South Africa: Selected Issues
Author: International Monetary Fund
Publication Date:
23 Jan 2003
eISBN:
9781451840995
ISBN:
9781451840995
Language:
English
Keywords:
ISCR; CR; GDP; price; debt ratio; growth rate; FDI model; South Africa's FDI position; inflows to South Africa; FDI level; FDI to South Africa; Africa
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This Selected Issues paper estimates an equilibrium path for South Africa’s real effective exchange rate. The paper briefly describes the dynamics of the real exchange rate and its determinants. It investigates the presence of a long-term relationship between the real exchange rate and certain explanatory variables, estimates the speed at which the real exchange rate converges toward its equilibrium level, and derives measures for the equilibrium real exchange rate. The paper also examines the real money demand, consumer prices, and the real exchange rate in South Africa.

Abstract

This Selected Issues paper estimates an equilibrium path for South Africa’s real effective exchange rate. The paper briefly describes the dynamics of the real exchange rate and its determinants. It investigates the presence of a long-term relationship between the real exchange rate and certain explanatory variables, estimates the speed at which the real exchange rate converges toward its equilibrium level, and derives measures for the equilibrium real exchange rate. The paper also examines the real money demand, consumer prices, and the real exchange rate in South Africa.

VII. Determinants of Foreign Direct Investment in South Africa71

A. Introduction and Summary

121. Foreign direct investment (FDI) has played a considerable role in the development of South Africa’s economy in the past. In more recent years, however, FDI has remained at relatively low levels compared to other emerging market countries. Despite improvements in macroeconomic conditions and South Africa’s advantages in terms of natural resources and market size, foreign investors have shown limited interest in acquiring, creating, or expanding domestic enterprises. Annual FDI inflows to South Africa averaged less than 1 percent of GDP during 1994–2000, compared with 3–5 percent in a group of comparator countries (listed in Box VII. 1).

122. It is generally considered that foreign investment can act as a catalyst for investment and economic development in South Africa. The significance of FDI for engendering growth was particularly stressed in the Growth, Employment and Redistribution Strategy (1996) and has been reiterated in official statements since then. As private investment has been inhibited by South Africa’s low saving rates, foreign investment can help address the saving deficiency and promote economic growth. The role of FDI is also buttressed by developments in the growth literature that highlight the dependence of growth on the rate of technological progress and the empirical belief that FDI, by triggering a diffusion of new technologies and management practices to host countries, can support a faster pace of economic growth. Borensztein, de Gregorio, and Lee (1995), McMillan (1999), and Mody and Murshid (2002) show that FDI can “crowd-in” domestic investment as efficiency spillovers make private investment more profitable.

123. In addition to its positive impact on growth, FDI has been presented as a vehicle for strengthening South Africa’s international reserves. In its recent report, Standard & Poor’s underscores the need to improve the country’s ability to attract FDI to allow for a sustained improvement in South Africa’s weak external position. In recent years, the South African Reserve Bank (SARB), considering FDI resilient to swings in market sentiment, has used these flows to reduce the net open forward position (NOFP).72 Market analysts have suggested that higher FDI levels could set the stage for the removal of the remaining capital controls.

124. Given FDI’s potentially important role to South Africa’s economy, this section seeks to:

  • describe historical trends and characteristics of FDI to South Africa;

  • compare South Africa with a group of countries with similar credit characteristics to put South Africa’s FDI position in perspective; and

  • discuss a simple framework to examine factors that are empirically important in attracting FDI to emerging market countries and derive implications for South Africa.

B. Trends and Characteristics of FDI

FDI in South Africa

125. Over the last 20 years, South Africa has attracted very little foreign investment (Figure VII.1). For much of the time, this was due to political developments. The imposition of trade and financial sanctions on South Africa in the mid-1980s, the subsequent financial crisis, the implementation of capital controls and the moratorium on payments to external creditors effectively cut off South Africa from the international capital markets. Cumulative FDI inflows in 1980–93 amounted to just over US$0.3 billion. After 1993, FDI increased significantly and peaked at about 2.5 percent of GDP in 1997 (largely due to the partial sale of Telkom). However, FDI has not been persistent, averaging just under 1 percent of GDP during 1994–2000.

Figure VII.1.
Figure VII.1.

