Exchange rate movements do affect FDI values because they not only greatly affect the amount of cash inflows received from investments but also affect the amount of cash outflows required to pay to continue operating these investments. Currencies appreciate and depreciate according to prevailing Market conditions (Kabura 2013). These movements of exchange rate affect inflation and interest rates which may greatly hamper Developing countries economic growth and also lead to reduced FDI levels.
LDC’s and Developing countries economic difficulties do not originate in their perceived isolation from Developed countries but rather from the way they are enjoined to the International system. Kiat (2008), contend that an economic policy that provides a favorable economic environment is always desirable. Inflation which is referred to a general increase in price levels hinders FDI especially when the general price level is high (high inflation) but when general prices are stable (low inflation) then FDI becomes attractive. Low inflation leads to low nominal interest rate and low cost of capital.
FDI embodies a package of potential-growth enhancements such as technology and access to the global market, but the host country must satisfy certain preconditions so that it can absorb and retain these benefits since not all emerging markets possess such qualities (Gregorio and Lee 1998, and Collier and Dollar, 2001). Exchange rate and Inflation and Inflation are therefore inherent in FDI because investors from other countries would want to bring their money, assets, and resources into a host country where Inflation, exchange rates, the cost of capital, purchasing power and a host country’s policies play a significant role in making that foreign entry decision.
Economic growth basically refers to annual changes of gross domestic product of a country. Todaro and Smith (2007) have defined it as a steady process by which the productive capacity of an economy is increased overtime to ensure raising levels of national output and income while Jhingan (2003) define it as a quantitative sustained increase in the county’s per-capita income accompanied by capital, expansion, and volume of trade.
Li (2006) refers to the existence and nature of inflation-economic growth nexus as one of the most salient macroeconomic controversies. FDI’s dynamic role as a trigger for economic growth is increasingly becoming more imperative for developing countries. According to World Bank (2007), global FDI inflow reached a record of 1.1 trillion US$ in 2006 and these has seen a continuous increase of FDI inflows into developing countries.
FDI being a major source of development-financing greatly contributes to the growth by increasing total investment in the recipient Nation and also increasing productivity gains through technological and managerial skills. However on the other hand, FDI may injure the host economy for instance where foreign investors reduce investment opportunities for domestic investors or where investors claim scarce resources (Herzer et al., 2006). These kinds of ambiguities have opened the scope for a large empirical literature on the FDI and growth nexus on both the developed and developing countries (Mello, 1999).
Kenya has had a long history of FDI and in 1970’s and 80’s it was the most preferred FDI destination in Eastern Africa. However over the years Kenya seems to have lost this most-favored appeal. Rwanda and Tanzania have recently been preferred by Investors over Kenya. A new infrastructure construction like the standard gauge rail (SGR) which could have connected Kenya, Uganda, and Rwanda and encourage investors to establish a presence along the SGR seems to be elusive as Uganda and Rwanda have opted for the Tanzania route.
Moreover other than 2005 Kenya recorded a lower annual GDP growth than the average for the sub-Saharan Africa (SSA) GDP from the years 2005 to 2015. Kenya’s decade growth stood at an average of 4.6%, compared to 6% for the SSA, 6.9% for Tanzania, 7.1% for Uganda, and 7.2% for Rwanda. All is not yet lost since Kenya has got a great potential given the fact that in 2015 it was ranked as the 72nd largest economy in the World (IMF, 2015). It recently has been ranked as the third most improved country globally on the ease of doing business (World Bank, 2016). A greater ease of doing business attracts investors, Kenya having been a non-aligned country since independence has experienced substantial FDI from both the East and the West. Its policies have always been favorable since foreign investors are still guaranteed ownership and the right to remit dividends, capital, and royalties despite the occasional tightening of restrictions to encourage domestic enterprise.
