FINANCING COST AND PRIVATE INVESTMENT IN GHANA
JOSEPHINE OFOSU-MENSAH ABABIO (MRS.)
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THIS THESIS IS SUBMITTED TO THE UNIVERSITY OF GHANA. LEGON, 
IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD 
OF MPHIL FINANCE DEGREE
JUNE, 2010
33798  1
DECLARATION
I. JOSEPH INE OFOSU-MENSAH ABABIO (MRS), do hereby declare that except for 
references to other works, which have been duly acknowledged, this thesis is entirely my own 
work, and that neither the whole nor part o f it has been submitted for another degree elsewhere.
JOSEPHINE OFOSU-MENSAH ABABIO (MRS) 
Dat V . - - < 50 J __ — r  _   -  
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DR. KOFI OSEI 
(Supervisor) 
Date......... 0
Ku
MR. SARPONG KUMANKUMA 
(Supenisor) .
D ate... I |.( .9........................
i
DEDICATION
This thesis is dedicated to my beloved father, MR. SAMUEL KWASI NTIR I, who sacrificed 
marriage for our education and good nurturing.
My profound and utmost gratitude to the Almighty God for Jlis grace and favour which have 
seen me through this arduous academic feat.
With a very grateful heart, I thank my able and indefatigable supervisors. Dr. Kofi Osei and Mr. 
Sarpong Kumankuma for their invaluable advice, comments, constructive criticisms and 
suggestions during the course o f writing this thesis. I also appreciate very much their concern 
and encouragement during the ill health o f  my child.
I acknowledge, with thanks and appreciation all the lecturers o f  the University o f  Ghana 
Business School, most especially lecturers o f  the Department o f  Finance, whose contributions in 
diverse ways have seen to the successful completion o f this work. I deeply appreciate the 
assistance and encouragement from Dr. Adjasi, Mrs. Esther Asiedu, Mr. Ojorbio and Mrs. 
Josephine Amuzu, all o f  the Business School, University o f  Ghana.
I would like to put on record my indebtedness and immeasurable gratitude to Dean o f  Graduate 
School, Professor (Mrs) Yaa Ntiamoah Baidoo, the acting Dean o f  the Business School. Mr. 
Takyi Asiedu, the Executive Secretary o f the Business School. Mr. Tabi and the head o f  
Department o f Finance, Professor Joshua Abor. for approving the request to pursue this MPhil. 
Program.
A special note o f gratitude to the staff o f  Balme Library, for allowing to bring my child there to 
work and also to the Liberians o f the Business School. Mr. Afenvo and the Department o f  
Economics, Mr. Anane, for permitting me to borrow journals and textbooks to enable me to work 
outside their libraries.
iil
I wish to express my sincere thanks to the staff o f  the Department o f  Research, Bank o f Ghana 
for providing me most o f  the data I requested for. I own profound thanks and acknowledgement 
to the various authors mentioned in the reference section o f my work.
My heartfelt gratitude and appreciation goes to my husband, Mr. Ofosu-Mensah Ababio and my 
children; Nhyira Ofosu-Mensah, Aseda Ofosu-Mensah and Adom Ofosu-Mensah, for the 
financial assistance, encouragement and the many sacrifices they have to make to enable me 
pursue this programme.
Meanwhile, 1 wholeheartedly deem it my sole responsibility for any errors or omissions in this 
thesis.
JOSEPHINE OFOSU-MENSAH ABABIO (MRS)
iv
TABLE OF CONTENTS
Page
Declaration 1
Dedication
Acknowledgements iii-iv
Table o f Contents v-ix
List o f Tables x
List o f Figures x
Abstract xi
CHAPTER ONE: INTRODUCTION
1.0 Background o f the Research 1 -5
1.1 Research Problem 5-8
1.2 Objective o f the Research 8
1.3 Hypothesis 8-9
1.4 Significance o f  the Research 9-10
1.5 Organization o f the Research 10
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CHAPTER TWO: AN OVERVIEW OF INVESTMENT IN GHANA
2.0 Introduction
2.1 Development in the Ghanaian Economy
2.2 Domestic Private Investment in Ghana
2.3 Foreign Direct Investment in Ghana
2.4 Measures to Stimulate Private Investment in Ghana
CHAPTER THREE: LITERATURE REVIEW
3.0 Introduction
3.1 Theoretical Literature
3.2 Theories o f  Firm Investment Behaviour
3.3 Cost Factors and Private Investment:
3.3.1 Interest Rate
3.3.2 Inflation Rate
3.3.3 Exchange Rate
3.3.4 Government Budget Deficit
Page
11
11-17
17-20
21-22
22-30
Page
31
31-38
39-42
43-44
43
44
45-46
46-47
Page
3.4 Non Cost factors and Private Investment: 47-49
3.4.1 Real GDP/Output 49
3.4.2 Public Investment 49-50
3.4.3a Stock Market 50-51
3.4.4b Domestic Savings 51 -53
3.4.5 Credit to the Private Sector 53-55
3.4.6 External Debt 55-56
3.5 Empirical Literature 56-61
3.6 Conclusion 61
CHAPTER FOUR: RESEARCH METHOLOGY Page
4.0 Introduction 62
4.1 Research Approach and Strategy 62
4.2 Variables used 63
4.3 Justification o f Variables 64-67
4.4 Data type and source 68
vii
Page
4.5 Model Specification 69
4.6 Econometric Techniques for Estimation 69
4.6.1 Unit Root (Stationarity) Test 70
4.6.2 ADF Unit Root Procedure 70
4.6.2 Johansen Co-integration Test 71-73
4.6.3 Johansen Co-integration Procedure 73-75
4.7 Error Correction Model 75
4.8 Diagnostic Test 75-76
4.9 Pairwise Correlation Test 76-77
4.10 Conclusion 77
CHAPTER FIVE: EMPIRICAL RESULTS AND ANALYSIS Page
5.0 Introduction 78
5.1 ADF Unit Root Results at their levels 78-80
5.2 ADF Unit Root Results at their difference 80
5.3 Diagnostic Test 80-82
viii
5.4 Pairwise Correlation Test 82
5.5 JohansenCo-integration Analysis 83-90
5.5 Error Correction Model 90-92
5.6 Error Correction Results 92
5.7 Analysis o f  Short Run Dynamics 93-95
5.8 Conclusion 94
CHAPTER SIX: SUMMARY, CONCLUSIONS AND POLICY RECOMMENDATIONS
6.0 Introduction 95
6.1 Summary o f findings and Conclusions 95-101
6.2 Recommendations 101-105
6.3 Limitations o f  the Research 106
6.4 Future Research Area 106
REFERENCES 107-115
APPENDICES
APPENDIX: A 
APPENDIX: B 
APPENDIX: C
Ix
LIST OF FIGURES
FIGURE 1. CUSUM Test for Stability
FIGURE 2. CUSUMSQUARE Test for Stability
FIGURE 3. Recursive Residual test for stability
FIGURE 4. Graphs o f  level o f  the variables
FIGURE 5. Graphs o f  first difference o f  variables
LIST OF TABLES
Table 1. ADF unit Root test at their levels
Table 2. ADF Unit Root test at their difference
Table 3. Correlation Matrix o f Dependent (PINV) and Independent Variables Results:
Table 4. shows the results o f  the co-integration analysis performed.
Table 5. Normalized Co-integration Coefficients
Table 6. Johansen Long Run Results
Table 7. Results o f the Error Correction Model (Private Investment Model)
Table 8. Short Run Error Correction Model (Slock Market Model)
ABSTRACT
This study has investigated empirically the effect o f Financing Cost on Private Investment in 
Ghana, over the period 1970 - 2008. To this end, the variables used were classified as Cost 
factors and Non Cost factors o f  private investment, using the latter as control variables. The 
private investment function derived is a variant o f  the flexible accelerator principle designed to 
account for the objective o f  the study. It employed the Augmented D ickey-Fuller (ADF) test to 
address the problem o f  unit root faced in time series analysis. The long run estimate o f  the 
private investment function for Ghana was estimated using the Johansen co-integration 
technique. The Error Correction model was used to determine the short-run dynamics o f  the 
variables used in the model.
The study found that all the cost factors (interest rate, inflation rate, exchange rate and budget 
deficit) had negative and statistically significant impact on private investment in the long run. 
On the other hand, in the long run. the non cost factors (credit to the private sector, real GDP and 
public investment) impacted positively on private investment but external debt had adverse 
effect. The results also found that with the exception o f the stock market variable, all the 
variables used co-integrated with private investment. The study further revealed that not all the 
variables used were significant in the long run, since variables such as public investment and 
external debt had the expected signs but were not significant.
This study provided direct evidence that high cost o f financing is associated with low private 
sector participation in investment activities in Ghana. Accordingly, the study recommended 
among others that long term policies should be directed towards cost control and macroeconomic 
stabilization in order to boost private investment in Ghana.
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CHAPTER ONE 
INTRODUCTION
1.0 Background o f the Research
Investment is fundamental for economic growth both in the developing and developed 
countries. Recent empirical studies conducted in Africa. Asia and Latin America have 
established beyond doubt, the critical linkage between investment and the rate o f  growth 
(Acosta and Loza, 2005; Ghura and Hadjimichael, 1996; Khan and Reinhart 1990). 
Throughout the 1990s, the ratio o f total gross domestic investment (GDI) to gross domestic 
product (GDP) in Asia, which experienced a high average rate growth compared with the rest 
o f the world, was about 27 percent, while in Latin America and sub-Saharan Africa the 
corresponding ratios were 20 percent and 17 percent respectively, (Seruvatu and Jayaraman. 
2001).
The desire for growth and development o f  the economies o f developing countries brought up
the issue o f the role o f  the private sector. Private sector investment is noted as being directly
related to economic growth in developing countries. Hence the emphasis is now on private
investment as the engine o f economic growth and development. Econometric evidence
(Beddies 1999, Ghura and Hadjimichael 1996. Ghura 1997) indicates that private investment
has a stronger, more favorable effect on growth rather than government investment, probably
because private investment is more efficient and less closely associated with corruption. It is
estimated that the ratio o f private investment to GDP in the sub-Saharan African countries
which had experienced poor rates o f  growth in the 1990s was less than 10 percent, compared
with 16 percent in Latin America, 18 percent in advanced countries and 16.5 percent in newly
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industrialised countries in Asia (Hemandez-Cata 2000). Viewed against the background o f 
growing evidence o f  a strong link between high private investment and sustainable growth, a 
steady decline since the mid 1970s in Ghana’s GDP has been a matter o f  considerable concern 
to policy makers. Furthermore, in the context o f observed policy shift in the 1980s, placing a 
greater emphasis on the private sector following the initiation o f public sector reforms, a 
perceptible slide in the ratio o f  private sector investment to GDP is all the more worrying 
(Aryeetey, 1994).
The much-awaited role o f  the private sector as an engine o f growth has not yet materialized in 
developing countries including Ghana. This may be largely due to the fact that wealth holders, 
in behaving rationally, prefer holding their wealth in foreign assets and government securities 
rather than in real domestic assets due to high risk and low returns associated with real 
domestic assets. Consequently, in most developing countries, policies have been formulated 
to promote reduction in cost o f  financing investment projects in order to increase investment 
vis-a-vis growth. This is due to the observation o f existence o f  high correlation between 
investment and growth, given empirical evidence o f the East Asian exemplar) growth 
attributed to investment (Kipngetich, 2003).
In recent years, emphasis has been put on the development o f  the private sector, in developing 
countries to help boost economic growth and reduce poverty. For example, the International 
Financial Corporation created the African Enterprise Fund, and the United States via its 
Overseas Private Investment Corporation initiated the African Growth Fund. In the early 
1990s, a strategy was introduced by the African Development Bank to help boost private 
investment to 25 percent o f GDP (Pfefferman and Madarassy. 1990). In the context o f Ghana, 
the government adopted a comprehensive package o f policy reforms aimed at creating an
improved business environment since the 1980s. The World Bank, through the International 
Finance Corporation, provided financial assistance to help private enterprises. During that 
same period the IMF concluded an Enhanced Structural Adjustment Agreement with Ghana, 
which was designed to promote the private sector, alleviate poverty, and strengthen 
governance. More recently, the Ghana government submitted a new private sector 
development strategy to the World Bank. The overall objective o f the strategy is to enhance 
the investment climate o f  the country and to help achieve and sustain steady private sector 
based GDP growth which in turn would create jobs.
Investment generally is present sacrifice for future benefit. Investment in an economy is 
composed o f  public and private sector investment. Public investment refers to investment by 
the government sector primarily, but not exclusively, in the areas o f  social and economic 
infrastructure. Private investment refers to investment by private businesses for the purpose o f 
profit generation. Domestic government and citizens or foreign governments and citizens can 
own both public and private investment. Thus investment at any given time in an economy 
can also be divided into domestic investment and foreign direct investment (FDD. Investment 
can be in the form o f fixed business investment (buildings, equipments, real estate); current 
investment (inventory); changes in business investitures (installation, inaugurations) or in 
financial assets such as stocks and other securities. Some o f these investments are o f  short 
term duration while others are o f long-term duration.
Investment projects with long term horizons generally require long term financing. In Ghana.
due to high cost associated with long term financing (Asantc. 2000). a number o f businessmen
or enterprises tend to use short-term sources o f funds, usually bank borrowing, in financing
major investment projects. These projects include expansions, introduction o f  new products,
3
acquisition o f  new plant and machinery or equipment. Subsequently, a number o f enterprises 
run into financial difficulties as they try to cither renegotiate credit facilities with their banks, 
contract new loans to repay existing debt, or are simply unable to honour their obligations. 
The idea o f contracting short term facilities with a view to renegotiate or extend on due dates 
is rather costly and does not facilitate long-term planning (Brealy and Myers, 2007).
Financing and Investment decisions are thus theoretically interdependent. Myers and Majluf, 
(1984) have explored this interdependency and there is ever increasing themes in that 
exploration. Financial decisions consist o f a number o f  interdependent decisions with the 
result that financing decisions generally affect the firms cost o f capital (financing cost) which 
in turn affects the firm 's investment decisions. Thus it is argued that a firm 's investment 
decisions could depend on the financial constraint o f the firm. Brealy and Myers (2007), 
observe that investment decisions are simpler than financing decisions because projects are 
often evaluated wrongly, on a stand-alone basis; such that financing cost is not included.
According to the businessdictionary.com, financing cost: in general means, price o f  obtaining
debt (loans and bonds) and equity (common stock) capital. Also, according to Baum and
Tolbert (1985). interest, inflation, exchange rates among other macroeconomic variables are
price. According to Jongwanich and Kohpaiboon, (2008). the user cost o f capital can be
grouped into three- Interest rate, depreciation and the price o f  obtaining the capital stock. In
Ghana, firms cannot effectively raise much funds needed to finance investment because cost
o f finance is a major obstacle (Asantc, 2000). The implication o f  high cost o f  financing is that
firms rely on internally generated funds rather than external sources o f  funds. Traditionally.
long-term sources of finance include: Internal sources that is retained earnings (internally
generated cash flow from operations that is reinvested in the firm); External financing
4
generally consisting o f  debt (loans and bonds) and equity (common stock). These may be in 
the form o f bank borrowing, expanded trade credits, equities, bonds, notes and debentures. In 
the broad sense, however, the two main external sources o f  long term financing are debt and 
equity. Firms have the choice o f issuing either equity or debt securities or a hybrid o f the two.
The effect or impact o f  financing cost on a firm’s rate o f  investment is o f  much concern. The 
present value rate o f  investment decision is determined through the cash flow o f the 
investment. The cash flow is based on the costs and revenues associated with the investment. 
Government policies often affect factors like cost o f  inputs, prices o f  output, exchange rates, 
deficit spending, taxes, interest rate, inflation rates etc. Consequently, unavailability o f 
favourable policies will affect investment decisions. The growth o f  an economy depends on 
the rate o f  investment particularly private investment. Therefore any effect on private 
investment resulting from a change in cost o f  financing will subsequently affect the growth o f 
the economy. Hence, this research is an attempt to investigate how financing cost has affected 
private investment in Ghana.
1.1 Research Problem
High cost o f  financing private investment is a major problem to the private sector in Ghana. 
Private enterprises are increasingly finding it difficult to attract and repay credit needed for 
their investment projects. The main challenge facing private enterprises is access to affordable 
credit, (Asante, 2000). This state o f affair has made it difficult for these private enterprises to 
attain their corporate goals and to compete in a dynamic environment. Cost o f  financing has 
been a major impediment to private investment due to the changes in the variables such as; 
interest rate, exchange rate, budget deficit and inflation rate etc that influence them.
5
The results o f  the Modigliani and Miller theorem is that under perfect conditions the 
investment and financing decisions o f the firm are independent and therefore, can be made 
separately but on the contrary capital markets are sufficiently imperfect that firms must 
consider financing in their investment decisions. Myers and Majluf (1984), argue that 
information asymmetries lead markets to undervalue firms with the consequences that firms 
rely on internal funds to finance investments. However, when internal funds are fully 
exhausted, firms fall on external finance and where external funding is at high cost, it is likely 
to lead to a problem o f  underinvestment. Thus the central theme o f this study is the evidence 
o f Ghanaian private firms’ investment sensitivity to financing cost. Ghana, like many other 
developing countries has limited domestic resources for its economic development.
In consequence to this, all efforts must be made to mobilize the available resources for her 
development if  the objectives o f  vision 2020 are to be achieved. Specifically, the vision 2020 
projects total investment, to be 26.0% o f GDP by the year 2000. O f this, total private 
investment was estimated to be 16.5% o f GDP while total public investment was to be 9.5% 
o f GDP (Ghana Vision 2020 the first step: 1996 -  2000). However, available statistics show 
that even though private investment as a percentage o f  GDP was 7.9% in 1970. this dropped 
to 5.24% in 1986 and by 1996 it has drastically reduced to 2.04%. At the same time, the ratio 
o f public investment to GDP has been increasing. Even though priv ate investment increased 
to 4.23% in 1997 while that o f public decreased to 10.42% in the same year, it appears the 
mobilization o f resource for investment vis-^-vis growth and development has not been 
effective due to high interest rates on loans in particular. Against this background there exist a 
gap between desired and actual investment and the response o f  the priv ate inv estment to this 
gap depends mainly on affordable cost o f finance among other factors.
6
The ability o f  the private sector to play the role as the engine for economic growth more 
effectively will depend on the ease with which the private sector mobilizes funds for 
investment. This obviously can be achieved in the presence o f  affordable credit or finance. 
Then the issue o f cost o f  finance becomes important and in particular, how cost o f  finance 
affects private investment. Unfortunately, very little empirical work has been done on this 
issue in Ghana. One major work done by Asante, (2000) examined the Determinants o f 
Private Investment behaviour in Ghana and finds that the cost o f  finance constituted about 
82% o f the impediment to private sector participation in investment in Ghana. Similarly, 
Aryeetey. (1994). studied Private Investment under Uncertainty in Ghana and also finds that 
macroeconomic stability that ensures private sector participation in investment in Ghana is a 
necessity.
However, while A sante's work did not only examine finance cost variables independently on 
private investment. A ryeetey's study equally ignored the role o f  variables such as the stock 
market or domestic savings. This research is therefore, different from the previous studies 
because it applies the Johansen multivariate co-integration approach to examine the effect o f 
cost of finance on private investment and as well test for the direction o f  causality between 
finance cost variables and private investment in Ghana. Further, even though, private 
investment behaviour has been studied in Ghana, the focus o f  those studies were on the 
determinants, uncertainties, irreversibility, financial liberalization, macroeconomic conditions 
and fiscal impact on private investment (Asante, 2000; Aryeetey. 1994; Pattillo. 1996: Killick. 
1978).
Financing cost has come up as an important issue in private investment. Financing cost is
therefore noted to be a necessary factor in private investment decisions. However, empirical
7
work on cost o f  financing on private investment is virtually unavailable in Ghana, hence the 
key motivation for this research. Thus, the impact or effect o f  financing cost on private 
investment remains to a large extent unexplained. Indeed the proposition favouring private 
sector response to the high cost o f  finance for projects appear to rest more on theory than on 
empirical studies. Without such empirical studies, however, Ghana will not find itself in a 
good position when it comes to designing policies intended to stimulate private investment.
1.2 Objectives o f the Research
The foremost objective o f  this research is to assess and analyze the impact o f  the various 
forms o f  financing cost factors independently on private investment in Ghana. In order to 
achieve this objective, the study identified relevant cost v ariables as well as other relev ant non 
cost variables that determine private investment, using the latter as control variables.
More specifically, the study pursued the following objectives:
i. To find the relationship and the direction o f causality between financing cost factors and 
priv ate investment in Ghana over the long run.
ii. To determine the impact o f the control variables: non cost factors on priv ate inv estment in 
the long run.
iii. To establish whether any o f the variables used co-integrate with the dependent 
variable: Private Investment.
iv. To make appropriate recommendations based on the findings.
1.3 Hypothesis
The study evaluated the following hypotheses:
Hoa: financing cost factors have negative and significant impact on long run private 
investment in Ghana.
8
Hi„: Financing cost factors do not have negative and significant impact on long run private 
investment in Ghana
Hot,: All the determinants o f  private investment identified in the literature and used in the 
model have significant impact on the long run private investment demand function in Ghana 
Hu,: At least one o f  the determinants o f private investment identified in the literature does not 
have significant impact on the long run private investment demand function in Ghana 
Hoc: There exist a cointegration among the determinants o f private investment and private 
investment in Ghana.
H |C: There is no cointegration among the determinants o f the private investment and private 
investment in Ghana.
