DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN

ETHIOPIA

BY:- RAGO TESHOME

ADVISER:- TEMESGEN Y. (MSC)

A SENIOR ESSAY PROPOSAL SUBMITTED TO THE DEPARTMENT OF

ECONOMICS IN FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF BACHELOR OF ARTS IN ECONOMICS

JIMMA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ECONOMICS

January 2015

Jimma, Ethiopia
Acknowledgment
First of all I would like to thank almighty god and for his kindness, for his givens and
guidance through rough road give us the patience and endurance to do this proposal.
Also my deep gratitude goes to my advisor Mr.TemesgenYekob for his continues
support, guidance and constructive comment; it was a pleasure to do this proposal
under his advising. Furthermore I would like thank my friends those who help me
and encouragement. Finally I also like to thank my family for their financial up to
moral support for accomplishing of my education.
 TABLE OF CONTENT
Content page

Acknowledgement........................................................................................................

Table of content.............................................................................................................

Acronyms……………………………………………………………………………..

CHAPTER ONE

1. Introduction.........................................................................................................
1.1. Background of the study.....................................................................................

1.2. Statement of the problem....................................................................................

1.3. Objective of the study..........................................................................................

1.3.1 General Objective........................................................................................

1.3.2 Specific objective.........................................................................................

1.4. Research Question................................................................................................

1.5. Significance of the study.......................................................................................

1.6. Scope of the study.................................................................................................

1.7. Organization of the study………………………………………….……………

CHAPTER TWO

2. Literature Review................................................................................................
2.1. FDI concept and definition………………………………………………………

2.2. Theories of FDI.....................................................................................................

2.3. FDI performance in Ethiopia……………………………………………………

2.3.1 The pre -1991 period........................................................................................

2.3.2The post-1991 period.......................................................................................

 2.3.3 The FDI regulatory Framework......................................................................

2.3.4 Regional distribution of FD…………………………………………………

2.3.5 Sectorial distribution of FDI.............................................................................

2.3.6 FDI flow by country of origin..........................................................................

2.3.7 Flag FDI institution of framework...................................................................

2.4. Empirical study......................................................................................................

CHAPTER THREE

3. Model specification and methodology………………………………………

3.1 Data and empirical methodology…………………………………………..…….

3.2 Definition of the variable...............................................................................,,......

3.3. Model specification.........................................................................………..……

3.4. Methodology of the study......................................................................................

3.4.1. The Engle Granger Approach.......................................................................

3.4.2. The ADF test of unit root...............................................................................

CHAPTER FOUR

4. Budgeting andscheduling....................................................................................
4.1 Research timetable................................................................................................

4.2 Cost budgeting......................................................................................................

 ACRONOMY

EEA- Ethiopian economic agency

EIA- Ethiopian investment association

FDI-Foreign direct investment

GDP- Gross domestic product

GNI- Gross national income

IMF- International Monetary fund

MNO- Multi-national Corporation

SSA-sub-Sahara of Africa

UNCTAD- united nation conference of trade and development

WB- World Bank

WTO- world trade organization

 CHAPTER ONE

1. Introduction

1.1. Background of the study

Foreign direct investment (FDI) is an integral part of an open and effective international
economic system and major catalyst to development. However the benefit of foreign direct
investment do not accrue automatically and evenly across countries sectors and local
communities, national policy and international indictment architect are matter for attracting
foreign direct investment to a large number of developing countries and for reaping the fall
benefits of FDI for development the challenges primary policy instrument for investment and to
build the human and institution capacity to implement them (UNCTAD, 1999).

Sustainable economic growth is highly determined by the rate investment which in turn is mainly
determined by the national saving level of the countries in Ethiopia is quite substantiate (i.e.
between 1990 and 1997 gross domestic investment as proportion of GDP rose from 12% while
gross domestic saving remained at the same rate (UNCTAD.2002). this saving gap can be filled
by loan and development assistance from multilateral agency such as the world bank or private
foreign investment. Foreign direct investment is an alternative source of capital to bridge the gap
between saving and the required investment level. Nevertheless the development role of FDI is
highly debated. The proponent of FDI point out that FDI fill saving of foreign exchange and
local revenue gap of developing economics. FDI can also provide managerial, entrepreneurial
and technological skill and increase export and integrate the country’s economy into global
economic .NETWORK,(SOLOMON,2008).

In recent time however, most empirical studies conclude that FDI enhance for productivity the
efficiently of resource use and national income of the host country. A study on 58 developing
countries also concludes that FDI enhances private domestic investments. The rapid growth in
FDI over the last few decade has spurred large body of empirical literature to examine the
determinants and growth enhance effects of FDI can be wide ranging since FDI typically
encompasses package of capital as well as technical managerial and organizational known how
FDI is particularly important for developing countries since its contribution to economic
development and therefore, poverty reduction come though its role as a conduct as arises of
these benefits of FDI may developing countries are now actively seeking working investment by
taking measures that include economic and political reform designed to improve their
investment.(Getinet and Hirut ,2006)

Foreign direct investment inflows (FDI) to developing countries have remained a small fraction
in the countries total investment most of which is accounted for by domestic sources however,
that forcing investment may be qualitatively different from domestic investment. Moreover in
recent years FDI has become far away the largest source of foreign countries funds flowing to
developing countries. In 2003 for example FDI accounted for 72 of all resource flow to
developing countries. This in sharp constant to late 1980s and early 1990s,when official flow and
FDI flow were nearly equal. This is also different picture in comparison with the mid 1990s
when portfolio flow plus commercial loan and FDI flow in to LDCs reached new record after
2005. MNC’s, employ relatively small through rapidly growing number of people in LDC’s the
job to be concentrated in the modern urban sector. But foreign direct investment involves much
more than he simple transfer capital or the establishment of local factory in development
(UNCTAD, 1998).

