinant of foreign direct investment are: saving, exchange rate, government policies, inflation, population and interest rate etc.

FDI= f(saving,exchange rate, policy)

FDI= saving+exchange rate+policy,I will use mathematical formula In order to clarify this study mathematical formula, I will use the following Econometric model. FDI=Bo+B1S+B2EX+B 3P+Ui

Where; BO, B1, B2, B3 are parameter of the exogenous variable

FDI=Foreign direct investment

S=Saving

EX=Exchange rate

Ui=the error term in which they affect the FDI but they excluded from model Expression; saving; saving and FDI are positive relationship with each other, i will collect the data of saving from 1992 to2007, Exchange rate and FDI are positive relationship with each other and I will collect the data of exchange rate from the year 1992to2007, Govrenment policy and FDI are positive and negative relationship with other, the government policy may changed with in a programs so this policy affect the FDI positively and negatively, if the policy is comfortable and uncomfortable respectively and I represent (1) when it is comfortable for investor and (0) when it is uncomfortable. 1.5 Signif icance of the study

This study will be indicate the necessary measure to taking by the policy maker of the country on FDI inflow, and it can help to enhance investment activates and calls further research s in finding feasible solution s to the low level of FDI in the country.

1.6 Scope of the study

This study will undertake at national level to identify the main factors that determine FDI inflow in Ethiopia. And it includes all foreign investors who engage in all type of investment activities. And it covers the year ranging from 1992 up to 2014.

LIMITATION OF THE STUDY

This study will challenge by lack of efficient data, lack of finance and internet access.

CHAPTER TWO

Literature Review

2.1 Main concept and definition of FDI

An investment by a foreign investor will regard as FDI if the direct investor hold at least 10% of the FDI is not just on a capital movement. In addition to capital will control subsidiary often receives direct input of managerial skills, technology and other tangible and intangible assets. Unlike portfolio investors have substantial control over the

management of foreign subsidiary In fact, balance of payment accountants define FDI as follow of lending to, or purchase of ownership in foreign enterprise that is largely owned by the resident (usually firm’s) of the investing country (Thomas A, Peter H, 2000).According to, the IM (1993) balance of payment manual, ordinary share or voting power of a firm.

FDI will also be classifying in to market seeking export-oriented and government initiated FDI. A market –seeking FDI is highly determined by the growth potential and size of national market, access to regional and global market and country-specific consumer preference. When government s of developing countries invite and give incentives to direct foreign investor to invest in specific sectors and industries with a few to addressing socio economic problem like unemployment’s, regional disparities and deficits in the balance of payment (Accoley Delai and Pearimmanagoe, 1997).Ina similar vein, again based on the primary motive the direct foreign investors, FDI can also be classified in three group: market seeking ,resource-oriented, asset seeking and efficiency seeking (UNCTAD,2007).Resource-asset seeking FDI is attracted by availability of low cost unskilled and skilled labor , strategic nature resources and material. Efficiency seeking FDI is significantly determined by productivity of labor resources, cost of inputs and determined goods (UNCTAD,1998).

According to Chryssochoidis, Millar and Clegg(19970, there are five different types of FDI.The first type of FDI is made to gain access to specific factor s of production, e.g. resources ,technical knowledge , patent or brand names etc.Owned by company in the host country. If such factors of production are not available in the home economy of

the foreign company, and are not easy to transfer, then the foreign firm must invest locally in order to secure access.

The second type of FDI is developed by Raymond Venon in his product cycle hypothesis. According to this model the company shall invest in order t gain access to cheaper factor of production, e.g low cost labor. The government of the host country may encourage this type of FDI if it is pursuing an export oriented development strategy. Since it may provide some form of investment incentive to the foreign company, in form of subsidies, grants and tax concessions. If the government is using an import substitution policy instead, technical or managerial know how that is not available to domestic industry. Such know how may be transferred though licencesing. It can also result in a joint venture with a local partner.

The third types of FDI involves international competitors under taking-mutual investment in one another, e.g. through cross-shareholding or through establishment of joint venture , in order to gain access to each other’s product ranges. As a result of increased competitors among similar product and R&D –induced specialization these types of FDI emerged. Both companies often find it difficult to compete in each other’s home market or in third-country market for each other’s product. If one of the products gain the dominant advantage, the two companies can invest in each other’s area of knowledge and promote sub-product specialization in production.