Despite the many studies on inflation, exchange rates, and on the direction and causality of FDI-economic growth, the empirical evidence is not clear for country groups. Criticisms in the recent studies (Kholdy, 1995) of the traditional assumption of a single-way causal link from FDI to growth, new studies have also explored on the possibility of a bidirectional or a non-existent causality between FDI and growth. A causal link between FDI and growth is dependent upon a set of conditions in the specific host country’s economy. Chowdhury and Mavrota(2005), have suggested that individual country studies be done to examine the causal links between FDI and economic growth since it is country-specific. These sentiments are also echoed by Ayanwale(2007) that this relationship is not clear and recent evidence show that the relationship may be country and period specific and this calls for the need to carry out more studies on their relationships .
1.2 Research Problem
The opening of Nations boundaries brings manpower, ideas, goods, services, and transfers technology to the host country and as a result, wealth is also transferred. Investments of assets, systems and technologies in a host country and subjecting them to the laws of that country seeks to provide a country such as Kenya with its many advantages. Mwangi (2013) asserts that research using a detailed industry-level data finds that the growth spillovers across industries depend on the industries into which FDI flows. Growth ramifications are therefore expected to be strongest when foreign affiliates and domestic firms compete mostly with each other unlike in the case of previously protected industries.
FDI is a major component of capital flow for developing countries with its contribution towards economic growth is widely contested although most researchers concur that the benefits far much outweigh its cost on the economy (Musila and Sigue, 2006). Mc Aleese(2004) observes that FDI incorporates a package of potential growth enhancing-attributes like technology and access to International Market. In supporting the fore going position Collier and Dollar (2001), argue that a host country can not absorb nor retain such benefits without satisfying certain preconditions.
Foreign Direct Investment (FDI) is a component of international capital flows and it has been the largest single source of external finance for developing countries since 1993 as it is widely believed that economic growth depends critically on both domestic and foreign investments, equally the rate of inflow of foreign investment depends on the rate of economic growth. (Andenyangtso, 2005).
Stability in prices both in developed and developing countries leads to high and sustainable economic growth. The Central Bank of Kenya has been pursuing it in order to attract investors this has seen annual average inflation drop from 15.1% in 2005 to 6.63% in 2015. The mean exchange rates of major trading currencies of US$, pound and the Euro, grew from 72.36, 124.98 and 85.9 respectively in 2005 to 102, 151, and 111.7 in the year 2015 with similar scenario witnessed in the GDP of US$ 69.97 billion and Foreign direct investment inflows which increased by KES 89,928 million . These trends may imply a correlation between exchange rate, inflation, FDI, and economic growth but this does not imply causation.
Studies related to the effect of foreign direct investments and economic performance in general in Kenya are many they include, Nyamwange (2009) who carried out a study on the foreign direct investment in Kenya, Voorpijl (2011), the gains and losses of foreign direct investment in Kenya, Musau (2011) , Muema (2013) analysis of the determinants of FDI in Kenya, Maingi (2014), the effect of foreign direct investments (FDIs) on economic growth in Kenya, Kabura (2014) looks at the relationship between exchange rate and FDI in Kenya comes close however her study only focuses on exchange rate and FDI relationship. The only studies done which are very close is by (Omankhanlen 2011 and Andinuur 2014) on the effect of exchange rate and inflation on FDI and economic growth specifically in Nigeria and Ghana respectively over a period of 30 years.
This study will attempt to fill the research gaps, a period of last 10 years may provide a clear and better indication outcome on what policy makers and the government ought to address. No known study has been undertaken to find out the effect of foreign exchange rate and inflation on FDI and the bidirectional influences between FDI and economic growth in Kenya. The ones done mainly capture the correlation between inflation, FDI and growth or exchange rate and growth yet these correlations do not imply causation. This study will, therefore, seek to answer the following question: What is the effect of exchange rate and Inflation on FDI and the bidirectional influences between FDI and economic growth in Kenya?
1.3 Research Objective
The objective of the study will be to find out the effect of exchange rate and inflation on Foreign Direct Investment (FDI) and the bidirectional influences between FDI and economic growth in Kenya.
1.4 Significance of the Study
The government which is interested in the welfare and equality of Kenyans will be able to tell whether policies are being undertaken to promote FDI. It will also trigger the government to review, enact and implement policies that improve on the Gini coefficient which stands over 40%.