1.4 Significance o f the Research
Even though the effect o f  financing cost on private investment is noted, much empirical work 
has not been done on it. This has provided the interest in undertaking this research. The 
significance o f the study is to make beneficiaries o f this study know that a firm 's success 
depends on its ability to raise affordable funds to finance its investment programs. The results 
from the study will also provide an insight into the importance o f financing cost as a tool for 
success in business, to entrepreneurs in Ghana and beyond. Thus this research will provide an 
insight into how cost o f financing influence private investment decisions and as well bring to 
light how lack o f private investment hampers economic growth and national development.
Also, this study will contribute significantly towards efforts at improving private inv estment
in Ghana. Thus the present research will contribute immensely to investment growth and
survival in Ghana particularly private sector investment. The research outcome will greatly
influence Ghanaian policy making for the private sector. It will inform policy makers as to
9
which variable o f  financing cost really impede private investment in a developing country like 
Ghana, so that appropriate measures can be taken to curb its effect. The study would be of 
much importance to the academia, finance practitioners, policy-makers, regulators and the 
general public as well as serve as a reference point for further studies or research.
1.5 Organization o f the research
The research has been organized in six main chapters: Chapter one looked at the background 
o f the research, research problem, objectives, hypothesis, significance and organization o f  the 
research. Chapter two presented an overview o f the Ghanaian Economy and Investment in 
Ghana. Chapter three reviewed, discussed and synthesized detailed literature on the study. In 
this chapter literature on Investment, Financing Cost and other related concepts were 
reviewed. The literature review formed the basis upon which the methodology and data 
analysis were carried out. Chapter four outlined the detailed methodology used in the study. 
The chapter detailed the type and sources o f data used for the study, the approach and strategy 
adopted to achieve the objectives o f  this empirical research. The econometric model used was 
well detailed in this chapter where consideration o f  a suitable model o f  investment was given. 
Chapter five look ed at data analysis and presentation o f  findings from the study. Thus, 
findings from the econometric results were presented in this chapter. Chapter six summarized, 
concluded the research work and gave policy recommendations, limitations as well as 
suggested area for further research.
10
CHAPTER TWO
OVERVIEW OF INVESTMENT IN GHANA  
2.0 Introduction
This chapter presents an overview o f investment in Ghana, by reviewing the developments in 
the Ghanaian economy, domestic private investment in Ghana, foreign direct investment in 
Ghana and measures to stimulate the performance o f private investment in Ghana.
2.1 Developments in the Ghanaian Economy
A look at the Ghanaian economy shows that it experienced a sudden and dramatic decline in 
the 1970's and early 1980s. During this period, GDP grew at an average rate o f  0.2 percent, 
which was far below the rate o f  population growth o f  about 3 percent per annum. The 
Economic Recovery Program (ERP) introduced in April 1983. contributed to reversing the 
negative growth rate in GDP experienced in the 1970s and early 1980s. GDP recorded an 
annual growth rate o f  5 percent in 1985 and 1986. Since 1986. the growth rate o f GDP has 
been positive although it has been below target in some years. Policies were implemented 
under the ERP to enhance the performance o f industry. The strategies adopted involved the 
development o f a more internationally competitive industrial sector based on increased 
exports and efficient import substitution. Also, measures were introduced to attract 
entrepreneurs and investors particularly, the private sector into all major sub-sectors with 
emphasis on the development o f appropriate technologies in the small and medium-scale 
manufacturing sector, (Samuel, World Bank, 1989).
11
Aryeetey (1994). though Ghana's economic crisis started from the early 1960's and mounted 
in the 1970s, it was in the early 1980s that its near collapse became evident. To sum up, 
domestic savings and investment declined rapidly both in the public and private sectors. Thus 
the growth dynamics o f  the economy vanished. This resulted in a steady decline in output. 
How-ever, population continued to grow at an average o f  about 3 percent per annum resulting 
in the decline o f  the per capita income. The need for investment in Ghana was realized early. 
Thus efforts were made to provide investment incentives under investment codes and through 
other legislation. The first investment code was the Pioneer and Companies Act o f  1959. As 
the need for foreign investment was realized, the Capital Investment Act o f  1963 (Act 172) 
was introduced to encourage foreign investment. The 1973 Investment Decree (NRCD 141) 
and Investment Policy Decree (NRCD 329) o f  1975 were introduced to centralize investment 
promotion functions at the Capital Investment Board and consolidate all investment 
legislations.
The 1985 Investment Code (PNDCL116) established the Ghana Investment Centre to serv e as 
the Central Investment Promotion Agency. In order to revise the laws relating to investment 
and provide for other related matters, the Ghana Investment Promotion Centre Act, 1994 was 
promulgated to re-establish the Ghana Investment Centre for the encouragement and 
promotion o f  investment. The climate o f  private investment in Ghana has been poor due to 
macroeconomic imbalances. The political climate o f  the country in the late 1970s and the 
early 1980s further reduced interest in private investment. The high inflation rates also served 
as a tax on private savings as real interest rates were negative. The policy o f  fixed exchange 
rate adopted for a long time resulted in the overvaluation o f  the domestic currency. Lack o f 
foreign exchange coupled with import controls affected the importation o f inputs thereby
reducing interest in private investment, (Aryeetey, 1994).
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A number o f  policy reforms have been included in the ERP to enhance the promotion o f 
private sector development in the country. These policies were intended to provide incentives 
to private investors and strengthen the private sector. Thus a crude estimate shows that in 
1986. 64.3 percent o f  the GDP was generated by the private sector. The private sector 
accounts, for about 50 percent o f  the output in the trade, agricultural, manufacturing and 
transport sectors. However, private investment can be said to have recovered in limited terms 
and has not reached the level expected since the reforms began. Private investment has been 
targeted at 15 percent o f  GDP per annum in the second half o f  the 1980s but it actually 
increased from 2.9 percent in 1983 to 5.4 percent in 1985 and went down again to 2.4 percent 
in 1986. Private investment increased from 5.5 percent to 8.7 percent during 1987-1990. This 
includes an increase in foreign direct investment in the gold mining sector. Apart from the 
growth in the mining sector with the support o f multilateral loans, the private sector 
performance has not been encouraging particularly the manufacturing sector. (World Bank, 
1990).
The private sector investment levels have been low in the 1980s compared to the public
sector. Public investment grew from 6 percent o f  GDP in 1986 to 8.2 percent in 1995 and
estimated at 8 percent in 1996. Private investment however, recovered from 1990 onwards
and is about 10 percent o f GDP for the 1993 to 1996 period. Gross domestic inv estment was
20 percent in 1960. By 1970, the investment to GDP ratio was about 14.2 percent. This
dropped below 5 percent in the early 1980s with 1982 recording about 3.4 percent o f GDP.
Though the investment GDP ratio has been increasing since 1984, it has remained below the
level o f the early 1960s with an average o f about 19 percent. In 1990. the share o f  inv estment
in GDP rose to about 15 percent made ol 8 percent private investment and 7 percent
13
government investment. This level o f private investment according to the World Bank is low 
and requires a growth rate o f  about 15 percent to 20 percent o f  GDP to push the economy 
forward (World Bank, 1990).
Though inflation was low immediately after independence, it attained double digits in 1964. 
Between 1967 and 1972 it was moderate but soared up after a rate o f  about 10 percent in 1972 
reaching triple digits o f  about 117 percent in 1977 and 1981. In 1983, the rate o f inflation 
attained an all high level o f  about 123 percent. Since then efforts have been made to curb the 
high rates o f  inflation in the economy. Though it has been high throughout the ERP period 
and in the 1990s. remarkable achievements have been made. The rate o f  inflation dropped to 
about 10 percent in 1985, after fluctuating between 25 percent in 1992. However, efforts by 
the Bank o f Ghana could not sustain this low level o f  inflation and it started gradual rise again 
reaching about 60 percent in 1995, (Aryeetey and Harrigan. 2002).
In the period prior to the 1960s. international trade and payments in Ghana were relatively a 
free system. In the 1960s however, restrictive foreign exchange regime involving licensing 
and control systems were introduced. The introduction o f  a fixed exchange rate system in the 
midst o f hyperinflation and balance o f  payments problems in the late 1970s and early 1980s 
resulted in a sharp fall in Ghana's foreign trade during the period. The share o f  total external 
trade to nominal GNP fell from 39 percent o f  GNP in 1975 to about 6 percent in 1983and in 
the 1990s, remarkable achievements have been made. The rate o f  inflation dropped to about 
10 percent in 1991 and went further down to 10 percent in 1992. However, efforts by the 
Bank o f Ghana could not sustain this low level o f  inflation and it started a gradual rise again 
reaching about 60 percent in 1995. In the period prior to the 1960s, international trade and 
payments in Ghana were relatively a Iree system. In the 1960s however, restrictive foreign
exchange regime involving licensing and exchange control system in the midst o f 
hyperinflation and balance o f  payments problems in the late 1970s and early 1980s resulted in 
a sharp fall in Ghana's foreign trade during the period (Aryeetey and Harrigan, 2002).
A major characteristic o f  the ERP has been massive reforms in the exchange rate regime. The 
country7 moved from the era o f fixed exchange rates to "managed float” regime in which rates 
are determined at weekly auctions. In April 1983, a system o f multiple exchange rates based 
on bonuses and surcharges applied to specific transactions were tried and abandoned. In 
October 1983, there was a unification o f  the exchange rate system at the rate o f 
C30.00=US$1.00. The exchange rate o f  the cedi was adjusted three times in 1985 resulting in 
a rate o f c60.00=US$l .00. In January 1986, the exchange rate was again adjusted to 
C90.00=US1.00. As a further step to liberalize the foreign exchange regime, the government 
o f the PNDC introduced the auction system in September 1986. Under this system, the rates 
are determined through the "market forces” through bidding under the supervision o f  the 
Bank o f Ghana. The auction system involved two windows. "Window 1” was responsible for 
some transactions described by the government as “vital transactions", for example crude oil 
purchases, essential drugs, government debt servicing and cocoa exports. These transactions 
went on with the exchange rate o f  09O.OO=US$1.00. All other transactions went on at 
“Window 2”. The first auction was held on September 1. 1986 at the rate o f 
Cl28.00=US$l .00. The two windows were merged in February 1987 and all foreign 
transactions took place at the auction, determined rates (World Bank. 1994).
Until 1987, interest rates in Ghana were fixed by the Central Bank. These had always been
fixed behind the rate o f  inflation. In 1977 with inflation at about 117 percent, the lending rate
was fixed at 12 percent and the deposit rate was 8.50 percent. It was raised to 15.50 percent in
15
1986. There has been a gradual increase in the lending rate from 21.82 percent in 1987 
reaching 29.45 percent in 1991 before starting a gradual decline reaching 20.96 percent in 
1996. The deposit rate increased from 15.33 percent in 1987 and reached 20.67 in 1991 before 
declining gradual reaching 13.5 percent in 1996. With the high level o f  inflation rates, the real 
interest rates (deposit and lending) have been negative between 1972 and 1983. Throughout 
the 1980s. except in 1985. the real rates o f interest had been negative. For example in 1980, 
the real deposit rate was -26 percent and the real lending rate was about -21 percent. In 1987 
the real deposit rate was about -16 percent and real lending rate about -7 percent. As part o f 
the liberalization policies, in 1987 interest rates were allowed to be freely determined by the 
forces o f demand and supply (World Bank, 1994).
The effect o f macroeconomic instability on private investment in Ghana has been mentioned 
by Asante (2000). Looking at the trends in inflation, as mentioned earlier it is clear that 
inflation has been high in the country. Comparing the trends in inflation with real private 
investment in Ghana, one can clearly see a relationship between inflation and real private 
investment. Between 1970 and 1983 when inflation was highly volatile, the level o f  real 
private investment was very low. This volatile nature o f inflation was bound to create 
uncertainty in the minds o f investors with regard to certain policies. For example, savings 
have been regarded as a necessary' source o f  investment financing. In order to boost savings, 
policies during the ERP period, aimed at restoring positive real interest rates. Since inflation 
was high, the focus was on increasing nominal interest rates in order to achieve this objective. 
The result o f this policy has been a high cost o f  credit. The trends in real exchange rate, and 
private investment in Ghana, also, show a clear negative relationship between the real 
exchange rate and real private investment in Ghana.
16
Up to about 1982, when the real exchange rate was appreciating, private investment in the 
country was very low. This was the period when the country adopted the fixed exchange rate 
system. Nominal exchange rates were far below the real exchange rate. The likely result o f 
this was capital flight. With the introduction o f  the flexible exchange rate during the ERP 
period, the real exchange rate started depreciating. Real private investment responded by 
increasing. However, these developments in the real exchange rate create doubts in the minds 
o f investors. The flexible exchange rate resulted in an increase in the value o f the cedi o f 
debts on past imports o f  inputs. Also, the perceived costs o f  importing o f  inputs had gone high 
and will certainly affect their investment decisions (Aryeetey (1994).
In addition to the volatile economic environment, Aryeetey, (1994) noted the credibility of 
government policies as very essential to private investment decisions in the country. 
Government policies in 1979 and 1982 regarding private property created doubts in the minds 
o f the private sector as to the credibility and sustainability o f  these policies. Such volatile 
political and economic environments affect prices (cost o f  funds) and thus create insecurity 
regarding them. It is therefore necessary to look at the extent o f  the influence o f  cost o f funds 
on private investment
2.2 Domestic Private Investment in Ghana:
Ghana began its journey to sustainable growth and development through rapid
industrialization in the 1960s. using variety o f control measures and state interv ention. During
the 1970s and early 1980s. economic policies were simultaneously not conducive to
investment and discouraging to saving, especially in a useful financial form. This period was
also characterized mainly by political instability; inconsistent economic and public policies;
and economic decline (Aryeetey and Harrigan, 2002). The economic and public policies were
17
likewise not conducive for private investment in Ghana. Moreover, by the perception o f 
uncertainty in political and economic environment, the picture o f  private investment in Ghana 
over the years seemed gloomy.
Private sector investors were deterred because o f risk in investment due to inappropriate 
measures, programs and institutions o f  the economy as well as financial setbacks to a large 
extent. Quite recently, the assurance o f  operating in secured and safe environment has 
stimulated private sector investors both foreigners and indigenes to open more and new 
businesses. Consequently, the private investment drive seems to be on course notwithstanding 
certain challenges evidently inherent in the economy.
The public policy towards private investment has changed very little overtime. The first 
republic under Dr. Nkrumah witnessed a seriously inhibited environment with regards to 
private investments. In the 1950s and early 1960s the policy o f  the government towards local 
private investment was hostile. Due to the following: the belief that there was little realistic 
prospect o f  fostering an indigenous entrepreneurial class capable o f  industrializing at the 
speed and scale they wanted: the thought that the country would be hampering its 
advancement o f  socialism if Ghanaian private capitalism were encouraged: the threat that a 
wealthy Ghanaian business class might pose to the president's political power, thus Nkrumah 
saw the possible affluence o f the local private investors as a threat to his continued reign. 
Ironically, the President (Dr. Nkrumah) advocated the need for foreign direct investment 
(FDI) with string attached (Killick. 1978).
After the overthrow o f the Nkrumah government in 1966. not much was done in terms o f
promoting the local private sector by the National Liberation Council (NLC). Though this
18
regime expressed the desire to give full encouragement to the Ghanaian enterprises in the 
private sector, their efforts, which included tax holidays for some industries did not yield 
appreciable results. The NLC regime also sought to reduce some other forms o f  taxation in 
order to induce savings to support development programs but the outcomes fell short o f 
expectations (Killick, 1978).
The Busia government (1969-1972) adopted a free market approach as the means to promote 
economic growth. Though this produced some recovery it was short lived. The years that 
followed witnessed not only low levels o f investment but declining levels as well. However, 
the governments o f  the National Liberation Council (NLC) 1966-1969 and that o f  Prof. K.A. 
Busia 1969-1972, made a pro private enterprise statements. Apart from wanting more foreign 
private investment, their major thrust was one o f  assisting domestic private investment. The 
NLC passed a decree setting out a time table for "Ghanaianization" and the Busia gov ernment 
supplemented this with further legislation that accelerated this program. However, there was 
little change in the degree o f  state participation in economic activities during the NLCTJusia 
era. Out o f  53 public enterprises and corporations that existed at the end o f  1965, 43 remained 
wholly state-owned by the end o f  1971 and five (5) new ones had been created (KLillick, 
1978).
During the era o f  the National Redemption Council (NRC) and the Supreme Military Council
(SMC) 1972 to 1979, the state dominated all economic activities. The return to a command
economy under these regimes sparked off political turbulence, which may have created a
climate hostile to private investment. Hence, there was little success in attracting private
investment. The repression and control o f private sector activity during the early 1980s by the
then Peoples National Defence Council (PNI)C’) government lead by IZx President Rawlings,
19
posed serious threat to private investors. Even after the introduction o f  the ERP, the public 
policy remained somewhat hostile to the private sector. Foreign companies were threatened 
with nationalization. In the 1990s. the state made a marked retreat from some o f the advanced 
positions it had taken in the economy through a privatization program in which a number o f  
state provided services were subcontracted to private operators and most o f the country's over 
three hundred (300) parastatals were earmarked for divesture (Gyimah-Boadi, 1991).
Finally, the government enacted relatively liberal investment and trading codes aimed at 
attracting private investment. In furtherance to the aforementioned positive signals, the 
government o f  the New Patriotic Party (NPP) lead by Ex President Kuffuor. since assuming 
power in 2001. has created an enabling environment for the private sector to flourish rather 
than the government engaging in direct production. To this end. the government has ensured 
the maintenance o f  macroeconomic stability as a notable means o f  providing an enabling 
environment. This is reflective in the growth and poverty reduction strategy' (GPRS) programs 
o f the government and in 2004. the creation o f a sub ministry for private sector development 
to help in this direction.
Further, the Venture Capital Trust Fund (VCTF) was set up by Venture Capital Trust Fund 
Act (Act 680) which was promulgated in November 2004. The objective o f  the VCTF is to 
help private investors raise capital at affordable rates for investment activities. The rational 
for promoting private sector development is to enhance job creation and also accelerated 
economic growth. This was reflected in real GDP growth rate o f  7.3% in 2008. affirming the 
government was indeed bent on making the private sector the engine o f  economic growth in 
foreseeable future.
2 0
2.3 Foreign Direct Investment in Ghana
Foreign Direct Investment (FDI) has been viewed as a major stimulus to economic growth in 
developing countries. Its ability to deal with two major obstacles, namely, shortages of 
financial resources, and technology and skills, has made it the centre o f  attention for policy 
makers in low-income countries in particular. It can impact the host economy through a 
variety o f  channels. Principally, it helps by adding to resources available for private 
investment and capital formation. The transfer o f  technology, skills, innovative capacity, 
organizational and managerial practices between countries is also enhanced through the 
activities o f  foreign direct investors, Baah-Nuakoh, (2000).
The need to attract foreign direct investors into the Ghanaian economy has been one o f the 
major policy objectives o f  Ghana's Economic Recovery Program (ERP). which started in 
1983 under the auspices o f  the World Bank and the IMF. This initiative was started by the 
NDC administration and continued by the Kuffuor Government, which came to power in 
January 2001, as the encouragement o f  foreign private investment in Ghana is seen as an 
integral part o f Ghana's economic policy up to date. In President Kuffuor's January 2001 
inaugural address, he stated that, “Ghana is open for business and foreign investors are 
welcome" The country’s policy o f  encouraging foreign investment is demonstrated in many 
ways, including sending investment missions abroad and hosting major international events 
that focus on foreign direct investment in Ghana. Notable among these events were the 5th 
African-American Summit and the 3rd Pan African Investment Summit held in May and 
September 1999 respectively. These events generated much renewed interest in Ghana. Baah-
Nuakoh (2000).
21
According to Ibrahim (2004), domestic investors must also be given the necessary attention as 
their foreign counterparts. Most often than not, domestic investors are not given the necessary 
attention because they are perceived as lacking the necessary capital and expertise to 
undertake the kind o f  investment that is undertaken by their foreign counterparts. It is 
however, high time government take a critical look at this issues by given them the necessary 
support to ensure their growth and sustenance. Investments by domestic investors carry some 
advantages, which foreign investors may lack. While foreign investors always think o f 
repatriating profits back to their home countries, domestic investors keep theirs in the 
domestic economy and thereby improving on the foreign reserve base o f  the economy. They 
also employ the local population from management to labourers and as such do not have to 
pay huge expatriate fees in hard currencies.
2.4 Measures to Stimulate the Performance o f Private Investment in Ghana
Ansah. (2007), certain measures stimulated the performance o f  private investment, whilst 
others discouraged it. Before the introduction o f  1973 Investment Decree (NRCD 141) and 
the 1975 investment Policy Decree (NRCD 329); other Investment Acts such as the Pioneer 
and Companies Acts o f  1957 and the capital Investment Act o f 1963 had been in place. The 
previous Acts sought to encourage foreign investment, while the decrees encouraged both 
local and foreign investment. The 1981 Investment Code (Act 437) sought to centralize 
investment promotion functions at the Capital Investment Board and consolidate all 
investment legislation. The 1985, Investment Code (PNDC 116) established the Ghana 
Investment Centre as the main investment promotion agency.
All these investment codes attempted to provide a favourable investment climate by offering 
incentives to private investment. The incentives generally provided included tax holidays, 
accelerated depreciated allowances, exemption from import duty on machinery and 
equipment, investment allowance and arrangements for profit repatriation. Nevertheless, these 
laws did not have adequate provisions for the protection o f  foreign investors in respect of 
profit repatriation and equal opportunities. Coupled with this were the government’s 
compulsory acquisition o f  equity shares in large foreign companies and the nationalization o f 
many others through the indigenization policy in the 1970s. The result was that foreign 
investment declined during the period and given that it formed a very significant component 
o f private investment, it contributed greatly to the decline o f  private investment during the 
period.