The fourth type of FDI concern the access to customer in the host country market. In this type of FDI there is no observed shift in comparative advantage either to or from the host country. Export from the company home base may be impossible, for example, certain

service, or the capability to request immediate design modifications. The limited tradability of many services has been an important factor explaining the in growth of FDI in these sectors.

The fifth type of FDI relates to the trade diversionary aspect of integration. This type occurs when there are location advantages’ of foreign companies in third home country but the existences of tariffs or other barrier if trade prevent the companies from exporting to the host country. The foreign companies therefore jump the barriers by establishing a local presence within the host economy in order to gain access to the local market. The local manufacturing presence need only be sufficient to circumvent the trade barriers, since the foreign company wants to maintain as much of the value- added in its home economy.

Theories of FDI

Theories of FDI can be split in to two groups: micro- level and macro-level determinants of FDI. The micro-level theories of determinants of FDI try to provide answer the question why multinational companies prefer opening subsidiary in foreign countries rather that exporting or licensing their product, how MNCs choose their investment relations and why they invest where they do. The micro- level determinant deal with host country situation that determine the FDI.

2.2. Micro-level theories of FDI

2.2.1.1 The early Neoclassical and Portfolio Investment Approaches

According to the early neoclassical approach, interest rate differentials are the main reason for the firm to become a multinational company. In this line of argument, capital moves from a country where return on

capital is low to a place where on capital is high. This approach is based on perfect completion and capita movement free of risk assumption (Harrison,2000).The portfolio approaches to FDI react this early theory of FDI by emphasizing not only return differential but also risk (Alemayehu, 1999). However, the movement of capital is not unidirectional. Capital moves from countries where return on capital is high to countries where return on capital is low and vice versa.

2.2.1.2 The product Life Cycle Theory of FDI

This theory was developed Vernon in 1996. A new product is first produced and sold in home) market. At early stage, the product is not standard, i.e. per unit cost and final specification of the product era not uniform. As the demand for the product increase the productive will be standardize. When the home markets are saturated, the productive will be exported to other countries. The firm starts to open subsidiary in location where cost of production is lower, when the completion from the rival firm intense and the product reaches its maturity. Therefore, FDI is the stage in the product left cycle that follows s the majority s. Therefore, FDI is the stages in the product life cycle that follow the maturity stag(Dunning, 1993).However, it seems that the theory is not confirmed by empirical evidence, as the multinational companies start their operation at home and abroad simultaneously (Chen, 1983).

2.2.1.3 Internationalization Theory of FDI

To increase profitable, some transaction should be carried out with in a firm rather than between and this is one of the reasons why multinational companies exist. In other word, there is transaction that should be internalized to reduce transaction cost and hence increase profitability. This theory may answer the question why production is

carried out by the same firm in different location. One of the reasons of internalization is market imperfection’s any kind of economically useful knowledge can be sailed and licensed. However, sometimes, there are technologies that are embodied in the mind of a group of individuals and not possible to write or sale to other parties. This difficulty of marketing and pricing knowhow forces multinational companies to open a subsidiary in a foreign country instead of selling the technology. In addition, a number of problems may arise if an out of a firm an input to other firm in other country. For instance, if each has a monopoly position, they may get in to a conflict as the buyer f the input tries to hold the price dowel while the firm that produce input treys to raise it .Nevertheless, the problem can be avoided by integrated various activities within a firm rather that sub contracting the activities(Krugman and Obstfeld,2003).

2.2.2 Macro-level Determinates of FDI

The macro –level determinant of FDI include any host countries situation that affect the inflow of FDI ,like market size ,low labor cost ,GDP, inflation, exchange rate , foreign debt, the political situation, etc.

2.2.2.1 The Size of Domestic Market

The size of domestic market is a fundamental determinant of FDI. The wealth and development of a country can be used as proxy to measure the size of the domestic market. Most commonly, per capital income (PCI), which is an indicator of effective demand, is used to measure the size of local market. In addition to PCI, the GDP of a county and the population size are also used as an indicator to measure the size of local market. However, if a firm is export-oriented and not market

seeking, the size of domestic market will not be an important determinant o FDI (Root and Ahemed, 1979) A large market can help firm producing tangible product to achieve scale and scope economics. The domestic market growth rate which s measured in terms of population and GDP growth rate also determine the inflow of FDI into a country (UNTAD, 1998).