1.2. Statement of the problem

The Ethiopian economy was grows at annual growth rate of 10% for more than one decade. So
that country can attain the perceptive income level. However Ethiopian gross domestic saving as
proportion of GDP is out low and is unlikely to achieve this growth rate by mobilizing the
meager domestic savings (EEA, 2000 and 2007)

The current government of Ethiopia has realized the in adequacy of the domestic capital and
opened several economic sectors to foreign investors. The government has also issued several
investment incentive including tax holiday, duty free importation of capital good and export tax
exemption to encourage investment .furthermore, Ethiopian investment authority (EIA) has been
established to service investor and stream line the investment procedures. Nevertheless Ethiopian
performance in attracting FDI is very poor as compared to many African countries, f or instance
Ethiopian accounted for only 1.56% of the total FDI flow coming to Africa besides Ethiopia
precipitate inflow were only 5% in 2006 compared with and 39 for African countries. (Solomon,
2008).
As a recent study of foreign direct investment in Ethiopian, some researcher clarify different
variable that affect adversely and directly foreign direct investment inflows. For example,
Getinet Haile &HirutAssefa(2005) of FDI in Ethiopia , use growth rate of real GDP, export
orientation, liberalization, macroeconomic instability and poor infrastructure as a variable and
they identify that growth rate of real GDP, export orientation , and liberalization have positive
impact on foreign direct investment. On the other hand macroeconomic instability and poor
infrastructure have negative impact on FDI.

In general, the entire researcher identifies some important factor that determines the FDI in
Ethiopian and they also put the main reason that attracts foreign direct investment. But a few of
other does not compare the educational enrollment, openness and real growth domestic product
per capital to attract foreign direct investment in to the country.

To decide development and to come up with prosperous Ethiopia by identifying the problem of
foreign direct investment and gives the resolution is needed to investigate standard development
at hand. In this paper the justification of identifying determinants of foreign direct investment in
Ethiopia through econometrical analysis is a key step to know the factor responsible for the low
performance of Ethiopia in attracting foreign direct investment.

1.3. Objective of the study

1.3.1. General objective

 The general objective of the study is to identify the major determinant of foreign
direct investment in Ethiopia between 1975-2010.

1.3.2. Specific objective

 To analysis econometrically the macroeconomic determinant of FDI in Ethiopia between

1975-2010.
 To show the performance of foreign direct investment in Ethiopia.
 To investigate the major determinant of foreign direct investment inflow in Ethiopia
 To forward possible policy recommendation
1.4. Research question

 What are the major determinants of foreign direct investment inflow in Ethiopia?
 How the countries policy is essential for attracting foreign direct investment to Ethiopia?

1.5. Significance of the study

Both political and social effects are associated with foreign direct investment. Therefore, the
study will be gives as:

 It will give important source for policy maker to take appropriate measure as an input.
 It will be a guide line for investor and other organization to set up policy and strategy in
relation to foreign direct investment.
 It is important in filling the knowledge gaps as a research conducted in this area is scanty
and it will invite other research to investigate more.

1.6. Scope of the study

Even the scope is wide, but study is particularly emphasized on the major determinant of FDI
inflow in Ethiopia.

1.7 Organization of the study

This study will be organized into five chapters. The first chapter deal about introductory part, the
second chapter is literature review of FDI while the third chapter discusses the model
specification and the methodology and the fourth chapter is the estimation result. Lastly the final
chapter is conclusion and policy implication.
 CHAPTER TWO

2. LITERATURE REVIEW

Foreign direct investment (FDI) is the net inflow of investment acquire lasting management
interest (10 percent or more of voting stock) in an enterprise pirating on an economy other than
that of the investors .it is the sum of equity capital ,Reinvestment of earning other long term
capital and short term capital as show in the balance of payments. This shows total net, FDI in
the reporting economy from foreign source less net FDI by the reporting the economy to the rest
of the world (pigato, 2000).

Foreign direct investment is considered as a key ingredient for economic growth in developing
countries. Since host should clear the way to investigate development of FDI. Several studies
have been conducted on the road of development want. Therefore this chapter reviews theories
of determinant of FDI and macroeconomic variable of FDI studies accompanying the theories.

2.1 FDI Concept and Definition

Foreign direct investment is not a capital movement .In addition to capital a controlled subsidiary
receives direct input of managerial skills, technology and other tangible and intangible assets.
Unlike portfolio investor, direct foreign investor have substantial control over management of
subsidiary. In fact Balance of payment account define account define FDI as any flow of
purchase of owners in a foreign enterprise that is largely owned by the resident of the investing
country >> (Thomas Acited in Solomon, 2008).

According to the IMF (1993) balance of payment manual, an investment by investor is regarded
as FDI if direct investor hold at least 10% of the ordinary share or voting power of a firm, direct
investment reflect the aim of obtaining a last interest by residence entity of one economy (direct
the enterprise and all subsequent capital transition between them and among affiliated enterprise.

