COLLEGE OF BUSINESS, ECONOMIC AND SOCIAL

SCIENCE DEPARTMENT OF ECONOMICS

RESEARCH PROPOSAL
SUBMITTED TO THE DEPARTMENT OF ECONOMICS IN
THE PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE AWARD OF BACHELOR OF ART DEGREE IN
ECONOMICS
DETERMINANT OF PRIVATE INVESTMENT IN ETHIOPIA:
TIME SERIES ANALYSIS

Prepared By: LIYA TESHOME

ID Number: 0034/13

Advisor: MR, TESGAYE

JANUARY,2024

FICHE, ETHIOPIA
LIST OF ACRONIMS

CSA Central statistical agency

EPRDF Ethiopian People Revolutionary democratic Front

UNCTAD United Nations Commission for Trade and Development

FDI Foreign Direct Investment

GDP Gross Domestic Product

RGDP Real Gross Domestic Product

EEA Ethiopia Economic Association

EIA Ethiopia investment agency

EIC Ethiopia Investment Commission

EIG Ethiopian Investment Guide

LDC s Least Developing Countries

NBE National Bank of Ethiopia

OLS Ordinary Least Square

WB World Bank

MOFED Ministry of finance and economic development

ODA Official development assistance

Table of Contents
.................................................................................................................................................................1
LIST OF ACRONIMS.............................................................................................................................2
CHAPTER ONE......................................................................................................................................4
1. INTRODUCTION...........................................................................................................................4
1.1 BACKGROUND OF THE STUDY..........................................................................................4
1.2. Statement of the problem..........................................................................................................5
1.3. Research question....................................................................................................................7
1.4. Objective of the study.............................................................................................................7
1.5. Scope of the study.....................................................................................................................7
1.6. Significance of the study...........................................................................................................7
1.7. Limitation of the study..............................................................................................................7
1.8. Organization of the study..........................................................................................................8
CHAPTER: TWO....................................................................................................................................8
2. Review literature..............................................................................................................................8
2.1 Definitions.................................................................................................................................8
2.1. Theoretical literature reviews...................................................................................................8
2.2. Determinates of private investment in Developing countries.................................................14
2.2. Empirical literature reviews....................................................................................................17
CHAPTER: THREE..............................................................................................................................20
3. Methodology..................................................................................................................................20
3.1 Research design.......................................................................................................................20
3.2 Source and types of data..........................................................................................................20
3.3 Method of data analysis...........................................................................................................20
3.4 Model specification..................................................................................................................20
3.5 Description of variables...........................................................................................................21
5. Reference.......................................................................................................................................23
CHAPTER ONE

1. INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Private investment plays a great role in country’s development especially in developing
countries whose capital is scarce and their government lack enough capacity to cover all
constraints and bring economic change for development. Thus, if privet investment (sectors)
involved in investment, the output and growth domestic product (GDP) of a country will
increase. Investment is a critical determinants of a long-run economic
performance .investment involves the formation of capital; fixed (tangible) capital, such as
reputation or technical knowledge; human capital such as skills or education (Bond and
Jankinson;1996).

The private investment is the main engine of growth in market economics. It thrives and
delivers sustained growth when number of factors combines to produce conductive
environment for the private sectors to develop. Privet investment is crucial pre-requisite for
economic growth because it allows entrepreneurs to set economic activity in motion by
bringing resources together to produce goods and services (IBID).

Rapid and sustained growth is facilitated by virtuous circle whereby entrepreneurship and
investment leads to higher productivity, and which makes possibility to invest large sums in
the future. In cause of this process, job is created and new technology is introduced,
especially through international trade and investment linkages. Economic growth could be
realized through a proper development policy. One of which could be promoting demand
countries have shown that growth the economics have come through increased investment.
Thus, investment plays a vital role for economic growth and development and for improving
the welfare of the society recent studies (Collier and Gunning, 1999; Ndikumana, and
Herndeze-Cata, 2000) conducted in Africa, Asia and Latin America has established the
critical linkage between investment and the rate of economic growth. It also plays multiplier
effects through creating employment opportunity, reducing poverty ,transferring technology
through foreign direct investment (FDI),increasing capital accumulation and Government
revenue collected in very essential economic as well as social institution in which the private
sectors is not involved which requires huge investment like construction of roads ,electricity
generating ,telecommunication ,and so on (Brihanu and Befikadu,2003/04).The growth rate
of investment is much greater in developed countries than that of least developed countries.
The reason for this is that investment needs skills, certainty, updated information and
appropriate policy to go with the existing circumstances, which are common problem of
LDCs. Our country Ethiopia is not exceptional to the above deep rooted problem of
investment growth. After the 1992 reform, the government has taken various measures to
attract private investment particularly FDI and investment codes has been revised many times
to make private investment more attractive. Moreover; the Ethiopia Investment Commission
has been established to cater efficient and effective techniques and services as well as to

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promote private investment in a country (EEA, 2005/06). Private investment is relevant to
economic growth in developing countries like Ethiopia. It has been argued that the marginal
productivity of investment is much higher and those plays more important role in the growth
process than public investment (Khan and Rinehart; 1996).