2.2.2.2 Low Labor cost

As noted neo-classical economics labor cost is one of the factors that affect the investment decision of foreign investor and this fact has been proven in numerous locations. UNCTAD (2004) reported that availabilities of cheap labor in Chain are taking jobs from Europe and United States. In addition to cheap labor, the out-put labor ratio (Labor productive it also determine the inflow of FDI.

2.2.2.3 INFELATION

Through its effect on the cost of inputs and the price of output, inflation reduce the real return on investment and firms competitiveness’ .Hence , countries that Pursue policies that reduces inflation rate have better chance in attracting FDI. Low and predicate inflation rate is central for the long-term investment of both domestic and foreign companies.. Therefore, higher and unpredictable inflation will decrease the inflow of FDI (Birehanu, 1998).

2.2.2.4 Exchange Rate

Frequent and erratic changes in exchange rate of the domestic currency affect the inflow of FDI (Godberg and Klein, 1997). Exchange rate devolution has two fold roles in explain variations in FDI. On the one hand, the real value of foreign investor’s capital increases when the

host countries currency is devaluated. On the other hand, frequent and continues line in the value of host country’s currency would decrease FDI inflow, as it creates high uncertainty (Accolley et al, 1997)

2.2.2.5 Foreign Debt

Excessive foreign debt is one source of instability and uncertainty in macroeconomic environment of under developed countries and hence this foreign debt is likely to affect adversely the FDI. Excessive foreign debt may signal imminent facial crises and foreshadow the further economic situation in a country (Serven and Solimanon, 1992).

2.2.2.6 Political Stability

The economic process of a country and in particular the inflow of FDI in to a country can be disrupted by unsettled, implicitly, internal or external political disputes and crises. Without stable political situation, whatever the economic environment may be, a country’s effort to create a more hospitable environment for oversea investors cannot be fruitful. Political instabilities can delay FDI until the storm weathers away or diverts away for good (Birhanu and Kibre, 2003).

2.2.2.7Other determinant of FDI

In addition to the mentioned macro –level determinant of FDI, numerous other factors are mentioned as host country determinant of FDI in the literature. Some of them are : contract law, the image of the host country, availability of investment fund, governance, human resource development, degree of openness, urbanization, coherent and stable macro and sectoral policy etc (e.g. Birhanuand Kibre(2003),Asiedu(2002),UNCTAD,1998).

Empirical ReviewGlobally, many empirical studies were conducted to identify the factor that influences the inflow of FDI. Nevertheless, the variables which were identified as determinants of FDI vary from study to study and from country to country. Therefore, in reviewing these studies it is difficult to drive one list of determinants of FDI, especially as some have gained or lost importance over time (UNCTAD, 1998). This review focuses on the empirical studies conducted on determinants of FDI in developing countries and Africa. Batra et al (2003) argue that the determinants of FDI to Africa are different from the determinants to the other parts of FDI. Noorbakthe word. Asiedu (2004) agrees with this argument and states that the in a country leads African countries.Schneider and Frey (1985) research on 80 developing countries conclude that country’s level of development is the major determinant of FDI. Moreover, they explain that political instability in a country in lead to a sharp decline in the flow of FDI. Noorbakhsh et al (2001) find hat human capital is the chief determinant in export-oriented and labor-intensive industries. Root and Ahemed(1979)study thee determinants of non extractive FDI in70 developing countries and find that urbanization, better infrastructure and higher GDP per capita increase FDI inflow.Asiedu(2002) conducted a study on 32 sub-Saharan African countries and 39 non-sub-Saharan African countries over a period of 10 years (1988-1997). She argued that FDI inflows in to sub-Saharan African countries are market seeking. Asiedu(2004) argue

that natural resources and market size the chief determinant of FDI in Africa. She also said that FDI inflow to Africa can be promoted by political and macroeconomic stability, by educated labor force, less corruption and an efficient legal system. UNCTAD (1999) indicates that the bad image of Africa has deterred the FDI inflow in to the continent.Getinet and Hirut (2006) analyze determinants of FDI in Ethiopia and conclude that growth of real GDP, export orientation and liberalization promotes the inflow of FDI while macroeconomic instability and poor infrastructure deter the inflow of FDI.

CHAPTER THREE