However, several other measures were instituted later to enhance private investment 
behaviour. Perhaps the most important legislation that was aimed at improving the investment 
environment in Ghana, under the reform period, was the Ghana Investment Promotion Centre 
(GIPC) Act o f  1994 (Act 478). The Centre as established by the Act is to serve as an agency 
o f the government for the encouragement and promotion o f investment, coordinating and 
monitoring all the investment activities and to revise the laws relating to investment. The Act 
gave foreign investors in Ghana an unconditional guarantee for a free convertibility o f 
currencies through any authorized bank dealer as well as the transferability, div idends and net 
profits o f foreigners, payments in respect o f loan serving where foreign loans are obtained, 
fees and charges in respect o f technology transfer agreement registered under the laws o f 
Ghana. In addition remittances o f proceeds in the event o f  sale or liquidation o f the enterprise 
or any interest attributable to the investment was also provided for. By December 2000. the
GIPC had registered 1160 projects mainly services (314). manufacturing (300). tourism (129).
23
building and construction (92) and agriculture (87) sectors o f the economy. The projects have 
also generated a total amount o f 1608.2 million US dollars with the service sector contributing 
the highest.
A USAID five-year sponsored program, the Trade and Investment Program (TIP), which 
started in 1993, aimed among other things at removing various constraints in investments and 
expanding exports. One major weakness identified in the investment drive was lack o f 
effective monitoring o f  policies to ensure their efficient and timely implementation. In 
response to this, TIP put in place a mechanism called the Trade and Investment Management 
Unit, with a board, the Trade and Investment Oversight Committee (TIOC) comprising all the 
ministries and other organizations whose activities related to investment and export 
development. This contributed tremendously in promoting investment in Ghana as the public 
and private stakeholders worked hand in hand.
Other institutions which have been created to promote investment in Ghana, include, the 
Ghana Trade Investment Project (GHATIP). Private Enterprise Foundation (PEP), the Ghana 
Stock Exchange and other international initiatives. The GHATIP was established in 1998. 
with the aim o f attracting many export-oriented investors to Ghana and to make Ghana the 
trade and investment hub in West Africa. The project further seeks to support the private 
sector development by operating an export free zone and providing finance for off-site 
infrastructure. In addition, it is to enhance the performance o f front leading institutions like 
the GIPC, Customs, Immigration Service, Ghana Free Zone Board and the Environmental 
Protection Agency to re-engineer them into proactive trade and investment facilitators.
24
Under the initiative o f  the Association o f Ghana Industries (AGI), the Ghana Employers 
Association (GEA), the Federation o f  Association o f Ghana Exporters (FAGE) and the Ghana 
Chamber o f Commerce, the Private Enterprises Foundation (PEF) was established in order to 
achieve the objective o f  making the private sector the engine o f  growth. The PEF has as it 
policy objective, the lessening o f government interventions and the creation o f congenial 
atmosphere for private investment by engaging in a continuous dialogue and establishing 
partnership between government, the private sector and the developmental stakeholders.
To provide long term capital for development, actions were initiated to quicken the pace o f 
making the Stock Exchange Act o f 1971 (Act 384) operational. The Ghana Stock Exchange 
(GSE) was given recognition as an authorized stock exchange in October 1990. even though it 
was incorporated in July 1989. as a private company limited by guarantee under the Ghana 
Companies Code o f  1963 (Act 179). Later it status was changed to public company limited by 
guarantee. The Ghana stock exchange was adjudged the best performing capital market 
among emerging market in 1994 and 1998 and it currently rated one o f  the best stock 
exchanges in Sub Sahara Africa. The performance o f  the GSE has been encouraging as more 
corporate bodies showed their willingness to raise funds through the GSE.
In order to train and finance private enterprises for them to take their rightful roles o f creating 
jobs, the Transitional Corporation and Management Division o f  the United Nations executed a 
comprehensive technical co-operation program: EMPRETEC Ghana in 1990. Since its 
inception, it has embarked on numerous training and workshop programs geared towards 
enhancing private sector participation in national development by assisting small and medium 
scale entrepreneurs to operate in that sector , thereby encouraging private sector enterprise 
and job creation, (Ansah, 2007). .
25
In 1983, the Economic Recovery program (ERP) was introduced, the main objective o f the 
ERP was to control inflation and promote private investment among others. To stimulate local 
production, duty rates on basic raw materials and capital goods were reduced in 1985. Within 
this same period, the government published a new investment code to affirm its commitment 
to a mixed economy. The financial sector was also liberalized to ensure adequate credit to the 
private sector. In an attempt to counteract inflation, the monetary authorities resorted to 
constant introductions o f  new Bank o f Ghana rediscount rates and revision o f  reserve 
requirements, resulting in variability in credit flows and undermining the private sector’s 
confidence in the banking system.
Consequently, in line with the quest to promote a more vigorous private sector, the 
government went further to streamline the legal and administrative framework for the private 
sector and also made improvements in the financial and incentive framework. Other measures 
in the 1990s included the abolition o f the manufacturing Industries Act, 1971 (Act 356). 
which removed a redundant and bothersome requirement in the investment establishment 
process and the repeal o f  a number o f price control laws which did not permit the 
manufacturers to price their goods according to the dictates o f the market forces. Furthermore, 
the Investment code, 1985, (PNDCL 116) was amended and the Ghana Inv estment Promotion 
Centre was transformed from a regulatory body to a promotional one.
Another development worthy o f noting within this period was the conversion o f the sales tax
into the Value-Added Tax (VAT) at a flat rate o f 12.5 percent from 15 percent. The broad
coverage and relative neutrality o f VAT made it an appealing tax scheme for most
economists. I he neutrality stemmed from the exemption given to export and investment
26
goods. Despite these measures private investment was still low because the perception o f 
uncertainty in the political and economic environment persisted, Killick, (2002).
In July 2007. the Venture Capital Trust Fund (VCTF) was launched. The VCTF was 
established by Venture Capital Trust Fund Act (Act 680) which was promulgated in 
November 2004. with the objective to provide Investment Capital to Small and Medium 
Enterprises (SMEs). Further, to provide low cost financing to businesses so they can grow, 
create wealth and jobs. The vision o f  Government is that the scheme enriches businesses with 
enough resources to create jobs. Consequently, with enough wealth and jobs created, 
government revenues would increase (through taxes) and ultimately add to the pool o f  funds 
available to be down-streamed to businesses for investments.
In the Ghanaian economy, more than 90% o f the companies are SMEs, Gov ernment in its
desire to support this vital sector o f the economy established the VCTF. This is because the
SMEs are important area that needs easy access to finance. The SMEs create a suitable
livelihood for the majority o f  the population supporting them is therefore vital for economic
growth. Unfortunatel y, t here is a dearth o f long term investment funds for SMEs (as a
consequence o f  the banks and other creditors shying away from the high risk investments in
these sectors), it has became imperative for the Government to set up a venture capital fund
that will provide long term funding for the high risk investment needs o f  the SME sector.
Thus, VCTF is to support SMEs to get increased access to credit at a cheaper cost so that they
can grow their business. The funds provided by the VCTF to businesses may come as an
equity investment or loan and a combination o f both loan and equity. If the funds are given as
Equity, the Venture Finance Company becomes a partner or shareholder o f the investee
company and no debt service is charged, however, the Venture Finance Company gets annual
27
dividend from time to time. If  a loan is granted by VCTF to a company, it is on a long term 
basis so that there is no immediate debt service that constraints the business. In most cases 
loans granted by VCTF carry an interest rate that is below the market rate or what the normal 
financial (banking) institutions ofler. The VCTF thus, provides an opportunity to businesses 
that is almost not available elsewhere.
The Venture Capital Trust Fund has established joint venture with financial intermediaries to 
assist SMEs, raise capital at a cheaper cost and or provide long term low cost financing to 
businesses. Hence the VCTF slogan: "with Venture Financing, you have a Long Term 
Partner". In addition, the purpose was to initiate relevant activities for the development and 
promotion o f the venture capital industry in the country. This is because the Government 
vision o f promoting the private sector as the engine o f growth cannot be fulfilled without the 
effective functioning o f  financial intermediaries.
The Fund's source o f  funding is an amount o f  money equivalent to twenty-five percent (25%) 
o f the proceeds o f the National Reconstruction Levy. The Trust Fund monies are made 
available to investee companies through intermediary institutions called Venture Capital 
Finance Companies. The fund is available to all sectors o f  the economy except imports to sell 
and construction works like hotels. However, based on the Government's economic 
development goals and agenda, the Board from time to time will select certain sectors o f  the 
economy as priority, for a greater percentage o f funding (about 55%) to be allocated. 
Currently, the priority sectors identified by the Trust Fund are Agriculture. Pharmaceutical. 
I d  and Tourism, (Venture Capital Trust Fund Act (Act 680); www.tiooule.com).
At the international front, Ghana, has instituted measures aimed at improving the investment 
climate in the country. As a member, Ghana ratified the convention establishing the 
Multilateral Investment Guarantee Agency (MIGA) in 1988. MIGA aims at encouraging 
equity investment and other forms o f FDI in developing nations, by reducing non commercial 
risk. Moreover, the government has entered into bilateral Investment Promotion and 
Protection Agreements (IPPAs) with a number o f  countries to further enhance the protection 
and security o f  the investment environment.
The government has a larger potential market for investors as a member o f  the ECOWAS 
which comprises o f  16 countries with a population o f  over three hundred (300) million. 
Overall development partner coordination in Ghana is strong. Adoption o f the Ghana Poverty 
Reduction Strategy (GPRS) by the Government o f Ghana in 2002 created the momentum for 
a group o f  donors to align their assistance under a common Multi-Donor Budgetary Support 
(MDBS) framework in June 2003. The World Bank's strategy in Ghana lays emphasis in 
deepening its collaboration with other development partners through the MDBS framework, 
through sector programmatic support (e.g. in the health sector. HIV/AIDS, private sector, 
financial sector and public sector reform), and through joint collaboration on country analytic 
work, fiduciary assessments and mission management. The Ghana portfolio is wide-ranging 
and is aligned on GPRS/GPRS 11 pillars and desired outcomes.
The International Finance Corporation (IFC) is the private sector development arm o f the
World Bank. IFC promotes sustainable private sector development primarily by: financing
private sector projects in developing world; helping private companies in developing world
mobilize finance in international financial markets; and providing advice and technical
assistance to businesses and governments. IFC 's strategy in Ghana includes supporting
29
private provision o f  infrastructure, building and deepening the domestic financial sector, 
expanding financing and technical assistance support to SMEs, promoting the development o f 
non-traditional exports and enhancing the business environment and investment climate.
In 2004, the IFC launched four (4) new technical assistance programs through the Private 
Enterprise Partnership for Africa (PEP Africa) in Ghana: the SME Enterprise Development 
Initiative, the Ghana Leasing Program, the Ghana Housing Finance Program and the Ghana 
Private Schools Support Program. Moreover, the IFC-supported Africa Management Service 
Company (AMSCO) continues to provide management expertise and capacity building to 
SMEs in Ghana.
By 2008, these measures had begun to yield positive results, with private investment 
recording relatively higher levels (from 3% o f GDP in 1983 to about 7.2% o f GDP in 2008). 
It is worth noting, however, that the average level o f private investment is below the 15% 
minimum proposed by Gillis et al. (1987) and a high percent o f  25 by Killick. (1978). On the 
whole, it is obvious that the effort pursued were impressive, for private sector investment, 
which has shown improvements and also remained relatively stable, though not high enough 
to make the sector the engine o f  economic growth.
30
CHAPTER THREE  
LITERATURE REVIEW
3.0 Introduction
In this chapter literature on investment, private investment and cost o f  financing as well as 
other related concepts are reviewed. The literature review forms the basis upon which the 
methodology and data analysis were carried out.
3.1 Theoretical Literature
The theoretical literature on investment is rich and w ide-ranging. Investment is the flow o f 
output in a given period that is used to maintain or increase the capital stock in the economy. 
Investment plays a crucial role in models o f economic growth. It is an essential component o f 
aggregate demand hence fluctuations in investment have considerable effect on economic 
activity and long term economic growth. While theoretical growth models developed in the 
economic literature makes no distinction between private components o f  investment there is 
an emerging appreciation that private investment is more efficient and productive than public 
investment. This point to the fact that private and public capital investment contribute to 
aggregate production in different ways. Specifically, private investment contributing more 
than public investment stem from the premises that some public investment provides public 
goods and services to the private sector . The benefits from public investment contribute to 
the general well being than contributing to the productive capacity.
Thus investment in an economy is composed o f public and private sector investment. Public
investment refers to investment by the government sector primarily, but not exclusively, in the
31
areas o f  social and economic infrastructure. Private investment refers to investment by private 
businesses for the purpose o f  profit generation. Domestic government and citizens or foreign 
governments and citizens can own both public and private investment. Investment at any 
given time in an economy can also be divided into domestic investment and foreign direct 
investment (FDI). Investment can be in the form o f fixed business investment (buildings, 
equipments, real estate); current investment (inventory); changes in business investitures 
(installation, inaugurations) or in financial assets such as stocks and other securities. Some o f 
these investments are o f  short-term duration while others are o f  long-term duration. 
Investment projects with long-term horizons generally require long-term financing.
The theories o f  investment date back to the days o f  John Maynard Keynes. Keynes (1936).
was the first to call attention to the concept (existence) o f  an independent investment function
in the economy. A central feature o f  the Keynesian analysis is the observation that although
savings and investment must be identical ex-post savings and investment decisions are in
general taken by different decision makers and there is no reason why ex-ante savings should
equal ex-ante investment. He considered investment as a function o f the prospective marginal
efficiency o f  capital in relation to a given level o f interest rate reflecting the opportunity cost
o f the invested capital. He argued that investment is worth undertaking if  the present value o f
the future income stream from a given level o f capital investment is equal to or greater than
the initial cost o f capital. Furthermore, he pointed out the intrinsic volatility o f  private
investment as a consequence o f the underlying uncertainty associated with the expected
returns on investment. Accordingly, he considered the decision to invest as based on what he
referred to as the “animal spirits" of the investors rather than on the rational calculation o f an
inherently uncertain distant future. Investment theory has been in rapid evolution after
Keynes’ original formulation. The practice o f macroeconomic adjustment, reforms and
32
growth have added other determinants considered relevant to better understand investment 
decisions.
The next phase in the evolution o f  investment theory gave rise to the accelerator theory. The 
accelerator models o f  investment have their origin in the works by Chcncry (1952) and Koyck 
(1954). The models generally take the empirical form o f the linear relation o f  current net 
investment to current and past changes in output. The naive accelerator theory o f  investment 
posits that investment responds to changing demand conditions. It postulates a linear 
relationship between investment and output. The basic assumption o f  the model is that the 
desired capital stock at any point in time is a constant multiple o f  output at that time. That is 
K* = aY. where K* is the desired capital stock, a  is a constant multiple o f output and Y is 
output. In the naive accelerator model, expectations, profitability and capital cost play no role 
in the determination o f  investment. The theory is based on stable optimal capital-output ratio.
According to the theory, as output exogenously increases, firms immediately raise their 
capital stock, that is, invest sufficiently to ensure that the capital-output ratio remain 
unchanged. Hence given an incremental capital-output ratio, it will be possible to calculate the 
investment level required to achieve a given targeted level o f output growth. The problems 
with this theory are it simplistic assumptions that there is a fixed ratio o f desired capital stock 
to output and the unrealistic assumption that the capital stock instantaneously adjusts to its 
optimal level, failing to recognize the high cost o f adjustment and the time lag necessary for 
acquiring capital goods. Keynesians have traditionally favoured the accelerator theory o f 
investment while disregarding the role o f factor cost.
33
Following the limitations o f  the naive accelerator theory, the flexible accelerator theory 
emerged. T h e  naive accelerator theory was modified to what became known as flexible 
accelerator principle o f  investment. A more general form o f the accelerator model is the 
flexible accelerator model. The basic notion behind this model is that the larger the gap 
between the existing capital stock and the desired capital stock, the greater a firm 's rate of 
investment. Unlike the naive accelerator theory, the flexible accelerator theory postulates that 
firms do not instantaneously adjust their existing capital stock to the desired capital stock 
because o f  uncertainties and various adjustment costs. Rather, what happens is that once a 
‘shock’ to output occurs, firms gradually adjust their level o f  capital with the aim o f re­
establishing the optimal capital-output ratio.
The theory' therefore asserts that the gap between the existing capital stock and desired capital 
stock determines investment. The larger this gap, the greater the firm ’s rate o f  investment as 
firms attempt to close the gap in each period. Consequently, the net investment equation could 
be formulated as : 1=5 (K.*- K-i), where 1 represents net investment. K* is the desired capital 
stock, K i denotes last periods capital stock and 8 is the partial adjustment coefficient, which 
shows how fast the gap K*- K i will be closed. A large coefficient o f  adjustment depicts a 
faster pace o f  closing the gap between desired capital stock and the actual stock. In the 
flexible accelerator model, output, internal funds, cost o f  external financing and other relevant 
variables are included as determinants o f the desired capital stock. The model may be 
transformed into a theory o f investment behaviour by adding a specification o f  desired capital 
stock and a theory o f  replacement investment.
However, alternative econometric models o f investment behaviour differ in the determinants
of desired capital stock, the characterization o f the time structure o f the investment process,
34
and the treatment o f  a replacement investment (Asante, 2000). While desired capital stock is 
proportional to output in the flexible accelerator model, the desired capital stock, in the 
alternative models depends on capacity utilization, internal funds, the cost o f  external finance 
and other variables (ibid).
The neoclassical theory o f  investment (version o f  the flexible accelerator theory), which was 
pioneered by Jorgenson (1963, 1967, 1971), postulates that output levels and user cost o f 
capital are the key determinants o f  investment. In this approach, the desired or optimal capital 
stock is proportional to output and the user cost o f  capital. The user cost o f  capital in turn is 
determined by the price o f  capital goods, the real rate o f  interest, depreciation rate and the tax 
structure (Asante, 2000). In the neoclassical theory, the firm is assumed to reach an 
equilibrium level o f  capital stock when the value o f the marginal value product o f  capital 
equals it user cost.
The neoclassical investment theory suggests that the growth rate o f  real GDP positively 
influences private investment (Wai and Wong, 1982; Greene and Villanueva, 1991; Fielding, 
1997). Also the theory posits that private investment is negatively related to interest rate as 
high interest rate is believed to discourage investment by raising user cost o f  capital. The 
neoclassical model o f investment is based on the assumption o f  perfect capital market and 
little or no government intervention. These may hold for developed countries but for 
developing countries, these assumptions are unrealistic as financial markets in developing 
countries are characterized by imperfections. Imperfection in the credit markets is believ ed to 
prevent firms from borrowing as much as they wish, thereby constraining investment.
35
Against this background, in the early literature o f  financial liberalization, another approach 
dubbed “Neoliberal” (Galbis, 1979:423), emerged. The proponents o f  ‘Neoliberal’ theory 
(McKinnon. 1973 and Shaw, 1973) emphasized the role o f  financial liberalization in savings 
mobilization to stimulate economic growth. Thus they emphasized the importance o f  financial 
deepening and high interest rates in stimulating growth. They argued that developing 
countries suffer from financial repression (which is generally equated with controls on interest 
rates in a downward direction). Liberalizing interest rate mainly by allowing market forces to 
determine real interest rates would therefore exert a positive effect on growth rates as interest 
rates rise toward their competitive market equilibrium. They claimed that administratively- 
determined interest rates reduces savings, capital accumulation and discourages the efficient 
allocation o f  resources.
The “Neoliberal” approach therefore holds the view that investment is positively related to the 
real rate o f  interest. This view provides a direct contrast to the neoclassical school, which 
hypothesizes a negative relationship between investment and real interest rate. The rationale 
behind this view is that a rise in the interest rate will stimulate the level o f  financial savings 
through financial intermediaries and therefore increases the level o f  investible funds. This 
phenomenon by which the volume o f investment could be raised via the resultant increase in 
the level o f investible funds made possible by a rise in the rate is what McKinnon referred to 
as the “conduit effect” . Thus, while it may be true that demand for investment declines with 
the rise in the real rate o f  interest, realized investment actually increases because o f  the 
greater availability o f  funds. This conclusion applies only when the capital market is in 
disequilibrium with the demand for funds exceeding supply.
3 6
Another strand in the literature on investment is the disequilibrium approach to investment. 
“Disequilibrium approach o f  investment” has it origin in the works o f  Malinvaud (1982) and 
Sneesens (1987). Here, investment is a function o f  profitability and demand conditions. 
According to Malinvaud, investment decisions can be divided into the decision to expand the 
level o f  productive capacity and the decision concerning the capital intensity o f  extra 
capacity . Whilst the former depends on the degree o f  capacity utilization in the economy 
reflecting demand conditions, the latter is dependent on the relative cost o f  capital and labour. 
Serven and Solimano (1992) considered the distinction between the aforementioned two main 
investment decisions relevant because o f  the assumption o f  a putty-clay technology, so that 
factor proportions are flexible ex-ante but rigid ex-post. This means that the proportions in 
which inputs are combined before investment vary but fixed thereafter.
The importance o f  financial factors that are external to the firm was highlighted by Tobin. 