The lasting investment implies the existence of a long term relationship between the direct both
in cooperated establishing the relationship between the investor and

There are different types of FDI. These include green filed investment, cross border- merger and
acquisition and reinvestment earning .FDI can also be classified in to market –seeking export
oriented and government initiated FDI, a market –seeking FDI , a market –seeking FDI is highly
determined by the growth potential and the size of national markets asses to regional and global
markets country –specific consumers preference .when a foreign firm produce row materials,
Intermediate and final goods and sells these product for non –local market ,This FDI is called as
expert –oriented FDI. An investment is called gov’t initiated FDI, when gov’t of developing
countries invite and incentive to foreign direct investor to invest in a specific sector and
industries with a view to addressing socio economic problems like un employment ,regional-
disparities and defect in the balance of payment (Accolly etal,1997).

In similar vein again based on the primary motive of the direct Foreign investor FDI can also
classified in to the following three group market –seeking ,resource/Asset-seeking and efficiency
seeking (UNCTAD,2007)Belied these, there are also two other crucial determinates of FDI; host
country FDI policy France work and business facilitation .

2.2 Theories of FDI

Theories of FDI can be split in to two groups: micro –level determinant of FDI and macro- level
determinant of FDI. The micro level theories determinant of FDI try to provide answer the
question why multinational companies prefer opening subsidiaries .In Foreign country rather
than exporting or licensing their product ,how MNG, choose their investment location and why
they harvest were they do. The macro-level determinates deal with the host countries situation
that determines the inflows of FDI. According to the early neo-classical approach, in fenestrate
differentials are the main reason for the frame to be comes a multinational company. In this line
of agreements capital moves form a computation and capital movement free of risk assumption
(Harrison teal, 2000).The portfolio approach to FDI reacted to this early theory of FDI by
emphasizing not only return differentials but also risk(Alemayo,1999).

The eclectic Paradigm view that FDI is determined by the dynamics of three interdependent
variables. Firm specific ownership advantage, location specific advantages, and cross border
intermediate product and market internationalizations advantages.

Macro level determinates of FDI; it includes the any host countries situation that affects the
inflow of FDI, like market size, the economic growth rate, GDP, infrastructure, natural resource,
the political situation, exchange rate variability, geographical proximity etc.
2.3 Foreign Direct investment performance In Ethiopia

The Ethiopian economy is highly dependent on agriculture, which accounts for 45

Percent of GDP. Around 80 percent of the population derives its livelihood directly or
indirectly from agricultural production. Various studies indicate that agricultural
exports, mainly coffee and processed and semi-processed hides and skins, account for
over 80 percent of all exports, with coffee alone accounting for over 64 percent of
Foreign exchange earnings. Manufacturing, mining, trade, tourism, construction,
services, and other sectors make up the remaining 55 percent of GDP.
The Ethiopian economic and FDI performance over the study period (1975-2010) can
be reviewed on the basis of the two regimes that have been in place in the country.
The first period, 1974-1991 (the pre-1991 period) relates to the period when policies
that were in place were more or less in line with the command system of economic
Management. The second period, the post-1991 period, signify some move away from
The command system and commenced with the stabilization and adjustment programs
(SAP) of the World Bank (WB) and the International Monetary Fund (IMF). In the
section that follows some of the major features of the two periods in terms of
economic performance and the FDI policy framework in Ethiopia will be reviewed.
2.3.1 The pre-1991 period
This period marked the introduction of the command system of economic
Management in 1974. The mainly liberal policies of the pre-1974 Imperial/feudal era
Were replaced with centralized policies that discouraged market economy and private
Property. The land reform measure that was undertaken in 1975 was one of the major
Policy reforms that took place immediately. Land was nationalized and private
Ownership of land ceased. Medium-size and large enterprises were also nationalized.
The government also nationalized and subsequently reorganized private banks and
Insurance companies. In general, the economic performance of the pre-1991 period
Was characterized by three phases. During the first phase of the regime 1974-78,
Economic performance was poor due to the emerging new policies and the
Nationalization measures. Average annual growth rate of GDP was 0.3 percent while
per capita growth was negative. During the second phase of the regime, 1978-80, the Economy
began to recover and the growth rate increased to 4.6 percent. This period was characterized by
stability and it also benefited from good weather.
Agricultural Production increased at an average annual rate of 3.6 percent. But in the third phase
1980-1985, the economy performed badly again. The major reason for this was the
Severe drought that affected almost all regions of the country. After this period the
economy continued to stagnate. To tackle the structural problems of the country the
government eventually adopted a long-term plan (the Ten Year Perspective Plan). The
aim of the plan was to reduce the share of agriculture in GDP, increase the share of
industry, increasing foreign exchange earnings, diversification of the country’s export
sector and real GDP growth of 6.9 percent per annum during the target period
However, most of the targets were not realized. Growth remained at about 2 percent
and GDP per capita was negative during the pre-1991 period (Geda and Degefe,
2002)
The investment climate in general and FDI in particular was not encouraging during
this period. The problems of political instability, insecurity, and the nationalization of
major industries severely discouraged foreign private investment. Realizing the
importance of FDI, the government then attempted to revive FDI through the 1983
Joint Venture Proclamation. The proclamation offered incentives such as a five-year
period of income tax relief, import and export duty relief, tariff protection and
repatriation of profits and capital. However, the proclamation failed to attract foreign
investors. In 1989, the government revised the 1983 proclamation by allowing
majority foreign ownership in many sectors. It also attempted to provide more
protection to investors. However, the political instability and the prolonged civil war
at the time further discouraged FDI. The political instability got worse and it
consequently led to the overthrow of the regime in 1991.
2.3.2 The post-1991 period
The post-1991 period began with the coming to power of TPLF/EPRDF in 1991 and
the adoption of the WB/IMF sponsored Structural Adjustment Program soon after.
Among the stated objectives of the new government were/are: reducing
macroeconomic imbalances, eliminating structural distortion, improving the country’s
human capital and infrastructure as well as poverty reduction. Also the government
implemented a series of reform measures in order to change the command economic
system that had been in place to a free market economy.