It will single out the Kenyan specific factors that explain the variability in FDI. The study will be useful in the determination of the exchange rates to achieve a balance of domestic and foreign levels of investment in a bid to attract FDI and Stimulate growth. It will be useful for key players of the foreign exchange market as the relationship between exchange rates and FDI will determine the level of trading at any given time.
Kenya has discovered oil in northern part which has seen foreign firms like Tullow engage in exploration because we don’t have the local expertise needed. This study will, therefore, be useful to Learning institutions and government through interrelated ministries to review how skills are imparted to students and employees because Innovation and technology aspects are ingredients of FDI.
Finally, this study will close the obvious research gap that already exists in the literature. It will also serve as a point of departure for further research in addition to providing information to future researchers who may be interested in studying the Inflation-Exchange rate -FDI- Economic growth nexus in Kenya.
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter presents the relevant theoretical and empirical literature on the effect of foreign exchange and inflation on foreign direct Investment and the linkages between foreign exchange, inflation, FDI and economic growth. The first section will explore the theoretical underpinning of the study, the second section will examine the empirical literature of interest to the topic and the last section draws the conclusion from both the theoretical and empirical literature.
2.2 Theories on Inflation and foreign direct Investment
2.2.1 Fischer Equation
The Fisher equation explains that the nominal riskless interest rate (krf) is composed of the real riskless rate of interest (k*) plus expected inflate rate (EI). This equation can mathematically be expressed as: (krf) =k*+EI………………………………………. (1)
Equation (1) was developed in terms of the expectations of financial markets participants. This means that investors determine their required riskless rate of return before they invest their money. This is because; the nominal riskless rate of interest is the base upon which all other rates of return are built on.
From the Fisher equation; when inflation is low, the nominal interest also falls. This implies the anticipated rate of return on investment will be high. In addition, the cost of capital would also be low and hence financial cost on new investment will be low. Since foreign investors try to reduce their financial cost in order to maintain price competitiveness, the availability of capital at low lending rates will enable foreign investors not only locate better partners in the host country with sufficient domestic investment to supplement but also to maximize the return on their investment. Hence the easy availability of capital at a lower nominal interest rate in the host country would attract investors from foreign countries.
Thus, from the Fisher equation, when inflation is low, the nominal interest rate is also low. Therefore, financial cost on foreign direct investment is low, and rate of return on investment is high. Therefore, inflation negatively affects foreign direct investment.
2.3 Theories on Foreign exchange and Foreign Direct Investment
Kidwell et al (2008) defined an exchange rate as the price of one monetary unit stated in terms of another currency rate. These theories are differentiated by the long and short run. In the long run, if two countries produce an identical good, holding all factors that include transportation and legal costs constant, the price of that good should be constant throughout the world no matter which country produces it. This is referred to as the law of one price which is only relevant in the long run (Mishkin and Eakins, 2009).
Kidwell et al (2008) argue that exchange rates tend to move to levels at which the cost of
goods in any country is the same in the same currency. PPP is based on the notion that without international trade barriers and transport costs, consumers shift their demand to wherever prices are low; suggesting that prices of the same basket of products in two different countries should be equal when measured in a common currency (Madura and Fox, 2011).
The continuing increases in the world trade and capital movements have made the exchange rates as one of the main determinants of business profitability and equity prices (Kim, 2003). Foreign exchange movements by affecting commodity prices also has a spiral effect on the value of the firm and this is a key observation to any investor be it foreign or domestic. Ambunya (2013) concurs that foreign exchange not only affects the value of the firm but also determines its global competitiveness.
The salient issue about PPP is that it helps us to observe the ideal situation. In perfect conditions, FDI would not be influenced by exchange rates as the profit gained by operating in a country whose currency is weaker would not materialize. All costs would be the same thus no need to invest elsewhere other than your home country.