Regarding trends of private investment performance in Ethiopia, the overall performance in a

country since the era emperor’s regime shows allow rate of growth, which fluctuation
through time. In the regime emperor Haileselasse (pre-1975) investment had shown a
progress there both domestic and foreign investors growing at good pace. But through the
change of ideology, the Derge period (1975-1991) reduced the development of investment.
The government nationalized the property of national business and other devastating
measures were taken that demolished private investment. It is after 14 years at the last period
of derg period, that a mixed economy policy was designed. Then another government came to
existence in May 1991 it this destitute country with different ideology Ethiopia people’s
revolutionary democratic front (EPRDF), during its stage of transition reformed and
formulated the first investment code in 1992 based on the mixed economic policy amendment
of derg.

Since Ethiopia started a free market economic policy and the investment activity started
reviving parallel to the reformed policies of investment (Asmelashe, 2007). In 1994, the share
of private investment out of the total investment was 39.5% and it dropped to in 11.7% in
1990 and 1991 as the derg regime started ‘’reform’’ early in 1989 and proclaimed a mixed
economy in much 1992, the rate of privet investment continued to in increase substantially
through change in market principle of the present government (Workie, 1996).With regard to
economic performance, Ethiopia has been registering a remarkable GDP growth rate over the
past seven years starting from 2004(which is around 11% according to official reports).
However, according to WB(2013), as of 2012, the annual per capital income is still very low
(which is 255.69 at constant 2005 US$).The economy is predominantly based on agriculture,
which accounts for about 44% of GDP, around 75.9% of foreign currency earning, and above
80% of total employment. The service sector accounts for about 45.6% GDP, while the
industry sector comprises only about 10.85% GDP (which is mainly small and medium
enterprises) as of 2011/12 (Mo-Fed 2013)

1.2. Statement of the problem

Privet investment is an engine for creating innovation, economic growth and poverty
reduction. Domestic investment in Ethiopia shows progressive trends with speedy starting
from announcement of liberal policy in 1992. Nevertheless, the gap between domestic
investment and saving has remained wide thereby reinforcing the need foreign direct
investment in development of the economy (UNCTAD, 2002).Although the investment
climate has improved greatly in recent years, there are still many aspects of investment
promotion where improvements are urgently needed. In other words, even if the situations or
investment has improved from the previous period, the participation of private sector is not
satisfactory. Conducive Government Policies: In recent years, the government has adopted a
robust growth and poverty reduction strategy, focusing on infrastructure development,
commercialization of agriculture, improvements in access to basic services, as well as on

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private sector development, including the creation of appropriate regulatory and institutional
frame works to support private business. (Economic Brief, 2010).

A Nov. 2020 publication by the World Bank, Ethiopia Economic Update, shows on average
the share of total national investment from its GDP in the years between2016-2018 was
22.9%. Growth and Transformation Plan (GTP), Ethiopia’s latest lead economic development
plan, aspires to make investment contribute some 31.5% to the nation’s GDP by the end of
2022 . In line with this, and following the government’s incentives in the form of various
investment policies and trade laws and regulations, many sectors are now seeing new foreign
entrants with new innovation and technology. Ethiopia’s public investment rate is the third
highest in the world, but private investment rate is the sixth lowest. The current ‘big push’ of
public investment-led development has delivered positive results in the past but the
development of a strong, vibrant private sector is needed to sustain high growth. (World
Bank, 2021).

A more difficult relationship to discern is that between public and private investment.
Crowding in of private investment is defined to occur when increase public investment is
associated with increase private investment. This may arise because of public infrastructure
provision affects return on private investment positively, hence enhancing the incentive to
carry out such private investment.

Crowding-out occurs when the opposite in the case. Some empirical literatures inclined with
the crowding- in effect are Oshikoya (1994); finding that public investment in infrastructure
is complementary to private sector investment. Opposing to this, Clements and Levy (1994);
suggest that public investment is crowding-out private investment. Finally, Ghura and
Goodwin (2000); suggests that public investment have mixed effect on private investment in
different cases, which are investing in information equipment, credit market and generally on
non infrastructure have a crowding-out effect; otherwise the effect is opposite. Therefore the
researchers support that this mixed effect case. And; according to, Ashebir Tsegaye (2012)
the determinants of private investment in Ethiopia case were: inflation rate, RGDP growth
rate, government expenditure, and real effective exchange rate.

Given the above fact; researchers were initiated to conduct a study by considering the gap
between determinants of private investment and the available good climate. That means there
are other basic factors that determine private investment; like Gross fixed capital formation
and real lending interest rate. On the other hand, most of the paper done in this area; in the
past, does not include recent data. The researcher believes that even if the overall prevailing
determinants of private investments are diverse and complex, it’s necessary to identify the
major one and to investigate them properly to achieve the expected growth of investment or
to fill the gap and suggest measures to be taken to promote private investment in the
economy.

1.3. Research question

The researcher is eager to answer the following questions, in order to meet the research
objectives;

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  What are the factors that determine private investment in Ethiopia?
 What are the benefits of private investment in Ethiopia ?

1.4. Objective of the study

1.4.1. General objectives

The main objective of this study is to investigate the determinants of private investment in
Ethiopia.

1.4.2. Specific objectives

The researchers want to identify the following specific objectives

 To examine factors that determines private investment in Ethiopia.

