Institutional quality, foreign direct investment, and economic development in sub-Saharan Africa

The paper addresses why FDI, though recognized as vital for growth in capital-deficient SSA economies, has not consistently translated into improved economic development. It explores how institutional quality—covering governance, accountability, political stability, and infrastructure—shapes FDI inflows and their development impact. Against a backdrop of declining global FDI returns and Africa’s marginalization in global FDI flows, the study posits that weak institutions deter FDI or channel it into extractive sectors with limited domestic spillovers, potentially displacing domestic investment. The purpose is to empirically assess how institutional quality influences FDI inflows and how, together with domestic investment and infrastructure, these factors affect economic development (proxied by the Human Development Index, HDI) across SSA countries.

Empirical literature shows mixed evidence on the FDI–growth relationship in developing countries. Several studies report positive impacts of FDI on growth via capital accumulation, productivity, technology transfer, and job creation (e.g., Dees 1998; De Mello 1999; Blomstrom et al. 1994; Ayanwale 2007; Osabohien et al. 2020), while others find weak, insignificant, or even adverse effects depending on context and reverse profit flows (Hein 1992; Singh 1998; Herzer et al. 2008; Ojewumi and Akinlo 2017). Determinants of FDI inflows in SSA include infrastructure, market size, natural resources, and institutional factors; corruption and political instability deter FDI (Asiedu 2006; Cleeve 2008). The theoretical framing draws on: (1) neoclassical theory (capital flows to higher returns), (2) intangible capital/monopolistic advantage and internalization theories (Lall 1980; Rugman 1986), and (3) new growth theory (Romer 1986) emphasizing technology, human capital, and increasing returns. Recent discourse stresses the enabling role of institutions in attracting and leveraging FDI for development.

Design: Panel data analysis of SSA countries using fixed-effects and random-effects regressions with a Hausman test to select the preferred model. The dependent variable is Human Development Index (HDI) as a proxy for economic development. Key independent variables include FDI inflows, domestic investment (DOMINV, proxied by gross fixed capital formation), infrastructure (INFSR, access to electricity), political stability and absence of violence (PSAV), government effectiveness (GE), and accountability (ACC). Variables such as control of corruption, rule of law, and regulatory quality were considered but excluded due to multicollinearity. Model specification: HDI_it = a + a1*FDI_it + a2*DOMINV_it + a3*INFSR_it + a4*PSAV_it + a5*GE_it + a6*ACC_it + e_it. This is motivated by new growth theory, where capital includes investment, infrastructure, and human development. Data: Cross-country panel of 39 SSA countries from four subregions (East, Central, Southern, West Africa) over 2000–2016 (country selection based on data availability). Data sources: World Development Indicators (WDI) for HDI, FDI, DOMINV, INFSR; Worldwide Governance Indicators (WGI) for PSAV, GE, ACC. Descriptive statistics summarize means and dispersion across regions. Estimation: Both fixed and random effects were estimated; the Hausman test (p-value 0.00) indicated fixed effects as the appropriate estimator. Pairwise correlations were examined; the highest correlation (0.788) was between HDI and infrastructure, below the 0.8 threshold, indicating acceptable multicollinearity levels.

- Hausman test favored fixed effects (p = 0.00), indicating time-invariant country heterogeneity is correlated with regressors. - FDI inflows are positively associated with economic development (HDI). The model indicates that a unit increase in FDI raises HDI by at least four units (as reported qualitatively), affirming a significant direct association between FDI and development in SSA, particularly pronounced in regions with historically lower FDI inflows (Central and East Africa). - Infrastructure has a positive effect: a 1-unit rise in infrastructure correlates with approximately a 0.03-unit increase in HDI. - Political stability and absence of violence positively affect HDI, with about a 0.01-unit increase associated with a 1-unit improvement in PSAV, and also enhance both FDI inflows and domestic investment. - Government effectiveness and accountability are important institutional determinants influencing FDI attraction and development outcomes; weak accountability and instability deter FDI. - Descriptive patterns: Southern Africa shows the highest average HDI; West Africa the lowest. Central Africa exhibits the greatest challenges in accountability. East Africa recorded high average FDI inflows in the sample period. - Multicollinearity diagnostics indicate acceptable levels (maximum pairwise correlation 0.788 between HDI and infrastructure).

The findings support the hypothesis that institutional quality shapes FDI inflows and conditions their translation into economic development in SSA. Political stability and effective governance create an enabling environment that attracts FDI and strengthens domestic investment, thereby improving human development outcomes. Infrastructure amplifies development effects both directly and by enhancing absorptive capacity for foreign capital. The stronger impact of FDI on development in regions with lower historical inflows suggests that when domestic investment is relatively constrained, marginal FDI can have larger developmental returns, provided institutional conditions are supportive. Conversely, weak accountability and instability discourage FDI and limit spillovers, helping explain why rising FDI volumes have not uniformly yielded broad-based development in SSA. Policy implications include prioritizing institutional reforms and infrastructure to maximize FDI’s developmental impact and to avoid displacement of domestic investment.

The study concludes that improving institutional quality—especially political stability, government effectiveness, and accountability—alongside strengthening infrastructure is essential for attracting FDI and converting it into tangible improvements in human development across SSA. While FDI contributes positively to economic development, its benefits are maximized when domestic investment is nurtured and when foreign capital is directed toward productive real sectors rather than narrowly into extractives. Governments should implement favorable, stability-enhancing policies, upgrade infrastructure, and guide FDI toward sectors that complement and stimulate domestic investment, enabling a gradual reduction in reliance on foreign capital as domestic capacity expands and living standards rise.

- Data constraints limited the analysis to countries and years with available data (39 SSA countries, 2000–2016), which may affect generalizability across the entire region and longer periods. - Some institutional variables (control of corruption, rule of law, regulatory quality) were excluded due to multicollinearity, potentially omitting relevant dimensions of institutional quality. - Results are based on observational panel regressions; while fixed effects mitigate omitted variable bias, causal interpretation remains cautious due to potential endogeneity between FDI, institutions, and development.