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CHAPTER ONE
INTRODUCTION
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1.1 Background of the Study
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Foreign Direct Investment (FDI) not only
offers countries with
much-needed resources
for domestic
investment but also
creates job opportunities, help
transfer managerial
expertise and
technology all contributing to the
advancement of the
economy. Most
governments
have appreciated the critical role the FDI plays and have established various
ways of attracting it. In theoretical literature, the purpose of
FDI is that of a carrier
of
foreign technology
that can promote
economic growth (Jones,
1999). The most
outstanding
motivation of FDI has been
resource seeking (Dunning,
2003). Economists
consider FDI as
an essential component of economic
progression. The need for better
economies,
technological advancement, economic
growth, poverty eradication and better
standards of living has seen Africa’s nations endeavor to get Foreign Direct
Investments
pumped into
their economies to help accomplish these (Mishkin & Eakins, 2009).
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This study was
guided by several theories such as the
open system theory, internalization
theory and
foreign direct investment
dependency theory that
tried to explain
the
relationships
between foreign direct investments and stock
market development. These
theories examine
the ways through
which FDI contribute
to economic growth
their
respective
countries. These theories demonstrate the extent
to which FDI contribute to
technological change
enhancement through
acquisition of new
knowledge and capital
goods,
i.e. the technological diffusion process. There was a lot
of speculation about the
contribution
of FDI in the recipient countries with many arguing that it
is based on the
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existing circumstances in
those respective countries.
The theories relate
FDI with
economic growth
of a country which in return leads to stock market development.
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The financial
sector greatly contributes
to economic growth since
it increases direct
foreign direct
investment. Studies have shown that
well organized and run stock markets
increase investment, economic growth
and efficiency. Kenya’s stock
market has been
defined as both
shallow and narrow. There has been
less than 1% growth financing in the
stock market
despite the aim to achieve an annual economic growth of 10% by 2030 with
a 30%
investment rate which is to be mainly financed by use of domestic resources. A lot
of initiatives
such as the institutional development
of stock market was established so as
to put more focus
on the stock market. These efforts are assumed to facilitate adequate
resources
mobilization and efficient
allocation so as to attain growth objectives (Ngugi,
Amanja &
Maana, 2010).
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1.1.1 Foreign Direct Investment
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Foreign direct
investment can be described as an
investment made in a corporation by an
interested
party from another country for which
the foreign investor has control
over the
acquired
company. This transaction brings about a long term association between the
host
and home country investors (Olson, 2008).
UNCTAD (2002) describes three different
types of
FDI. These are:
reinvested earnings, equity capital and
other capital which
mainly consist
of intercompany loans. FDIs create
new job opportunities as upon setting
of the business, recruitment and training of
the locals in the host country is undertaken
transferring
skills and technological know-how as
well as providing jobs.
According to
Ismaila and
Imoughele (2010), FDI represent long term commitments to the host country.
It is a
preferred form of investment because it has no obligations to the host
country.
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FDI is important in adopting new technologies, skills and managerial capabilities in the
different
sectors of the economy which are traditionally difficult to raise through use of
domestic
savings, and if not, there would be difficulty in importation of the technology
from abroad.
This would be compounded by the fact
that transferring technology to firms
with little
experience is risky and they will find difficulty in the use of it and
it comes at a
great cost
(Olson, 2008). FDI is responsible for
many externalities that come in the
form
of benefits to
the home country that are not responsible for generating incomes to the host
country. FDI is
important for developing countries
as it avails resources
necessary to
optimize
the level of economic development (Ismaila & Imoughele, 2010). The reason
for this is that their economies face challenges such as low
domestic savings, revenues,
low levels of
productivity and low foreign exchange earnings.
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A country’s appeal for FDI is affected by changes in restrictions that include removal of
government barriers
to trade as
well as privatization of
government agencies. The
country’s economic growth potential
influences the appeal for the
country for FDI since
countries with
higher economic growth
potential make it
easier for firms
to take
advantage of that
growth by setting
up business there. Tax
rates and Exchange rates
influence a country’s appeal
for FDI. Low tax rates on
corporate profits encourage
Foreign
Direct Investment while firms prefer to direct FDI
to countries where the local
currency is
expected to appreciate against their own currency (Mishkin & Eakins,
2009).
