The Effect of Interest Rate on Foreign Direct Investment in Nigeria (1999-2009)

The Effect of Interest Rate on Foreign Direct Investment in Nigeria (1999-2009)

Chapter One of The Effect of Interest Rate on Foreign Direct Investment in Nigeria (1999-2009)

INTRODUCTION

Background to the Study

Nigeria just like other developing nations in the world can boast of foreign direct investment (FDI) as one of the fundamental components in that determine her economic growth and development. Foreign direct investment is significant to the Nigerian economy if it can seriously blot its spill-over effects. FDI is no obviously a fundamental source of capital inflows with positive effects on the host country’s economy which includes technology transfer, technological, specialized human capital, expansion in international trade, and a viable business environment (OECD, 2002). However, the macroeconomic environment in the home country must be favorable to attract foreign investors and one of the main factors of the operational monetary policy regime are real interest rates offered in a given country relative to others (Mishkin & Eakins, 2009).

A nation’s desire for FDI is hindered by changes in some restrictions which also include the desire of the government to remove barriers to trade and also privatization of government agencies. Potential economic growth is also a factor that affects a country’s appeal for FDI as countries that have greater potential for economic growth may enable the firms to be able to take advantage of that growth by setting up business there. Exchange rates and tax rates make up some factors that affect a country’s appeal for FDI. Low tax rates on corporate profits are more likely to attract foreign direct investment while firms prefer to direct FDI to countries where the local currency is expected to appreciate against their own currency. A company that seeks to invest in another will always seek out a host country that has a local currency that will be expected to strengthen against their own. Madura and Fox (2011) opined that an organization will always try to invest capital in a nation whose currency is presently weak in a bid to earn from new operations which may regularly be converted back to the foreign firm’s currency at a better exchange rate and interest.

The inter-relationships between interest rate, foreign portfolio investment and in emerging economies like Nigeria are dynamic depending on the absorbing capacity of the country and her responsiveness to technology. According to the UNCTDA report of 2002, foreign direct investment can be defined as an investment involving a long term business interest and control by a foreign investor in another country different from that of the investor. The role played by foreign direct investment in actualizing economic development in a nation cannot be underestimated. As such, across the border transaction is celebrated mostly in the developing countries as it is seen as an avenue to promote and encourage inflows of technology, skill, materials and bridge the gap between savings, exchange rate and government spending.

The effect of the instability of interest rate is very significant to foreign direct investment inflow to a developing nation like Nigeria experiencing transition and emerging markets. A rise in interest rate will cause an increase in current real exchange rate. Hence, the variation between exchange rate and interest rate consistently correlates to Foreign Direct Investment inflows and thus amplified economic development. Foreign Direct Investment inflows are very important for an arriving resource-based economy like Nigeria. The required prerequisites to attract adequate Foreign Direct Investment are classified into political, economic, legal and social factors. Higher profitability on investments, political stability, suitable investment climate, cheap labour and production cost, adequate and functional infrastructure amenities and a stable regulatory environment also help to invite and retain Foreign Direct Investment in a nation.

Foreign direct investment inflows to Nigeria fluctuated from 1999 to 2009 and then began to increase until 2015. This means that multinationals and their subsidiaries continued to increase production of goods and services in Nigeria until Nigeria entered recession in 2015. Most developing economies for example Nigeria has interest in foreign direct investment to be a source of capital for industrialization. This is due to the fact that foreign direct investment presents a long term commitment by the foreign investor to host country. In addition foreign direct leverage has significant contribution to a host country’s fixed capital formation (Abala, 2014). In Nigeria, fixed capital formation stands at 19% of GDP of which 6% is contributed by FDI (World Bank, 2016). From 1999 until 2018 interest rate in Nigeria were at an average of 7.2%. Hence this necessitated the investigation on the effect of interest rate on foreign direct investment in Nigeria from 1999 to 2009.

Statement of the Problem

Since FDI inflows into a country relies on a number of issues whose importance varies with evolvement in the as the economic environment over time, therefore the host country’s economy too changes in conjunction with evolvement in the international environment. As a result the FDI factors also pervert (UNCTAD, 1998). Despite the fact that old determining factors together with kinds of FDI related with them have not become extinct due to globalization, their value is depreciating. For instance, one of the most valuable convectional FDI determent factors; market size, has weakened in level of importance, yet modern determining factors have become prominent. Cost of the factors of production, economic growth levels, total factor productivity, discount rates over time has increased on its value (UNCTAD 2008). According to these, countries need to seek new ways of attracting FDI stock since motives of investors are varying over. Research is therefore crucial for investment decision making and predictability of FDI inward stock is imperative.

