Analysing the effects of foreign direct investment on economic growth in South Africa: The role of institutions

Abstract

Foreign direct investment plays a crucial role in promoting economic growth by stimulating productivity, creating employment opportunities, and facilitating the transfer of technology across countries. However, its contribution to growth depends largely on the quality of domestic institutions. While many studies have examined the relationship between foreign direct investment and economic growth, little attention has been paid to how institutional quality shapes this relationship. Strong institutions promote stability, transparency, and effective policy implementation, thereby enhancing the benefits of foreign investment, whereas weak institutions may discourage investors and limit its positive effects. This study analysed how institutional quality, in interaction with foreign direct investment, influences economic growth in South Africa. Institutional quality was measured using the World Governance Indicators, specifically the rule of law, government effectiveness, and control of corruption. Additional macroeconomic variables, including inflation, exports, labour, and gross fixed capital formation, were incorporated to provide a broader understanding of growth dynamics. The analysis used annual time series data from 19190 to 2022 and applied appropriate econometric techniques to assess both short-run and long-run relationships, supported by diagnostic and causality tests. The findings indicate that foreign direct investment positively and significantly influences economic growth in the short and long run. Exports, labour, and gross fixed capital formation support growth in the long run, while inflation and imports negatively affect it. The results further revealed that institutional quality strengthens the growth-enhancing impact of foreign investment. The study concludes that improving institutional quality is essential for maximizing the benefits of foreign direct investment and sustaining long-term economic growth in South Africa.