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1.1.2 Stock Market Development
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A stock market is
a market where individuals and
entities trade shares at
prices that
reflect
demand and supply and
low transaction costs (Yartey, 2008). Markets function
through
placement of various interested
sellers and buyers, including
firms, households,
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private
firms and government agencies in one location at a
given time so that trade can
take place.
Stock market development involves the
establishment of institutions, markets
and instruments that
supports investments and
growth process. Stock
market
development enhances
the capability of
the stock market
to act efficiently as
an
intermediary. A highly
liquid stock market
is able to accommodate
large and varied
issuance of
stocks with minimum price effect (Adam & Tweneboah, 2009).
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Stock market
development and efficiency
is influenced by a
number
of factors and
according to
Garcia and Liu (1999), it is a multifaceted concept which is measured by a
number of
factors namely, the
stock market capitalization, volatility, liquidity,
concentration, integrating with world
capital markets and compliance
with legal rules
with regard to
supervision and
regulations in the market. The
main measures of stock
market development that was
looked at in this paper
were stock market liquidity
and
market capitalization. Market capitalization or stock market capitalization or is the sum
of market value
of the outstanding shares of a company. Market capitalization is therefore
the total value
of domestic stocks. Stock market capitalization is
therefore used in the
measurement
of the stock market size
and is among the main indicators of growth and
development in
stock market (Levine, 2003).
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The liquidity
of the stock market can was used to
measure stock market development and
it refers to
the simplicity with which
investors can buy and sell
their stocks or share
holdings on the
stock exchange or on the stock market.
It is usually measured in terms of
the total value traded of the shares to GDP and the stock market turnover ratio to GDP.
The ratio
of total value of shares (domestic) traded to GDP is used to measure the value
of
equities traded relative to
the size of an economy;
it doesn’t measure the costs and
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uncertainties
of trading the securities at the prices
posted. There is one shortfall with
this
measure as
proxy to stock market liquidity
in that when investors anticipate
large profits
in firms, their
share prices will rise. This rise in price increased the stock value traded
and
thereby
boosting the total value
traded to GDP (TVT/GDP) ratio
(Levine, 2003). This
therefore means
that the liquidity indicator has
increased without an
increase in the
number of
transaction or even might increase
with the number of transaction falling.
The
solution to
this problem is to add the market
capitalization to GDP ratio in the
regression
to try and
look at the extent of the price effect. In essence the price effect affect both the
total value
traded and the market
capitalization but the
only variable that is
directly
related to the
pricing effect is the value traded ratio (Levine, 2003).
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1.1.3 Foreign Direct Investment and Stock Market Development
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Theoretically,
there has been a prove of a triangular causal association between the FDI
and the
development of the stock market whereby
FDI inflows is considered a wellspring
of progress
in terms of technology and decreasing unemployment in most countries that
are still developing. This will then increase the production of goods and services which
ultimately result
to increased GDP.
Therefore, increased GDP
means the growth
of
economy which
has a positive effect to the development of the stock market and the rise
of share prices (Adam & Tweneboah, 2009). The lasting effect of FDI
inflows on both
the increased investor’s involvement in
stock exchange and the domestic
capital markets’
development
were earlier confirmed by Errunza (1983). Yartey
(2008) argued that the
variety of investors and
trading volume is increased
by the greater confidence
in the
domestic
capital market which is promoted by
both institutional and
regulatory reforms
which are encouraged by FDI. Batten and
Vo (2009) confirmed a linkage
between FDI
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and stock market development whereby FDI possessed a stronger positive effect on the
economic growth in
countries that had higher
levels in the
development of the stock
market.
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FDI has various
positive effects which may
be seen via the
positive influence of the
economy. This
results in economic growth. Other
effects are seen through the transfer
of
better technology
in the market
which assist developing
countries, the increase
in
knowhow
and also indirectly, capital markets. The studies surrounding this reveal that
the justification for
the increased long
term association includes
the underlying
presumption that the
existence of FDI inflows
results in spillover effects on
the local
stock market and therefore motivates the law makers
to put into effect market-friendly
regulations in
their various countries, which encourage stock trading (Rogoff, 2005).