2.3.2 Smith-Choi Interest Theory
Choi (2011), shows that Adam Smith (1776/1976) has long offered the best theory of interest rate. In particular, he rediscovers the following lending consideration by a Bank-like Institution.
il q + (1-δ1) q >(1+id) q
Where il is the lending interest rate, q the lending amount, δ1 the lending default rate, and id the deposit interest. This explains why countries with high default rate, like Greek and Ukraine, offer extremely higher interest rate for their bonds, in order to attract investors. That is, a bank will lend the amount q to a borrower, if the interest revenue plus the residual value of the amount (that is net of default payment) is greater than the cost of the fund (deposit). This derives the lending supply function. A producer’s profit consideration can derive another demand function for borrowing, to determine the equilibrium interest rate. However, this interest rate is generally positive
Conversely, if the expected return on foreign assets is higher than on local assets, both foreigners and locals will not want to hold any local assets and will want to hold only foreign assets. The domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency. When the domestic interest rate is higher than the foreign interest rate, there is a positive expected appreciation of the foreign currency which will, in turn, compensate for the lower foreign interest rate (Mishkin and Eakins, 2009).
2.4 Theories of Inflation and Growth
In this section, the Keynesian and the Neo-classical models are used to underpin the relationship between inflation and growth.
2.4.1 Keynesian Theory
The Keynesian model is based on Aggregate Demand (AD) and Aggregate supply (AS) analysis of Inflation –Growth relationship. The main feature of this theory is that, in the short-run, the AS curve slopes upwardly instead of being vertical. When the AS curve is vertical, shocks to the demand side of the economy affects only prices. However, Dornbusch, et al., (1996) hint that due to this upward sloping nature of the AS curve, and changes in demand can result in changes in prices and output. As a result of the short-run dynamic equilibria of the AD and AS curves, there is the formation of an adjustment path which initially exhibits a positive relationship between inflation and growth, but later turns negative towards the latter part of the adjustment path. The positive interaction between inflation and growth (illustrated by the movement form point E0 to E1 in figure 1) usually occurs as a result of time inconsistency problem. Therefore, some producers will be of the opinion that their output prices are raising while those of others’ remain the same, however in reality, overall prices have risen. Therefore they produce more thereby increasing the overall output (Dornbusch, et al, 1996).
On the contrary, Blanchard and Kiyotaki (1987) think that this positive relationship is traceable to the agreements which firms make to produce goods at a higher price in the in future. Soon after that, the link becomes negative which describes the occurrence of stagflation when output falls or remains constant against rising prices ( Gokal & Hanif, 2004).
Under this model, there is a short-run trade-off between output and the change in inflation, but no permanent trade-off between output and inflation. For inflation to be held steady at any level, output must equal the natural rate . Any level of inflation is sustainable; however for inflation to fall there must be a period when output is below the natural rate.
2.4.1 Keynesian Theory
The Keynesian model is based on Aggregate Demand (AD) and Aggregate supply (AS) analysis of Inflation –Growth relationship. The main feature of this theory is that, in the short-run, the AS curve slopes upwardly instead of being vertical. When the AS curve is vertical, shocks to the demand side of the economy affects only prices. However, Dornbusch, et al., (1996) hint that due to this upward sloping nature of the AS curve, and changes in demand can result in changes in prices and output. As a result of the short-run dynamic equilibria of the AD and AS curves, there is the formation of an adjustment path which initially exhibits a positive relationship between inflation and growth, but later turns negative towards the latter part of the adjustment path. The positive interaction between inflation and growth (illustrated by the movement form point E0 to E1 in figure 1) usually occurs as a result of time inconsistency problem. Therefore, some producers will be of the opinion that their output prices are raising while those of others’ remain the same, however in reality, overall prices have risen. Therefore they produce more thereby increasing the overall output (Dornbusch, et al, 1996).
On the contrary, Blanchard and Kiyotaki (1987) think that this positive relationship is traceable to the agreements which firms make to produce goods at a higher price in the in future. Soon after that, the link becomes negative which describes the occurrence of stagflation when output falls or remains constant against rising prices ( Gokal & Hanif, 2004).
Under this model, there is a short-run trade-off between output and the change in inflation, but no permanent trade-off between output and inflation. For inflation to be held steady at any level, output must equal the natural rate . Any level of inflation is sustainable; however for inflation to fall there must be a period when output is below the natural rate.