This became known as Tobin 's q. According to Larrain, et al (1993), the q ratio is the ratio o f 
the cost o f the acquisition o f a firm through the financial market to the cost o f acquiring the 
firm 's capital in the output market. In the “q" theory o f  investment (which is also in the 
neoclassical framework), the ratio o f the market value o f the existing capital stock to its 
replacement cost (the “q” ratio) is the main force driving investment. Tobin argues that 
delivery lags and increasing marginal cost o f investment are the reasons why q would differ 
from unity. In this theory, the catalyst o f investment is the ratio o f the stock market valuation 
o f existing capital asset to its replacement cost. This is the "q" ratio. In accordance with 
Larrain et al definition, q>l implies that the desired capital stock is greater than the actual 
level o f capital, meaning that the market value o f  the firm exceeds it cost. If q< l, the reverse 
holds. So as long as q > l , the firm must continue investing until q = l .
3 7
The cash flow approach to investment (Duesenberry, 1958), provides a more general 
framework which incorporates financial conditions that arc internal to the firm. According to 
this approach, investment is affected by the availability o f  internal funds, which in turn 
depends on profits. The view is that internal funds could be less costly than external finance if 
the market for borrowed funds is imperfect, perhaps due to difference in information about the 
riskiness o f  new investment. Larger amounts o f internal funds might therefore lower 
financing cost and increase investment demand.
More recent literature has introduced an element o f  uncertainty into investment theory due to 
irreversible investment (Pindyck, 1991). The argument is that since capital goods are often 
firm-specific and has a low resale value; disinvestment is more costly than positive 
investment. He argues that the net present value rule o f investment, when the value o f a unit 
o f capital is at least as large as its cost must be modified when there is an irreversible 
investment because when an investment is made, the firm cannot disinvest should market 
conditions change adversely. This lost option value is an opportunity cost that must be 
included as part o f  the cost. Accordingly, “the value o f the unit must exceed the purchase and 
installation cost, by an amount equal to the value o f keeping the investment option active” 
(Pindyck, 1991: 1112). The theory o f investment irreversibility suggests that the cost o f 
investing in machinery and equipment is usually not recovered by a future resale, (Acosta and 
Loza. 2005). Three major sources o f uncertainty have been identified: unstable 
macroeconomic environment, unstable policy environment and external shocks.
38
3>2 Theories o f Firm Investment Behaviour
Economic theorists are o f  the view that the firm under assumptions o f  rational behaviour will 
continue to invest until the marginal yield on physical assets are equal to the market rate o f 
interest, which derives from two criteria in rational decision-making-profit maximization and 
market value maximization and are assumed to yield similar conclusions under certainty. 
Under the profit maximization criterion it is only worthwhile to acquire an asset if  the asset 
will contribute to increases in net profits to the owners o f  the firm. Thus, managers seek to 
maximize the value o f  the firm and therefore seek to achieve optimum use o f  financial 
resources in order to maximize shareholder wealth. On the other hand, under the market value 
maximization criteria, an asset is worth acquiring only if  it increases the market value o f 
owners equity. In a nutshell, a firm acting rationally would invest until such a point that the 
expected rate o f  return on the asset exceeds the cost o f  the asset. (Bodie. et al (2007).
Additionally, economic theory states that investors base their investment decisions on the
present value o f an investment project. This involves the calculation o f the present value o f
the income stream associated with the investment project and comparing it with the cost o f the
project. Due to uncertainty associated with an investment project this process is difficult. The
process involves the estimation o f the income stream based on year by year estimates o f  the
increase in output associated w'ith the increase in productive capacity, the price or prices at
which the additional output can be sold and the operating costs associated with the project.
Net income is found by subtracting the operating costs from the revenues associated with the
project. The prospective investor uses the net income stream to determine its present value.
The present value is then compared with the cost o f  the project. If the present value associated
with the project is greater than its cost, the rule is that, the investor should undertake the
39
project. If on the other hand, the present value is less than the cost, the prospective investor 
should not undertake the project. The market rate o f  interest plays an important role in the 
investment decision process. The interest rate is used to discount the future income stream 
associated with the project. The present value o f the future income stream is then compared 
with the cost o f  the project in order to make the investment decision. Any change in the 
interest rate alters the present value o f  the income stream. The result is that an investment 
project could be profitable at the old interest rate but unprofitable at the new rate or vice 
versa. Thus investment largely depends on the market interest rate.
An alternative investment decision-making process is the comparison between the marginal 
efficiency o f  investment and the market rate o f  interest. The marginal efficiency o f  investment 
is the rate o f  interest, which equates the cost o f the project and the discounted value o f  the 
future income stream associated with the project. The marginal efficiency o f investment is 
often referred to as the internal rate o f  return. The decision o f the investor in this case is based 
on the comparison o f  the marginal efficiency o f  investment with the market rate o f  interest. If 
the marginal efficiency o f  investment is less than the market rate o f  interest, the investment 
project is unprofitable or at least, less profitable than lending the money at the market rate o f 
interest. Thus the investor should not undertake the project. On the other hand, if  the marginal 
efficiency o f  investment is greater than the market rate o f interest, the inv estment project is 
profitable or at least, more profitable than lending the money at the market rate o f  interest. 
The market rate o f interest plays a significant role in the investment decision making prcicess.
A project is unprofitable if the interest rate is too high. The project is however, profitable if  
the interest rate is sufficiently low. The market interest rate therefore, strongly determines
4 0
whether an investment should be undertaken or not. There is an inverse relationship between 
investment and the market interest rate, (Brealey and Myers, 2007).
An explanation is offered by Goyal and Yamada (2004) that under tight monetary policy 
interest rates generally rise and overall financial conditions become tight. Goyal and Yamada 
(2004) observed, macroeconomic factors have a significant effect on the cost o f  external 
financing and the severity o f  financing constraint faced by the firm determine their investment 
level. Myers and Majluf (1984) showed that external capital is more costly than internal 
capital. Consequently, firms that require more external capital relative to internal capital will 
have lower investment; there is a direct relation between capital costs and investment levels. 
Moreover, firms that we claim have higher costs o f  accessing external capital (e.g.. small 
firms) have a higher sensitivity o f  investment to volatility.
Investment decisions are also often based on the nature and timing o f investments. According 
to Pindyck, (1991 ) and Pattillo (1996). an important aspect o f  investments is that most 
investments are irreversible. This implies that, such investments involve sunk costs that 
cannot be recovered. Investment expenditures are sunk cost and therefore irreversible because 
most often, the capital is firm or industry specific and cannot be used by a different firm or in 
a different industry. Certain investments may not be firm or industry specific but are often 
partly reversible because o f  what is referred to as the “lemons" problem. In such instances, a 
newly purchased equipment, for example, vehicles and computers are not industry specific 
but their resale value will be less than the purchase cost, even if new. Irreversibility in 
investment can also be created by government regulations or institutional arrangements.
41
Another factor, which can affect investment decisions when the investment is irreversible, is 
the possibility o f  delay o f  the investment. When this possibility exists, it makes it possible for 
firms to wait and take advantage o f  information about prices, costs and other market 
conditions before taking investment decisions. However, firms do not always have the 
opportunity to delay investments. This happens when strategic conditions compel a firm to 
invest quickly in order to prevent other competitors from doing so. Delay o f  an investment is 
however, important in most cases. The ability to delay irreversible investment expenditure can 
to a very large extent, affect investment decisions. When investments are irreversible and can 
be delayed, they become sensitive to uncertainty to delay investments. This happens when 
strategic conditions compel a firm to invest quickly in order to prevent other competitors from 
doing so.
The poor performance o f  private investment in Africa has been attributed to uncertainty and 
instability (Anita and Morisset, 1993; Serven, 1997). Firms may be uncertain about future 
prices and wages, or they may be uncertain about future productivity. The source o f 
uncertainty may be changes in consumers’ tastes, technology, or institutions. Macroeconomic 
uncertainty variables that include the variability o f inflation and the real exchange rate have 
been determined as significant deterrents o f  private investment. Other measures o f 
macroeconomic instability that affect private investment include the variability o f  the 
government deficit and variability o f external debt. Another source o f  uncertainty that affects 
private investment is political instability, Aryeetey, (1994).
Fazzari. et al (1988) noted that investment is essential for long-run growth, and it plavs a
central role in engendering the course o f the business cycle providing a semblance o f the
theoretical link between macroeconomic factors and firm investment behavior. It is generally
42
argued that financing constraint o f  the firm is linked with the real economy because such 
constraints are exacerbated under periods o f recession and monetary contractions. Fazzari et 
aJ (1988). observed that financing constraint effect is more pronounced during recessions 
when cash flow is low and the value o f collateralized assets are equally low as well. In 
addition, other researchers have concluded that in recessions firms facing liquidity constraints 
are more likely to cut investment in inventory.
The growth o f  private investment in developing countries is important for the success o f 
macroeconomic policies. The fact is that if firms are not sure about the success o f  macro 
policies, they will be afraid to invest. When they fail to invest, then macro policies are in fact, 
doomed to fail. It is therefore clear that investment depends on risk factors that are at least 
partly under government control like price, wage and exchange rate instability, the threat o f 
price controls or expropriation and changes in trade regimes. Most macroeconomic policy 
variables -  interest rates, inflation rates and exchange rates are prices. It has been observed 
that countries that enjoy relatively high growth rates are those that have managed to avoid 
significant rates, keeping interest rates and the price o f capital positive in real terms, av oiding 
high inflation and avoiding real wage increase that are not justified by rising productivity , also 
enhanced investment activities as well, (Dixit and Pindyck, 1994).
3.3 Cost Factors and Private Investment:
3.3.1 Interest Rate
The relationship between interest rates and investment as portrayed by theory are v aried and
ambiguous when looked at as a whole. The marginal productivity o f  capital are determined by
productivity and thrift, thus for any given profitability level, investment expenditure varied
negatively with interest rate, implying firms rate their investment projects in order o f  the
43
expected profitability, net o f  the cost o f borrowing the funds to finance these projects. At a 
higher interest rate therefore, the net profit o f  most projects will be lower or even negative 
thereby discouraging potential investors from investing. Symmetrically, at a lower interest 
rate level, more projects will become profitable, encouraging investors to invest more. 
Empirical tests have been less successful in establishing a robust negative relationship 
between the interest rate and investment. Neoclassical theory suggests that high interest rates 
raise the cost o f  capital, which reduces the investment rate.
However, McKinnon (1973) and Shaw (1973) suggest that there could be positive relationship 
between investment and real rate o f  interest rate, because higher real rate o f  interest would 
increase savings, volume o f domestic credit will increase as a result, and equilibrium 
investment will be higher. This hypothesis, known as McKinnon and Shaw hypothesis, is 
based on assumption that quantity o f  financial resources is main constraint on investment 
rather than cost o f  funds. In most African economies, nominal interest rates are high but real 
rates are often negative due to high inflation rates. In such a context, the interest rate can have 
a negative effect on investment only through the saving channel. Low or negative real interest 
rates discourage saving, which reduce the amount o f funds available for investment.
33 .2  Inflation Rate
Besides the factors derived from the neoclassical investment model, the domestic inflation
rate has also been proposed as affecting private investment rates in developing countries.
where inflation is less often correlated with a rise in economic output than in industrial
countries (Dombusch and Reynoso. 1989). High rates o f  inflation adversely affect private
investment by increasing the riskiness o f longer-term investment projects, reducing the
average maturity o f commercial lending, and distorting the information content o f relative
44
prices. Also, high inflation rates are often considered an indicator o f  macroeconomic 
instability and a country's inability to control macroeconomic policy, both o f  which contribute 
to an adverse investment climate. Thus, the domestic inflation rate is negatively related to the 
rate o f private investment.
Inflation also discourages long-term lending by financial intermediaries, which further 
reduces the investment rate. In general, inflation is an indicator o f the quality o f
macroeconomic policy-making. Fischer (1993, p. 487) puts it as follows: “ In essence, the 
inflation rate serves as an indicator o f  the overall ability o f the government to manage the 
economy. Since there are no good arguments for very high rates o f  inflation, a government 
that is producing high inflation is a government that has lost control'’. Evidently, there is little 
incentive to invest in a country where the government has lost control over the
macroeconomic environment.
333 Exchange rate
It is the rate at which domestic currency can be converted into foreign currency. As the 
exchange rate fluctuates, the domestic value o f  goods priced in foreign currency similarly 
fluctuates. One o f  the major reasons for the downward behaviour o f  private investment in the 
in developing countries, including Ghana, is the overvaluation o f the exchange rate. The 
consequence o f  the overvaluation of the exchange rate is that the demand for foreign currency 
far outweighed its supply. This creates scarcity, so that imports o f  basic needs such as inputs 
for investments like plants and machinery, gasoline and spare parts which are needed to
supplement and stimulate investment, could not be brought into a country.
4 5
Aryeetey (1994) also observes that the rapid depreciation o f  the cedi has led to a general 
business uncertainty, which has inhibited the private sector investment needed to increase 
productivity. This ironically is at a time when the private sector development is seen as the 
prime mover o f  the economy. Massive frequent depreciation o f  the exchange rate has a direct 
implication for the cedi outlay required to import a given quantity o f  imported inputs such as 
raw materials, equipments or machinery. In this case, relying too much on imported raw 
materials implies that producers demand for working capital has to increase which might lead 
to a reduction in output. Asante and Addo (1997), indicated that production in the 
manufacturing sector was constrained by the limited availability o f  imported inputs in Ghana. 
This indicates that most o f  the firms in Ghana rely on imported inputs for their investment 
projects.
33 .4  Government Budget Deficit
It is the difference between government spending and revenue. Any budgetary shortfall must 
be offset by government borrowing. Large amounts o f  government borrowing can force up 
interest rates. Thus, excessive government borrowing “crowds out" private borrowing and 
investing by forcing up interest rate, thereby choking o ff private sector investment. Stated 
differently, government consumption spending may crowd out domestic investment through a 
raise in interest rates, thereby reducing the pool o f  funds in the credit markets, and also by 
increasing distortionary taxation on investment activities.
It is also possible, however, for government spending to "crowd in" domestic investment
through the accelerator channel. The net effect is theoretically unpredictable; it can only be
determined empirically. Government borrowing from the domestic financial system is another
factor that has reduced investment over the years. In most African countries, credit markets
46
are often regulated while the institutional environment establishes borrowing privileges for 
the central government and other government entities, which reduce private investors’ access 
to credit (Collier and Gunning, 1999).
Moreover, like private borrowers, governments can be bad debtors, with a tendency to default 
on their loans due to budgetary problems or simply because o f  bad management. This 
increases the fragility o f  the financial system, which further depresses investment. Inefficient 
government policies also have resulted in consistently high and unpredictable inflation rates 
in many African countries. High and unstable inflation adversely affects investment by 
increasing the degree o f  uncertainty about the macroeconomic environment. This discourages 
firms from undertaking long-term and illiquid investment projects. The extent to which 
government deficits create a “crowd out” problem i.e., government borrowing which diverts 
savings that would otherwise be borrowed by private businesses to purchase new plant and 
equipment into government hands, reduces the level o f  private investment. Crowd out 
theorists argue this competition between business and government for savings, forces interest 
rates up and substantially reduces the amounts business find profitable to borrow to invest, 
(Spencer and Yohe, 1970; Heim, 2007, 2008).
3.4 Non-Cost Factors and Private Investment:
3.4.1 Output (real GDP) Growth
Neoclassical investment theory suggests that the growth rate o f  real output is positively
related to investment because it indicates changes in aggregate demand for output that
investors seek to meet. Thus the Neo-classical investment theory suggests that the growth rate
o f real GDP influences private investment in a positive manner (Greene and Villanueva 1991.
Fielding 1997). This is also known as the "accelerator effect" Theoretically, this relationship
47
can be derived from a flexible-accelerator principle with the assumption that the underlying 
production function has a fixed relationship between the desired capital stock and the level of 
real output. Empirical evidence is consistent with this accelerator effect and shows that high 
output growth are associated with high investment rates, (Fielding, 1997, 1993; Greene and 
Villanueva. 1991; Wai and Wong. 1982).
Similarly, in Jorgenson (1963). the value o f  the desired capital stock for a typical firm 
depends positively on the demand level. The output o f  a country (GDP) would be a 
reasonable proxy to aggregate demand as a determinant o f  private investment in a country. 
However, to reduce the risks o f  simultaneity basis, the GDP variable, either in levels or in 
percentage form, is specified with a one-period lag. Further, the growth rate lagged by one 
period could also be construed as a proxy for expectations about future demand for. and 
returns from, the output o f  investments.
In the same vein, private investment has been hypothesized as a positive function o f  income 
per capita. Greene J. and Villanueva D., (1991), affirmed that countries with higher per capita 
income (real GDP) could devote more resources to domestic savings, which could be used to 
finance investment projects. Real output (GDP) growth is key to investment boost in 
developing countries including Ghana. It has been suggested that private investment is 
positively related to the growth o f real output. Nevertheless, "what determines investment" 
remains very much an open question in research on economic growth. Among the few recent 
studies on the subject is Blejcr and Khan (1984). which examined the impact o f  government 
economic policy on private investment in some 24 developing countries. This study found 
that the level o f private investment activity was positively related to the change in expected
4 8
real GDP, negatively to excess productive capacity (the shortfall o f  actual GDP from its trend 
value).
3.4.2 Public Investment
In developing countries, the public sector generally plays a large part in economic activity 
through public sector investment. The public sector investment may have “crowding out" or 
“crowding in" effects on private-sector investment. When the public sector invests 
predominately in infrastructure, public and private investment can complement each other. 
Hence, the relationship between public and private investment would be positive. In addition, 
if there is some slackness in the economy (e.g., the onset o f  the crisis), an increase in public 
investment can encourage domestic demand expansion, inducing an expansion o f private 
investment. On the other hand, with limited physical and financial resources, an increase in 
public investment can “ crowd out”  private investment, thereby inducing a negative 
relationship.
Thus public investment activity may be complementary to and consequently support private 
investment, particularly where public investment involves useful infrastructure: transportation 
systems, schools, water and sewage systems, and the like. Projects in these areas tend to raise 
the expected rate o f  return on private investment. On the other hand, public sector inv estment 
may detract from private investment activity to the extent that it substitutes for or crowds out 
private investment. This may occur when the investment involves parastatal enterprises 
producing goods that compete with the private sector, or when heavy spending for public 
capital projects leads to high interest rates, severe credit rationing, or a heav ier current or 
future tax burden (Aschaucr, 1989). As identified by Tsikata et al. (2000). on their study on
4 9
the determinants o f  foreign direct investments in Ghana, electricity and water combined, were 
listed by 82.1% o f the respondents as posing an obstacle to foreign direct investments.
3.4.3a Stock Market
The stock or capital market offers a relatively cheaper source o f  obtaining funds for 
investment projects. Capital markets are view- as a medium to encourage savings, help channel 
savings into productive investment and improve the efficiency and productivity o f  investment. 
Therefore another important factor that affects the private sector investment is 
underdeveloped capital markets and financial intermediation in developing economies. 
Because o f  the absence o f  long-term financing and the futures market, bank loans and external 
borrowing may be the only sources o f  credit available for private sector investment financing.
A well-developed stock market can help align the interest o f  owners and managers and 
thereby spur efficient resource allocation and economic growth in an economy. Ghana's 
vision 2020 program recognized the private sector as the engine for economic growth, the 
ability o f  the private sector to play this role more effectively as the engine o f  economic 
growth will depend on the ease with which the private sector mobilizes long-term funds for 
investment. This vision obviously can only be achieved by an effective and well developed 
stock market.
In view o f this the Ghana Stock Exchange (GSE), with eleven (11) listed equities and one (1) 
debt instrument at it in caption in 1990, the number has grown to: equities- thirty five (35), 
depository shares- one (1), preference shares- one (1), corporate bonds- three (3) and 
government bonds- one hundred and fourteen (114) by the end o f  2008. The value and
5 0
volume traded increased from GH0m 0.0064 and 222 million in 1990 to GH0m 365.51 and 
531,660 million in 2008 respectively. By end o f 2008, the GSE had total market capitalization 
o f  GH0m 18.465.15. (Ghana Stock Exchange, Market Statistics, February, 2010). 
Consequently, the CiSE was adjudged the best performing African Market and the World Best 
Performing emerging market in 1994. 1998 and 2003 by various stock market watchers.
Despite these remarkable achievements, studies have shown that the GSE is constrained by 
several factors, such as low income, lack o f  public awareness about the capital m arket high 
treasury bill rates, the absence o f underwriters and venture capital firms, among others. 
Further, there appear to be some sort o f apathy on the part o f  local investors to get their 
companies listed on the exchange, apparently due to the general unwillingness o f  business 
owners to relinquish control o f their companies, unwillingness to disclose certain vital 
information about their companies and the inability to meet the strict listing requirements o f 
the GSE (Osei, 1998; Ziorklui et al, 2001).
3.4-3b Domestic Savings
Domestic savings is used as a proxy for the stock market variable, during the period when the 
Ghana Stock Exchange was not in existence. The work o f  McKinnon-Shaw (1973) offered a 
theoretical and empirical foundation for the relationship between monetary factors and 
investment. These authors advanced the hypothesis that investment in developing countries is 
positively associated with the accumulation o f real money balances. The McKinnon-Shaw 
hypothesis is based on the assumption that limited access to credit in developing countries 
forces investors to accumulate enough real balances before they can initiate investment 
projects. This view establishes a positive relationship between real interest rate and
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investment. Higher interest rates on deposits attract more real balances, which allow them to 
finance more investment. This is in contradiction o f the neoclassical view that higher interest 
rates increase the user cost o f capital and thus reduce investment. Evidence on this 
neoclassical interest rate (relative price) effect is mixed at best.
