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 countys 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, Ethiopias 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 ,Ethiopias 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 study

General 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 Ethiopias 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 firms) 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 exportoriented 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 unemployments, 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 others
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 others home market or in
third-country market for each others product. If one of
the products gain the dominant advantage, the two
companies can invest in each others 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 imperfections
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 investors capital increases when the host
countries currency is devaluated. On the other hand,
frequent and continues line in the value of host countrys
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 countrys 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 Review
Globally, 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 countrys 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 laborintensive 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