2.4.2 Neo-classical Theory
Neoclassical school consists of several other models that attempt to explain the economic growth of countries. However, the dynamic relationship between inflation and growth in output can be deduced.
One of the earliest neo-classical models was postulated by Solow (1956) and Swan (1956). The model exhibited diminishing returns to labour and capital separately and constant returns to both factors jointly. Technological change replaced investment (growth of K) as the primary factor explaining long-term growth, and its level was assumed by Solow and other growth theorists to be determined exogenously, that is, independently of all other factors, including inflation (Todaro, 2000).
Mundell (1963) was one of the first to articulate a mechanism relating inflation and output growth separate from the excess demand for commodities. According to Mundell’s model, an increase in inflation or inflation expectations immediately reduces people’s wealth. This works on the premise that the rate of return on individual’s real money balances falls. To accumulate the desired wealth, people save more by switching to assets, increasing their price, thus driving down the real interest rate. Greater savings means greater capital accumulation and thus faster output growth.
Tobin (1965) also presented a similar mechanism which relates inflation with economic growth by developing Mundell‘s model. Tobin followed swan (1956) and Solow (1956) and factored in the assumption that money is a store of value in the economy. In Tobin‘s model, when the rate of inflation worsens, it motivates people and traders to replace interest-bearing assets with money leading to a greater capital intensity and triggering economic growth. Thus, inflation relates positively with growth in output.
Sidrauski (1967) proposed a model where money is ‘Super neutral’ and he explains that Super neutrality only holds when real variables, including the growth rate of output, are independent of the growth rate in the money supply in the long-run. The major result in Sidrauski‘s economy is that an increase in the inflation rate does not affect the steady-state capital stock. As such, neither output nor economic growth is affected.
Stockman (1981), another neo-classical theorist established another explanation that relates inflation and growth. His model postulates that, an increase in inflation could significantly reduce the output level. In the Stockman‘s model, money is assumed as a complement to capital. So when inflation increases, the purchasing power of money erodes and this leads to low capital accumulation and consequently, there is a fall in output growth. In this way, Stockman provided a strong justification for a negative linkage between inflation and the economic growth.
2.5 Theories of Foreign Direct Investment and Growth
2.5.1 Endogenous Growth Theory
Endogenous growth theory explains that economic growth is mainly generated by factors like economies of scale, increasing returns, or induced technological changes which are within the production process. Romer (1990) and Grossman and Helpman (1991) developed growth models within the endogenous growth theory to explain the relationship between FDI and growth with an assumption that technological progress is the principal driving force of economic growth. The theories focus on the creation of technological knowledge and its transfer, and view innovation as major engines of growth. Therefore, these models place emphasis on human capital accumulation and externalities on growth. They argue that FDI is the main channel for the process of advanced technologies by developing countries and that Developing countries are generally not able to innovate, generate, and sustain new technologies. Therefore, they have to adopt technologies that are produced from advanced countries through the channel of FDI.
New growth theories indicate bidirectional causality between FDI and growth. This is because FDI is expected to lend a hand in improving economic growth by encouraging the incorporation of new inputs and foreign technologies in the production function of the beneficiary country. In addition, FDI enhances growth by adding to the host country‘s existing knowledge base through human resource training and development. FDI also increases competition in the host country by overcoming entry barriers and reducing the market power of existing firms (Dunning 1993; Blomstrom et al., 1996; Borensztein et al., 1998 and De Mello, 1999).
Dowling and Hiemenz (1982), and Lee and Rana (1986) nevertheless contend that FDI inflows can also be induced by a rapid economic growth because high sustainable growth usually creates high levels of capital requirements in the recipient economy and as a result, the host country needs more FDI by creating the necessary macroeconomic climate to attract foreign investors. The speedy growth in the host nation also builds the self-assurance of foreign investors investing in the host country. Thus, both FDI and economic growth relate positively and lead to bidirectional causality.
