Efficiency of Foreign Capital Inflows, Institutional Quality, and Economic Development in Sub-Saharan Africa.

Abstract

Foreign capital inflows – specifically foreign direct investment (FDI), official development assistance (ODA), and remittances are essential sources of financing in Sub-Saharan Africa (SSA). However, their transformation into economic development remains inconsistent. This study evaluates the efficiency of foreign capital inflows, the threshold effects of institutional quality on their attraction, and the moderating role of efficiency on economic growth across 35 SSA countries (1990–2021). The first objective measures the utilization efficiency of foreign capital inflows based on the growth paths of macroeconomic and human development. The results derived from the Data Envelopment Analysis (DEA) and Malmquist Productivity analyses suggest that while the efficiency of these foreign inflows is generally low in Sub-Saharan Africa, it is comparatively higher in human development. The efficiency levels for growth along the macroeconomic path are 40.7% for FDI, 40.9% for ODA, and 43.6% for Remittances. Human development growth is much higher, with efficiency levels of approximately 69% for FDI, 63% for ODA, and 65% for Remittances. The results also suggest that efficiency growth has stagnated over the period from 1990 to 2021. The findings show that overall utilization efficiency in SSA is low. For macroeconomic growth, efficiency averages about 40.7% for FDI, 40.9% for ODA, and 43.6% for remittances. Human development performs much better, with efficiency levels of about 69% for FDI, 63% for ODA, and 65% for remittances. The results also revealed that efficiency changes remained stagnant between 1990 and 2021, with no clear trend. The relative rankings of countries in terms of efficiency performance place Sierra Leone, Botswana, Burkina Faso, Senegal, and Gabon among the top five countries along the human development growth path. In contrast, Burkina Faso, Ethiopia, and Mali are ranked better along the macroeconomic growth path than their peers. Burkina Faso is the only country with consistent efficiency performance in both dimensions. Efficiency spikes were observed in the immediate years following major global financial crises, emphasizing the importance of international economic crises in SSA countries. The study's findings indicate that policymakers in the sub-region will need to implement prudent, pragmatic policies to promote the efficient use of foreign capital by addressing the significant inefficiencies in deploying these inflows to foster economic development. The second objective, employing fractional regression modeling, explores the institutional and macroeconomic determinants of FDI, ODA, and remittance efficiencies. The results show that institutional quality factors such as control of corruption, rule of law, political stability, and regulatory quality significantly enhance the efficiency of all three capital inflows. This underscores the crucial role of governance reforms and institutional capacity-building in attracting and better utilizing foreign capital inflows in sub-Saharan Africa. The third objective examines the threshold effects of institutional quality on foreign capital inflows using the dynamic panel threshold model (DPTM). The results identify distinct institutional quality thresholds — 0.332 for FDI, -0.402 for remittances, and -0.142 for ODA— indicating a nonlinear relationship. Below these thresholds, institutional improvements drive capital inflows. However, beyond these thresholds, all three inflows decrease. This suggests that SSA countries tend to attract resource-seeking, high-risk investors who prefer high potential markets with weaker regulations. Specifically, regarding remittances, institutional quality exerts a negative impact above the threshold but shows no significant relationship below it. Conversely, ODA inflows significantly decline regardless of the level of institutional quality. On average, 78% of SSA countries fall below the thresholds across all three categories of foreign capital inflows, while only 22% are above them. Therefore, from a policy perspective, prioritizing the quality of institutions and implementing governance reforms to attract quality, sustainable foreign capital, especially FDI, ODA, and remittance inflows, is critical to the continent’s economic success. Also, given the negative impact of FDI above the threshold, the policy should prioritize the quality of these inflows rather than focusing solely on attracting FDI volumes. By focusing on attracting quality capital rather than quantity and on ensuring that improved governance translates into investments that contribute to inclusive growth, technology transfer, and sustainable development, investors with long-term goals would be attracted for mutual benefit. Given that high institutional quality might reduce remittance inflows, policymakers should promote formal remittance channels by improving financial infrastructure and lowering transaction costs. This would ensure that remittances flow through regulated systems, contributing more effectively to financial inclusion and development. The final objective investigates the moderating role of foreign capital efficiency in the relationship between foreign capital inflows and economic growth using a dynamic Generalized Method of Moments (GMM) approach. The findings reveal that while capital inflows alone often show a negative or insignificant impact on growth, their interaction with efficiency is positive and significant, indicating that efficiency acts as a necessary catalyst for growth. The study underscores the crucial role of policymakers in promoting the efficient use of foreign capital resources. To address inefficiencies and align foreign capital inflows with development goals, policymakers must shift their focus from merely attracting volume to enhancing the economy's absorptive capacity. Achieving this requires institutional reforms that strengthen the rule of law, improve governance effectiveness, reduce corruption, and ensure regulatory quality. Specific recommendations include establishing performance-based monitoring for Official Development Assistance (ODA), digitizing remittance channels to fund education and health, and enforcing the rule of law to reach the identified institutional thresholds necessary for positive capital spillovers.