To speed up the integration of the economy into the world economy and to encourage the wider
participation of the private sector in the development process of the national economy (FDRE-
MOFED,2002).
The specific measures taken to promote the export sector and participation of
the private sectors include the following:
_ Deregulation of domestic prices
_ Devaluation of the national currency by 141.55 percent, from 2.07 birr per
dollar to 5 birr per dollar;
_ Liberalization of the foreign exchange market
_ Elimination of Export taxes except for coffee;
_ Lowering of Maximum import duties from 230 percent to 60 percent;
_ Simplification of Export licensing regulation and procedure;
_ Provision of adequate incentives, strengthening and enhancing
institutional support for the export sector.
Increasing the role of the private sector in the economy being one of the main
objectives of the government, the privatization program was started in 1994. The
Ethiopian Privatization Agency (EPA) which has the power and duties of transferring
state-owned enterprises to private ownership was established. To date, the
government had privatized 200 enterprises to domestic and foreign investors
(AFDB/OECD, 2003). The government has also adopted “agriculture-led
industrialization” as a central plank of its development program, with a focus on
productivity growth on small farms and labor-intensive industrialization” (Economic
Commission for Africa, p.83, 2002). Except for the two year period of conflict with
Eritrea (1998-2000), the reform measures have brought about some positive changes.
Economic growth during this period (1992-2001) has improved with an average rate
of 5 percent. GDP per capita has also grown by 2.4 percent per annum and the rate of
inflation declined from 21 percent in 1992 to less than 5 percent in 2001. By 2000/01
total investment accounted for 16 percent of GDP (Geda and Degefe, 2002; Economic
Commission for Africa, 2002). The overall GDP growth rate over this period (1991-
2003) stands at 4 percent (Andrews, et al. 2005) faring moderately better to the pre-
1991 growth performance that stood at 2.8 percent.
Although domestic investments constitute the main component of capital formation in
Ethiopia, accounting for about 64 percent of total investment, FDI has started to play
some role in the country following the 1992 liberalization program (see Table 1 in
the appendix). The reforms as well as the government introduction of investment
guarantee schemes and incentives helped to raise the share of inward FDI in total
investment form 0.04 percent in 1992 to 27 percent in 1997 (Figure 1). However, the
war with Eritrea in particular has disrupted the rising trend of FDI inflows.

Table 1.investment capital project,1992-2001

Indicator Number of project Investment capital(in Percentage of total
million of birr) investment
Private domestic 6195 46167 64.3
investment
Public domestic 33 11072 15.4
investment
Foreign domestic 282 14610 20.3
investment
Total investment 6510 71850 100
SOURCE: UNCTAD (2004)
According to Ethiopian Investment and Innovation Policy Review (UNCTAD, 2002),
the Middle East accounted for the largest share of the post-1992 FDI projects in the
country. This was followed by the European Union as the second largest source of
FDI to Ethiopia over the period 1992 to1998 (see Table 2 in the appendix).
Table 2. Foreign investment project by region of origin 1992-mid1998

Region of origin Number of project percentage

Middle east 49 32
European union 42 28
Africa 26 17
North America 14 9
Asia 13 9
Other Europe 6 4
Other 2 1
Total 152 100
Source: UNCTAD (2002), Ethiopian investment and innovation policy review.