Empirical evidence is largely inconsistent and quite varied on the influence of interest rates on foreign direct investments. Chingarande (2011) investigated the effect of interest rates on foreign direct investment in Zimbabwe. The study outline the determinants of FDI which includes interest rates and other factors which affect rate of return on investment such as inflation, exchange rates, labor cost, GDP and risk factors. The researcher noted that there existed no connection between interest rates and the inflow of foreign direct investments. Consequently, interest rates should not be considered when making key policies regarding foreign direct investment. Hunady and Orviska (2014) investigated key determining factors of FDI inflows in European Union (EU) using panel data and regression models. The study focused on country lending interest rates and the effect of FDI inflows using data from 27 EU countries. The study found that interest rates had had a weak positive relationship with FDI inflows.

Kinuthia (2010) conducted a study on the factors affecting FDI in Kenya with the main focus being on policy framework and economic determinants. The study findings showed that policy framework and maintaining political stability are key factor in attracting FDIs in Kenya. Ochieng and Anyango (2012) studied on the impact of fluctuating exchange rates in determining FDI in Kenya. The findings of the research showed that fluctuating exchange rates is not significant in attracting FDIs. Exchange rates increase fluctuation which results to an increase in FDI inflows in Kenya. Munyoki (2010) studied the role of Kenya investment authority in attracting foreign direct investment in Kenya. In this study, Munyoki was keen on the development of the Kenyan markets. He analyzed the financial sector and the manufacturing sector and also looked into the Greenfield Investment where there is investment on establishment of new fixed assets such as buildings and Brownfield investment where there is investment on already existing fixed assets.

The lack of consensus among the various scholars on the influence of interest rates on foreign direct investments by researchers is a reason enough to conduct further examination on the area of study. In addition, most of the existing empirical evidence has expounded on the impact of different variables on foreign direct inflows while others researched on the outcome of foreign straight investments on growth in the economy. However, there exist few studies on the result of interest rates on foreign direct investment in Nigeria. Thus, this study intends to overfill this research gap by addressing this question; what is the effect of interest rates on foreign direct investment in Nigeria?

Objectives of the Study

The broad objective of this study is to determine the effect of interest rate on foreign direct investment in Nigeria from 1999 to 2009. The specific objectives are:

i)      To understand the relationship between interest rate and foreign direct investment

ii)      To examine the relationship between foreign direct investment and economic growth

iii)    To highlight the determinants of foreign direct investments in Nigeria

Research Questions

The following are the research questions that guide this study:

i)         Is there any relationship between interest rate and foreign direct investment?

ii)       What is the relationship between foreign direct investment and economic growth?

iii)       What are the determinants of foreign direct investments in Nigeria?

Research Hypotheses

The following hypotheses shall be tested for this study:

i)        There is a significant relationship between interest rate and foreign direct investment

ii)       There is no significant relationship between foreign direct investment and economic growth

Significance of the Study

The finding of this research forms a reference basis to researchers, scholars and students in the same area of study. The study will be valuable to them in identifying areas that need more research in the view of literature reviews and identifying existing gaps.

The findings are hoped to be of benefit to policy makers in developing investment strategy policies and developing the necessary institutional framework required to market Nigeria as an ideal foreign investment destination. Also, it will help them in coming up with monetary policies that ensure setting interest rates that are consistent with the objective of attracting foreign direct investments.

The study may also help the government to have some sense of control on the operations of different stakeholders in the sector. A clear picture of the FDI flows can be painted which may help in doing comparative analysis with other developing countries. Policy makers may use the findings to overcome disadvantages as the study outlines the potential strengths and weaknesses of Nigeria.

Scope of the Study

This study is limited to some selected financial organizations in Lagos State. The area of concentration was the interest rates and its effects on foreign direct investment in Nigeria from 1999 to 2009 and how it contributes to the economic growth of Nigeria. Lagos State was specifically chosen for this study because it is regarded as the financial hub of Nigeria.

 Limitations of the Study

There was only one problem the researcher faced in the course of conducting the research work and it includes: Time constraint: The conduct of all activities relating to the research work was time consuming whereas the institution has a specified limited time for the conduct of the research work. The allotted time for study was too short for the conduct of the research and this limited the scope of the research work to only Lagos State.