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Using an augmented Neoclassical Production function, we specify the growth equation as:

2 2 GDPGRit = β21 + β22 LABit + β23GDIit + β24OPENit + β25 REALit 2 2 6 ε η λ β + + + + i t i t F D I

(3)

where FDI= Foreign Direct Investment, GDPPC= GDP per capita,GDPGR= Annual growth rate

of GDP, INF= inflation rate, PUB= public investment, POL= political Stability, RI= real

interest (lending rate minus inflation rate), GDI= Gross Domestic Investment, LAB=

labour force, OPEN= trade openness measured as export plus import over GDP, REAL=

real exchange rate overvaluation, i = 1,…5; t = 1970,…2002.

1j

are coefficients to be

estimated.

i

is the group dummy,

t

is the time dummy, and

1,

2

are the stochastic

disturbance terms.

Equation (2) states that FDI is positive function of per capita income, the growth rate of

GDP,

and

nominal

price

changes.

The

relationship

between

FDI

and

GDP

related

variables represents the market size effect; foreign firms are attracted by large aggregate

demand.

Public

investment

can

have

positive

or

negative

effect

on

FDI

depending

on

the nature of such investment. Public investment can be an effective tool in the creation

of conducive business environment that can easily attract foreign direct investment.

However, this should be cautiously handled to avoid the ugly effect of public investment

crowding out private investment. So long as public investment is on the provision of

social infrastructure it can promote foreign investment. But where the government is

found competing with the private sector in those sectors where the private investors have

comparative advantage it may be very harmful. Debt overhang effect is captured by the

inclusion of the debt service ratio. This effect will be negative on FDI. Political

instability and inflation rate are also expected to have a negative effect on FDI. These

15

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