Recent studies go beyond the McKinnon-Shaw tradition and relate investment to financial 
development in general by emphasizing the special services that financial intermediaries 
provide to investors. The financial system is key to matching financial resources to investors 
needs both through short-term credit expansion and, through its maturity transformation 
function, by channeling saving into long-term credit markets. Financial markets play an 
important role in allocating investment capital to high return activities (Greenwood and 
Smith. 1997). The emphasis on the role o f  finance for investment constitutes a major 
improvement on the traditional view that domestic investment is primarily determined by 
domestic savings.
Indeed a number o f  studies have documented a close connection between low investment 
rates and low domestic saving in developing economies (Bayoumi. 1990: Dooley, Frankel and 
Mathieson. 1987; Feldstein and Horioka. 1980). These studies find that countries with low 
saving rates also have low investment rates. The positive relationship between domestic 
savings and domestic investment is often viewed as evidence o f  imperfect international 
capital flows and various country specific institutional and non institutional rigidities 
(Feldstein and Horioka, 1980). Greene and Villanueva (1991) asserted that countries with 
higher per capita income could devote more resources to domestic savings, which could be 
used to finance investment projects.
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Private investment activity has been hypothesized as a positive function o f  income per capita 
because o f the greater ability o f higher income countries to devote large resources to savings. 
This ability is particularly important given the imperfection o f capital markets, since it 
appears that most investment projects must be financed, at least in substantial part, through 
domestic savings. This approach that assumes, however, that saving directly causes 
investment has important limitations. First, this view is an equilibrium (static) approach. 
Second, this view only considers the real side o f the saving behavior and regards saving as a 
residue o f income after consumption. Pollin, (1997), it.is more appropriate to consider saving 
as a financial phenomenon. Under this view, saving is regarded as a mechanism o f supply o f 
funds (directly and indirectly) to the capital markets that channel the funds into the investment 
process. In that sense, the financial sector benefits from positive externalities from the real 
sector through the volume o f saving (Berthelemy and Varoudakis, 1994). However, Keynes 
(1973. p. 222) pointed out that investment is constrained not by low savings but by low credit 
supply: "The investment market can become congested through shortage o f  cash, it can never 
become congested through shortage o f savings.
3.4.4 Credit to the private sector (funds availability)
Credit is defined as a means o f  facilitating the temporary transfer o f purchasing power from 
one individual organization to another, Batterham and Majid, (1987). Many private 
enterprises in developing countries depend on credit to cam ' out their investment projects. 
Therefore access to credit as far as investors are concerned is an important factor since it 
provides external finance to investors. The issue of the allocation has a profound implication 
at the national level. When credit is allocated poorly, poor investment projects are undertaken 
and the nation's resources arc squandered.
53
There is the belief that adequate credit and other financial assistance channeled through 
investment in the private sector could propel the economy to achieving high growth levels. 
However, lack o f access to finance is consistently cited in surveys as constraint to private 
sector investment in Africa countries. There is evidence o f  demand for external finance by 
enterprises that want to expand beyond the limits self-finance but have historically lacked 
access to credit (Aryeetey et al. 1994). Undoubtedly, the limited flow o f credit to 
entrepreneurs especially those in the productive sectors has serious adverse consequence on 
the macroeconomic performance o f  the country.
In Ghana, over the years, a large proportion bank credit has been directed towards fiscal 
deficit financing to the neglect o f the private sector. Subsequently, by the end o f  year 2001. 
Parliament passed into law a Bank o f Ghana Act (BOG Act 612). This Act gives operational 
independence to the Bank o f Ghana making it independent o f instructions from government or 
any other authority in the maintenance o f  price stability. Monetary policies from 2000 to 2005 
were focused on creating conducive environment for accelerating growth and wealth creation 
by sustaining the progress made in reducing inflation and maintaining exchange rate stability 
prior to year 2002, (Bank o f  Ghana. Annual Bulletin. 2002-2005).
It is generally argued that it is sometimes the availability o f capital rather than the cost o f 
capital that determines the level o f investment. A firm may have a good investment 
opportunity and yet it may have to give it up because the firm does not have access to enough 
financing in which case underinvestment arises. The consequence o f  unavailability o f  funds is 
that it makes firms unable to raise funds from outside parties to finance positive net present 
value projects either in the form of equity or debt, (Myers and Majluf, 1984). Thus the firm 's
54
investment is restricted to internally generated funds. Also the reliance on internally 
generated cash flow is a sign o f  under investment if outside finance could be cheaper.
3.4.5 External Debt
The presence o f  large external debt burdens constitutes another source o f uncertainty in the 
macroeconomic environment. . A high external debt signifies that part o f  the future returns on 
any investment must be used to sen  ice the existing stock o f debt. A higher external debt level 
could be an indicator o f  over-indebtness o f  external credit for investment financing, signaling 
the lack o f viability and sustainability o f current macroeconomic policies in the long term, and 
most likely negatively impacting investors' expectations due to the increase in the degree o f 
uncertainty on future policies.
Foreign debt may affect private investment in several ways: first, the size and timing o f 
external transfers to the country's creditors may be uncertain as it depends on future levels o f 
world interest rates, terms o f trade, the purchasing power o f  exports, and the ability to 
reschedule debt. Thus, the level o f  the real exchange rate and the timing o f demand 
management policies consistent with the required transfer also become uncertain. Second, 
funds available for investment will be reduced where a higher debt sen ice  payment is 
involved. Third, many developing countries including Ghana, face liquidity constraints in 
international capital markets because o f large arrears on debt sen  ice obligations.
Further, high debt can depress investment in various ways: first, high debt implies that a 
higher proportion o f domestic output is used to meet debt obligations. This phenomenon, 
referred to as debt overhang" (Krugman, 1988). creates a disincentive effect that discourages 
domestic investment. Second, high debt obligations adversely affect the country's position in
55
international credit markets and can even cause credit rationing. The credit rationing effect 
can be important, especially for sub-Saharan African countries given their low domestic 
saving rates that force them to depend on foreign funds for investment. Credit rationing thus 
amplifies the debt overhang effect in reducing domestic investment. Third, high levels o f 
external debt depress investment by making the macroeconomic environment more uncertain. 
Higher indebtedness increases the vulnerability o f  African economies to exogenous shocks, 
such as fluctuations in exchange rates and commodity prices, which can reduce the countries' 
ability to honor their debt obligations. Chronic trade deficits combined with ill-advised 
monetary and exchange policies have created a shortage o f  foreign exchange in sub-Saharan 
African countries.
Several studies have emphasized that a heavy debt over-hang reduces the incentive to invest 
because o f  the anticipated foreign tax on future income and returns on investment. Empirical 
results have confirmed that high debt has a strong negative impact on the private investment 
rates in developing countries (Oshikoya, 1994). Further, studies on developing countries in 
general and on sub-Saharan Africa in particular find a negative relationship between external 
debt and domestic investment (Jenkins, 1998; Greene and Villanueva, 1991).
3.5 Empirical Literature
Empirical literature on the relationship between cost o f financing and private investment as 
well as other related areas has been examined to validate the linkage between the dependent 
and independent variables.
Hubbard (1994) argues that a firm will want to suspend operations if  operating costs cannot
be covered. He assumed that, a project’s operation can be costlessly ceased when the current
56
price is less than the operating cost and can be costlessly restarted if the current price rises 
above the operating cost. Hubbard noted two regions for the value o f the project depending on 
whether the current price is greater than or equal to the operating cost or the current price is 
less than the operating cost.
The role o f  exchange rates, inflation rates and interest rates in investment decisions are 
important. Thus any uncertainty about real exchanges rates, inflation rates and real interest 
rates will have serious consequences for investment decisions. Dixit (1987) and Krugman 
(1988) noted that when sunk costs o f  entry are combined with uncertain exchange rates, firms 
are discouraged from entering the market even though current exchange rates would seem to 
make entry profitable. Ingersoll and Ross (1988); Tornell (1988). examined interest rate 
uncertainty in the context o f  irreversible investment where future returns are known with 
certainty. They found that there will be a great effect o f  interest rate uncertainty on the 
optimal timing o f  investment. Also an expected decline in future interest rates may not lead to 
increased investment because the change lowers the cost o f  waiting, so that the effect on 
investment is ambiguous. This means the volatility o f  interest rates may have a more 
important effect on investment than the actual levels o f interest rates. Pindyck and Solimano 
(1993) also found that inflation appears to be a major cause o f volatility; and strongly and 
negativ ely related to measures o f investment performance.
Huizinga (1993) studied how inflation uncertainty affects investment decisions. He noted the
uncertainty about the net present value o f  investment projects as the main tool for inflation
uncertainty to influence investment. He observed that if higher inflation uncertainty raises
uncertainty about the net present value o f an investment project it can be in the firm 's best
interest to delay undertaking the project until the uncertainty decreases or until the expected
57
payoff from the project increases enough to offset the higher uncertainty. Huizinga (1993) 
investigated the association o f  inflation uncertainty and uncertainty about real wages, real 
output price and profit taxes based on the premise that uncertainty about these variables 
contribute in an important way to uncertainty about the net present value o f  an investment 
project.
Hadjimichael and Ghura (1995) carried out an empirical analysis on private investment 
performance o f  thirty-two (32) African countries over the period 1986 to 1992, using a 
specification that includes the variability o f inflation and the real exchange rate as measures 
o f economic uncertainty, and an index o f  political and civil liberties as proxy for the 
definition o f  property rights. Their estimation results showed that either measure of 
macroeconomic uncertainty has a strong adverse impact on investment, while the political 
variable had a positive but insignificant effect. Ghura and Greenes (1993) had similar results 
when they studied the macroeconomic performance in thirty-three (33) sub-Saharan African 
countries during 1987 to 1992. They found that real exchange rate volatility has a strong 
adverse impact on the (total) investment/GDP ratio.
Asante (2000). in a study to analyze the determinant o f  private investment in Ghana for the
period 1970-1992. using times series analysis, cross sectional analysis and the ordinary least
square (OLS), came out with the findings that the overall measure o f  macroeconomic
instability has been a major hindrance to private investment: credit to the private sector has a
positive and significant effect on private investment; public investment was complementary to
private investment; military takeovers created a climate hostile to private investment whilst
the real GDP growth showed a positive sign in all the trials. Based on the findings.
recommended that policies that address only some components o f  macroeconomic instability
58
may not be enough to revive private investment; the question o f  cost o f  finance must therefore 
be properly address in order to attract participation o f private sector in investment, also there 
is the need for government to continue to develop the infrastructural base o f  the economy to 
boost the private sector. It is clear from the survey that lapses and hindrances to the private 
investment need be given serious attention if the private sector is to stand as the “engine o f 
growth" in the Ghanaian economy.
Aryeetey (1994) concluded that the poor growth in private investment in Ghana might be 
attributed to the perception o f uncertainty in the political and economic environment since 
1982. He observ ed that the uncertainty is derived from the low credibility o f  government, as it 
has been unable to assure investors that earlier decisions that showed a bias against private 
wealth will not be repeated. Private investment impacted by macroeconomic variables like 
real exchange rates and interest rates were identified as important to investment decisions.
Solimano (1989), in his paper on how private investment reacts to changing macroeconomic 
conditions in Chile, showed that the volatility o f the real exchange rate has a significant 
negative effect on private investment. He found that the large swings in the real exchange rate 
and output in the 1980s may have reduced private investment as compared to the situation o f 
lower variability o f  relative prices and output. Serven and Solimano (1993) investigating the 
role o f  some factors in the observ ed performance o f  investment in dev eloping countries using 
a pooled cross-section-time series data for a group o f fifteen (15) developing countries found 
that inflation instability index and the real exchange rate instability index (measures o f 
instability) had negative impact on private investment. They noted that, though their 
individual significance is not about five (5) per cent level, taken together, they are significant.
5 9
Khan and Reinhart (1990), using relatively smaller sample and narrower time periods in their 
cross country studies, estimated a model for 24 developing countries and found private 
investment has a larger positive impact on growth than public investment. They recommended 
that government should aim at an enabling environment for the private sector in their 
endeavor to promoting sustainable long run economic growth which can eventually raise the 
standard o f  living o f  the population.
Ang James (2006) explored the determinants o f real private investment for Malaysia, using 
time series data for the period 1960-2003. variables used included user cost o f  capital among 
others. In the analysis, use was made o f a private investment model drawn on the Neo­
classical framework and found a robust long run co-integrating relationship between private 
investment and all its determinants. Consistent with the predictions o f  the neoclassical model, 
higher cost o f  capital retards private investment whilst higher level o f  output raises private 
investment. This implies that cost o f borrowing is very important in making investment 
decisions.
Badawi (2003) in investing the impact o f macroeconomic policies on private investment on
Sudan and employing annual data over the period 1969-1998. he focused on public
investment credit, devaluation and interest rate policies. He used co-integration, vector
autoregressive and error correction techniques to estimate long and short run coefficients. The
results suggest that public sector investment had a negative crowing out impact over the
period o f study. Devaluation policy also contributed to discouraging private sector capital
expansion. Monetary policy in the form o f restricting domestic credit appears to have had a
significant impact on private investment. Increase in interest rate has been deleterious to
private investment, indicating that costs o f funds did matter for private investors in Sudan. In
60
general the effect o f  interest rate on investment has been studied mostly within the notion of 
financial liberation (Morisset, 1991).
3.6 Conclusion
Various studies reviewed found financing cost factors to have negative and significant impact 
on private investment. Most o f  these studies although carried out outside Ghana, except 
Asante (2000) and Arveetey (1994). support the view that cost o f financing is essential for 
private sector investment participation. Unlike Asante, Aryeetey and others, this study 
specially, looks at the extent o f influence o f  financing cost on private investment. While the 
focus is on private sector cost o f  financing, which appears the major problem o f private 
investors, it needs to be proved as a sufficient condition in this regard since investors operate 
under different conditions in different countries.
61
CHAPTER FOUR 
RESEARCH METHODOLOGY
4.0 Introduction
The methodology details the approach and strategy adopted to achieve the objectives o f this 
empirical research. It details the types and the sources o f  data used, the model used, the major 
criterion for accepting the econometric results and the econometric techniques o f estimation.
4.1 Research Approach and Strategy
Following the research work done by Asante (2000); Seruvatu and Jayaraman (2001) and 
others, it is clear that private investment depends on three broad categories o f  variables: 
Keynesian, neoclassical, and uncertainty variables. Variables that may be included in the 
Keynesian tradition include growth rate o f GDP (output growth), internal funds and capacity 
utilization. The neoclassical determinants o f  private investment include Tobin's Q. real 
interest rate, user cost o f  capital and public investment. There are three uncertainty v ariables; 
the first is variability o f  the user cost o f capital (real interest rate, real exchange rate, inflation 
rate, distortions in the foreign exchange market) and real GDP. The second uncertainty 
v ariable is the debt GDP ratio and the third is debt serv ice as a ratio o f  exports o f  goods and 
services. Hence the determinants o f private investment would be specified as consisting o f 
Keynesian, neoclassical and uncertainty variables. In general private investment is a function 
o f output, cost o f capital, and adjustment coefficient (Jongvvanich and Kohpaiboon. 2008). 
Unlike other estimations, the model estimated here includes cost variables and non-cost 
variables as control variables.
62
4.2 Variables Used
This research investigates the impact o f cost variables or factors on private investment in 
Ghana, controlling for non-cost variables or factors o f  private investment. The hypothesized 
investment function which has been examined in this study has Private Investment (PINV) as 
the dependent variable whilst the independent variables have been grouped into Cost variables 
and Non-Cost variables. Cost variables are defined to mean factors that affect the cost o f 
credit directly. According to the businessdictionary.com. financing cost: in general means, 
price o f obtaining debt (loans and bonds) and equity (common stock) capital. Also, according 
to Baum and Tolbert (1985). interest, inflation, exchange rates among other macroeconomic 
variables are price. According to Jongwanich and Kohpaiboon. (2008). the user cost o f  capital 
can be grouped into three- Interest rate, depreciation and the price o f  obtaining the capital 
stock. Subsequent! y, the investment function which was examined in this study has th e 
following cost variables:
i. Interest rate(INTR)
ii. Inflation rate(NFL)
iii. Exchange rate(EXR)
iv. Government Budget Deficit (BD)
Whilst Non-Cost variables: include other factors that affect private investment aside the cost 
variables. Therefore the non-cost components o f the investment function are as follows:
i. Public or Government Investment(GI)
ii. Stock Markct( Proxied by domestic savings for 1970-89)(SM)
iii. External Debt(EXD)
iv. Credit to private sector (Availability o f credit)(CPS)
v. Real Gross Domestic Product( Output growth)(RGDP)
63
4.3 Justification of Independent Variables:
i INTR= Interest rate
Keynes notes that “ investment will he pushed to the point on the investment schedule 
where the marginal efficiency o f  capital is equal to the market rate of interest” 
(Keynes 1973; page 136-137). In this model, the interest rate used is a year-on-year of 
the annual percentage interest rate produced by the Bank o f Ghana, which is the 
lending interest rate charged by commercial banks. High lending rate has been a major 
impediment to investment. According to the neoclassical theory, interest rate is 
expected to have negative influence on investment. However, McKinnon (1973) and 
Shaw (1973) suggest that there could be positive relationship between investment and 
real rate o f  interest, because higher real rate o f  interest would increase savings, volume 
o f domestic credit will increase and as a result equilibrium investment will be higher.
ii NFL = Inflation rate
The rate at which general prices o f goods and services change over time has been a 
very relevant variable that determines financing cost o f investment. Inflation is 
believed to be an important factor that influences investment decisions in any 
economy. Inflation pressures raises interest rate and relative instability in foreign 
exchange rates. Furthermore, this may result into change in real income ot the 
economy as a whole, thus altering the production capacity. In this model, the rate o f 
inflation (measured by consumer pricc index) will be included. Inflation rate is 
expected to have negative influences on investment. Pindyck (1991). rising inflation is 
a major causc o f price uncertainty in an economy. It is therefore expected to have an 
inverse relationship with private investment.
6 4
EXR= Exchange rate
It is the rate at which domestic currency can be converted into foreign currency and 
vice versa. The exchange rate used in this study is the cedi / dollar rate from Bank of 
Ghana. As the exchange rate fluctuates, the domestic currency value o f  goods priced 
in foreign currency similarly fluctuates. The exchange rate influences the relative 
prices o f  foreign and domestic investment o f  goods and services, and which, when 
rising, augment total purchasing power o f business income (Heim, 2008). The effect 
o f the exchange rate on private investment is hazardous; Chibber and Mansoor (1990) 
argue that a real depreciation acts as an adverse supply shock in the “production” o f 
investment goods. A change in currency value changes the real costs o f  purchasing 
imported capital goods, the profitability o f  the private sector is affected and possibly 
causing investment to retard. The exchange rate is therefore expected to have negative 
influence on investment.
BD= Government Budget Deficit.
The government budget deficit that is the difference between government spending
and revenue (Taxes less Government Expenses) creates a 'crowd-out' problem (Heim.
2008). Any budgetary shortfall is offset by government borrowing. Large amounts o f
government borrowing forces up interest rate by increasing the total demand o f credit
in the economy. Excessive government borrowing crowds out private borrowing and
investing by forcing up interest rates and choking off private sector investment. Thus.
deficit spending finance through bank borrowing causes interest rate to go up hence
increasing the cost o f funds available to the private sector and as well leads to credit
rationing and increased tax burden. Consequently, private investment is expected to be
negatively related with the budget deficit.
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GI = Government or Public Investment
Government or Public sector investment has been found to affect private investment, 
although its impact remains ambiguous. For instance public investment can boost 
private investment by increasing private returns through the provision o f infrastructure 
(Communication, transports, energy, etc.). Conversely, public investment may crowd 
out private investment if  the public expenditure was made in especially non- 
developmental programs such as on defense and debt servicing. Hence it can impact 
private investment in either ways.
SM= Stock market.
Keynes again notes that "the daily reevaluations o f the Stock Market inevitably exert a 
decisive influence on the rate o f  current investment" (Keynes 1973: page 151). All 
things being equal if  the evaluation reveals a better performance, investment is 
expected to increase. This study used the Ghana Stock Market All Share Index to 
measure reevaluation o f  the stock exchange. Further, the study used domestic savings 
as a proxy for the stock market all share index. This is as a result o f unav ailability o f 
data on the all share index from 1970 to 1989. when the GSE was not in existence. 
The stock market variable is expected to have a positive impact on priv ate inv estment.
EXD= External debt.
A further impediment to private investment is external debt o f  the nation. High debt
levels divert the resources previously used to finance the local private sector, towards
debt payments and charges being transferred abroad. Stated differently, high debt
66
levels divert the resources previously used to finance local companies toward service 
payments and charges being transferred abroad. Therefore a negative relationship is 
expected; the higher the debt the lower the private investment and vice versa.
viii CPS= Credit to the private sector
Another important factor that affects the private sector investment is credit 
availability. Due to underdeveloped capital markets and financial intermediation in 
developing economies, thus the absence o f long-term financing and the futures market, 
bank loans and external borrowing may be the only sources o f credit available for 
private sector investment financing. A positive relationship is expected, the higher the 
credit made av ailable to the priv ate sector the higher the lev el o f  investment.
ix Output growth= real GDP =RGDP
The real gross domestic product (RGDP) is used as a proxy for output growth. Real 
GDP is expected to induce the private investor to invest more, hence expected to have 
a positive impact on private investment. The neoclassical theory o f  investment, based 
on the work o f Jorgenson (1963). treats the value o f the capital stock desired bv a 
competitiv e enterprise as a positive function o f its output lev el. Accelerator theory also 
suggests that as demand or income increases in an economy, so does the investment 
made by firms. Furthermore, when demand levels result in an excess in demand, firms 
increase investment to match demand. Thus, a positive relationship is expected 
between output (proxied by real GDP) and private investment.