2.3.3 Regulatory and institutional framework of FDI in Ethiopia

Implementing market oriented development strategies encourages the role of the
private sector involvement in the development process. In order to encourage,
promote and expand private investment in the country; the Ethiopian government has
set out some private sector development initiatives. These initiatives are about
enabling the enhanced utilisation of the country’s resources through the growth of
private businesses by providing predictable and enabling environment (FDREMOFED,
2002). The programmed highlights the importance of competitiveness as a
key to success for sustained economic development in the country. Some of the
important factors mentioned as a basis for competitiveness include conducive
Investment climate, which focuses on macro-economic stability, sound policy and
regulatory framework for the private investment sector and strong institutions that run
and support the system.
2.3.3.1 The FDI regulatory framework
Under the current regulatory framework, foreign participation in investment may be
carried out either through the establishment of branches or through locally
incorporated enterprises. Foreign investors are encouraged to invest in all economic
sectors, except those currently reserved for domestic private and state investment.
The piecemeal nature of the reform process and inefficiency associated with it, the growing
culture of corruption, the expansion of parastatals and, particularly since 1998, the growing
political Uncertainties in the country are also to blame for the drop in FDI. According to recent
reports, Ethiopia is one of the countries in Africa, the continent with the least attraction for FDI,
that fares poorly in terms of its rank in ‘Ease of doing business.
There is also a continuous review of the investment code regarding the sectors
excluded from FDI. For example, the revised investment proclamation No.116/1998
has opened up the hydropower generation to local and foreign investment. The 1998
investment code also allowed private-government joint investment in defense and
telecommunication. The main business sectors which are open and in which the
country is currently seeking foreign investment include:
 Manufacturing industries (including food, beverages, chemicals and
Pharmaceuticals, plastics, metallic and non-metallic products, paper products,
Leather and leather products, textiles and garments);
 Agriculture, including agribusiness and processing for exports;
 Real-estate development;
 Education and health services;
 Grade 1 construction contract;
 Mining and quarrying of gold, marble and granite; and
 Engineering and management consultancy.
Since 1996, with the objective of promoting private investment and the inflow of
foreign investment, a series of investment proclamations have been issued. These
proclamations impose some requirement and ownership limitation. There is a
minimum entry capital for FDI for both wholly-owned operations and joint ventures
with Ethiopian companies or individuals. In the case of joint venture the investment
proclamation requires that domestic partners must hold a minimum of 27 percent
equity ownership interest. Moreover both FDI and domestic investors are required to
submit progress reports every six months. Apart from these requirements, investors
are not required to meet specific goals like local content requirement or operational
guidelines (UNCTAD-ICC, 2004). The investment legislation has also attempted to
provide a favorable investment climate by offering fiscal incentives and investment
guarantees to foreign and domestic investors engaged in new enterprise development
and expansion. The major investment incentives for FDI include: 100 percent
exemption from payment of import duties and import taxes levied on all capital
equipments; exemption from payment of export taxes (except for coffee); income tax
holidays varying from one to five years; tax deductible research and development
expenditure; no taxes on the remittance of capital; the carrying forward of initial
operating losses and investor choice of depreciation model of capital assets.
The Ethiopian investment codes also provide guarantees to create a reassuring
business environment for potential foreign investors. Specific investment guarantees
that have been issued for FDI include: full repatriation of capital and profits including
dividends and interest payment on foreign loans; payments for technology transfer
and management agreements; full repatriation of proceeds from sale or transfer of
shares or liquidation of enterprises. Moreover, the investment proclamation
No.37/1996 provides investment guarantees against measures of expropriation and
nationalization, except in major cases of public interest when full market value will be
paid promptly (UNCTAD-ICC, 2000).
2.3.3.2 The FDI Institution frame work

The government of Ethiopia has established the Ethiopian Investment Authority (EIA)
to promote, coordinate and facilitate foreign investment in the country. According to
the Investment Guide to Ethiopia (UNCTAD-ICC, 2000) the functions of the EIA,
Among others, include:
 Providing all the necessary information required by foreign investors;
 Approving foreign investment applications and issuing investment Permits;
 Providing registration services to newly incorporated business
Organizations;
 Approving expatriate posts in approved investments and issuing work
Permits to foreign employees;
 Issuing trade and operating licences for foreign investments;
 Monitoring the implantation of licensed investment projects;
 Approving and registering technology transfer agreements between
local companies and foreign technology suppliers; and
  Facilitating the acquisition of land by foreign investors in accordance
with the relevant federal and regional Government laws and
regulations.
It has been reported that as of December 2003 the EIA has processed a total of 572
FDI projects, of which 77 projects have become operational while another 103
projects are under implementation. The rest 392 projects are approved foreign
investment projects awaiting implementation (Table 4). Out of the 392 FDI approved
projects the manufacturing and processing sector accounted for the highest share,
46.57 percent, followed by trade, hotels and tourism 40.7 percent; and agriculture and
mining 12.7 percent. (UNCTAD, 2004).
Table 3.foreign direct investment in Ethiopia, December 2003.
Status Number of project Foreign investment
cumulative in million dollar
Operational 77 486.66
Under construction 103 724.43
Approved 392 2172.49
Total 572 3383.58
Source: UNCTAD(2004)
The establishment of the Ethiopian Privatisation Agency (EPA) is also another
significant step in the promotion of FDI. The government is keen to encourage the
participation of foreign investors in the privatisation programme, particularly in large
state owned companies. Other government departments that are involved in the
attraction of FDI to Ethiopia include: the Ministry of Trade and Industry; the
ministries and agencies associated with specific sectors such as mining and tourism;
the ministry of Foreign Affairs and ministries dealing with taxation remits including
customs. Moreover there are regional investment promotion agencies that encourage
FDI into their region (UNCTAD, 2002). The establishment of the EIA and other
investment promotion and support institutions is also a step forward in the right
direction. This, however, necessitates high coordination among the various
institutions to raise the effectiveness of the present national effort to attract FDI.
Thatthe Ethiopian Investment Authority has recently restructured itself to improve the
efficiency and effectiveness of the service delivery processes for investors is a
measure that recognises the need for effective co-ordination.

2.3.4 Regional Distribution of FDI

FDI flows to Ethiopian have been unevenly distributed among the region .Even though the
incentive system encourage Foreign investor to invest in the least developed region (Gambela
Afar, Somalia, and Benshangul gumuz) of the country by providing special benefit including
provision of land free of any charge their performance in attracting FDI is very poor (EIA ,2008
and tagesse ,2001)

2.3.5 Sectorial Distribution FDI

The FDI flow to Ethiopian is fairly diversified in to the three main sectors. The primary sectors,
the secondary sectors and tertiary sectors. According to the statistics provided by Ethiopian
investment Authority (EIA), cash crop forming is the most attractive sector for foreign investor
in Ethiopia.