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Adam and Tweneboah (2009) stated that
in developing economies, following financial
and political
transformation, FDI has grown rapidly.
Most countries have embarked on a
number of practices so as
to increase their share of FDI
flows. Such activities include
relaxing FDI
restrictions, macro stability
strengthening, domestic financial
report,
liberalizing capital
account, and instituting tax
incentives and subsidies
(Oseni &
Enilolobo,
2011). In addition, there is establishment and development of stock
markets so
as to direct
funds towards viable projects for
investments. Foreign investors have become
major
players in the emerging and
developing stock markets by either
buying already
existing
equity or disposing the same in
capital markets though the resultant impact on
the development
of these emerging stock markets especially in the developing countries
has been ignored. The foreign direct investment affect price of companies shares either
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positively or
negatively as it
increases the supply
and demand for
the shares
(Al-
Halalmeh &
Sayah, 2010).
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1.1.4 Foreign Direct Investment and Stock Market Development in
Kenya
FDI in
Kenya is covered
in all the
sectors, be it
in the banking,
automobile or
telecommunications
sector. Various multinational companies have
set up operations in
Kenya and they
include Car and General, Coca-Cola as
well as communication firms like
Airtel. In every aspect of our lives, FDI is felt that is in
the goods and services that we
use. FDIs
are not in
isolation as they
have provided jobs
and with them,
technical
knowledge as
they train their Kenyan employees to maintain the standards that are there
in their
other investments all
over the world. They
are the major
source of foreign
exchange
to the country. FDI has not
been consistent over the years with some
periods
recording low
inflows. In the 1980s and 1990s, FDI inflow was low due to deterioration
in
economic performance as well as rising problems of poor infrastructure and the high
cost of living
greatly impacted negatively
on FDI inflows in
Kenya (KPMG, 2012).In
total, Kenya
has more than 200 multinational companies across the sectors with Britain,
USA, Germany,
South Africa, Netherlands,
Switzerland, China and India being the
main
traditional
sources of FDI (Kinuthia, 2010).
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Kenya
serves as the East African business hub for many
international businesses. This
translates
to a dependence of FDI for capital
inflow that in turn reflects on
provision of
jobs and an economy that is helped to grow by these foreign investments.
Kenya’s FDI
average percentage growth between
2007 and 2015 was forty
percent (40%) with the
inflows primarily
channeled into retail
and consumer products,
technology, media,
telecommunications,
minerals, oil and natural gas
sector mainly from the UK,USA and
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India
(Ernest & Young,2015). In 2015, FDI inflows stood at USD 1076.9 million (KES
105.29
billion), up from USD 670 million (KES 65.51 billion) a year earlier which is a
sixty per cent
(60%) increase. This capital mainly
went to oil, gas and the manufacturing
industries
(UNCTAD, 2015).
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The Nairobi
securities exchange NSE has been one of the best performing and top stock
market indices
in Africa in recent history. Trading in Kenya started in the 1920s and there
was no
formal market as there were part time brokers that comprised of accountants and
real estate
agents. Officially the NSE was
established in 1954 it has since
developed and
evolved from
once being called
the Nairobi Stock
Exchange to now
the Nairobi
Securities exchange
to incorporate other
securities such as
derivatives and debt
instruments.
The NSE has also seen a change in
its regulatory policies from the
situation
before
independence where there was little or no regulation on the trading that took
place.
There has been
the formation of the capital markets
authority in the 1990s, the CMA was
set up with the aim of creating investor incentives for long term investments (The NSE
website).
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The NSE All
Share Index was rated the best stock exchange in the world in 1994 in terms
of performance
with gains of
up to 179%
in dollar terms
in that year.
This shows
significant
growth of the Kenyan stock
market. Other various developments
on the NSE
include the
increase of the number of companies
that have been listed, the creation of
the
NSE 20-Share
index, the FTSE-NSE 25 index and also
the introduction of the automated
trading system
ATS in 2006. The various strides that
have been done have resulted in the
NSE being transformed to
become one of the
top performing bourses on the
African
continent.