67
4.4 Data Type and Sourcc
The research covered the period o f 1970-2008 and made use o f  secondary data that were 
sourced from the Bank o f Ghana. International Financial Statistics CD-Rom o f the IMF, 
World debt tables o f  the World Bank and the Ghana Stock Exchange. Data on interest 
(lending rate), inflation (CPI, base year 1997) and exchange rates were obtained from the 
Bank o f Ghana and IMF: International Financial Statistics CD-Rom each covering the above 
stated period. Data on external debt was obtained from the World Bank, World debt tables for 
the period o f  1970-2008. Data on real GDP (base year 1993) was obtained from the Bank o f 
Ghana, for the period 1970-2008. Data on credit to the private sector was obtained from the 
Bank o f Ghana, for the period 1990-2008 and another data on the same variable was obtained 
from IMF: International Financial Statistic CD-Rom for the period under study. Data on 
government budget deficit also comes from International Financial Statistics CD Rom for the 
period 1970-1982 and then complemented with data from the Bank o f Ghana for the period o f 
1983-2008.
Data on private investment and public investment (as % GDP) were obtained from Asante. 
(2000). for the period o f  1970-1992, then supplemented with private inv estment (using priv ate 
capital formation as proxy) and public investment (using government capital expenditure as 
proxy) data from IMF: International Financial Statistic CD-Rom for the period o f  1993-2008. 
Finally, the stock market variable comes from Ghana Stock Exchange (market statistics. 
February 2010) for the 1990-2008. Domestic savings was obtained from IMF: International 
Financial Statistics CD-Rom was used as proxy for the period o f 1970-1989, when the Ghana 
Stock Exchange was not in existence. Surprisingly no workable data was obtained from the 
Ghana Statistical Service and Ghana Investment Promotion Centre.
6 8
4.5 Model Specification
The model specification o f  this study follows that o f  Ribeiro and Joanilio (2003) with little 
modification in terms o f  the cost factors and the non cost factors. The modified model is given 
as in equation (1):
P1NV = (V  p,SM + p:GI + p,RGDP + P..CPS + pdNTR + P„BD + p7EXR + pgNFL + p,EXD + e ...(1) 
Where P1NV is private investment. SM is the stock market. GI is government or public sector 
investment. RGDP is the real gross domestic product, CPS is the credit to the private sector. 
INTR is the real interest rate. BD is the government budget deficit. EXR is the real exchange 
rate. NFL is the inflation rale and EXD is the external debt.
Where pi > 0 . P2 < 0 or (32 > 0 . 03 > 0 . P4 > 0 . (35 < 0 . 06 < 0 . P7 < 0 . p8 < 0 . 09 < 0 , 
are the coefficients o f  the explanatory variables in the model whilst e  is the error term and Po  
is the constant term. The private investment function derived is a variant o f  the flexible 
accelerator principle designed to account for the objective o f the study. The study employs the 
Johansen-Juselius (1990) multivariate cointegration technique for estimation o f the long run 
private investment function.
4.6 Econometric Techniques for Estimation
4.6.1 Test of Unit Root.
Current standard regression analysis begins with the investigations into the stationarity o f the 
variables that are used. The Augmented Dickey-Fuller (ADF) test is employed to determine 
the level or degree o f integration o f the variables -  how many times the v ariables need to be 
differenced to attain stationarity.
6 9
Thus ADF test equation :
AY, = f l +yT+SY ,_ ,+ f i^AYl_, + £ ....................................m
i = l
Where )] represents the variable in question, is the trend, k is the lag length and £  is a 
random variable assumed to be a "white noise".
Hypothesis to be tested is as follows:
H0 : is having a unit root/ or nonstationary/ not integrated o f order zero 
Hi Yt is having no unit root/or stationary/integrated o f order zero
4.6.2 ADF Unit Root Test Procedure
The time series properties o f  the data were examined so as to ensure consistency. Hence a unit 
root test using the ADF test was conducted to establish the order o f integration for the 
variables. All the variables were not stationary in their levels at both 1% and 5% significant 
levels. This implies that running any model here could produce spurious relationships. To 
make the variables stationary, the first difference o f the variables were taken. Table 1 presents 
the ADF test on each variable in levels and table 2 presents the variables in first difference.
Determining the order o f  integration, the critical values were less than the calculated v alues in 
absolute terms for all the series in all cases. The results showed that the first differences o f  all 
the variables were stationary at 1% significant level. Thus all the nine variables being 
considered under the study were integrated o f  order one. In other words, all the variables in 
the model are 1(1). T able 2 showed the results o f  the ADI Unit Root test in their difference 
which is stationary at the conventional 5% level o f significance. Also, a line graph o f the
7 0
variables in levels and first differences are reported in appendices A and B respectively. This 
is in support o f  the stationarity o f the variables. Generally, the graph o f variables in first 
differences, show stochastic movement around the zero mean confirming that the variables 
are indeed stationary in first difference.
4.6.3 Test of Cointegration
Since the variables to be used are all not likely to be stationary, applying ordinary' least 
squares (OLS) will produce spurious result as noted by Granger and Newbold (1974). Engle 
and Granger (1987) developed a two-step approach, which is based on an OLS estimation o f 
the long-run equation and a unit root test o f  the residuals. If the residual series is stationary it 
is included in the (differenced) short-run specification as an error correction term, whose 
coefficient provides information on the speed o f adjustment to equilibrium. Although popular, 
the single-equation approach has its shortcomings. If there are more than two v ariables in a 
model, there may be more than one cointegrating vector. With the single-equation approach 
these different cointegrating vectors cannot be identified. But even if  there is only a single 
cointegrating vector, the univariate approach is inefficient if not all variables on the right- 
hand side o f the cointegrating vector are weakly exogenous. The multivariate error correction 
approach, which has been developed by Johansen (1988. 1991) and Johansen and Juselius 
(1990). overcomes most o f  the problems o f the two-step approach. The EC model for the 
money investment function takes the form:
k - \
(3)
Where:
Z = (RGDP, INTR, NFL, EXR, GI. SM. EXD, BI), CPS). 1 , 1 1 .  '1' (4)
71
The variable «, represents random disturbance while k represents the number o f  lag 
length. D, is a vector o f  exogenous variables and 'P. II, f ,  are vectors o f parameters. The 
matrix n  = a/? ' contains information on the long -  run relationship where a  represents the 
speed o f  adjustment to disequilibrium while P  is a matrix o f long -  run coefficient. Using 
the methods provided by Johansen (1988), the rank o f the matrix n  is tested to establish the 
presence o f cointegration or not. If there is cointegration then an Error Correction Model 
exists. The linear restrictions on parameters a  and P  are also tested using likelihood ratio 
tests.1
Consequently, the Johansen procedure for cointegration was used to carry out the long run 
relationship analysis between the variables. The method was chosen over the Engle-Granger 
Cointegration Test because the latter is used for bivariate models and there was more than one 
cointegration equation in the regression. The Johansen test is carried out under two main 
assumptions. These are the no deterministic trend and the linear deterministic trend. In 
carry ing out the cointegration test for this study, the no deterministic trend assumption was 
used because it is consistent with the ADF test.
4.6.4 The Johansen Cointegration Procedure
To test for cointegration the Johansen (1988) methodology is applied to the regression 
framework. Gonzalo (1994), argues that the Johansen approach has clearly better asymptotical 
properties to detect long-run equilibrium than a range o f  other estimators. Specifically, the 
Johansen procedure performs better than others even when the errors are not normally 
distributed or when the dynamics are unknown.
1 see Johansen 1988, 1991; Johansen and Jusclius 1990
72
Given that the variables are 1(1). the regression process R(p) with the form o f Equation (5) 
can be represented by the ECM (p-1) as in Equation (6):
Where: n, (O.Q)Vf and £ ( / / , . / / , . ,)  = OV.v * 0 . x, is an (n x 1) vector o f  endogenous
variables and At ..-1, n . r , r ,  T n are the parameter matrices. Whether or not the
1(1) variables are cointegrated, and if so how many cointegrating vectors exist, depends on the 
rank o f the matrix n  . Before estimating the rank o f the matrix n . we need to determine how 
many lags should be included in Equation (6). Johansen (1991) suggests that the lag length 
should be specified such that the regression residuals are empirically Gaussian. As a lag 
selection strategy, we add lags incrementally until the series correlation o f  the residuals in the 
estimated regression is eliminated.
To determine the rank o f  the matrix n  or the number o f cointegrating vectors. Johansen 
(1988) proposes the trace test and the maximum eigenvalue test. The trace test takes the 
following form:
Where: At. A :,..., Am arc the estimated eigenvalues arranged in descending order and T is the 
number o f usable observations. The null hypothesis is that the number o f distinct 
cointegrating vectors is less than or equal to r against a general alternative.
  -  .-tfl + i V , :  + + - 5 -   (5)
dx, =  + n  v ,  , +  1 td x t | +  I , dx, : +  . . .  +  1 (6)
TR(r) = - T  £  ln(l -  )
73
The maximum eigenvalue test takes the following form:
MX(r) = - T  l n ( l - 5 „ , )
Where: A1.A 2  A„ are the estimated eigenvalues arranged in descending order and T
represents the number o f  usable observations. The null hypothesis is that the number o f 
cointegrating vectors is r against the alternative o f  1 +r cointegrating vectors. After 
determining the number o f  cointegrating vectors r(0 < r < n), the matrix n  can be 
decomposed into two matrices a ( nx r )  and P(n  x r ) such that n  = a P .
Therefore, equation (6) can be rewritten in the form:
dx, =.4t + a ( 0 ' x , . l ) + r idx,_[ + r 2dxl_,+.. .  + r p_[dx,_(r_h + i i l .................................................. (7)
Where: P  is the matrix o f  cointegrating vectors and a  is the matrix o f  speed o f adjustment 
parameters. The P  matrix measures the long-run equilibrium relationship among the 
variables, and the a  matrix measures the responses to deviations from long-run equilibrium. 
Equation (7) can be estimated using the maximum likelihood method. Once or and P  are 
determined, various restrictions on a  and p  can be examined by a likelihood ratio (LR) test 
which compares the maximized value o f the log-likelihood function o f unrestricted and 
restricted models. The statistic for this test is given by 2[Z.„ - I r].  where Z.t and L, denote
the maximized values o f  the log likelihood function o f  the unrestricted and restricted models, 
respectively.
4.7 Error Correction Model
The error correction model (ECM) was constructed in order to appreciate the short-run 
dynamics o f the private investment function, having established that a long-run relationship
74
exists between the variables. The error correction model has both the short run and long run 
components. The long run component o f the model is given by the error correction term. As 
already mentioned, the fact that the variables are co-intcgratcd indicates that the ECM can be 
formulated to assess the linkages between the variables. The error correction term in the 
model allowed the variables to be assessed, so as to find out which variables move to balance 
the long run relation. In other words, the error correction model shows the short-run direct 
effects between variables but not the total effect resulting from both direct and indirect 
impacts. If the error correction term is insignificant the estimated co-integration relation is 
unlikely to be valid or strong.
4.8 Diagnostic Test
To ensure that the model conforms to standards and render the results reliable, the following 
tests are carried out to assess the performance o f  the model. These tests include pairwise 
correlation test (correlation matrix o f  dependent and independent variables), autocorrelation 
tests. Jarque-Bera Normality test. Heteroscedascity tests, and Ramsey reset test. In addition, 
stability tests are also undertaken to ascertain the stability or otherwise o f  the models using 
the Cumulative Sum (CUSUM), Cumulative Sum o f Squares (CUSUM Square) and 
Recursive Residual tests.
The stability o f the private investment functions is important for effectiveness o f investment
policy in Ghana. In stability tests, the estimated investment function is assessed to see if it has
shifted or not over the study period. The Cumulative sum (CUSUM). Cumulative Sum of
Squares (CUSUM of Squares) and Recursive residual tests are applied. The CUSUM test is
based on the cumulative sum o f the recursive residuals. The expectations o f the CUSUM
statistics are zero under the null hypothesis o f  constant parameters. The CUSUM and
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CUSUM Square statistics are plotted within a 5% significance confidence bounds. For the 
hypothesis o f  parameter constancy to be accepted, the statistic must revolve around zero 
within the confidence bounds. The CUSUM and CUSUM Squares tests show that the 
hypothesis o f  parameter constancy is not rejected as their statistic falls within the 5% 
confidence bound. This is supported by the Recursive residual test which shows that the entire 
variables lie within the r  2 standard error bound. The recursive residuals are used to test for 
structural changes in the models over time.
4.9 Pair-wise Correlation Test
The pairwise correlation test (i.e. the correlation matrix o f dependent and independent 
variables) establishes the association between the dependent variables and all the independent 
variables used in the study. The dependent variable in this case is private investment whilst 
the independent variables are the cost factors (interest rate, exchange rate, inflation rate and 
budget deficit) and the control variables: non cost factors (real GDP. public investment, credit 
to the private sector, stock market and external debt).
4.10 Conclusion
Using econometric testing the study will be able to determine which o f  the hypothesized 
model o f investment actually do move in ways consistent with the hypotheses that they really 
impact on investment. The testing procedures will also be able to suggest something about the 
possible marginal effects on investment that may result from changes in the variables. 
Reliability and Stability o f estimates can also be established.
7 6
The choice o f time series analysis for the study is based on the fact that most time series data 
are non-stationary and therefore give "spurious regression the study used Johansen co­
integration and Error correction method technique. Basically, co-integration means non- 
stationary time series tend to move together such that a linear combination o f them will be 
stationary. Estimation o f long run equation o f  variables using ordinary least squares and the 
estimated residuals from this regression was used in the estimation o f  a short run equation 
(error correction model) which eliminated the bias in the regression.
7 7
CHAPTER FIVE 
EMPIRICAL RESULTS AND ANALYSIS
5.0 Introduction
This chapter presents the empirical results and discusses the contextual interpretation or 
findings o f  the research. Thus the chapter discusses the unit root test, test o f  co-integration, 
the error correction model and the empirical findings.
5.1 ADF Unit Root Test Results
Under the ADF test, the null hypothesis is that the true values o f  the coefficients are zero (unit 
roots) which would be rejected if the computed t-ratios are larger than their critical values. 
The table below reports the results o f  the ADF test statistics for unit roots (stationarity) which 
includes a constant and a trend.
Table 1. ADF Unit Root Test Results in Levels.
VARIABLE t-ADF value Order of 
Integration
Number o f 
lags
PINV -0.4049 1(0) 1
SM -1.7192 1(0) 1
GI -1.8000 1(0) 1
RGDP -1.7896 1(0) 1
CPS -0.5623 1(0) 1
EXD -1.0374 1(0) 1
INTR -1.1745 KO) 1
BD -0.6951 1(0) 1
EXR -1.5059 1(0) 1
NFL -1.6817 1(0) 1
Critical Values (ADF) in levels are: 
5% = -1.95 1% =-2.626
78
The results below indicate the non-stationary series in the first difference are now stationary. 
All the series seem to 1(1) (i.e. integrated at order one) in levels so the necessary condition for 
co-integration among variables is satisfied.
Table 2: ADF Unit Root Test Results in First Difference
VARIABLE t-ADF value Order of 
Integration
Number o f 
lags
D(PINV) -7.663** HD 1
D(SM) -10.58** KD 1
D(GI) -6.455** KD 1
D(RGDP) -2.8652** KD 1
D(CPS) -5.741** KD 1
D(EXD) -4.518** HD 1
D(INTR)
I
-8.176** KD 1
D(BD) -5.786** KD 1
D(EXR)
i
-2.7345** KD 1
DfNFL) -10.98** KD 1
Critical Values (ADF) in first difference are:
5% = -1.95 1% =-2.626
NB: ** = 1% level o f  significance * = 5% level o f significance
7 9
5.2 Diagnostic Test
Below is the summary o f  the diagnostic statistics:
Normality Jarque -  Bera
Breuseh -  Godfrey Serial Correlation I.M Test
F -  Statistics 
TR3
White Heteroscedasticity Test (no cross products)
F -  Statistics 
TR:
Ramsey Reset Test
F -  Statistics
ARCH (3) F - Statistics
1.122033 10.570629)
1.097045 (0.351437) 
3.083359 |0.214021)
1.352623 [0.275284] 
20.04934 [0.271713]
1.168735 [0.290867]
0.843030 [0.480477]
NB: Figures in square brackets are significance probabilities
The Diagnostic tests conducted indicate that the specification is correct based on the Ramsey 
Reset test. In addition, the tests showed that there is no autocorrelation, no heteroscedasticity 
and the errors are normally distributed. Thus, the index o f  each o f  the independent variables 
influences Ghana's private investment function over the period under study. The low 
probability associated with the F-test for the overall regression also lends credence to the 
short run model.
The CTSUM. CUSUM o f Squares and Recursive residual tests o f stability confirm that the 
estimated model is stable as shown in Figures 1. 2 and 3 below:
80
FIGURE 1. CUSUM Test for Stability
FIGURE 2. CUSUMSQUARES Test for Stability
FIGURE 3. Recursive Residual test for stability
10
5
0
-5
76 78 80 82 84 86 88 90 92 94 96 98 00 02 
Rccunhv Residuals i 2 S.li
- 1 0
81
Table 3: Correlation Matrix o f Dependent (PINV) and Independent Variables Results:
PINV SM GI RGDP EXD CPS INTR BD EXR NFL
PINV 1 0.4029 0.4622 0.6503 -0.4495 0.6705 -0.5193 -0.6751 -0.6122 -0.5986
SM 0.4029 1 0.4771 0.5493 0.4636 0.5198 0.3661 -0.4947 -0.6523 -0.2046
GI 0.4622 0.4771 1 0.5051 0.9969 0.5067 0.4211 0.4176 0.6327 -0.2132
RGDP 0.6503 0.5493 0.5051 1 0.4889 0.8611 0.6417 -0.7927 0.9502 -0.3756
EXD -0.4495 0.4636 0.9969 0.4889 1 0.4926 0.3734 -0.4008 -0.6185 -0.2063
CPS 0.6705 0.5198 0.5067 0.8611 0.4926 1 0.3952 0.5943 0.8621 -0.4863
INTR -0.5193 0.3661 0.4211 0.6417 0.3734 0.3952 1 -0.7514 0.5357 -0.2064
BD -0.6751 -0.4947 0.4176 -0.7927 -0.4008 0.5943 -0.7514 1 -0.6978 0.4771
EXR -0.6122 -0.6523 0.6327 0.9502 -0.6185 0.8621 0.5357 -0.6978 1 -0.3186
NFL -0.5986 -0.2046 -0.2132 -0.3756 -0.2063 -0.4863 -0.2064 0.4771 -0.3186 1
Source: computed from data collected; significance at 5%
8 a.
A look at the correlation matrix (table 3) shows that for Ghana, the relationships between 
private investment and all the cost variables are strong, with the BD having the strongest 
negative correlation with PINV. ( BD = -0.6751). T he cost variables correlations are negative 
meaning that as the value o f  for instance BD falls; the value o f PINV tends to go up. On the 
other hand the non cost variables, except external debt has positive relationships with PINV 
with the CPS having the strongest positive correlation, meaning that as the value o f for 
instance CPS rises, the value o f PINV tends to go up. In general, the positive coefficients 
exhibit a direct relationship with the PINV variable whilst those with the negative coefficients 
exhibit an inverse relationship with PINV. So this means these variables are associated with 
PINV. so it can be predicted that the variables would be statistically significant predictor 
variables in the regression model.
§ J  Johansen Cointegration Analysis
The result o f the Johansen eigenvalue trace test is reported in the table below. The model was 
estimated using a one lag including a restricted term. At this lag the residual v ectors from the 
system satisfies the no-autocorrelation assumption which is a critical assumption in the 
Johansen procedure. The trace eigenvalue test statistics suggests that the co-integration rank 
o f the system is equal to one. This provides evidence that priv ate inv estment and the other 
variables are tied together by one long run relationship or equivalently that they share a 
common stochastic trend.
83
Table 4 shows the results o f the co-integration analysis performed:
Trace test: 
Eigenvalue
Max-Eigen
statistic
1% critical value Hypothesized 
No. o f  CE(s)
0.979815 145.23571 87.39755 None *
0.825324 83.74878 76.38569 At most 1 *
0.783216 62.84647 65.29746 At most 2
0.657139 41.77783 45.29846 At most 3
0.557677 32.07664 37.73728 At most 4
0.482138 24.41278 30.28746 At most 5
0.357126 15.24173 25.22947 At most 6
0.297315 10.42975 18.10935 At most 7
0.126839 6.38974 11.63829 At most 8
0.047834 2.90457 6.35781 At most 9
Table 5: Normalized Co-integration Coefficients
PINV SM GI RGDP CPS EXD INTR BD EXR NFL c
1 (XX) (J (XX) -0 0114 -0 0074 -00283 0.0063 0.0219 0.0125 0.0194 0.0328 -■’ .4185
(00142) (0 0029) (00131) (00049) (0 0095) (00027) (0.0052) (00049) (2.6772)
0 (XX) 1 (XX) 0 0472 -0 1037 -0 0215 -0.0578 -0.0452 0 0613 -0.0839 0.0503 1 298 1
(0 0176) (0.0812) (0.0092) (0.0140) (0.3904) (0 0257) (0.0216) (0 0371) (1.0219)
Log likelihood ratio = -  69.374
NB: Standard Errors are in parenthesis.