FDI Inflows, 1980–2000

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A007

126. In terms of sectoral distribution, the FDI inflows have been relatively diversified. Contrary to what one would expect, the role of natural resources is less important, despite South Africa’s large mineral reserves.73 Nonmining activities have drawn more than 70 percent of the FDI inflows, suggesting that the main aim of foreign investment in South Africa has been to capture domestic and regional markets (Figure VII.2.).

Figure VII.2.
Figure VII.2.

FDI by Sector

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A007

127. The European Union has been the largest investor accounting for about 90 percent of total FDI inflows. Investment from the United Kingdom outstrips investment from any other country and account for three-fourths of the total (Figure VII.3). The United States and Asian countries complete the list of investors in South Africa.

Figure VII.3.
Figure VII.3.

FDI by Origin

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A007

128. In terms of the forms of FDI, a large part is investment in existing assets. Cross border mergers and acquisitions are increasingly prominent, accounting for more than 60 percent of total.74 The restructuring and divestiture of state assets continue to be important levers to attract FDI, as evidenced by the partial sale of Telkom in 1997 and South African Airways in 1999. “Greenfield” investment is relative uncommon in South Africa.75

Comparison with other countries

129. The reduction of macroeconomic imbalances in the last several years has helped South Africa capture some of the FDI flows to emerging markets. Notwithstanding recent trends, South Africa receives far less FDI than countries with broadly similar credit risk characteristics (Box VII.1). As a percent of GDP, South Africa receives about one-third of the flows to similar Asian or Latin American countries. South Africa also attracts less FDI than countries with a noninvestment credit rating (Figure VII.4).

Figure VII.4.
Figure VII.4.

Ratios of FDI to GDP, 1994–2000

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A007

130. Not surprisingly, FDI has added modestly to capital formation in South Africa. FDI as a share of gross fixed investment over the 1994–2000 period is under 6 percent, compared with about 10 percent in Asian countries and 14 percent in Latin America ones (Table VII.1). More important, the ratio of investment to GDP, at just 16 percent, is one of the lowest among the countries in the sample. Significantly higher investment rates are unlikely to be supported by future domestic savings. Private domestic savings declined from 16 percent of GDP in 1998 to under 14 percent in 2001. Total domestic savings remained broadly stable at about 15 percent of GDP, largely due to higher public savings. Public savings are unlikely to increase further in the future. Even if the recent decline in private savings is reversed, external capital is still likely to be needed to supplement the domestic savings required for higher investment and growth. To this end, the role of FDI both as a source of growth and source of capital is becoming increasingly important.

Comparator Countries and Sovereign Credits Ratings

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Notes: Ratings are Standard Poor’s sovereign ratings for long-term currency risk as of April 2002. The list excludes newly independent European countries, owing to the unavailability of data prior to 1992, and oil-producing small countries.
Table VII.1.

FDI as a Source of Capital, 1994–2000

(Averages, in percent)

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Source: IMF, World Economic Outlook database.

C. Determinants of FDI

131. The theoretical foundation of the location pattern of FDI is rather fragmented. Several theories have been put forward to explain FDI based on corporate strategies and investment decisions of firms facing worldwide competition and in the context of choosing to operate in a foreign location instead of exporting or entering into a licensing agreement with a local producer.76 Shatz and Venables (2000) use two types of distinct theoretical models: a horizontal FDI model, in which the motive for FDI is to reduce the cost involved in supplying the market (domestic market-oriented flows), and a vertical FDI model, where the motive is to take advantage of the low cost of production in a particular location (export-oriented flows). Both horizontal and vertical FDI models explain that FDI tends to cluster around a certain location (agglomeration) as linkages among firms create incentives for them to locate close to each other.

132. These models as well as Lim (2001) and Basu and Srinivasan (2002) suggest that five broad categories of factors are important for influencing FDI. These comprise market demand and size, agglomeration infrastructure, cost-related locational factors, the investment environment, and country risk. Box VII.2 indicates variables that have been used in the literature to proxy these factors.

Empirical methodology

133. Within this framework, a panel data analysis is adopted to examine the determinants of FDI. The panel covers 17 countries over the 1984–99 period. The data sources are the IMF’s WEO/IFS databases and the World Bank’s World Development Indicators database. As discussed above, the country size is determined by the number of countries with a sovereign credit rating between BB and BBB+ in early 2002. The dependent variable is the ratio of gross FDI to GDP.

