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Archives of Business Research – Vol. 13, No. 03

Publication Date: March 25, 2025

DOI:10.14738/abr.1303.18382.

Masengesho, E. J., Dada, S., & Ogboi, C. (2025). Effect of Monetary Policy on Foreign Direct Investment (FDI) inflows in East African

Countries: The Moderating Impact of Institutional Quality. Archives of Business Research, 13(03). 44-57.

Services for Science and Education – United Kingdom

Effect of Monetary Policy on Foreign Direct Investment (FDI)

inflows in East African Countries: The Moderating Impact of

Institutional Quality

Masengesho, Esther Josiane

Department of Finance, Babcock University

Dada, Samuel

Department of Accounting, Babcock University

Ogboi, Charles

Department of Finance, Babcock University

ABSTRACT

The majority of developing countries have heavily relied on foreign direct

investment (FDI) inflows over the past years due to the gap between domestic

savings and investment. Studies on the interactive effect of monetary policy and

institutional quality (IQ) on FDI inflows are still scanty in East African countries.

This study examined the effect of monetary policy (monetary policy rate (MPR),

exchange rate (ER), reserve requirements (RR)) on FDI inflows in East African

Countries with a special focus on the moderating impact of institutional quality. A

fixed effect model was applied to analyse panel data spanning from 2003 to 2022.

The results showed that incorporating institutional quality into the relationship

between monetary policy and FDI inflows marginally improves the model's

explanatory power from 56 percent to 57 percent with the interaction of IQ and

monetary policy variables suggesting that institutional factors contribute to

understanding FDI dynamics. The findings revealed a positive relationship

between, IQ and MPR-IQ interaction and FDI inflows, though it was not strong. The

results further showed a negative but weak relationship between ER-IQ interaction

and FDI inflows. Thus, it is concluded that IQ slightly mitigates the negative impact

of MPR on FDI, suggesting that strong institutions create a stable environment that

offsets the deterrent effect of higher interest rates. Additionally, though IQ

enhances stability, exchange rate fluctuations continue to undermine investor

confidence. It is therefore recommended that Policymakers consider a holistic

approach, focusing on structural reforms and stable macroeconomic policies to

boost investor confidence and attract FDI.

Keywords: Foreign direct Investment inflows, Monetary policy, Institutional quality, East

Africa (EA)

INTRODUCTION

Foreign direct investment (FDI) is widely recognized as a critical driver of economic growth,

particularly in developing regions like East Africa. FDI contributes to the transfer of technology,

the creation of jobs, and the enhancement of productivity, ultimately fostering sustainable

development [1]. Despite the acknowledged benefits, East African countries have faced

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Archives of Business Research (ABR) Vol. 13, Issue 03, March-2025

Services for Science and Education – United Kingdom

Objectives of the Study

i. To investigate the effect of monetary policy (monetary policy rate, exchange rate, and

reserve requirements) on FDI inflows in East African countries.

ii. To evaluate the moderating effect of institutional quality and monetary policy

(monetary policy rate, exchange rate, and reserve requirements) on FDI inflows in East

African countries.

Research Hypotheses

➢ H01: Monetary policy does not significantly affect foreign direct investment inflow in

East African countries.

➢ H02: There is no significant effect of monetary policy with the moderation of institutional

quality on foreign direct investment inflows in East African countries.

LITERATURE REVIEW

Empirical Literature Review

[5] examined how money supply and GDP influence FDI in Pakistan from 1970 to 2013, utilizing

the Generalized Method of Moments (GMM) with data from the World Bank, IMF, and local

statistical bulletins. Their findings indicate that money supply (M1) and GDP significantly and

positively impact FDI. Conversely, inflation and interest rates negatively affect FDI, with higher

inflation and interest rates deterring investment inflows. Equally, [6] investigated the effect of

interest rates on FDI in Sierra Leone using multiple regression analysis with time-series data

from 1985 to 2012. The study found that trade openness and exchange rates significantly and

positively influenced FDI, while inflation, GDP, and interest rates were insignificant in explaining

FDI variability. They recommended enhancing trade openness, combating corruption,

improving infrastructure, and stabilizing exchange rates to attract foreign investment.

Conversely, [7] found that interest rates significantly affected FDI inflows from 1990 to 2016,

highlighting their relevance for policymaking.

[8] explored key factors influencing FDI attraction in Rwanda by surveying 30 foreign investors

across various sectors, including manufacturing, ICT, banking, and agriculture. Using SPSS for

data analysis, the study identified constitutional and legal FDI protections, free capital transfer,

resource availability, strategic location, security, investor-friendly tax policies, market demand,

and reasonable competition as major drivers of FDI in Rwanda. Similarly, [9] analyzed the

impact of institutional, governance, and economic factors on FDI inflows in eight East African

countries from 1996 to 2010 using panel data and a fixed-effects model. Their findings

highlighted that factors such as corruption control, political stability, rule of law, and

infrastructure significantly influenced FDI inflows in the region.

[10] investigated the effect of exchange rates on FDI in Somalia using 41 years of time-series

data (1970–2010) from the World Bank and SESRIC. Applying location theory and multiple

regression models under the OLS method, the study found a significant negative relationship

between exchange rates and FDI. Inflation and domestic investment showed a positive

significant effect on FDI, while lack of government had a negative but insignificant impact. The

study recommended stabilizing exchange rates through strict monetary and fiscal policies and

enhancing central bank efforts to effectively manage monetary policies to attract FDI.