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1.1 Background to the Study

Foreign direct investment (FDI) has played a leading role in many of the economies of the Africa. There is a widespread belief among policymakers that foreign direct investment (FDI) enhances the productivity of host countries and promotes development. There are several studies done on FDI and economic growth.

Foreign direct investment (FDI) is a direct investment into production or business in a country by an individual or company of another country, either by buying a company in the target country or by expanding operations of an existing business in that country.

Foreign direct investment is in contrast to portfolio investment which is a passive investment in the securities of another country such as stocks and bonds. World Bank (1996) conceptualized Foreign Direct Investment (FDI) as investment that is made to acquire a lasting management interest (usually 10% of voting stock) in an enterprise and operating in a country other than that of the investors (define according to residency) the investors purpose being an effective voice in the management of earning either long term capital or short term capital as shown in the nations balance of payments account statement (Macaulay, 2012). Broadly, foreign direct investment includes mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations and intra company loans. In a narrow sense, foreign direct investment refers just to building new facilities.

The interest rate policy in Nigeria is perhaps one of the most controversial of all financial policies. The reason for this may not be farfetched because interest rate policy has direct link to many other macroeconomic variables most especially investment.

Interest rates play a crucial role in the efficient allocation of resources aimed at facilitating growth and development of an economy and as a demand management technique for achieving both internal and external balance. The term cyclical volatility of interest rates refers to the variability of interest rates over periods that correspond to the length of the typical business cycle, the variation of interest rates affects decisions about how to save and invest. Interest rate policy in Nigeria lacked consistency during the

Structural Adjustment Program (SAP) as periods of liberalization were intertwined with impositions of some credit controls (IMF, 1997). The business environment, in general, is very risky and uncertain so firms may not be able to service debt. Apart from this, the judicial system is reportedly inefficient and banks cannot easily enforce contracts, consequently, banks charge high interest rates and request for high levels of collateral. In addition to the above, high interest rate in the Nigerian financial system is a reflection of the extremely poor infrastructural facilities and inefficient institutional framework necessary to bring about substantial reduction in the risk associated with financing an extremely traumatized economy (World Bank, 2002).

The administration of low interest rate which was intended to encourage investment before the SAP era and during SAP era of 1986 ushered in a dynamic interest rate regime where rates were more influenced by market forces and it failed to yield desired result of stimulating investment growth in Nigeria. All these problems highlighted persist due to the inconsistency of monetary policy and inability to formulate interest rate reform that will be a component of the broad policy package aimed at facilitating financial intermediation and monetary management that can induce investment spending through low interest rate. Against this background, this paper attempts to establish an empirical relationship between investment and other macroeconomic variables, including interest rates in Nigeria.

The Nigerian macro-economy witnessed different interest rates for different sectors in 1970s through the mid 1980s under regulation between 1960-1985 .The preferential interest rates were based on the assumption that the market rate, if universally applied, would exclude some of the priority sectors. Interest rates were, therefore, adjusted periodically with invisible hands to promote increase in the level of investment in the different sectors of the economy. The factors influencing interest rates would obviously vary with the extent of openness of the economy since forces of demand and supply determine it, for a highly opened economy with dynamic and sophisticated financial markets, the uncovered interest parity theory states that the differential between the domestic and foreign interest ratio equals the expected rate of depreciation/appreciation of domestic currency (Horobet, Dumitrescu&Dumitrescu, 2009).

The effect of real interest rates on private investment spending was first formalized in an investment equation by Jorgenson (1963) in his paper capital theory and investment behavior, who derived the desired stock of capital as a function of real output and the opportunity cost of capital. In this approach, known as the neoclassical approach, a representative firm maximizes the present value of its future cash flows. The desired capital stock is directly related to output and inversely related to the cost of capital a decrease in the real interest rate lowers the opportunity cost of capital and, therefore, raises the desired capital stock and investment spending.

The role of financial markets on capital formation (McKinnon, 1973; Shaw, 1973; Fry, 1989), includes suggestions that an increase in the real interest rates has a positive effect on the volume and quality of investment in those financially repressed economies like Nigeria. The former effect is given because self-finance is important and investment is lumpy. Then, the economic agents must accumulate resources before any investment project is executed. An increase in real interest rates thus stimulates both total and financial savings and consequently investment. The latter effect, improvement in the quality of investment, occurs because a higher interest rate will rule out investment projects with low productivity. At the same time, higher rates move resources from less efficient (e.g. goods facing some depreciation) to more efficient forms of accumulation (e.g. bank deposits with a more favorable return).In particular, McKinnon (1973), when explaining the link between interest rates, money and investment, suggests a nonlinear relationship between the real interest rates on deposits and the rate of private investment.

Interest rate policy is among the emerging issues in current economic policy in Nigeria in view of the role it is expected to play in the deregulated economy in inducing savings which can be channeled to investment and thereby increasing employment, output and efficient financial resource utilization (Uchendu 1993). Also, interest rates can have a substantial influence on the rate and pattern of economic growth by influencing the volume and disposition of saving as well as the volume and productivity of investment (Leahy, 1993 as cited in Lensink 2000).There is yet no detailed conclusion on the actual link between interest rate and investment whether negative or positive but there is actual link between them.



1.2 Statement of the Problem

One of the most salient features of today’s globalization is the increased flow of capital across the nations. Foreign capital is considered by many countries (especially developing ones) as a major source of resources needed to attain economic growth and development. It is seen as a means of bridging the resources gap inherent in many developing nations. Foreign capital, especially foreign direct investment, is seen as an amalgamation of capital, technology, marketing and management, and thus its role in economic growth and development cannot be overemphasized.

With overwhelming attractive theoretical arguments in support of foreign investment, authorities in Nigeria have at various times articulated a plethora of incentives for attracting foreign investment. These included new industrial policy and other incentives like tax reductions for the construction of Infrastructure, research and development activities in Nigeria, and in-plant training programmes.

Despite these incentives, performance on the Foreign Direct Investment remain unimpressive. Indeed, it is disappointing in order to bridge the investment gap, a few options are open to the authorities given the narrowness of Nigerian financial markets, the need for capital inflow into an import-dependent economy like Nigeria is crucial. Nigeria has posted trade imbalance for a longtime, suggesting that total payments had exceeded total receipts. According to CBN (1999), the overall balance of payments deteriorated in 1999 mainly due to increased outflow from the capital account.

There is however, a need to critically examine the various factors that determine the flow of foreign direct investment into the Nigeria economy, hence the necessitating facts for this study.

1.3 Research Question

This research seeks to examine the impact of interest rate on foreign direct investment and therefore attempts to answer these research questions.

  1. Does interest rate have any significant impact on FDI in Nigeria?
  2. Is there any long-run relationship between interest rate and FDI in Nigeria?

1.4 Objectives of the Study

The main objective of this study is to examine the impact of interest rate on foreign direct investment. Other specific objectives include the following.

  1. To determine the impact of interest rate on FDI in Nigeria.
  2. To determine the long run relationship between interest rate and FDI in Nigeria.

1.5 Research Hypothesis



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