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1.2 Research Problem
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The stock
market is a major section of any given economy and its financial structures. It
is
considered to be a major financing source for new entities and ventures based on the
profitability
level expected. Further, for a country
to increase the level of
savings and
investment therefore
resulting to a
growth in the
economy the securities
market is
considered
essential and its role is significant
in any country or economy. It is considered
to be a replica around the world of the economic strength of most countries. Studies by
various
scholars indicate the positive role
of the stock market which results to economic
growth in
various countries (Levine &
Zervos, 2005).Some factors
that result in the
securities
market development include the political stability of a country,
the exchange
rate, economic
liberalization and foreign direct investment
(Adam & Anokye, 2008). The
importance
of the development of stock
market in developing economies as a result
of
FDI is considered to be
very strong. Research from studies
shows a triangular causal
relationship
in; economic growth stimulation by FDI;
positive effects are observed
as a
result of
economic growth and the ultimate
effect is the development of the stock
market
promoted by FDI
(Adam & Anokye, 2008).
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In the Kenyan
context, the World Bank issued
the Doing Business 2017 report
which
showed that
Kenya was ranked
position 92nd out of 189
countries in terms
of FDI
inflows. From 2016,
this was a 16 gain
of places and therefore
an improvement. The
reason behind
this was the fact that Kenya simplified its procedures followed in creating
business and
ownership transfer and improvement of
electricity and credit access. Kenya
has also embarked on several activities in order to enhance
a positive influence on FDI
inflows in the coming
years such as relaxing
conditions for obtaining business licenses
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and
public-private partnership development which is a
strategy in the Vision
2030. In
addition, Kenya
has also opened
most sectors to
foreign investment such
as the
telecommunications
sector which has mostly
attracted FDI due to the
fiber optics that
were introduced
in 2009-2010.
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Local
researches done on the area of stock
market include; Seile (2009) who did a study
on the association between
stock market and specific macroeconomic variables
in the
NSE such as inflation, GDP, Treasury and interest bill rates.
The findings revealed that
market share index
had a positive
correlation with Treasury bill
rate, gross domestic
product and
inflation rate whereas it had a negative correlation with interest rate but the
study did
not focus on the effect of FDI on the volatility of securities. Dinga (2009) and
Kimotho (2010)
researched on the connection
between FDI and economic growth
in
Kenya and concluded that
FDIs influence economic growth level. Omoke
(2010) and
Ndung’u (2011) also studied the link between the growth of economy and Kenya’s stock
market development and
the findings was
a positive connection
between the two
variables. Philbert
(2012) has also
studied the nexus
between FDI, financial
market
development and
the growth of economy in Kenya and concluded that financial markets
influences the
economic growth.
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Most of the
existing empirical evidence has studied the influence of different variables
on
the development of
stock market while
still others have
examined the effect
of
development
of stock market on economic growth. However, there exist
few studies on
the influence
of foreign direct investment on stock market development in Kenya. Thus,
this study
intends to fill this research gap by addressing the question; what is the effect of
foreign direct
investment on stock market development in Kenya?
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1.3 Research Objectives
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This study seeks to
determine the effect of foreign
direct investments on
stock market
development in
Kenya.
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1.4 Value of the Study
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The study
findings are hoped to be of benefit to policy makers in developing investment
strategy
policies and developing the necessary institutional framework required to market
Kenya as an ideal
foreign investment destination.
Also, it will help them in
coming up
with policies
that ensures consistent development of
the stock market and thus protecting
the profit
margins and net present values of current and potential investors alike.
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The finding
of the study
has formed a future
reference to researchers, scholars
and
students
who may aspire to take out research on the same or
correlated field. The study
will be helpful
to scholars and researchers in
identification of further areas of research on
other related
studies by highlighting related
topics that require
further research and
reviewing the
empirical literature to establish study gaps.
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The study
findings will inform
the policy direction
taken by the
Capital Markets
Authority and
other stakeholders through issuance
of regulations that touches on
the
market
initiatives that would ultimately
result in increased stock market development in
Kenya.
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