134. Two types of equations are estimated, one using the full sample of annual data, and one with three-year averages to explore longer-run relations. The equations are estimated using both OLS with the White correction for heteroschedasticity and with generalized least squares (GLS) estimation, allowing for fixed effects in the cross section. A fixed-effects estimation allows for country-specific factors to drive FDI in individual countries; these effects are captured in the respective intercepts of the equations. Overall, a relatively large share of the variation in FDI can be explained by a small number of factors (Table VII.2). The results are fairly robust across the two specifications (three-year and annual data). As expected, the GLS approach, which adjusts for group wise heteroschedasticity, gives stronger results.

Possible Determinants of FDI

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Table VII.2.

Regression Results—Dependent Variable: FDI as a Percent of GDP

(White heteroschedasticity-consistent t-statistics in parentheses)

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135. The GDP growth rate was used to proxy for potential market demand and the log of GDP per capita to proxy for market size. To avoid endogeneity problems (a larger market size may attract FDI that increases GDP) we lagged these variables by one period.77 The results showed that countries with high growth rates tended to attract more FDI. Given the relative persistence in growth rates, firms observing high growth rates could expect high future growth rates and thus establish their presence in fast-growing countries. The GDP per capita variable had negative effects on FDI. This outcome was unexpected and probably due to the specific country sample. Nonetheless, some studies have used the inverse of per capita GDP as a proxy for the return to capital (the return on capital is higher in capital-scarce countries, which tend to be poor).78 In this context, per capita GDP can be expected to be inversely related to FDI.79

136. Agglomeration factors and infrastructure development were proxied by telephone lines per 1,000 people. Across all equations, the impact is positive and significant, indicating that the quality of infrastructure is a dominant factor influencing FDI.

137. Cost-related location factors were captured by a labor quality variable. Two reasons motivated this decision. First, data on wages were not available for many countries. Second, recent studies have shown that although raw labor costs are not a significant attractor of FDI, labor quality is.80 We proxied labor quality by illiteracy rates, and they were inversely related to FDI.

138. We used the ratio of tax revenue to GDP to proxy fiscal burden. As expected, the coefficient was negative and significant.

139. The variability of the real exchange rate is expected to influence the choice for location of the production of a multinational company. The conventional belief is that exchange rate volatility affects sales and, influences the location decision of firms that want to capture/serve domestic markets.81 The standard deviation of the level of the real effective exchange rate (REER) and of the change in the REER were used to measure exchange rate variability in the regressions. The first definition proved to be significant and had a positive effect on FDI.

140. The degree of trade openness is positively and significantly correlated with FDI, supporting the arguments that trade liberalization, by reducing trade and administrative barriers, improves the business environment and attracts FDI.

141. Country risk, as proxied by the International Country Risk Guide (ICRG) or the Investment Profile index, had mixed results and was not significant in several equations. This is hardly surprising, since the sample consists of countries with similar risk ratings.

D. Implications for South Africa

142. Several conclusions emerge from the analysis:

  • Given South Africa’s low levels of domestic savings and investment, higher FDI inflows are critical to spur growth.

  • The degree of infrastructure development, trade liberalization, skills availability, and potential market size are among the important factors for determining FDI in a group of countries comparable to South Africa.

  • South Africa has some room to go before it reaches the performance of comparator countries. Table VII.3 indicates that South Africa has lower rates of growth, less trade openness, less deep telecommunication infrastructure, weaker labor skills, and uncompetitive taxation. In part, this explains why South Africa scores below other countries in cross-country FDI comparisons.

  • The empirical analysis also suggests that fixed effects for South Africa are significant and negative. This suggests that other omitted factors, unique to South Africa are important in influencing firms’ investment decisions. The statistically significant negative value of the intercept in South Africa’s equation implies that other factors reduce the ratio of FDI to GDP by 1.0–1.5 percentage points relative to other countries.

  • Recent business surveys have identified crime as the leading constraint on investment, followed by the cost of capital, labor regulations, and skills shortages.82 To the extent that these factors are perceived to be less of a problem in other countries, there would be perceived costs to investing in South Africa and would be reflected in the negative fixed effects coefficient.