 To analyze the benefits of private investment in Ethiopia

1.5. Scope of the study

Investment is a broad topic; however this study intends to look only on private investment.
Even though the determinants of private investments; controlling for non- macro-economic
factors, which have an intense effect on it. The study will focus on the determinants of
private investment in Ethiopia from 1987-2023 by using the determinants variables of :
Inflation rate, real interest rate , Real effective exchange rate, Real gross domestic
product(RGDP) growth rate, with regard to private investment in Ethiopia.

1.6. Significance of the study

It is not new for all that investment would provide an important role for countries economic
growth which further leads to development. The paper would have its own importance for
policy makers to improve the level of private investment. In addition to this; the paper would
consider as basis for further research literature in this area.

1.7. Limitation of the study

As has already been pointed out in this study, investment is an engine to economic growth.
The apparent limitations of the study are that it concentrates on macroeconomic variables and
uses aggregate data. This means that there are other important factors, other than
macroeconomic factors that explain the relatively good economic growth in Ethiopia. This
controversy itself is a topic for further research and is not addressed in this study. A study
that utilizes more disaggregated data and seeks to explore sectorial private investment may
arrive at different results.

1.8. Organization of the study

This section of the study set a foundation of the study. Chapter one the background of
the study, Statement of the problem, Research question, objectives of the study , scope and
limitations; and Chapter Two discusses, and reviews related private investment literature. The
Methodology (Chapter Three) discusses the research framework assumed and justification
of the methods to ascertain their suitability given the expectations of the study.

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CHAPTER: TWO
2. Review literature
2.1 Definitions
* What is privet investment ?

Before explaining about private investment let us define what is investment. Investment is a
core reason for ones country economic growth.

Investment is defined as the commitment of current financial resources in order to achieve

higher gains in the future. It deals with what is called uncertainty domains. From this
definition, the importance of time and future arises as they are two important elements in
investment.

This proposal is more concerned on private investment so we should elaborate it.

A private investment, also commonly referred to as an alternative investment, is a financial

asset outside public market assets such as stocks, bonds, and cash. Qualified investors often
access private investments through an investment fund.

Private investment, from a macroeconomic standpoint, is the purchase of a capital asset that
is expected to produce income, appreciate in value, or both generate income and appreciate in
value.

2.1. Theoretical literature reviews

“Peoples can choose either to spend their time picking apples or planting apple trees. In the

first case there are more apple today; in the second more apple tomorrow.” Steven

2.1.1. Basic Concepts of Investment

An investment is simply any vehicle in to which funds can be placed with the expectation that
they will generate positive income or that their value will be preserved or increased. The
reward or returns, from investing are received in either of two basic forms current income
increased value. For example, money invested in a bank saving account provides current
income in the form of periodic interest payments; similarly, buying apiece of raw land is an
investment, because. The land is expected to increase in value between the time it is
purchased and the time it is sold. In short investment funds placed within the expectation
value the time between purchasing and sold. (Lawrence J. gateman and Michael D. Joe bonk,
1998).

Investment broadly, defined as a flow of expenditure devoted to product, producing goods

and services, which are mostly not intended for immediate consumption where this project
may take the form of adding to both physical and human capital as well as investors.
(Dictionary of modern economics).

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The relevance of investment to economic growth in developing countries has received a
particular attention among researchers and policy makers only after 1990s. While the
government to concentrate on improving to social over heads capital and poverty alleviating
goals is based on two reasons. First there has been growing empirical evidence the relative
efficiency of private over public investment in the productive sector. Second, there is
physical complementary between private and public investment (world development report).

Given the above fact proposition we can understand that investment is one of critical element
which determines the level and pace of economic growth. Investment helps to introduce
technology change and the quality of resource, which in turn improving productivity
(Ethiopian economic association, 2005/06).

Investment in the Keynesian system defined in desired business investment, expenditure were
one of the major factors that Keynes through were responsible for change in income. Keynes
believed that consumption was a stable function of disposable income, consumption was
primary induced expending; meaning expenditure that depends directly on income that be
lived that investment was the most highly variable of the autonomous components of
aggregate demand believed that variable investment spending was primary responsible for
income instability (Foreign, 2005).

According to the classical economists, investment is interest elastic, this important from the
point of view of monetary policy because if this the case investment could be increased
sufficiently enough by increasing the money supply particularly in a slump, a resource to the
easy money policy would have been sufficient to review the economy and ensure full
employment. Keynes .challenged this faulty classical view which held that the investment
was influenced more by income rather than by interest rate except marginally. During
depression when the marginal efficiency of capital suffers a near collapse, no amount of
lowering of the interested rate would help review the investment in the economy. (Vals,
2006).

2.1.2. Importance of investment

Individual investor can participate in the growth and prosperity of the country, by investing
the security market more importantly even small investors can share the growth investing
small amount of money over long period of time. If you are for a long term intensified group
of societies, you will proper financially and which help economic system work even better
long term investment helps to create new jobs and new economic opportunities (Mankiw,
1994).

