On the allocation puzzle and capital flows: Evidence from foreign direct investment and real sector growth in Africa

Abstract

This paper takes a new dimension on the foreign direct investment (FDI)–growth nexus through the lens of the allocation puzzle. We examine how the influx of FDI affects the broader economy through its impact on real economic sectors in a panel of 42 Sub‐Saharan African (SSA) countries over 1980–2017. Using a dynamic panel model and decomposing the real sector into its parts, we test for the possibility of a two‐way bi‐directional relationship between growth in agriculture, manufacturing, industry and service value additions, and FDI. There is no evidence of an allocation puzzle at the level of the real sector and the components parts, which suggests that SSA countries with relatively high growth in the real sector will attract more FDI. While the effect of FDI on the real sector is positive at the disaggregated level, there is a positive bi‐directional effect between FDI and growths in manufacturing, industry and service value additions. The results are robust to key determinants of the growth–FDI nexus.