84
Table 6: Johansen Long Run Results
VARIABLE COEFFICIENT Standard Error t-statistics
D(DPINV<-1)) 1.0000
D(DSM(-1)) 0.0000
D(DGI(-1)) 0.0114 0.0142 0.8028
D(DRGDP(-1)) 0.0074 0.0029 2.5517
D(DCPS(-1)) 0.0283 0.0131 2.1603
D(EXD(-1)) 0.0063 0.0049 1.2857
D(INTR(-1)) 0.0219 0.0095 2.3053
D(DBD(-D) 0.0125 0.0027 4.6296
D(DEXR(-1)) 0.0194 0.0052 3.7308
D(DINFL(-I)) 0.0328 0.0049 6.6939
C 7.4185 2.6772 2.7710
Log likcli lood ratio 69.374
NB: The results does not produce probabilities, all the same, the long run results is significant 
when the absolute t-value is above two (2).
It can be observed from table 4 (Ma\-Eigen statistic > 1% critical value) and table 5. that 
there are two (2) co-integrating vectors that span the variables in the system as expressed in 
the normalized equations (1) and (2) below.
5.4 Normalized Equations
The normalized equations from the co-integration analysis are:
PINV = 7.4185 + 0 .0114GI + 0.0074RGDP + 0.0283CPS - 0.0063EXD -  0.0219INTR
0.0125BD - 0 0194EXR -  0.0328NFL.......................................................................................... (1)
SM = -1.2981 - 0.0472GI + 0.1037RGDP + 0.0215CPS + 0.0578EXD + 0.0452INTR - 
0.0613BD + 0.0839EXR - 0.0503NFI......................................................................................... (2)
85
Equation one (1) is chosen over the second equation because the dependent variable is the 
variable o f interest and secondly it is compatible with theory. However the results o f  the 
regression analysis o f  the second equation are reported in appendix C.
Therefore the estimated long run equilibrium had the following form:
PINV = 7.4185 + 0 .0114GI + 0.0074RGDP + 0.0283CPS - 0.0063EXD -  0.0219INTR - 
0.0125BD - 0.0194EXR -  0 .0328NFL ................................................................................ (1)
The results indicate the existence o f a long-run effect o f the independent variables in the 
normalized equation. Thus, there is a long-run relationship between private investment and all 
the independent variables in the model except the stock market variable.
5.5 Analysis o f the Long Run Econometric Results
The econometric result shows that all the cost variables had negative and statistically 
significant impact on private investment in the long run, with the inflation variable having the 
strongest and highly significant impact.
The interest rate variable had a negative and significant impact on private investment in
Ghana. A 1% increase in interest rate lead to about 2.2% decrease in private investment in the
long run. This confirms as in Neo-Classical theory that interest rate is a very important tactor
in any investment decision by the private sector. When the interest rate is increased by raising
the cost of bank credit (lending interest rate) or by increasing the cost o f retained earnings,
which is the main source o f financing for the private sector, there would be a decline in
private investment. On the other hand, Mckinnon and Shaw, view administered low interest
86
rates as detrimental to increased savings and hence investment boost. They argued that high 
interest rate induces savings which can be channeled into investment, this result therefore 
does not confirm the Mckinnon and Shaw theor y. Furth er, the findings from this study 
confirmed the negative relationship between interest rate and private sector investment which 
is consistent with other empirical works like Greene and Villanueva (1991); Khan and Khan
(2007) and at variance with other studies likes Seruvatu and Jayaraman (2001); Jongwanich 
and Kohpaiboon (2008). Interest rates can have a substantial influence on the rate and pattern 
o f  economic growth by influencing the volume and productivity disposition o f  savings as well 
as the volume and productivity o f investment. Consequently, the evidence from the regression 
results shows that high interest rate is indeed detrimental to private investment in Ghana.
It can also be seen from the result that government budget deficit is significantly and 
negatively related to private investment in the long run. As a 1% increase in budget deficit 
would lead to 1.25% decrease in private investment. This finding is in line with the one 
obtained by Heim (2008). It is important to note that the spillover o f large budget deficit can 
compel private investors to shift some o f their portfolio into short-term activities such as 
purchases o f  treasury' bills, due to high yield and safety. Thus, the monetization ot the budget 
deficit is crowding out private investment by attracting investible tunds from business 
activities into treasury bills. Also, the large budget deficit with no check and balance on 
government expenditure is an example o f institutional weakness.
The exchange rate also affectcd private investment negatively in Ghana. According to this
result a 1% increase in exchange rate would cause private investment to decrease by 1.94%.
The results revealed that the exchange rate was negatively related to private investment and
was significant just like the works o f Froot and Stein (1991) as well as Asante (2000) which
87
also found a negative relationship between exchange rate and private investment. However, 
the result is contrary to the empirical work o f Jongwanich and Kohpaiboon (2008). This 
negative effect can be explained by the fact that a real depreciation raises the cost o f imported 
capital goods and since a large chunk o f investment goods in Ghana is imported, domestic 
private investment would be expected to fall with a real depreciation. Again, this may be due 
to the fact that in the past the exchange rate was fixed but currently it is floating and 
depreciating at an alarming rate and therefore causing a lot o f concern for investors.
The findings o f  the empirical analysis also indicate that the effect o f  inflation is the strongest, 
it is negatively related to private investment and was significant. The result shows that a 1% 
increase in inflation would lead to a drastic fall in private investment by 3.28%. The result o f 
this study is consistent with many empirical findings like, Jongwanich and Kohpaiboon
(2008): Greene and Villanueva (1991); Pindyck and Solimano (1993) and at variance with 
Ndikumana. (2000). Inflation rates are noted to be an indicator o f  macroeconomic instability, 
which can have adverse impact on private investment. High and unpredictable inflation 
distorts the information content o f  relative prices and increases the riskiness o f  longer-time 
investment. A high rate o f  inflation tends to discourage private savings and investment.
Similarly the control variables also impacted on private investment as explained below:
Government or Public investment variable had a positive and insignificant relationship with
the rate o f private investment. The result may be interpreted as 1% increase in public
investment would lead to 1.14% increase in private investment all things being equal. This
positive relationship suggests complementarity between the public investment and private
investment. These results suggest that the productivity o f  these types o f  investments may be
as important as their magnitude in influencing private investment. The positive relationship
88
between private-sector investment activity and government investment in Ghana, suggests 
that a long-run investment rate has a positive impact. The meaning o f this is that a lot o f 
infrastructural investment has been undertaken by the government which has a positive 
impact on private investment. Again this result is similar to the findings o f  Asante (2000). The 
crowding out effect o f  public investment on private investment was not the case for Ghana in 
this study.
The regression result shows that Real GDP has a positive and significant impact on private 
investment in the long run. This result is similar to findings from Greene and Villanueva 
(1991). Asante (2000), Badawi (2005) among others. They also found private investment to 
be positively related to real output. The result shows that a 1% increase in real GDP will lead 
to about 0.74% increase in private investment. The accelerator model suggests a positive 
relationship between changes in aggregate demand and real output growth, which investors 
attempt to satisfy. Increased output may also mean increased savings that can be used to 
finance domestic investment (Elhiraika, 2001).
The result also indicates that bank credit to private sector have a positive and significant 
impact on private investment activities in Ghana. Bank credit remains the most important 
source o f investment financing among private enterprises in developing countries including 
Ghana. The direct impact o f credit availability on priv ate investment is confirmed in several 
empirical studies including that o f  Asante (2000) and Badawi (2005). The growth ol real 
credit to the private sector had a positive and statistically significant impact on private 
investment. The results revealed that 1% increase in credit to the private sector would 
improve private inv estment in Ghana by about 2.83%. It is therefore very important to 
encourage financial institutions to increase their credit facilities to the private sector
especially the productive sector o f the private sector.
89
The results also show that high external debt has a negative impact on the private investment 
in Ghana but not significant. The empirical figures indicate that a 1% increase in external debt 
may cause private investment to fall by 0.63%. Several studies have emphasized that a heavy 
debt over- hang reduces the incentive to invest because o f the anticipated foreign tax on future 
income and returns on investment. A high external debt signifies that part o f  the future returns 
on any investment must be used to service the existing stock o f  debt. The presence o f  large 
external debt burdens constitutes another source o f uncertainty in the macroeconomic 
environment. Thus, the level o f  the real exchange rate and the timing o f demand management 
policies consistent with the required transfer also become uncertain. A higher external debt 
level could be an indicator o f over-indebtedness, signaling the lack o f  viability and 
sustainability o f  current macroeconomic policies in the long term, and most likely negatively 
impacting investors' expectations due to the increase in the degree o f uncertainty on future 
policies. The results confirm the findings o f  Greene & Villanueva. (1991).
5.6 The Error Correction Model:
The Error Correction Model was constructed in order to appreciate the short-run dynamics o f
the private investment function, having established that a long-run relationship exists between
the variables employed. The error correction model has both the short run and long run
components. The long run component o f the model is given by the error correction term. The
coefficient o f the error correction term shows the amount o f  disequilibrium transmitted each
period into the equation. From the equations we observe that the error correction term from
the cointegration equation is correctly signed and significant. It has value o f  about 34%
percent indicating a low speed o f adjustment to the long run equilibrium. A negative and
significant coefficient on the ECM implies a positive response o f  private investment to
90
fluctuations that depress the value o f the stationary combination. Conversely, if  the ECM 
were insignificant, it would mean that there is an absence o f  any long-run adjustment o f the 
investment measures to movements amongst the explanatory variables.
The estimated Error Correction results are presented in table 7, below: 
Table 7: Results of the Error Correction Model (Private Investment Model)
Dependent Variable: DPINV 
Method: Least Squares 
Sample (adjusted): 1972 2007 
Included observations: 35 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C -2.328105 0.319211 -7.293311 0.3022
DPINV -0.012252 0.005113 -2.396245 0.0024
DPINV(-l) -0.001342 0.000412 -3.257282 0.0032
DSM -0.014622 0.005329 -2.743854 0.0143
DSM(-l) -0.042714 0.023162 -1.844141 0.0427
DGI -0.002842 0.001290 -2.203107 0.0014
DGI(-l) -0.011432 0.002724 -4.196769 0.0227
DRGDP 0.003354 0.002176 1.541360 0.0543
DRGDP(-l) 0.000914 0.000425 2.150588 0.0056
DC PS 0.010042 0.009462 1.061298 0.0761
DCPS(-I) 0.001232 0.000361 3.412742 0.0023
DEXD -0.002393 0.002182 -1.096700 0.1304
DEXDH) -0.001724 0.000891 -1.934905 0.0084
DINTR -0.025318 0.020321 -1.245903 0.3245
DINTR(-l) -0.050221 0.009314 -5.391991 0.0004
DBD -0.032013 0.022545 -1.419960 0.0545
DBD(-1) -0.208452 0.118734 -1.755622 0.0137
DEXR -0.020314 0.013225 1.536031 0.0379
DEXR(-I) -0.012543 0.005052 2.482779 0.0074
DNFL -0.004294 0.003794 -1.131787 0.0633
DNFL(-I) -0.031325 0.032163 -0.973945 0.2107
ECM(-I) -0.342615 0.087140 -3.931776 0.0037
R-squared 0.712412 Mean dependent var 0.450854
Adjusted R-squared 0.721129 S.I), dependent var 0.054218
S.E. of regression 0.1 14589 Akaike info criterion 3.731611
Sum squared residual 0.144436 Schwarz criterion 3.941251
Log likelihood -74.73465 I--statistic 0.035138
Durbin-Watson stat 2.025314 Prob (F-statistic) 0.000211
91
The Akaike Information Criterion (AIC) indicates that a lag length o f  one (1) was optimum. 
This is consistent with the small sample size o f the data. From the error correction analysis, 
the error correction terms is correctly signed and significant with the absolute t-values above 
two (2).
5.7 Analysis of the short run dynamics
There was a strong negative and highly significant impact o f interest rate on private 
investment in the short run. A 1% increase in the interest rate discouraged private investment 
by 5.02O/o in the short run. This is consistent with the findings in previous studies. ( Greene 
and Villanuena. 1991; Serven and Solimano, 1991) and inconsistent to the results o f 
Jongwanich and Kohpaiboon, (2008); Khan and Khan (2007). The strong impact o f the 
interest rate variable supports the fact that interest rate is a major hindrance to private 
investment in the short run.
The exchange rate (EXR) was positive and statistically significant, a 1% depreciation o f EXR 
(i.e.. an increase in EXR) leads to an increase in private investment in the short run by 1.25%. 
The positive and significant coefficient corresponding to EXR. may not reflect the nature ot 
an import-led economy in Ghana. Also, in the short-run. the inflation rate was negative and 
insignificant. However, an increase in the variable by 1% leads to an decrease in private 
investment by 3.13%. This result is consistent with the findings in Khan and Khan. (2007).
In the short run, the budget deficit had a negative and insignificant impact on private
investment. Thus, a 1% increase in this variable leads to a 2.08 % reduction in private
investment. This result is contrary to Heim (2008). I lovvever.the insignificance impact of
budget deficit in the short run would be due to the impact o f  credit availability that is likely to
92
overshadow the short-run effect o f the former, thereby preventing the role o f the budget 
deficit spillover in determining private investment.
In the short-run among the cost factors, interest rate (5.02%) was the most important 
constraint on private investment, where as in the long run it was the inflation rate (3.28%). 
Therefore, emphasis should be on promoting a conducive investment climate, especially 
concerning inflation and interest rate. Even though changes in price levels (resulting from 
inflation and interest rates increases) to a certain extent reflect market forces acting on them, 
leaning against the wind o f  these changes could generate positive spillover in terms of 
generating a conducive investment climate and promoting long-term private investment.
On the other hand, in the short run the stock market activities which is proxied by domestic 
savings had a negative and insignificant impact on private investment. In the short-run. the 
real GDP was positive and significant, thus an increase in output growth (real GDP) by 1% 
leads to an increase in private investment by 0.09%. The positive and significant impact o f 
output growth on private investment is consistent with the findings in previous studies. Blejer 
and Khan. (1984).
In the short run. public investment (GI) had a negative and insignificant impact on private
investment implying a crowd out o f public investment. This means a 1% increase in the
public investment variable leads to a 1.4% reduction o f private investment. This is consistent
with the findings in previous empirical work. Ghani and Din. (2006). T his means that most o f
the public investment undertaken in the short run has been for replacement purposes, rather
than for expanding production capacity, raising a concern for the country 's long-term growth
sustainability. In the short run the credit to the private sector variable (C’PS) was positive and
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significant just like the long run. A 1% increase in CPS variable resulted in a 0.12% increase 
private investment. This is consistent with the findings in previous empirical work o f 
Jongwanich and Kohpaiboon, (2008). Implying more credit made available would ensure that 
potential and prudential investors can access credit adequately and help speed up the sluggish 
investment in the country. This is o f importance especially for small and medium enterprises, 
which rely heavily on bank financing. The external debt (EXD) was positive but not 
significant in the short run. However, this means that a 1% increase in the EXD variable 
would lead to 0.17% increase in private investment, which is somehow contrary to the 
expected. This suggests that the debt overhang has become more important.
5.8 Conclusion
The findings from this study confirmed the first hypothesis that all the financing cost 
variables, thus interest rate, inflation rate, exchange rate and government budget deficit in the 
model have negative and significant impact on long run private investment in Ghana. Hence 
the results failed to reject the first null hypothesis. Concerning the second hypothesis, the 
study revealed that not all the determinants o f private investment in the model were 
significant in the long run since variables such as public investment and external debt had the 
expected signs but were not significant as explained earlier. So it can be concluded that the 
second hypothesis is rejected and the second null hypothesis accepted. Last but not the least 
the assertion that there exists cointegration among the variables used and inv estment in Ghana 
which is the third hypothesis is also rejected on the grounds that the private investment 
variable, which is the dependent variable cointegrated with all the variables used in the study 
except the stock market variable proxied by domestic savings.
l>4
CHAPTER SIX 
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
6.0 Introduction
I his research has investigated empirically Financing Cost and Private Investment in Ghana 
over the period o f 1970-2008. To this end, theoretical explanations and relevant literature 
pertaining to financing cost and private investment has been reviewed. It employed the 
Augmented D ickey-Fuller (ADF) test to address the issue o f unit root faced in time series 
analysis. The long run estimate of the private investment function for Ghana was estimated 
using the Johansen co-integration technique. The Error Correction Model was used to 
determine the short-run dynamics o f the variables used in the model. This study provides 
direct evidence that high cost o f financing is associated with low investment. Financing cost 
thus remains a significant negative determinant o f investment after controlling for the non 
cost factors o f private investment.
6.1 Summary o f Findings
The research found evidence that private investment, interest rate, exchange rate, inflation 
rate, budget deficit, public investment, real GDP growth, credit to the private sector and 
external debt are bound together in the long run. The evidence suggested that private 
investment is negatively affected by interest rate, exchange rate, inflation rate, budget deficit 
and external debt whilst public investment, real GDP and credit to the private sector affected 
private investment positively. The econometric results showed that the stock market was not 
found to have a statistically significant impact on private investment in Ghana during the 
period o f the study.
95
The study showed that the components o f cost (interest rate, inflation rate, exchange rate and 
budget deficit) are a major hindrance to private investment in Ghana. O f these cost variables, 
inflation rate and interest rate appeared to have had the strongest negative impact on private 
investment, whilst exchange rate and budget deficit had mild negative effects. For policies to 
improve private sector response, all four components must be addressed simultaneously. 
Policies to stabilize macroeconomic variables such as interest, exchange and inflation rates 
and as well cut down on government domestic borrowing for consumption purposes. These 
measures would brin g deficit spending under control to relieve pressure on interest and 
inflation rates.
High interest rates reduce the present value of future cash flows thereby reducing the 
attractiveness o f  investment opportunities. For this reason interest (lending) rate is a key 
determinant o f  private expenditure, so the level of interest rate must be the most important 
macroeconomic factor to consider in the short run private investment analysis. At a higher 
interest rate therefore, the net profit o f most projects will be lower or even negative thereby 
discouraging potential investors from investing. Symmetrically, at a lower interest rate level, 
more projects will become profitable, encouraging investors to invest more. Therefore higher 
cost o f credit retards private investment, this implies that cost o f  borrowing is very important 
in making investment decisions.
The econometric results showed that inflation had the strongest negative and significant
impact in the long run. inflation affects investment by increasing the uncertainty o f
investment. A rise in domestic inflation relative to overseas inflation, given the nominal
exchange rate, results in the appreciation o f  the real exchange rate adversely affecting export
competitiveness. High rates o f inflation adversely affect private investment by increasing the
96
riskiness o f longer-term investment projects, reducing the average maturity o f commercial 
lending and distorting the information content o f relative prices. Also, high inflation rates are 
often considered an indicator o f macroeconomic instability and a country's inability to control 
macroeconomic policy, both o f which contribute to an adverse investment climate. Inflation 
also discourages long-term lending by financial intermediaries, which further reduces the 
investment rate.
According to Aryeetey (1994), massive frequent depreciation o f the exchange rate has a direct 
implication for the cedi outlay required to import a given quantity o f  imported inputs such as 
raw materials, equipments or machinery. In this case, relying too much on imported raw 
materials implies that producers demand for working capital has to increase which might lead 
to a reduction in output. Mean while Asante and Addo (1997), indicated that production in the 
manufacturing sector was constrained by the limited availability o f  imported inputs in Ghana. 
This indicates that most o f  the firms in Ghana rely on imported inputs for their investment 
projects.
The extent to which government deficits create a "crowd out" problem (i.e.. government 
borrowing which diverts savings that would otherwise be borrowed by private businesses to 
purchase new plant and equipment, into government hands), reduces the level o f private 
investment. Crowd out theorists argue this competition between business and government for 
savings, forces interest rates up and substantially reduces the amounts business find profitable 
to b o r r o w  to invest, (Spencer and Yohe, 1970; Heim, 2007. 2008). This may also occur when 
the investment involves parastatal enterprises producing goods that compete with the private 
sector, or when heavy spending for public capital projects leads to high interest rates, severe
credit rationing, or a heavier current or future tax burden (Aschauer, 1989).
97
On the other hand credit to the private sector had a strong statistically significant and positive 
impact on private investment whilst real output (GDP) growth and public investment had a 
mild positive impact on private investment. These results suggest that credit availability is 
pivot to the private sector participation in investment whilst government investment resulting 
from infrastructural development has been complementary to private investment in the 
country. Policies should be put in place to encourage lending to private investment activities 
as well as increase public spending for infrastructure development in order to increase 
production capacity and incomes levels to augment real output.
Credit however has been a problem and remains a problem for private investment. Credit 
must therefore be made available in order to ensure continuing participation o f  the private 
sector in investment. There should therefore be a change o f government investment strategy 
by promoting financial development. Financial development facilitates the channeling o f 
resources from savers to the highest-retum investment activities, increases the quantity of 
funds available for investment, and thus mitigates the liquidity constraints faced by 
entrepreneurs. Thus a large and liquid financial system reduces the overall cost and risks of 
investment, which stimulates capital accumulation. The financial system is key to matching 
financial resources to investors needs both through short-term credit expansion and through 
its maturity transformation function, by channeling saving into long-term credit markets.
Financial markets play an important role in allocating investment capital to high return
activities (Greenwood and Smith. 1997). Financial intermediaries have a special function of
alleviating information problems, reducing liquidity risk, reducing monitoring costs, and
channeling credit to certain classes of borrowers that cannot access non-intermediated forms
98
of credit (Levine, 1997; Pagano, 1993; Gertler, 1988). This analysis implies that low 
investment in developing countries including Ghana may be due to low financial 
intermediation characterised by a limited range o f financial instruments, limited long-term 
lending, inefficient lending practices (for example, politically motivated lending), direct credit 
control, and crowding out o f  private investment by public borrowing for consumption 
purposes.