2.1.3. An overview of investment theory

The theories of investment date back to Keynes (1936), who first called attention to the
existence of an independent investment function in the economy. A central feature of 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. The next phase
in the evolution of investment theory gave rise to the accelerator theory, which makes
investment a linear proportion of changes in output. In the accelerator model, expectations,

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profitability and capital costs play no role. Keynesian theory has traditionally favored the
accelerator theory of investment while disregarding the role of factor costs. A more general
form of 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. The hypothesis is that, firms plan to close a
fraction of the gap between the desired capital stock, K*, and the actual capital stock, K, in
each period. This gives rise to a net investment equation of the form of:

I = δ (K* - K-1)………….. (1)

Where I = net investment, K* = desired capital stock, K-1 = last period’s capital stock, and δ
= partial adjustment coefficient. Within the framework of the flexible accelerator model,
output, internal funds, cost of external financing and other variables may be included as
determinants of K*. The flexible accelerator mechanism may be transformed into a theory of
investment behavior by adding a specification of K* and a theory of replacement investment.
Alternative econometric models of investment behavior differ in the determinants of K*, the
characterization of the time structure of the investment process and the treatment of
replacement investment. In the flexible accelerator model, K* is proportional to output, but in
alternative models, K* depends on capacity utilization, internal funds, the cost of external
finance and other variables.

Jorgenson (1971) and others have formulated the neoclassical approach, which is a version of
the flexible accelerator model. In this approach, the desired or optimal capital stock is
proportional to output and the user cost of capital (which in turn depends on the price of
capital goods, the real rate of interest, the rate of depreciation and the tax structure). In the
“Q” theory of investment (which is also in the neoclassical framework) associated with Tobin
(1969), the ratio of the market value of 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 of investment are the reasons why Q would differ from unity.
Another approach known as “neoliberal” emphasizes the importance of financial deepening
and high interest rates in stimulating growth. The proponents of this approach are McKinnon
(1973); The core of his argument rests on the claim that developing countries suffer from
financial repression (which is generally equated with controls on interest rates in a downward
direction) and that if these countries were liberated from their repressive conditions, this
would induce savings, investment and growth. Not only will liberalization increase savings
and loanable funds, it will result in a more efficient allocation of these funds, both
contributing to a higher economic growth. In the neoliberal view, investment is positively
related to the real rate of interest in contrast with the neoclassical theory. The reason for this
is that a rise in interest rates increases the volume of financial savings through financial
intermediaries and thereby raises investible funds, a phenomenon that McKinnon (1973) calls
the “conduit effect”. Thus, while it may be true that demand for investment declines with the
rise in the real rate of interest, realized investment actually increases because of the greater
availability of funds. This conclusion applies only when the capital market is in
disequilibrium with the demand for funds exceeding supply.

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It is clear from the discussion in this section that private investment depends on three broad
categories of variables: Keynesian, neoclassical, and uncertainty variables. Variables that
may be included in the Keynesian tradition include growth rate of GDP, internal funds and
capacity utilization. The neoclassical determinants of private investment include Tobin’s Q,
real interest rate, user cost of capital and public investment ratio. There are three uncertainty
variables. The first is variability (variance, moving standard deviation or moving coefficient
of variation) of the user cost of capital, real exchange rate, inflation rate, distortions in the
foreign exchange market (proxies by the black market premium) and real GDP. The second
uncertainty variable is the debt/GDP ratio and the third is debt service as a ratio of exports of
goods and services.

Rostow argued that advanced countries had all passed the stage of “take off”. In to self
sustain growth and under developed countries where still in either the traditional society or
the “ precondition” stage had only to follow a certain set of development to take off in their
turn in to self sustain economic growth. The principal strategies of development necessary for
only take off was the mobilization of domestic and foreign saving in order to generate
sufficient investment to accelerate economic growth (Todaro, 2000)

2.1.4. Historical development of investment policy in Ethiopia

According to the document of the Ethiopian investment agency, there are many reforms,
investment condition, and exemption of various duties. These have radically changed the
Ethiopia’s investment today. The revised Investment Code of 1996, as well as the Investment
Proclamation provide incentives for development-related investments, and have gradually
removed most of the sectorial restrictions on investment; Ethiopia's investment code prohibits
foreign investment in banking, insurance, and financial services. The remaining state-
controlled sectors include telecommunications, power transmission and distribution, and
postal services with the exception of courier services. Manufacturing of weapons and
ammunition can only be undertaken as joint ventures with the government.

Other areas of investment reserved for Ethiopian nationals include: broadcasting; air transport
services; travel agency services, forwarding and shipping agencies; retail trade and
brokerage; wholesale trade (excluding supply of petroleum and its by-products as well as
wholesale by foreign investors of their locally-produced products); most import trade; capital
goods rentals; export trade of raw coffee, chat, oilseeds, pulses, hides and skins bought from
the market; live sheep, goats and cattle not raised or fattened by the investor; construction
companies excluding those designated as grade 1; tanning of hides and skins up to crust level;
hotels (excluding star-designated hotels); restaurants and bars (excluding international and
specialized restaurants); trade auxiliary and ticket selling services; transport services; bakery
products and pastries for the domestic market; grinding mills; hair salons; clothing workshops
(except garment factories); building and vehicle maintenance; saw milling and timber
production; custom clearance services; museums, theaters and cinema hall operations; and
printing industries. However, the GOE has indicated an interest in bringing foreign private
sector expertise to some of the above sectors. Ethiopian-Americans can obtain a local resident
card from the Ministry of Foreign Affairs that allows them to invest in many sectors closed to

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foreigners. Foreign firms can supply goods and services to Ethiopian firms in the closed
sectors.