2.5.2 Internationalization Theory
Internationalization theory was developed by efforts of Buckley and Casson (1976), Rugman (1981), and Hennart, (1982). The theory states that at a firm-level the MNC will exert proprietary control over an intangible, knowledge-based, firm-specific advantage. In this theory, all firm-specific advantages are efficiency-based .This theory also suggests vertical FDI enables firms to reduce their exposure to risks that arise from investments in specialized assets. The theory states that the tendency of firms to invest in a foreign country is dependent on a cost-benefit analysis of particular factors in both its home country and the receiving country.
This theory states that the decision to invest in a country is dependent not only on the anticipated returns but could also be of country-specific factors like barriers to entry, political stability, the cost of capital and production, economies of scale and demand for products. According to Carbaugh (2000), organizations may invest in countries where labour and raw materials are relatively cheaper in order to minimize the costs. This according to Mwangi (2014) partly explains the movement of foreign direct investments to Asia especially China and India where the cost of labour is relatively cheaper than the rest of the world.
Andenyangtso (2005) as cited by (Muhammad and Ijirshar 2013), observe that Foreign Direct Investment (FDI) is a component of international capital flows and it has been the largest single source of external finance for developing countries since 1993 since it is widely believed that economic growth depends critically on both domestic and foreign investments equally the rate of inflow of foreign investment depends on the rate of economic growth
2.5.3 The Acceleration Principle
The principle of acceleration explains the link between output and capital investment and is based on the fact that the demand for capital goods is derived from the demand for consumer goods which the former helps to produce. It states that an increase or decrease in the demand for consumer goods will cause a greater increase or decrease in the demand for machines required to make those goods (investment on capital goods). Thus there is a direct relationship between the rate of output of an economy and the level of investment in capital goods.
The accelerator coefficient is the ratio between induced investment and an initial change in consumption expenditure while Harrod and Domar captured investment as a functional variable in the economic growth process because investment has a dual role. The Investment represents an important component of the demand for the output of an economy as well as the increase in capital stock. This indicates symbolically that ΔK=σΔY. For equilibrium to prvail, there must be a balance between supply and demand for a nation’s output. Thus, these may be regarded as the demand and supply effect of investment. This equilibrium as regarded by Harrod-Dormar model is razor-edge equilibrium. If the economy deviates from it in either direction there will be an economy calamity. (Muhammad and Ijirshar, 2013)
2.5.4 The eclectic Theory
The eclectic theory describes FDI as a non-zero sum game being the most profitable form of investment for some oligopolistic industries and at the same time serving as a tool of economic progress of the host countries in LDCs. The theory postulates that the special factors of both the investing foreign firm and the host country are necessary for a firm’s foreign investment and for the firm to have a positive contribution to the economic growth of the host country. Dunning, the proponent of this theory, maintained that on the side of the organization, it must have organization-specific or ownership advantage. That is, the organization must have both tangible assets which may hardly be available to other organizations to enable the investing firm to have a competitive advantage in the global market.
2.6 Empirical Literature review
Numerous researchers have examined the inflation-FDI-growth nexus for cross country, developed countries and developing economies using a wide variety approaches. However, there are few widely agreed on results. In this section, a selected number of the empirical studies are reviewed. The empirical studies reviewed are classified into four groups: (i) Inflation and FDI, (ii) Exchange rate and FDI, (iii) FDI and Growth and (iv) Inflation, Exchange rate and Economic Growth
2.6.1 Inflation and Foreign Direct Investment
A study conducted by Sayek (1999) sought to explain the relationship between FDIs and inflation. The study which was a survey across many countries found that a three percent increase in Canadian inflation reduced US FDI in Canada by two percent while increasing USA domestic investment by one percent. In a similar way, a seven percent increase in Turkish inflation reduced US FDIs in Turkey by 1.9 percent, increasing US domestic investment by 0.3 percent. This study suggested that percentage change in FDI is negatively related to inflation in the recipient country.
A study by Azam (2010) that investigated the determinants of FDI in Armenia, Kyrgyz Republic, and Turkmenistan for the period 1991 to 2009 had inflation as one of the determinants. Results indicated a negative effect of inflation on FDI. However, in a case of Kyrgyz Republic, the effect of inflation on FDI was found to be insignificant with expected negative sign. Similarly, Kinaro (2006) using time series analysis finds FDI in Kenya is determined by inflation and other factors.
