Discussion Paper No. 127 of 2011 on The Effect of Infrastructure on Foreign Direct Investment in Kenya

Abstract

This study investigates the effect of infrastructure on foreign direct investment (FDI) in Kenya from 1980-2008. An index of infrastructure was constructed using sub-indicators from energy, transport and communication sectors, using principal component analysis (PCA) methodology. The model variables integrated at order (1), warranting the use of Ordinary Least Squares (OLS), and short run dynamic relationship was estimated using an error correction model (ECM). Results show that infrastructure index (lagged two years) coefficient is positive and statistically significant at 5 per cent level of significance. More specifically, a one unit increase in infrastructure index increases FDI by 0.32 per cent in the long run. In the short run, infrastructure index is positive but not statistically significant. Logarithm of exchange rate influences FDI positively in the long run, and it is also statistically significant at 5 per cent level of significance. The implication is that a stable exchange rate is necessary in attracting FDI. Overseas Development Assistance (ODA) has a negative coefficient at 1 per cent level, and it is inversely related to FDI in the long term. Results reveal that a unit increase in ODA, other variables under ceteris paribus, will reduce FDI by approximately 0.14 per cent in the long run. This result is rather puzzling, since for the case of Kenya, a direct relationship was anticipated. More investigation is recommended to ascertain the probable relationship between the two variable. Corruption impacts on FDI negatively. This study affirms that Kenya suffers from poor governance, as evidenced in low scores in the Transparency International Corruption Perception Index rating. Additionally, corruption constrains FDI, and therefore the government should not relent in the fight against it. Based on the findings, policies geared towards up-scaling infrastructure to attract more FDI are worth considering.