The 2012 amendment to Ethiopia’s investment proclamation introduced provisions for the
establishment of industrial development zones, both state-run and private, with favorable
investment, tax, and infrastructure incentives. The amendment also raised the minimum
capital requirement to US$200,000 per project for wholly-owned foreign investments and
US$150,000 for joint investments with domestic investors (or US$100,000/US$50,000
respectively in the areas of engineering, architectural, accounting and auditing services,
business and management consultancy services, and publishing). A foreign investor
reinvesting profits/dividends may not be required to allocate minimum capital.

Inflation rates, while still high, stabilized over 2012. The GOE has taken an active role in
managing inflation through a series of measures including strict monetary and fiscal policies
limiting the growth of broad money, resulting in year-on-year inflation undergoing a steady
series of declines and stabilization periods, dropping from 39.3% in November 2011 to
15.6% in November 2012. The GOE remains vigilant about combating inflation; however,
structural inefficiencies such as a state monopolized multi-modal logistics system and an
oligopolistic wholesale sector will likely continue to keep Ethiopia’s inflation rate in double
digits.

Ethiopia does not have discriminatory or excessively onerous visa, residence, or work permit
requirements for foreign investors; however, investors may face bureaucratic delays in
obtaining these documents.

2.1.5. Private Investment Development

The mobilization of private investment is essential for development, while public expenditure
whether by developing countries government or through official development assistance
(ODA) provided by developed countries governments is requires it has become clear that the
demand for finance out strips that which the public sector can provide. Report on
international conference on financing for development (UN, 2002).

The Monterey consensus, Recognized that a substantial increase in ODA and other resource
including private investment will be required if developing countries are to achieve the
international agreed development goal and objectives. Including those contained in the united
national millennium declaration. Mobilizing investment in developing countries can
contribute direct to economic growth the challenge for developing countries and their
development partner to identify the best way to influence the condition reads to increased
levels of private investment. This guidance documented focuses on the role of ODA can
play in helping developing countries to mobilize private investment. However on handing
private investment should not focus on attracting foreign perfect investment (FDI) alone.
While FDI to developing countries has increased significantly in the last 20 years the bulk of
investment is domestic (World Bank, 2004 E.C.).

Profitable private investments, where they do not rely on protection generally contribute to
economic development, through the productive use of capital. In addition, they may

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contribute to environmental, social, or corporate governance improvements traditionally this
contribution to these key components of suitable development has been through the use of
minimum environmental and social standards. The international fiancé corporation (IFC), as
part, of the world bank group has invested consider by in the development of such standards
they have become intrinsic part of contribution significantly of the understanding of
environmental and social influence and the processes through which the adverse impact can
be minimized.

2.1.6. Private Sector Development

There are different prospective on how private sector development might contribute to
poverty reduction and sustainable economic growth. The private sector was considered to
play a crucial role, creating opportunity for employment and income generating, with
emphasis than on the policy needed to make market explanation (work,) the processed of
structural adjustment sough to restrain the re orient government intervention in the markets to
ensure that the private sector ranging from small farmer comparatives to lager national and
multinational companies operated more freely (foster and Weston 2006).

Private sector development, the performance of private sector activities, is now seen as
crucial to economic growth and poverty deduction (reduction) in developing countries. It is
there for important to understand how donors think they can promote a vibrant private sector.
There have been various discussions in policy circles, including among donors. Where and
how to support private sector development in developing countries Regulate, structure and
Implement of competition law (Tempo and Willemetvelde, 2008).

The main obstacle to private sector development in transition economies is the shortage of
private business capital. The formal private sector only gradually absorbs workers released
from the state sector is that it takes time for entrepreneurs to create productive new private
businesses and for the competitive economy to select highly productive businesses through
national selection on the other hand, once the entrepreneur find a productive businesses
activates opportunities, he can immediately attain the optimal size of the business. There is no
limitation on the growth of the businesses for the individual entrepreneur. In the individual
entrepreneur often faces partialities not only in finding a highly productive business
opportunity but also in financing the businesses investment (Brixiorat and Kiyotaki, 1979).

2.2. Determinates of private investment in Developing countries

The relevance of privet investment developing countries has received particular emphases
among researchers and policy makers in the 1990s. this leads growth strategy, towards base
the private sector a leading role while allowing the government to concentrate on improving
social over head capital and poverty alleviation goals is based on two reasons, first there has
been growing empirical evidence on the relative efficiently of private over public investment
in the in the productive sector. Second there is physical complementary between private
investment and public infrastructural investment. Nevertheless promoting private investment
is a complex task because the factors affecting it are intricate and delicate, the specification of
the private investment and saving determinates can be drawn from empirical literature on
investment behavior or with appropriate consideration of the structural features of an

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economy among these are direst focal policy. Such as tax, public investment, and financial
variables such as interest rate and credit how. Hence the term work for private investment
combines not classical investment determinates with borrowing constraints, public
infrastructure and uncertainty variable, the foreign debt to output ratio and political and
business regulations. (Yasaba, 2003 E.C).