Ahn (1998) explored the effects of exchange rate policy and inflation on direct investment flows in developing countries. This was done in Indonesia by employing the data of twenty-three developing countries over the year 1970-1981. Real GDP, real GDP per capita, a growth rate of real GDP, proxy for market size and prospective purchasing power and expectations of future growth respectively were used as independent variables and FDI as a dependent variable. Three models were used to analyze the data. He established that inflation has a significant negative effect on FDI inflow. With the change in exchange rate policies, inflation can reduce but can’t be eliminated.
A research by Udoh and Egwaikhide (2008), that employed the GARCH model to estimate inflation uncertainty and exchange rate volatility. The findings indicated that inflation has a negative effect on FDI and it is statistically significant.
2.6.2 Foreign Exchange (FOREX) Rate and FDI
A study by Gitau(2014) undertaken to establish the relationship between exchange rates and FDI in Kenya, found a significant relationship between exchange rates and FDI. A Pearson correlation coefficient of 0.635 indicated a relatively strong positive relationship meaning that an increase in exchange rates will statistically increase FDI holding other factors constant. Muema(2013) reported a strong positive correlation between FDI rate and change in the rates of exchange indicating that higher FDI inflows were associated with the weakening of the Shilling.
Osinubi and Amaghionyeodiwe (2009) the empirical evidence on the effect of exchange rate volatility on foreign direct investment (FDI) in Nigeria, report that exchange rate volatility did not significantly affect FDI. Their study further revealed a significant positive relationship between real inward FDI and exchange rate implying that depreciation of the Nigerian currency increased real inward FDI flow. However, the above findings contradict Barrell et al. (2003) which found a strong negative relation between US FDI and exchange rate volatility in Europe and UK. They also conflict the work of Djokoto (2012) who investigated the effect of investment promotion on foreign direct investment inflow in Ghana over the period 1970 to 2009 and discovered a negative relationship between inflation and FDI.
Nyarko et al (2011) examined the effect of exchange rate regime on FDI inflows in Ghana economy between the period 1970 to 2008 by applying co-integration, OLS, and an error correction modeling approach. They took foreign direct investment as the dependent variable and exchange rate regime and another component as an independent variable. The results show that exchange rate regime has no effect on FDI hence no relationship between FDI and exchange rate.
2.6.3 FDI and Economic Growth (GDP)
Umoh, Jacob and Chuku (2012) empirically investigated the relationship between foreign direct investment and economic growth in Nigeria between 1970 and 2008. The study makes the proposition that there is endogeneity, that is, bi-directional relationship between FDI and economic growth in Nigeria. Single and simultaneous equation systems are employed to examine if there is any sort of feed-back relationship between FDI and economic growth in Nigeria. The results obtained show that FDI and economic growth are jointly determined and there is positive feedback from FDI to growth and from growth to FDI.
Bende et al. (2001), study on the relationship between FDI and growth in four developing countries using time series annual data over the period 1970-1998. The results showed a positive and significant relationship between FDI and growth.
Supporting the above findings, the results of Loesse et al. (2010) who examined the linkage and directional causality between FDI and growth of ten Sub-Saharan African countries using annual time series data from 1970 to 2007, employed the Pesaran et al. (2001) approach to co-integration and the Toda and Yamamoto (1995) causality test, realized a positive and significant long- run relationship between FDI and GDP growth in Kenya, Angola, Liberia, and South Africa. However, they found a unidirectional causality running from FDI to GDP growth. Both Loesse et al and Bende et al. have the same opinion on the relationship between FDI and growth. However, the difference in directional causality could be due to the difference in methodology and may make annual time series and panel data not to yield the same results. Lastly, the two econometric techniques could also yield the different results.
