The Impact of Foreign Direct Investment on Poverty Reduction in Ethiopia: A Cointegrated VAR Approach

Abstract

This study investigates the impact of Foreign Direct Investment on poverty reduction in Ethiopia over the period 1990 to 2023, employing a Cointegrated Vector Autoregressive model. The primary objective is to examine both the long-run and short-run dynamics between Foreign Direct Investment inflows and poverty, proxied by real Gross Domestic Product per capita, while controlling for trade openness, government expenditure, inflation, infrastructure development, and education expenditure. The research uses annual secondary data sourced from the World Bank, the United Nations Conference on Trade and Development, the National Bank of Ethiopia, and the Ethiopian Investment Commission. Stationarity was tested using the Augmented Dickey-Fuller and Phillips-Perron methods, followed by optimal lag selection based on the Akaike Information Criterion, the Schwarz Bayesian Criterion, and the Hannan-Quinn Criterion. Johansen cointegration analysis confirmed the existence of two long-run equilibrium relationships among the variables, leading to the estimation of a Vector Error Correction Model. The empirical findings reveal a positive and statistically significant long-run effect of Foreign Direct Investment on real Gross Domestic Product per capita, indicating that sustained Foreign Direct Investment inflows contribute to improved living standards and poverty reduction. Infrastructure and education spending were also found to enhance the poverty-reducing effects of Foreign Direct Investment, while inflation exerted a negative impact. Short-run effects of Foreign Direct Investment on poverty reduction were positive but smaller in magnitude, with the error correction term indicating a thirty-seven percent annual adjustment toward long-run equilibrium. Granger causality tests confirmed unidirectional causality from Foreign Direct Investment to poverty reduction. Variance decomposition and impulse response functions further underscored the importance of Foreign Direct Investment in explaining changes in living standards over time. The study concludes that Foreign Direct Investment plays a significant role in poverty reduction in Ethiopia when supported by investments in infrastructure and human capital, alongside macroeconomic stability. Policy recommendations include strengthening the investment climate, targeting Foreign Direct Investment toward labor-intensive and pro-poor sectors, expanding infrastructure, improving education and vocational training, and ensuring macroeconomic stability. These findings provide both academic and policy relevance, offering evidence-based guidance for maximizing the developmental benefits of Foreign Direct Investment in Ethiopia.