Foreign Direct Investment and Private Sector Development in Sierra Leone: Examining the Moderating Roles of Financial Development and Institutional Quality

Abstract

This study examines the long-run and short-run relationship between foreign direct investment (FDI) and private sector development in Sierra Leone for the period 1996–2023. The dependent variable is domestic credit to the private sector as a share of gross domestic product (GDP), which is considered as a proxy for private sector development. The study examines the moderating effect of institutional quality, proxied by a composite index of World Governance Indicators. This index is on the effect of FDI on private sector development. Annual data from the World Bank World Development Indicators and World Governance Indicators are used to conduct the analysis using the autoregressive distributed lag (ARDL) bounds testing framework. Robustness estimators are fully modified ordinary least squares (FMOLS) and dynamic ordinary least squares (DOLS) and short run dynamics are captured by an error correction model (ECM). The autoregressive distributed lag (ARDL) bounds F-statistic of 18.82 confirms the cointegration. Long-run estimates indicate that foreign direct investment (FDI) has a positive and significant impact on private sector development across all estimators. The interaction term between foreign direct investment (FDI) and institutional quality is positive and significant in all specifications. This suggests that improvements in governance enhance foreign direct investment's contribution to private sector development. The error correction term of − 0.346 (P = 0.01) implies that deviations from long-run equilibrium are corrected at 34.6% per annum. Results are robust to the exclusion of the Ebola shock period and to the decomposition of the governance index into its individual governance pillars. The results suggest that investment promotion and institutional reform are complementary policy priorities in post-conflict economies.