2.2.1. Inflation
The evidence for friend mans statement is straight forward whenever a country inflation rate
is extremely high or a sustained period of time; its rate of money supply growth is also
extremely high. Accordingly friend mans proposition actually says that upward movements in
the price level are a monetary phenomenon only if this is a sustained process. Inflation is
defined as continuing and a rapid rise in the price level. Most economists, whether monetarist
or Keynesian. Will agree with friend mans’ proposition that one alone is to balance.

Inflation too, has significant role in affecting the level of domestics investment as well as
private investment from its very definition, inflation is the rise of all or almost average price
of goods and services, or put the other way round, if it is the fall of the general purchasing
power of the monetary units economic literatures emphasized on stable price level as a goal
of economic policy (Mishkin, 1998).

Underlined the desirable feature of price stability because he explained, inflation create
uncertainty in the economy and usually lower the economic growth in the inflationary
environment, planning is hardly attained as it complicates decision making for consumers,
business and even government, when the price of one good rises, that price increases may or
may not be part of a large inflation. Remember, inflation is an increasing on the overall price
level. We measure inflation by looking at a large number of goods and services and
calculating the average increases in their prices during some period of time (CASE AND
FAIR, 2007).

Real estate and other tangible investments, including gold, other precious Metals and
collectibles such as art work and antiques. are generally more responsible to the rate of
inflation than to any Thing ales, housing prices and the price of commodities like coffee, oil,
meat, corn and sugar are component of consumer price index when consumer price starts to
rise the return on real estate and other tangible investment starts to rises as well as, but when
inflation comes back down to more normal level, returns on real estate and other tangible
investment also decaling. (Lawrence and Michael, 2008).

And public investment and financial variables such as interest rate and credit flows. Hence
the frame work or private investment combines no classical investment determinate with
borrowing constraints, public infrastructure and uncertainty variable, the foreign debt to
output ratio, and political and business regulations.

2.2.2. Interest rate

The real interest rate measures the opportunity cost of holding inventories. When the real
interest rate rises, holding inventories becomes more costly, so rental firms try to reduce their
stock therefore, an increase in the real interest rate depresses inventory investment. The real

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interest rates that prevailed during most of this decade are one possible explanation for this
change in business strategy (Mankiw, 2000).

Bond and other forms of fixed income security ; preferred stock and bond fund are highly
sensitive to movements in interest rate, infarct interest rate are the single most important
variable in determining the bond price behavior and return to investors. Because interest rate
and bond price move in opposite direction, so interest rate are unfavorable for outstanding
bonds already held in an investor portfolio. Of course high interest rate enhance the
attractiveness of new bonds be causes they offer high returns. (Lawrence and Michael, 2008).

The impact of interest rate can be seen by its power to influence capital stock by changing the
expected portability of various investment expenditure interest rate has special role in the
analysis of the net present value of investment, the higher purchasing of additional capital
goods Keynesians explain the impact of interest rate in deferent manner by using the concept
efficiency that expected how of return is less than the market interstate, the project is
regarded as profitable for Keynesian and investment project will be pursued by if its expected
profitability exceeds the cost of borrowing to finance the project at a higher interest rate
borrowing cost toward projects satisfy this criterion (foreign. 2005.)

The user cost of capital is an important factor in investment decisions by the private sector.
When the user cost is generally raised by increasing the cost of bank credit through raising
interest rate or by increasing the opportunity cost of retained earnings, which is the other
main source of investment financing, private investment declines (Jayaraman, 1996).
Findings of various empirical studies are not, however, consistent. The negative influence of
interest rates on investment is confirmed by certain studies in developing countries (Greene
and Villaneuva, 1991, Solimano1992). However, studies by others (Serven and Solimano
1985) have shown that, in the repressed financial markets in developing countries, credit
policy affects investment directly through the stock of credit available to firms with the
access to preferential interest rates, rather than through the interest channel). Thus
institutional set up of the financial markets is an important factor for the transmission
mechanism of the impact of monetary policy and credit policies on private investment.

In the classical system, the components, of commodity demand consumption, investment, and
government spending play their explicit role in demining the interest rate the equilibrium
interest in the classical theory was the rate at which the amount of funds individuals desired
to lend was just equal to the amount other desired to borrow. In classical system, the suppliers
of bonds where the firms, which financed all investment expenditures by the sale of bonds
and the government, which might sell bonds to financial spending in excess of tax revenues
for a given expected profitability , investment expenditures varied inversely with the
interest rate. At high interest rate, toward project will be profitable, net of interest cost, and
investment will increase, (foreign).

2.2.3. Availability of finance

Firms face financing constraints limit on the amount they can raise in financial markets.
Financing constraints can prevent firms from undertaking profitable investment, when a firm
is unable to raise funds in financial market, the amount can spend on new capital goods is
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limited to the amount if it is currently earning financing constraints influence the investment
behavior of firms just as borrowing constraints influence the consumption behavior of
households, borrowing constraints caused households to determine their consumption on the
basis of current rather than permanent income, financing constrains cause firms to determine
their investment on the basis of their current cash flow rather than expected profitability.
(Mankiw, 2000).

In many developing countries firms fire to generate adequate sale financing. In addition on
the amount of resource available for investment financing in these countries are so much
eliminated because of low income and low savings. This is further exacted based by the
absence and inefficiency of capital must, which mobilize saving and direct them in to
productive investment. Finance is therefore, an important constraint to promote investment
in developing countries. In these countries where financial markets are repressed, credit
policy affect investment directly through the stock of credit available to firms than through
the interest rate channel. In general, because the total amount of financing is limitedly, it
would seem legitimate to hypothesize that the private investment is restricted by the level of
available bank credit. (Abinet, 2006).