2.3.6 FDI Flows by Country of Origin

Word wide developed countries are the major source of FDI flows .Nevertheless more than 60%
of FDI flow to Ethiopian are originated from developing economies (Sudiarebia ,India And
China). This might indicate that Ethiopian could not provide an attractive business environment
for FDI originate from developed economies.
2.4 Empirical study

Previous study by different scholars has revealed several determinant of FDI in flow. Blongen
(2005) identified determinates of FDI in flow in partial Equilibrium frame work and general
Equilibrium frame work that is factors that affect FDI at firm level and country level .some
determinate which are covered by Blongen (2005) are exchange rate ,taxi institution and trade
protection (Blongen 2005). Tsen (2005) stated that education infrastructure market size or
current account balance leads to UN increase in foreign direct investment.

Through natural resource abundance is a common factor explaining much of the FDI inflow of
the few successful Africa countries have also put particular attention to the creation of favorable
economic social and political environment to FDI.

FDI is dependent variable and distance between host and home countries GDP growth ,market
size ,risk ,Trade openness are used in independent variables .The economic development which
is indicated by GDP growth rate is important factor for foreign direct investment inflows. trade
openness which is computed as export plus import divided by GDP had positive effect on FDI in
flow to the host countries inflation which is indicator of economic stability has negative effect
on FDI Flow. According to Astatike and aseffa (2005) studies they did time series analyses
determinant of FDI in Ethiopian .The study focused on market size (Real GDP per capital and
real GDP growth rate) Export orientation (export as a percentage of GDP), macroeconomic
stability (rate of in flatiron based on consumer price index), infrastructure (gross fixed capital
formation and number of telephone) human capital (rate of adult illiterate) and trade
liberalization.
CHAPTER THREE

3. Model specification and Methodology

3.1 Data and empirical methodology

This section present a general description of the data and empirical methodology used in this
study. Secondary data will be employed in the present study for the period 1975-2010 and the
data source are world investment report and country report published (UNCTAD) and the
Ethiopian Investment Authority (UNCTAD,NBE MOFED and EEA)

3.2 Definition of Variables

The word bank development indictor (2003) defined FDI as the net amount invested or invested
by non-resident to acquire a lasting interest in which they exercise significant managerial control.
These are number of FDI variable included in world development indicators. In line with the
approach used in the FDI literature, the dependent variable used in this study is the foreign direct
investment inflow as percentage of GDP.

The choice of independent variable is constrained by the data availability hence this study used
the following variable that are commonly used in studies of FDI.

1.Markat size -:the market size hypothesis state that multinational firms attracted to a larger
market in order to utilize resource efficiently and exploit economic of scale ,market size has been
represented by real percapita GDP and growth rate of real GDP (as markets growth potential)

Real GDP per capital is included in the regression as measures of market attractiveness and FDI
is expected to be positively related to these two variables.

2. Openness-Promote FDI and one indicator of openness is free Trade. Openness is

hypothesized to raise growth through several channel, such as access to advanced technology
from abroad, greater access to a variety of input for production, access to broader market that
raise the efficiency of domestic production through increased specialization. Hence a level
playing field is viewed by advocate to promote export by comparison with import substitution
policies.

3. Human Capital:- human capital is considered to be an important factor for location

Strategies of multinational companies. When investing for the long term in another
Country, multinational companies have in mind the human resources in the host
Country. Large, efficient, educated population is a requirement for an attractive
Investment. The more educated the population is, the more likely it is for a country to
Attract more FDI (Lewis, 1999). In this study, human capital is given by secondary education
enrollments level . This indictor is expected to be positively correlated with FDI.

4. Average weighted exchange rate.

Frequent and erratic change in exchange rate of the domestic currency affects the inflow of FDI.
Exchange rate devaluation have a twofold role in explaining variation in FDI. On the other hands
real value of foreign investor s capital increase when the country’s currency is developed . A
frequently and continuous decline in the value of host country’s currency would decrease FDI
inflow, as it creates uncertainty

5. Physical investment: has been defined as a fixed and initial resource used for production or
good and provisions of service and the development of science and technology .The importance
of physical investment hence lies on the fact that higher accumulation of capital stock in an
economy increase the potential for economic growth by increasing productivity. It is central
position in the economy.

3.3 Model Specification

The general form of the model estimated has the following form

FDI= f(RGDPC ,OPP,EDU,GFCF ,RWER)----------(1)

Where:

RGDPC- Real growth domestic product per capital

 OPP-Openness (Export plus import /GDP)

EDU-secondary education enrolment

GFCF- Gross Fixed capital formation

RWER-real weighted exchange rate.

Since this study covers the period of 1975-2010, and the variable discussed in the previous
section constitute time series information ,the modeling strategy is one involving time series
analysis, and the model employed can be given by:

FDIt= α+β1RGDPPCt +β2OPPt +β3EDUt+β4GFCFt+β5RWERt+et ..................(2)

3.4 Methodology of the study.

To identify the major determinable of foreign direct investment in Ethiopia, the researcher will
employ by the econometric model, the ’’VAR’’ is assuming the variable, within the model
endogenous.

If the variable are integrated of the same order I(1)then are stationary of integrated of order one
if is better to find the linear combination of the non- stationary variable which is stationary,
efficient estimate. This possible done by co-integration analysis of determining there long run
relationship by identifying the equation by using the angle granger approach. It will discuss en
brief of the methodology in the following sub section

3.4.1 The Engle Granger Approach

The Engle and Granger approach state that if all series are I(1) test the stationary of the error
term after predicting for the OLS estimation. If the error terms are stationary then the series have
long run relationship using OLS estimation

3.4.2. The ADF Test of Unit Root

The augment dickey fuller (ADF) statistic, used if the test will be used to identify the existence
of a unit root. Based on this, it will proceed to transform the non- stationary time serious to make
them stationary. If the time series under consideration has a unit root its first difference will be
stationary which called a difference stationary process, It is also used if the test is a negative
number. The more negative, it is the stronger the rejection of the hypothesis that there is a unit
roots at some level of confidence. The testing procedure for the ADF test is the same as for
dickey fuller test but it applied to the model.