In similar vein the public investment had a significantly positive coefficient in relation to 
private investment in the long run. The results suggest a “crowding in” effect o f the public 
investment on private investment. It seems the positive effect o f infrastructural investment 
outweighs the negative effect o f non-infrastructural investment. This result is consistent with 
the one obtained by Asante (2000). The government must undertake more infiastructural 
development to boost private investment in the country. Public investment on infrastructure is 
believed to have robust positive effect on private investment (Hadjimicheal and Ghura. 1995). 
These are believed to reduce private cost o f production thus raising profitability, which in turn 
will stimulate private investment.
According to Mankiw (1994). GDP equals; the total income o f every one in the economy and 
the total expenditure on the economy’s output o f goods and services. Thus GDP is a gauge of 
economic performance because it measures something people care about -  their incomes. 
Similarly, an economy with a large output o f goods and services can better satisfy the 
demands of households, firms and the government.
Ghana's ability to achieve faster economic growth led by private sector investment depends,
in large on developing efficient stock market that mobilizes funds from a w ide range o f the
population and makes them available to private investors at a cheaper cost. Inefficient capital
99
market apart from denying local companies the opportunity to raise long term capital for 
investment, would also deny potential investors the opportunity to invest their excess funds in 
long term return projects. The emphasis on the growth o f stock market for domestic resource 
mobilization has also been strengthened by the need to attract local and foreign capital in non­
debt creating forms.
6.2 Conclusions
The private sector is the prime mover o f an economy, however, private investors in Ghana, 
find it is difficult to raise affordable funds to finance their investment hence their investments 
are unable to grow as expected, (Asante, 2000). As a result, this study focused on financing 
cost o f  private investment in Ghana in order to ascertain what actually goes into the financing 
o f private investment. Among other things, the study aims at finding the relationship and the 
direction o f causality between financing cost factors and private investment in Ghana over the 
long run. To achieve the objectives o f  the study, three hypotheses were tested. The study also 
presented an overview o f the investment climate in Ghana over the years with emphasis on 
the economic development strategies in the Ghanaian economy, domestic private investment 
in Ghana, foreign direct investment in Ghana, measures to stimulate the performance o f 
private investment in Ghana, among others. It was shown that efforts over the years were 
quite impressive for the growth o f  private sector investment. Literature on investment in 
general, private investment and cost o f financing among others were reviewed which 
informed the design o f  methodology and the data analysis. With regards to the literature 
reviewed, most o f the studies found financing cost factors to be negatively related to private 
investment. Even though, most of these studies were carried out outside Ghana except that o f 
Asante (2000) and Aryeetey (1994), all the studies seem to support the view that cost of
financing is essential for private sector investment participation.
100
The empirical results and analysis presented in the previous chapter found evidence that 
interest rate, inflation rate, exchange rate and budget deficit statistically significant and 
negatively related to private investment over the long run. So the findings confirm the 
hypothesis that all the financing cost factors have a negative and significant impact on long 
run private investment in Ghana. Hence, the results failed to reject the first hypothesis. On the 
other hand, the control variables such as credit to the private sector, real GDP and government 
or public investment positively impacted on private investment, but the external debt had an 
adverse impact in the long run. The results also revealed that not all the variables o f  private 
investment in the specified model are significant in the long run since variables such as public 
investment and external debt were not significant. Hence, the results failed to accept the 
second hypothesis. Also, the notion that, there exists cointegration among the variables used 
and private investment in Ghana did not hold since the private investment variable 
cointegrated with all the variables used except the stock market variable. The study therefore 
provided direct evidence that high cost o f financing is associated with low private sector 
participation in investment activities in Ghana.
6 3  Recommendations
It is clear from the study that cost o f financing is detrimental to private investment in Ghana. 
This requires a look at conditions that create macroeconomic instability in the country. Thus 
there is the need to stabilize interest, exchange and inflation rates and as well reduce 
government budget dcficit for current expenditure whilst efforts are made to increase revenue 
generation. The current Vision 2020, with its focus on private investment as the engine o f 
economic growth, will only be successful if cost o f financing is low and there is stable 
macrocconomic environment.
101
The main policies that may be inferred from these results are: firstly, as regards the effect o f 
interest rate on private investment. In this circumstance therefore, the policy advice is that 
Government should explore the possibility o f reducing the interest rate as this would stimulate 
investment, but without running the risk o f keeping it very low as to discourage savings that 
provides loanable funds for investment. To do this effectively requires specifying a range 
within which fluctuation in the interest rate will not have an adverse effect on private 
investment. Obviously, this calls for interest rate regulatory body on all commercial banks by 
the Bank o f Ghana, in the interest o f  promoting private investment.
Secondly, the negative effect o f inflation on private investment in Ghana signifies the 
importance o f  a more focused macroeconomic policy environment that strengthens the 
economy and builds confidence for potential investors. Necessary steps have to be taken to 
contain inflation and stabilize exchange rate through the adoption o f sound fiscal and 
monetary policies. The present flexible exchange rate policy and possibly the failure o f 
policies to ensure stability are likely to be the cause o f the variability in the exchange rate. To 
be able to check this variability, the Bank o f Ghana must have the capacity to interv ene in the 
exchange rate market from time to time to curb the rapid devaluation o f  the currency and also 
manage inflation.
Thirdly, the results suggested that increasing budget deficit o f Ghana had a significant
harmful effect on private investment, suggesting that the government must be discouraged
from overspending its budget so as to refrain from financing its budget through the banking
system. This will go a long way to reduce interest rates and promote priv ate investment. There
is therefore the need for the government to be forced to spend within it allocated budget
102
through law. To this end a fiscal compliance law is recommended to be enacted so as to help 
compel the government operate within its allocated resources.
Similarly, the results suggest that increasing public investment has a significant beneficial 
effect on private investment, suggesting that if private investment is to help reduce poverty, 
government should increase capital expenditure, provide training to entrepreneurs, private 
credit channeling agencies and develop institutions. Public investment must concentrate on 
rehabilitation and construction o f  physical infrastructure (transportation networks- road, rail, 
sea and air: hospitals, schools/training centres, electric power, water, sanitation, improving 
property rights, restructuring judicial system, maintain law and order etc.) which would 
complement private investment. Public investment increase returns to private capital, Blejer 
and Khan (1984). In this regard, for Ghana to have statistically significant public investment, 
government needs to explore other means for financing public investment that do not involve 
increasing domestic borrowing.
Moreover, in view o f  the positive impact o f credit to the private sector on private investment
triggering off the financial resources or private capital accumulation is a useful channel to
boost private sector development in Ghana. Credit however is unavailable or not easily
accessible for productive investment in Ghana (Baah-Nuakuoh. 1996). Limited credit
available to the private sector is directed towards the unproductive sectors. Further, th e
demand o f the public sector for credit expended by the banking system further limits the funds
available for productive investment by the private sector thereby choking off the private
sector in the investment process. To overcome these problems, greater efforts must be
directed towards enhancing the efficiency o f credit allocation in the financial system while at
the same time discouraging the government from increasing its borrowing from the financial
103
institutions. In line with this, the securities regulatory commission and the BOG must be 
given more powers and legal authority to monitor and regulate the financial system properly 
and effectively. By this measure, the banks would increase their efficiency. Again, the 
government can give tax incentives to financial institutions that finance risky investment such 
as those in Agriculture and manufacturing sectors.
The significantly positive real GDP growth signals a country's economic prospects and 
encourages foreign investors. Keeping up the growth momentum and ascertaining its 
sustainability is a key to attracting private sector investment. In this regard, furthering the 
growth performance o f  the economy through the creation o f  favourable macroeconomic 
environment, developing vital infrastructure, ensuring the quality o f institutions as well as 
improving the quality o f  human capital are some o f the important measures essential to attract 
private investment.
Even though, the stock market variable could not cointegrate with private investment in the 
long run. The stock or capital market offers a relatively cheaper source o f obtaining long term 
funds for investment projects. The following policies should be pursued to promote effective 
and well developed stock market: educational campaigns about the existence and activities ot 
the GSE: Putting in place an attractive and flexible listing requirements, cheaper cost o f 
trading on GSE and hedging mechanism through financial derivatives: futures, and options to 
reduce investor exposure; Many potential investors prefer to go tor short term government 
treasury bills rather than equity. In this regard, it is advisable to make it attractive to potential 
investors and as well trade in more government bonds in order to keep the market active and 
liquid. I he nominal increase in the all share index should always exceed the annual inflation
104
rate so that the long-term returns on stock market investments will remain positive in real 
terms. Thus the profitability o f  the GSE listed companies should not be eroded.
Though political instability created a climate hostile to private investment, it was dropped in 
the process ol running the econometric regression. However, there is the need to create an 
environment conducive for investment. Also some policies adopted in the 1970s and early 
1980s scared away the private sector from participation in investment. It is therefore 
necessary for the government to give assurance to private investors that such situations will 
not arise again. The government must come out with a legislation that will secure private 
investment from any future seizures and forfeitures. Hence legislative and administrative laws 
should be enacted to enhance confidence among private investors. Confidence is a necessary 
condition for private investment and private investment is a necessary condition for economic 
growth and development.
The last but not the least, the much-awaited role o f the priv ate sector as an engine o f growth 
has not yet materialized. If all these criteria are met. priv ate investment will lead to economic 
growth. The government should therefore implement the above policy recommendations and 
create the enabling environment in order to raise the share o f  priv ate investment to change the 
status-quo. Clearly, it is equally important for policymakers in developing countries including 
Ghana, to be able to assess how private investment responds to changes in financing cost not 
only in designing long-term development strategies, but also in implementing shorter-term 
stabilization programs. In the long run, the cost o f  credit reduction path seems to be closely 
dependent on both well-developed financial and credit markets: and on perspectives of 
macroeconomic stability.
105
6-4 Limitations o f the Research
The major limitation encountered has to do with the availability and quality o f  the data used. 
There was no data available for private investment and public investment from GSS, G1PC, 
ISSER and BOG. As such data obtained from IMF-IFS CD-Rom on private capital formation 
and government capital expenditure were used as proxies for private investment and public 
investment respectively for the period o f 1993-2008. Furthermore, the set o f  data used were 
basically secondary, its accuracy and or reliability had some questions, though attempt was 
made to address them. This therefore implies that the analysis made and conclusions drawn 
thereof should be interpreted with this in mind. Secondly, due to data limitations, particularly 
regarding frequency with which secondary data are produced, normally associated with less 
advanced nations like Ghana, a more appropriate methodology (ADF test) was employed in 
the regression analysis. Finally, accuracy o f  the recorded data exerted a significant influence 
on the conclusions that were drawn from the findings o f  the study. A minor limitation o f the 
stud> is with respect to the time available for the research and fact that it focuses only on 
Ghana.
6.5 Future Research Area
A useful extension o f  the present study would be to empirically examine the effect o f private 
investment on economic growth, unemployment and poverty reduction in the context of 
Ghana. Another area worth o f  researching into is the exchange rate which had a positive 
impact on private investment in the short run, which is contrary to theory. This therefore calls 
for a further investigation to determine the exact behav iour o f  exchange rate on private 
investment.
106
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115
APPENDICES 
APPENDIX A 
Graphs o f  level o f  the variables
PINV SM
1970 1975 1980 1985 1990 1995 2000 2005
Gl RGDP
1970 1975 1980 1985 1990 1995 2000 2005
CPS
1870 1975 1980 1985 1990 1995 2000 2005
116
EXD INTR
8
7
6
5
4
3
2
1
0
-1
1970 1975 1980 1985 1990 1995 2000 2005
9 0
B D
85
80
75
70
65
60
55
1970 1975 1980 1985 1990 1995 2000 2005
NFL
90  
8 8 
8 6 
84  
8 2  
8 0  
78  
7 6
1970 1975 1980 1985 1990 1995 2000 2005
0.4 ,
0.0 j 
-0 4 i 
-0 8 ^
-12
- 1.6
-2 0  J _  - .............. . — r ------------
1970 1975 1980 1985 1990 1995 2000 2005
EXR
17.2
17.0 
16 8 
16.6 
16 4
16.2
16.0   ,_
1970 1975 1980 1985 1990 1995 2000 2005
117
87
6
5
4
3
2
1
0
-1
1970 1975 1980 1985 1990 1995 2000 2005
EXD INTR
B D
1970 1975 1980 1985 1990 1995 2000 2005
EXR
90  
85  
8 0  • 
7 5 
70  
6 5 
60  
55
17.2-
17.0
16.8
16.6
16.4
16.2
16.0 -
1970 1975 1980 1985 1990 1995 2000 2005
NFL
9.0
88
86
84
82
80
78
76  — r—
1970 1975 1980 1985 1990 1995 2000 2005
117
APPENDIX B 
Graphs o f  first difference o f  variables
DPINV DSM
04 
•1 6
1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005
DGI DRGDP
2 0 —■ , _■ „______   07
12; 
0 8
04
0 0
-04
-0.8
06 
05 
04 
03 
02
-05 01
1 5 
1 0 
05  
00
-1 0 .  00  -
1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005
DCPS
500
400
300
200
100
0
-100
-200
- 1 0(
-400
1970 1975 1980 1985 1990 1995 2000 2005
118
DEXD
THITS
1970 1975 1980 1985 1990 1995 2000 2005
DBD
1970 1975 1980 1985 1990 1995 2000 2005
DEXR
DNFL
1970 1975 1980 1985 1990 1995 2000 2005
119
APPENDIX C 
Short -  run error correction model (Stock Market Model)
Dependent Variable: DSM
Method: Least Squares
Sample (adjusted): 1972 2007
Included observations: 35 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C -0.239692 0.221451 -1.082371 0.3022
DSM -0.592939 0.536146 -1.105930 0.2924
DSM(-l) -0.709103 0.452116 -1.568409 0.1451
DGI -0.375312 0.363759 -1.031761 0.3243
DGI(-l) 0.457451 0.199666 2.291080 0.0427
DRGDP 0.327101 0.397824 0.822224 0.4284
DRGDP(-l) 0.696694 0.364994 1.908785 0.0827
DC PS 0.379528 0.349176 1.086925 0.3003
DCPS(-l) -0.600913 0.175090 -3.432028 0.0056
DEXD -0.272649 0.369528 -0.737831 0.4761
DEXD(-l) -0.492251 0.293791 -1.675514 0.1220
DINTR -0.207954 0.278082 -0.747816 0.4703
DINTR(-l) -0.238529 0.117181 -2.035550 0.0666
DBD -0.234678 0.187908 -1.248896 0.2376
DBD(-l) -0.210426 0.173900 -1.210040 0.2516
DEXR -0.232922 0.127297 -1.829752 0.0945
DEXR(-l) -0.484246 2.976230 -0.162704 0.8737
DNFL 2.216993 2.753891 0.805040 0.4379
DNFL(-l) 0.669725 2.546967 0.262950 0.7974
ECM2(-1) 0.170068 0.431061 0.394532 0.7007
R-squared 0.900323 Mean dependent var 0.012069
Adjusted R-squared 0.710029 S.D. dependent var 0.212796
S.E. o f regression 0.114589 Akaike info criterion -1.260218
Sum squared resid 0.144436 Schwarz criterion -0.262546
Log likelihood 42.79359 F-statistic 4.731240
Durbin-Watson stat 2.224939 Prob(F-statistic) 0.005438
120
APPENDIX D
UNIT ROOT RESULTS
Ox version 3.00 (Windows) (C) J.A. Doomik, 1994-2001 
PeGive 10.0b session started at 7:29:00 on 18-05-2010
Unit-root tests for 1972 (1) to 2008 (1)
Augmented Dickey-Fuller test for PINV; regression o f DPINV on:
Coefficient Std.Error t-value 
PIN V_1 -0.014090 0.034799 -0.40490
sigma = 1.43529 DW = 2.407 DW-PINV = 0.5131 ADF-PINV =-0.4049 
Critical values used in ADF test: 5%=-l .95, l%=-2.626 
RSS = 74.16225942 for 1 variables and 37 observations
Augmented Dickey-Fuller test for SM; regression o f DSM on:
Coefficient Std.Error t-value
SM_1 -0.50723 1.71925 -1.71924
sigma = 2.59482 DW = 2.343 DW-SM = 1.226 ADF-SM =-1.7192 
Critical values used in ADF test: 5%=-l .95, l%=-2.626 
RSS = 2.4238699346 for 1 variables and 37 observations
Augmented Dickey-Fuller test for GI; regression o f DGI on:
Coefficient Std.Error t-value
G l_l -0.25370 0.14094 -1.80006
sigma = 4.7604812 DW = 1.908 DW-GI = 0.6196 ADF-GI = -1 .800  
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 8.1583918426 for 1 variables and 37 observations
Augmented Dickey-Fuller test for RGDP; regression o f DRGDP on:
Coefficient Std.Error t-value 
RGDP 1 -0.150707 0.08422 -1.78955
sigma = 1.9497308 DW = 1.438 DW-RGDP = 0.03037 ADF-RGDP = -1.7896 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 1.368516088 for 1 variables and 37 observations
Augmented Dickey-Fuller test for CPS; regression o f DCPS on:
Coefficient Std.Error t-value
C P S J  -0.016418 0.029198 -0.56228
121
sigma = 1.48545 DW = 1.315 DW-CPS = 0.08847 ADF-CPS =-0.5623 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 79.43592065 for 1 variables and 37 observations
Augmented Dickey-Fuller test for INTR; regression o f DINTR on:
Coefficient Std.Error t-value 
INTR J  1.50199 1.27882 -1.17451
sigma = 4.0951 DW = 2.605 DW-INTR = 0.1441 ADF-INTR = -1.1745 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 60.37148584 for 1 variables and 37 observations
Augmented Dickey-Fuller test for BD; regression o f DBD on:
Coefficient Std.Error t-value
BD_1 -0.039344 0.056605 -0.69506
sigma = 2.13899 DW = 1.877 DW-BD = 0.1113 ADF-BD =-0.6951 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 16.47096574 for 1 variables and 37 observations
Augmented Dickey-Fuller test for EXR; regression o f DEXR on:
Coefficient Std.Error t-value
E X R l  -1.08658 0.72156 -1.50587
sigma = 5.1279 DW = 1.018 DW-EXR = 0.02841 ADF-EXR =-1.5059 
Critical values used in ADF test: 5% =-l.95, l%=-2.626 
RSS = 9.466320959 for 1 variables and 37 observations
Augmented Dickey-Fuller test for NFL; regression o f DNFL on:
Coefficient Std.Error t-value
N F L l  -0.27152 0.16149 -1.68167
sigma = 3.18341 DW = 2.678 DW-NFL = 1.347 ADF-NFL =-1.6817 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 3.648280902 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DPINV; regression o f DDP1NV on:
Coefficient Std.Error t-value 
DP INVI  -1.2456 0.16254 -7.6633
sigma = 1.395 DW = 1.988 DW-DP1NV = 2.433 ADF-DPINV = -7.663** 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 70.05731605 for 1 variables and 37 observations
122
Augmented Dickey-Fuller test for DSM; regression o f DDSM on:
Coefficient Std.Error t-value
DSM_1 -1.5133 0.14304 -10.580
sigma = 2.57765012 DW = 2.108 DW-DSM = 3.027 ADF-DSM = -10.58**
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 2.391931426 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DGI; regression o f DDGI on:
Coefficient Std.Error t-value
D G I l  -1.0730 0.16622 -6.4551
sigma = 5.08097012 DW = 2.025 DW-DGI = 2.146 ADF-DG1 =-6.455**
Critical values used in ADF test: 5% =-l.95, l%=-2.626 
RSS = 9.29386713 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DRGDP; regression o f DDRGDP on:
Coefficient Std.Error t-value
DRGDP 1 -0.37030 0.12924 -2.86521
sigma = 2.1316608 DW = 2.192 DW-DRGDP = 0.9305 ADF-DRGDP = -2.8652** 
Critical values used in ADF test: 5% =-l.95, l%=-2.626 
RSS = 1.6358233518 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DCPS; regression o f DDCPS on:
Coefficient Std.Error t-value
DCPS1  -0.85567 0.14904 -5.7411
sigma =1.4729 DW = 1.435 DW-DCPS = 1.293 ADF-DCPS =-5.741**
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 78.09926337 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DINTR; regression o f DDINTR on.
Coefficient Std.Error t-value
D I NTR l  -1.3024 0.15931 -8.1756
sigma = 3.90494 DW = 1.963 DW-DINTR = 2.656 ADF-DINTR =-8.176** 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 54.89490986 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DBD; regression o f DDBD on:
Coefficient Std.Error t-value 
DBD 1 -0.96888 0.16747 -5.7855
123
sigma = 2.15226 DW = 1.993 DW-DBD = 1.976 ADF-DBD = -5.786** 
Critical values used i n  ADF test: 5% 1.95, l%=-2.626 
RSS = 16.6760046 for 1 variables and 37 observations
A u g m e n t e d  D i c k e y - F u l l e r  t e s t  f o r  DEXR; r e g r e s s i o n  o f  DDEXR o n :
Coefficient Std.Error t-value 
D EXR J -0.31080 0.11366 -2.73447
sigma = 4.56118 DW = 1.976 DW-DEXR = 0.8171 ADF-DEXR = -2.7345** 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 74.89574809 for 1 variables and 37 observations
Augmented Dickey-Fuller test for DNFL; regression of DDNFL on:
Coefficient Std.Error t-value 
D N F L l  -1.5400 0.14031 -10.976
sigma = 28.8089 DW = 2.179 DW-DNFL = 3.079 ADF-DNFL =-10.98** 
Critical values used in ADF test: 5%=-1.95, l%=-2.626 
RSS = 29878.25223 for 1 variables and 37 observations
124