2.2.4. Sales and profit

The level of sales could be as affecting expectation of future output and thus affecting the
desired capital stock, not that output and sales differ by the amount of inventory
accumulation similarly. High profits may provide an indicator demand for the firms product,
and thus of future output. Alternatively, it is often argues that firms prefer to use retained
profit to financial investment, rather than borrow. The preference might result from the
expense of having to rise outside funds relative to using inside funds. However, it has to be
remembered that in using its retained protest to finance investment rather than borrow. The
preference might result from the expense of having to rise outside tends relative to them to
the firms owners (Fisher and Dorinbus, 1998).

2.2. Empirical literature reviews

Thomas, (1997) in his study of 86 developing countries examined data on terms of trade, real
exchange rates, property rights and civil liberties and concluded that while factors including
credit, availability and the quality of physical and human infrastructure are important
influences, uncertainty in the investment environment was negatively related to private
investment in sub-Saharan countries. Employing the variability in real exchange rates as an
explanatory variable in regression analysis, in his cross-country study on the macroeconomic
environment and private investment in six Pacific Island countries observed a statistically
significant negative relationship between the variability in the real exchange rate and private
investment.

Duncan et al. (1999) argued that although variability in the real exchange rate is a reasonable
proxy for instability in major economic variables as fluctuations in inflation and productivity.
Generally, fiscal and monetary management are reflected in the real exchange rate, which is
not a good measure of the uncertainty attached to policy or the insecurity of property rights

13 | P a g e
and enforcement of contracts or the level of corruption. It has been observed that these non-
economic factors appear to have significant influence on investment in the Pacific Island
countries. However, admitted that no quantitative or qualitative evidence is available of their
size or their impact. In the absence of such evidence, any study on private investment is to be
necessarily restricted to the conventional variables. It has been observed by many researchers
that monetary, fiscal and exchange rate policies for correcting unsustainable macroeconomic
imbalances are bound to affect private investment. There are two ways by which restrictive
monetary and credit policies included in stabilization packages affect investment. These are
the rise in the real cost of bank credit and the opportunity cost of retained earnings from
higher interest rates. The user cost of capital is increased by both mechanisms, leading to a
reduction in investment. (IBID)

Van Wijnbergen (1982) however noted that credit policy affects investment directly, because
credit is allocated to firms with access to preferential interest rates rather than through the
indirect interest rate channel. Thus the effect of monetary and credit policy on investment and
the means of transmission depend on the institutional structure of financial markets.

TunWai and Wong (1982) incorporated features of the neoclassical model into investment
models for developing countries. Their approaches take into account the relevant data
problems and structural features Journal of Economics and Sustainable Development.

That caused a gap between the modem theory of investment and the models that were
specified for developing countries. Blejer& Khan (1984) focused on the role of government
policy and derived an explicit functional relationship between the principal policy
instruments and private capital formation. Using the model they were able to assess the extent
of any “crowding out”. The second extension that did was to make a distinction between
government investment that is related to the development of infrastructure and government
investment of other kinds. Those researchers found a positive relationship between the share
of private investment in total investment and the ratio of total investment to income. They
also found that the larger the share of private investment, the higher the average growth rate
of the economy. These patterns indicate the relevance of private investment behavior in
developing countries and call for the testing of formal models of private capital formation in
individual countries.

Two principal conclusions emerged from (IBID) tests of formal model for 24 developing
countries. The first was the possibility of identifying well behaved empirical function for
private investment in developing countries. This challenged the traditional view that standard
investment theory is not relevant for developing countries. The second conclusion was the
establishment of a direct empirical link between government policy variables and private
capital formation.

Asante (2000) estimated a private investment equation that tried to assess the determinants of
private investment in Ghana. Among the independent variables were the incremental capital
output ratio, the lending rate, the exchange rate, credit to the private sector and public

14 | P a g e
investment. His preliminary results showed among other things a “crowding out” effect of
public investment.

Ariyo and Raheem’s (1991) country estimation of the determinants of investment consisted
of public investment rate of growth of GDP, domestic credit to the private sector and interest
rate as arguments in the private investment function. “Their results show that all variables
were statistically significant and evidence of the existence of crowding in”.

Bazoumana (2004) analyzed the determinants of private investment in general. He found a

significant relationship between private investment and its explanatory variables. Public
infrastructure investment was found to be positively related with private investment GDP,
credit to the private sectors and terms of trade has a significant negative impact in private
investment.

Bayraktar and Fofak (2007) derive a formal specification of a private investment function in
Sub-Saharan Africa. Using the Tobin’s Q theory and the neo-classical theory of investment,
their results point to the significant role played by aggregate profitability shock, and by
financing of investment in determining the level of private investment in Africa.

Khan and Reinhart (1990) carried out a study on private investment and economic growth in
developing countries. The conclusion from their study was that both private investment and
public investment have different effects on the long-run economic growth rate. Private
investment was seen to play a much more -significant role in the growth process than
domestic public investment. The only shortcoming in this study is that it failed to consider the
complementary effects of public investment on private investment. Such public expenditures
like construction of roads, building of schools, electricity and telecommunication do have a
strong effect on private investment.