The form of ADF is:

𝑝
FDIt=δ +βFDIt + ∑𝑖=1  FDIt − 1 +Ut

Augmented Dickey-fuller for FDI

Whereas: β=1-

H0: β= 0 VS H1: β≠ 0

This implies rejection of the null hypothesis shows that time series is stationary. whereas non- rejection of the

null hypothesis mean that time series is non- stationary.

The long rum model is expressed as

FDIt =α+ β1RGDPCt+ β2OPPt + β3EDUt+ β4GFCFt + β5RWERt + eit

Where FDI-dependent Variable

, RGOPC- expected sing positive

OPP - expected sign positive

E D U- >>> positive

GFCF- >>>> positive

RWER- >>> positive

CHAPTER FOUR

4. Estimation result and discussion

4.1. Tests for stationarity
Stationary time-series is said to exist if the mean and variance
are constant over time while the value of the covariance between two periods depends
only on the gap or lag between the two time periods and not the actual time at which
the covariance is computed (Gugarati, 2003). If the time-series is non-stationary, the
mean, variance or covariance will not be constant and one is likely to end up with
spurious regression where statistical inference on the basis of the classical regression
model will be invalid. For the purpose of testing the stationarity of the time-series used in this
study, Augmented Dickey-Fuller tests have been conducted. The null hypothesis in these tests is
that the underlying process which generated the time series in non-stationary. This will be tested
against the alternative hypothesis that the time-series information of interest is stationary. If the
null hypothesis is rejected, it means that the series is stationary i.e. it is integrated to order zero.
If, on the other hand, the series is non-stationary, it is integrated to a higher order and must be
differenced till it becomes stationary. As can be seen from the results given in Table
below, all the variables used in the model are stationary at level. This implies that the null
hypothesis cannot be rejected and that the time-series has to be differenced. We then conduct the
same tests on the first difference of the time series. As can be seen from the test results on the
first difference given in Table, the null hypothesis has been rejected for all variables indicating
that all variables become stationary at their first difference.
Test of stationarity

Without trend with trend

variable
Variable at level (I0) Variable at level (I0)
-3.0060** -3.683
dlnfdi
-4.627* -5.407
dlnrgdpc
-10.452* -10.289
dlngfcf
-3.215** -3.313
dlnrwer
-4.067* -3.944
dlnsde
-5.443* -5.478
dlnopp
1% critical value=-3.689 * state that rejection of non-stationary at 1 %

5% critical value =-2.975 ** state that rejection of non-stationary at 5%

10% critical value =-2.619 *** state that rejection of non-stationary at 10%

4.2. Long run analysis

The model specified for estimation purpose has been the following

LnFDI=α+β1lnRGDPC+β2lnGFCF+β3lnRWER+β4lnSDE+β5lnOPP+ui

The estimation result from the above equation is stated in the following table.
Long run model result

variable coefficient standerd error t-stastistics probability

lnrgdpc 0.3059085 0.1320257 2.32 0.028

lngfcf -0.0187884 0.485837 -0.39 0.702

lnrwer 0.4131647 0.817461 1.75 0.090

lnsde 0.3198465 0.446937 7.16 0.000

lnopp 0.3965542 0.736832 5.38 0.000

cons -4.267332 1.095632 -3.89 0.0001

Number of observation=35 prob>F=0.000

2
F(5,30)= 180.66 R =0.9679

ADJ - SQUARED=0.9625

Root MSE=0.1214

lnFDI=-4.27+0.3059lnRGDPC-0.01878lnGFCF+0.4131lnRWER+0.3198lnSDE+0.3955OPP+Ui

From the result of above table show that the model explained FDI very well as can be seen from
R2. Accordingly 96% of the change in FDI is due to the change in the independent variable
involved in the model. The F- statistics (the null of which is that the all slope of coefficient are
zero) indicate that all explanatory variable jointly explained the dependent variable at one
percent level. Moreover, all independent variable have heir expected sign and significant except
for the gross fixed capital formation is not its expected sign and insignificant.

The coefficient of real GDP per capital is positive and it is significant showing that FDI is highly
determined by RGDPC through utilizing resource efficiently and exploited economic of scale.
the coefficients of gross fixed capital formation is expected to be positive but it become negative
and insignificant on the estimation result. This may be due to low level of provision of service
and the development of science and technology. Openness to international trade has positive and
significant. This shows FDI is highly determined by openness and favorable to the economy
since the economy improve as it get more open to international trade, by increasing the
competitiveness and efficiency of the domestically operating in efficient industries. The
coefficient of real exchange rate showing positive expected sign and significant. Exchange rate
devaluation domestic currency attracts more investor to invest in to country. The coefficient of
secondary education enrollenment is positive and it is significant showing that the educated the
population is the likely it is for a country to attract FDI. Human capital, both in terms of quantity
and quality, is another important factor in promoting labor intensive and export oriented FDI in
particular. Noorbakhsh et al (2001), using secondary school enrolment ratio and the number of
accumulated years of secondary and tertiary education in the working age population as a proxy
to human capital, find human capital to be a significant determinant of FDI inflows for countries.
Lewis (1999) also provides support to the proposition that human capital in host countries is a
key determinant of foreign direct investment in countries. He notes that education, especially in
technical discipline, provides least developed countries with the skills that are required by the
Multinational companies. Nunnenkamp (2002) has analyses globalization-induced changes in the
relative importance of foreign direct investment in developing
Countries. His findings indicate that traditional market-related determinants are still
dominant factors but the availability of local skills has become a relevant pull factor
of FDI in the process of globalization. Salisu (2003) also finds low level of human
Capital, as measured by the illiteracy rate, having a discouraging effect on FDI in Nigeria.
4.3. Co-integration Analysis

