Finance and economic development in sub-Saharan Africa: Does foreign direct investment matter?

Abstract

This paper assesses the role of foreign direct investment (FDI) in the link between financial development and economic development in 39 sub-Saharan African (SSA) countries during the period 1995-2020. The study applied a two-step system GMM and Driscoll-Kraay estimator and found that economic development responds positively to a change in the level of financial sector development, and the channels are financial risk diversification, efficient resource allocation, technological development, and financial intermediation. The findings are that the development of the financial sector beyond 29.29% is detrimental to the economic development of the SSA region through high inflation. Also, economic development decreases as FDI increases. The interaction variable (financial development and FDI) indicates that FDI favourably affects the positive link between financial development and economic development in SSA. Also, based on the estimated coefficient for the financial development variable and the interaction term (FDI), it was found that 21.75% was the threshold value of FDI that could strengthen the positive effect of financial development on economic development. Therefore, the study recommended that governments in SSA should formulate policies that ensure inflows of capital beyond the threshold to enjoy the benefits of foreign capital inflows and financial development.