Asante, Y. (2000) studied the Determinants of Private Investment Behavior in Ghana using
data for the period 1970 to 1992. This study revealed that public investment as a ratio of
GDP, growth rate of real credit to the private sector, the real exchange rate, the real interest
rate, lagged private investment as a ratio of GDP; all have positive and significant impact on
private investment. Public investment, growth rate of real credit to the private sector, the real
exchange rate, is all significant at the 1% level. On the contrary, measure of macroeconomic
instability, political instability represented by coup dummy, and inflation all has a negative
impact on private investment in Ghana. The main strength of this study is that, it incorporated
many macroeconomic variables that are expected to affect private investment in the context
of a developing country. The only weakness of the study is that it used a short time period
coupled with the many explanatory variables. Given the short period of the study and the
many explanatory in the model, the degree of freedom will be very low and that may impose
constraints in the model estimation process.

15 | P a g e
CHAPTER: THREE
3. Methodology
3.1 Research design
We will detect and show my framework of research methods and techniques I choose to
conduct my study. This proposal aims to show what determines private investment and how
private investment is important for Ethiopia.

This research is mainly focused on one country that is Ethiopia and it more explains and see
with macroeconomic glasses using qualitative and quantitative data that are simple to
analysis. Due to the data that are going to be used to conduct the study the research design is
going to be flexible enough to avoid irrelevant delays.
3.2 Source and types of data
The study would conduct basically using secondary data. An attempt would make to gather a
36-years data (i.e. from 1980 to 2016, since there is poor performance of investment GDP
growth rate in the year 1980.) on some important variables. The data would gather from
various sources such as National Bank of Ethiopia (NBE), MOFED, EIA, CSA of Ethiopia,
and WB data basis, and from other relevant and reliable sources.

3.3 Method of data analysis

The methodology would uses in an attempt to learn more about the determinants of private
investment activities in the country, is econometric regression using OLS method over the
period 1980 to 2016. This model is select for its simplicity, and is also expect to fulfill the
assumptions of efficiency, consistency and unbiased and the researcher will employ
descriptive analysis; after collecting secondary data the researchers would summarize using
tables, charts and other appropriate statistical tools.

3.4 Model specification

For the purpose of this specific study, the researchers have used the theory of accelerator
principle. The principle uses the researchers to specify private investment. the principle states
that an increase in productive capacity requires an expansion of capital stock, which in turn
causes for a higher rate of spending (Shapiro;1982).Therefore, the rate of investment
spending depends on change in output.

As the literature proposed, there are key macroeconomic variables that play an important role
in explaining private investment behavior in Ethiopia.

“Factors that influence the ability and motives of private investors to implement their project
or to investment equally determine the speed with which private investors respond to the gap
between planned and actual investment” (Getachew, 1997). In our cause these determinants
are RGDP growth rate, real lending interest rate, inflation rate, real effective exchange rate;.
In addition to this the purpose of including the explanatory variables which affect private
investment and which are not included here; i.e. error term (ᵋ) is used.

When we put it in mathematical form, we get:

16 | P a g e
 Pri =β0 +β1RGDPt + β2RLIRt + β3INFt + β4REERt +Eit

Where

Pri -private investment

RGDP-real gross domestic product growth rate

RLIR-real lending interest rate

INF-inflation

REER-real effective exchange rate

t- on all variables represents time t and ᵝ0,ᵝ1……constant and coefficients respectively.

3.5 Description of variables

Private investment is the proxy for the performance of private sector in the economy, and it is
dependent variable, which depend on some explanatory variables for our case.

Real GDP growth rate is one of the most commonly used variable as explanatory variable, to
measure its effect on private investment. According to Fielding (1997), explain that private
investments positively related to real GDP growth rate of a given country. This is because
countries with higher income level inclined to allocate more of their wealth to domestic
saving, which could be then used to help in financing private investment.

Real lending interest rate is a proxy for cost of capital. The perceived negative relationship
between real lending interest rates and private investment is a long debated issue which pulls
in a number of prior studies. Pablo et al, notes that, the rate of return of an investment –
approached by literature through a real lending interest rate as a representative of the cost of
capital is a possible determinant of private investment. Here, it’s worth to make two
distinctions: the interest rate would have a negative impact in the level of private investment
made by domestic agents if the investment is financed in the local credit market. However, an
increment in interest rate could have a positive effect in the capital flow from abroad, like it
usually happens in emergent markets.

Inflation is the third variable that the researcher uses in the study as a proxy to measure
macro economics stability of the country. Models like the Tobin - Mundell model argues that
higher anticipated inflation lower the real interest rate which then causes to be made portfolio
adjustment away from real money balance to real capital which then expected higher inflation
to raises real investment (Ghura & Goodwin, 2000).

Real effective exchange rate is another explanatory variable, is also used as a proxy to
measure macro-economic stability. In most literatures the effect of real effective exchange
rate, either devaluation or appreciation of local currency on private investment is ambiguous.

17 | P a g e
Branson & Buffy (1986) discuses that real depreciation of local currency increases domestic
goods relative to the real cost of new capital goods which then increase the investment in
non-tradable activities; and it makes exportable product more competitive in the World
market.

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