The objective of this section is to use an appropriate method in order to empirically evaluate the
theoretical and empirical propositions illustrated above. The use of stationary variables in
regression models is required to reduce the spurious results that are likely to arise when the
variables are specified non stationary in their level form. However, use of variables in their
differenced form removes (long-run) information from the data, resulting in a model that can
only provide partial (short-run) information on the relationship between the variables.
Further, by not accounting for the potential long-run relationship among the variables, models
constructed using only differenced data may be miss-specified if there is existence of such long-
run influences, resulting in biased parameter estimates. To avoid such problems, one must test to
determine whether a long-run relationship exists between the variables in the model. Therefore,
in the present context, application of co integration technique would enable us to examine the
long-run equilibrium relationship between foreign direct investment and its determinants.

The co integration literature has expounded different methods of testing for the existence of
long-run relationship among economic variables. These methods include the residual based co
integration test by Engle and Granger (1987), the maximum likelihood based on Johansen test
(1988; 1991) and Johansen and Juselius (1990; 1992) tests. These tests have been identified to
give contradictory results and also provide less robust estimates. The residual-based co
integration tests are inefficient and can lead to conflicting results, especially when there are more
than two I(1) variables under consideration (Pesaran and Pesaran, 1997). The Johansen (1988;
1991) and Johansen and Juselius (1990) approaches are used in multivariate cases, where co
integrating vectors and rank has to be determined (verbic, 2003).

Test of co-integration

The existence of long run relationship in the variables in this context is seen by testing the
existence of co integrating relationship using residual based co integration test by Engle and
granger procedure.

Variable I(0) Result

Residual(e) -3.528** Stationary

** represent significant at 5% level(-2.975)

According to above result the residual from long run model is stationary at level implying that
the variables under consideration have a long run relationship.
Chapter five

5. Conclusion and policy implication

With the hope promoting FDI inflow, African countries have under taken numerous economic
reforms. The integral parts of the continent over all reforms are macroeconomic investment laws
and stream lining and simplifying business regulations. despite this effort, Ethiopians share in
FDI inflow to developing countries is very small. Furthermore the meager FDI coming to
Ethiopian are unevenly spread over the countries performance in attracting FDI is highly related
with their natural resource endowments, the political environments, and the business
environment are the major determinant of FDI. It also believed that FDI increase the productivity
of the labor force of the countries, but it requires a certain minimum level labor productivity.it
also improve the living standard of individuals.

The government of Ethiopia has been trying to boost FDI inflow in to the country by liberalizing
the investment regime of the country and providing a various investment incentives.
Nevertheless the amount of foreign direct investment coming to Ethiopia is un even, Saudi
Arabia is the major source country accounting for more than one half of total FDI follow to
country followed by Uk, india and USA respectively. The factor that determine FDI follow into
Ethiopia are low level of effective human capital, low level of exportation and importation per
GDP and real domestic product per capital income.

Through the study I has seen different determinants of FDI. Depending on the finding the
researcher conclude as follows:

 The positive and significant effect of economic growth on FDI emphasises

the crucial role of economic growth in stimulating investment by foreign
as well as domestic investors. Ethiopia has had a respectable growth
performance in the post-1991 period18. High rate of GDP growth signals a
country’s economic prospects and encourages foreign investors. Keeping
up the growth momentum and ascertaining its sustainability is a key to
attracting more FDI. In this regard, furthering the growth performance of
the economy through the creation of favourable macroeconomic
environment, developing vital infrastructure, ensuring the quality of
 institutions as well as improving the quality of human capital are some of
the important measures essential to attract FDI.
 For the devaluation of exchange rate in terms of birr per dollar to aware investor signifies
the importance of investment inflow to the country.
 A more focused on macroeconomic policy environment that strength the economy and
build confidence for potential investors, this step to be taken to release exchange rate
through adoption of monetary policy.
5.2 Policy implication
 Government should provide a way that that attract foreign investor in the
country. Example promoting free trade policy, providing adequate infrastructure
etc.
 Promoting rapid economic growth and increase GDP of the country to provide
educated /skilled man power in order to the essential requirements of FDI and
economic development.
 The creation of favorable macroeconomic environment and developing
exportation and importation in terms of GDP and reduction of domestic
currency to exchange are some of the important measure essential to attract FDI.
 A satisfying investor is an important promoter for potential investor, the
government should also support the existing investors.
REFERENCE

 Ajayi (2006) foreign direct investment in sub-Sahara of Africa.

 Getenet Astatike and Hirut Assefa( 2006) determinant of foreign direct investment
in Ethiopia : time series analysis
 Tesfanesh, (2012), determinant of foreign direct investment in Ethiopia mastritech
schoolof government.
 Todaro Michel p(1992) economic for developing world
 UNCTAD(1998),world investment report :trend and determinant new york: united
nation
 UNCTAD (1999), world investment report :trend and determinants. New York and
Geneva :united nation