Summary of JOIE article (16(6), December 2020) by Abel Mawuko Agoba, Department of Banking and Finance, Central University, Tema, Ghana, Elikplimi Agbloyor, Department of Finance, University of Ghana Business School, Afua Agyapomaa Gyeke-Dako, Department of Finance, University of Ghana Business School, and Mac-Clara Acquah, Zenith University College, Trade Fair, Accra, Ghana. The full article is available on the JOIE website.
In this paper, we examine the bi-directional relationship between financial globalization (proxied by FDI flows) and economic institutions (proxied by central bank independence) taking into consideration the role of political institutions. We test our argument on a sample of 48 African countries (1970-2012) using a two-step System Generalised Methods of Moments, with collapsed instruments and Windmeijer robust standard errors. Using two proxies for Central Bank Independence, the study finds that while legal CBI does not have a significant impact on FDI, high central bank governor turnover rates have a significantly negative impact on FDI inflows. However, higher levels of political institutions significantly enhance the impact of legal CBI on FDI inflows, and dampen the impact of high central bank governor turnover rates on FDI inflows. The study also shows that, higher FDI inflows have a significantly positive impact on both legal and de facto CBI. This impact is accelerated in countries characterized by higher levels of political institutions.
Financial globalization in the form of foreign capital flows has been on the rise in recent times (Gaies et al. 2019). Foreign Direct Investment (FDI) has been one of the most dominant forms of foreign capital flows predominantly because of its stability compared to, for example, portfolio investments and debt flows (World Bank, 2019) and have as such become a major focus for development. Empirical evidence on the impact of FDI inflows to host economies, however, has produced mixed results. Dellis et al. 2017, Kurtishi-Kastrati, 2013 and Udeh & Odo, 2017 have confirmed benefits of FDI to host economies whilst others have highlighted either a negative or no effect of FDI on host economies ((Ndikumana & Sarr, 2019; Chen et al. 2017; Al-Saleh & Allen, 2019). ). The latter results have largely been attributed to the exclusion of measures for absorptive capacity of which institutions have been projected to play a major role in facilitating the impact of FDI on host economies.
One measure of institutions that plays a major role in determining FDI inflows is Central Bank Independence (CBI). An independent central bank is a key economic institution countries put in place to increase the credibility of monetary policy (Warjiyo et al. 2019) and to promote price stability (Bodea & Higashijima, 2017), which guarantees the preservation of the value of investors’ funds. CBI can be a signal to investors about the future course of policy. It can also lower sovereign borrowing costs (Polillo & Guillen, 2005) which can ultimately lead to price stability. Based on a CBI panel data sample for 48 African countries from Garriga (2016), our study examines the empirical relationship between CBI and FDI.
The study used two proxies for CBI: legal CBI (De jure CBI) and central bank governor turnover rate (De facto CBI). Employing a two-step System Generalised Methods of Moments, with collapsed instruments and Windmeijer robust standard errors, we conclude that legal CBI does not have a significant impact on FDI. The insignificant impact on FDI, can be as a result of the ineffectiveness of CBI provisions in many Africa jurisdictions as seen in the literature on the impact of CBI on inflation and fiscal policy (Agoba et al., 2017, 2019a 2019b). This has been attributable to disregard for CBI provisions, thereby making CBI reforms ineffective in achieving price stability, effectively regulating financial markets, and contributing to achieving fiscal discipline through restrictions on lending and policy interest rates hikes. We however see a significant and negative impact of central bank governor turnover rates on FDI inflows. This implies that higher levels of central bank governor turnover rate, which signifies low levels of CBI, minimises the inflow of foreign capital in the form of FDI into African countries. This is because high turnovers usually signal a lack of independence of the central bank resulting in the exit of the governor due to political pressures.
The study also investigates the conditions under which CBI flows promote FDI arguing that political institutions are an essential channel for CBI to promote FDI flows. We postulate that there are certain conditions, under which investors find central bank reforms informative and one is the presence of strong political institutions which result in respect for CBI provisions. We find that higher levels of political institutions enhance the impact and effectiveness of CBI on FDI inflows. Independent central bank provisions are more respected in strong institutional environments. This strengthens the central bank’s credibility in the eyes of foreign investors, thereby resulting in lower cost of capital for foreign investors who desire to invest in an African country leading to higher FDI inflows.
Thirdly, the study also examines the relationship between FDI and CBI. Following Shan, 2017, we postulate that increasing FDI should bring about the adoption of reforms such as CBI that makes economic institutions more likely to produce and sustain the economic environment suitable for foreign enterprises in investment destinations. We find that FDI significantly and positively impacts De jure CBI in Africa. This means that higher foreign direct investment inflows lead to higher independence of central banks. This confirms the theoretical arguments that higher FDI inflows lead to higher central bank independence (Agoba et al., 2019a & 2019b; Bodea, 2013; Ugochukwu et al., 2013)
Finally, we investigate whether the quality of political institutions affects the impact of FDI on CBI. We argue that in strong political institutional environments, respect for the rule of law creates the necessary political and economic environment for foreign investors to do business and to seek to influence economic policies that preserve the value of their investments. We use a popular measure, proxied by civil liberties and political rights score variables obtained from Freedom House database to capture political/legal institutional quality. Our analysis shows significantly positive impacts of these variables on FDI inflows into Africa. This is so because in institutional environments where the rule of law is respected, foreign investors expect that their investments will be safe, cost of litigation will be low, and the right of creditors and property owners will be guaranteed. Further, there will be lower corruption which leads to a lower cost of doing business thus spurring FDI flows.
To check the robustness of our results, we conduct the Hansen test for the overall validity of the instruments as well as the Arellano–Bond test in first differences to test whether the residuals from the regression in differences is second order serially correlated.
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