Eke (2003) a causality study to analyze the impact of FDI on economic growth in Nigeria tested whether a foreign private investment caused a growth of GDP. The results showed that causality runs in both directions, that is FDI caused GDP growth and GDP growth caused FDI and thus concluded that FDI is significant in determining real development in Nigeria. However Chakraborty and Basu (2002) Investigation on the relationship between economic growth and foreign direct investment (FDI) in India by employing the co integration and error correction model method reported a unidirectional relationship with causation running from GDP to FDI and not the other way round.
2.7 Summary of the Theoretical and Empirical Reviews
The foregoing discussion of the literature reveals very interesting dimensions to the linkage between inflation, Exchange rate, FDI, and growth. From the theoretical literature reviewed, the relationship between inflation and growth can be positive or negative. Also, a negative relationship exists between inflation and FDI. In addition, a positive relationship exists between FDI and growth. The theoretical review demonstrates that models in the neoclassical framework can yield very different results with regard to inflation and growth. An increase in inflation can result in higher output (Tobin Effect) or lower output (Stockman Effect) or no change in output (Sidrauski). Furthermore, analysis of available empirical literature indicates that it may not be possible to arrive at any firm conclusion on the directional causality between the variables. The issue is basically empirical and critically depends on the type and nature of an economy being considered.
Even though there are studies on inflation- FDI and growth, there is scanty literature on inflation-Foreign exchange-FDI and growth. Muema (2013) concluded that exchange rates were a determinant of FDI. Kabura (2014) focused on the relationship between Foreign Exchange rate and FDI in Kenya. Andinuur (2013) however looked at Inflation, FDI and economic growth in Ghana but his study omitted real Exchange rate. In view of the above, there exists a gap on the effect of exchange rate and inflation on Foreign Direct Investment (FDI) and the bidirectional influences between FDI and economic growth in Kenya, Therefore, this study will attempt to fill the gaps in the literature
This chapter will focus on the methodology that will be used in gathering data, its analysis and the reporting for a ten year period from 2006 to 2015. It consists of the research design, data collection and its analysis.
3.2 Research Design
The research work will be fundamentally analytical as it will establish the effect of inflation and foreign exchange rate on FDI and also investigate FDI bidirectional relationship with economic growth. It will embrace the use of secondary data that will involve the collection and analysis of published material and information on the gross domestic product from sources such as the Kenya National Bureau of Statistics, Central Bank of Kenya, World Bank and IMF statistics.
3.3 Data Collection
It will embrace the use of secondary data that will involve the collection and analysis of published material and information on the gross domestic product from sources such as the Kenya National Bureau of Statistics, Central Bank of Kenya, World Bank and IMF statistics.
3.4 Data Analysis
An econometric model will be developed to examine the relationship FDI has with Kenya’s Economy. The variables to be used will include the country’s gross domestic product (GDP), exchange rate, Gross capital formation, government expenditure, inflation, exchange rate, and foreign direct investment (FDI). Models will be developed to analyze the exact relationship among these variables. It will be analyzed econometrically through regression analysis using the statistical package for social sciences (SPSS) package version 20.
Model specification
This study will be based on the assumption that the inflow of FDI affects economic growth (GDP).
And again, that inflation and exchange rate, in turn affect the inflow of Foreign Direct Investment (FDI). Hence
The model:
GDP = f (FDI) …………….. (1)
FDI = f (INFL., EXR.) …….. (2)
Where:
GDP = Gross Domestic Product in annual %
FDI = inflow of Foreign Direct Investment
INFL. = Inflation rate
EXR. = Annual Real Exchange rate
Considering the fact that the GDP of an economy is not determined by FDI alone, the inclusion of two more growth-determining variables will be made so as to get a more realistic model:
GDP = f (FDI, GXP, GFCF)……………… (3)
FDI = f (INFL, EXR.) ………………… (4)
Where:
GXP = Government expenditure
GFCF = Gross fixed capital formation.
Equations (3), and (4) show that the GDP is dependent on FDI, GXP, and GFCF.
They can be linearized hence the statistical regression models therefore will be:
GDP = α0 + α1 FDI + α2 GXP + α3 GFCF + e ……….. (5)
FDI = β0 ‐ β1 INFL. ‐ β2 EXR. + e ………………….. (6)
Where:
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