Table VII.3.

Differences Between South Africa and Comparator Countries

(Averages over 1994–99)

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143. The authorities recently announced a comprehensive industrial strategy to promote investment in an environment of macroeconomic stability. This strategy includes initiatives to address the skills shortage in South Africa and accelerate the implementation of the free trade agreements with the European Union and other Southern African Development Community (SADC) members. The empirical analysis presented here suggests that these measures go in the right direction, and that their timely implementation would have a positive impact on future FDI.

References

  • Asiedu, Elizabeth, 2002, “On the Determinants of Foreign Direct Investment to Developing Countries: Is Africa Different?,” World Development, Vol. 30, (January) pp. 107–19.

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  • Basu, Anupam, and Krishna Srinivasan, 2002, “Foreign Direct Investment in Africa: Some Case Studies”, IMF Working Paper02/61 (Washington, International Monetary Fund).

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  • Borensztein, Eduardo, Jose de Gregorio, and Jong-Wha Lee, 1995, “How Does Foreign Direct Investment Affect Economic Growth?,” NBER, Working Paper No. 5057 (Cambridge, Massachusetts: National Bureau of Economic Research).

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  • Claessens, Stijn, Michael Dooley, and Andrew Warner, 1995, “Portfolio Capital Flows: Hot or Cold?,” HIID Working Paper No. 501 (Cambridge, Massachusetts: Harvard Institute for International Development).

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  • Goldberg, Linda, and Charles Kolstad, 1994, “Foreign Direct Investment, Exchange Rate Variability and Demand Uncertainty,” NBER, Working Paper No. 4815. (Cambridge, Massachusetts: National Bureau of Economic Research)

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  • Lim, Ewe-Ghee, 2001, “Determinants of, and the Relation Between, Foreign Direct Investment and Growth: A Summary of the Recent Literature,” IMF Working Paper01/175. (Washington: International Monetary Fund)

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  • McMillan, Margaret, 1999, “Foreign Direct Investment: Leader or Follower?,” Discussions Paper Series No. 99-01 (Medford, Massachusetts: Department of Economics, Tufts University).

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  • Mody, Ashoka, and Antu Murshid, 2002, “Growing Up with Capital Flows,” IMF Working Paper 02/75 (Washington: International Monetary Fund).

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  • Nowak, Michael, 2001, “The Volatility of Capital Flows in South Africa: Some Empirical Observations,” Paper presented at the Bureau of Economic Research Conference (Stellenbosch, South Africa).

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  • Shatz, Howard, and Anthony Venables, 2000, “The Geography of International Investment,” World Bank Policy Research Working Paper No. 2338 (Washington: World Bank).

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  • World Bank 2001, Global Development Finance, (Washington: World Bank).

71

Prepared by Athanasios Arvanitis.

72

The empirical evidence for the relative volatility of FDI and other forms of capital is mixed. Claessens, Dooley, and Warner (1995) conclude that FDI can be as volatile as other types of flows. For South Africa, Nowak (2001) shows that, while FDI is less volatile than other capital flows, it does not exhibit any persistence over time.

73

In contrast, more than 60 percent of FDI in Africa is allocated to oil and natural resources, (UN Conference for Trade and Development (UNCTAD) estimates).

74

The more important mergers and acquisitions were the investment by Petronas’ in Engen, Dow Chemicals’ in Sentrachem, Coca Cola’s in SA Bottling.

75

Greenfield investment refers to investment executed in an area where no other company or production operations currently exist.

76

A summary of the recent literature on FDI is included in Lim (2001).

77

Lagged values are also indicative of information available to market participants.

79

The inverse relationship may also reflect a perception that investment risk rises as per capita GDP declines.

82

GJMC-World Bank Survey 1999, and World Business Environment Survey, 2000.

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Cover IMF Staff Country Reports
South Africa: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2003: Issue 018
Publisher:
International Monetary Fund
ISBN:
9781451840995
ISSN:
1934-7685
Pages:
103
DOI:
https://doi.org/10.5089/9781451840995.002

FDI Inflows, 1980–2000

FDI by Sector

FDI by Origin

Ratios of FDI to GDP, 1994–2000