CHAPTER ONE

. INTRODUCTION

1.1. Back ground of the study

Generally in all over the world the term manufacturing refers to the production of finished and
semi-finished goods for the components into purpose of use or resale by using labor and
machines, tools, chemical and biological processing, or formulation commerce or industry.
Manufacturing sector is the physical or chemical transformation of materials or new products,
whether the work is performed by power-driven machines or by hand, whether it is done in a
factory or in the worker’s home, and whether the products are sold at wholesale or retail. The
assembly of the component parts of manufactured products is also considered a manufacturing
activity (ISIC, 2007/08).

Ever since the industrial revolution moved of 19thcentury Europe in to modernity the significance
of manufacturing as vital engine for sustainable growth has been a questioned(UNIDO;1994 ). It
does not only feed and satisfy domestic demand for products, it also diversity economies, capture
mass employment and earn export driven income.( Mebugua,2000); In many LDCs countries,
their socio political and economic characterized by low productivity, low income per capita,
inadequate finance, weak technological progress, and lack of skilled man power results poor
performance of their investment level.

Celestin Mongo.(2012), Even though the manufacturing sector have a strong correlation with the
other stalk holders of the economy and un deniable vivid circumstance by ensuring faster and
enhanced development it began to appear in Ethiopia during the time of imperial regime in
1950s.but it starts much earlier than many of the Sub-Saharan African countries. Early l970s,
the government adopted industrialization policy included a range of fiscal incentives, direct
government investment and equity participation in private enterprises. This government's policy
attracted considerable foreign investment to the industrial sector. For instance, in 1971/72 the
share of foreign capital in manufacturing industries amounted to 41% of the total paid-up capital
and many foreign enterprises operated as private limited companies, usually as a branch or

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subsidiary of multinational corporations ( Ethiopian industrial development strategic plan 2013-
2025).

The Derg come to power with a new ideology, socialism, which emphasizes on a strong public
sector and a weak private sector in 1974.to this effect a decree was enacted in 1974, which
nationalized almost all of medium and large scale industries that were owned by the private
sector. in addition to this the manufacturing industries of the country was characterized by the
revolution included a predominance of foreign ownership and foreign managerial professional,
and technical staffing; heavy emphasis on light industries; inward orientation and relatively high
tariffs; capital-intensiveness; underutilized capacity; minimal linkage among the different
sectors; and excessive geographical concentration of industries in Addis Ababa. The economic
dislocation that followed the 1974 revolution had a significant impact on the manufacturing
industries. Private sector capital investment ceased and labor's marginal productivity began to
decline. A period of decline from l974/75 to l977/78 and an average annual growth rate of l8.9
% for l978/79 and l979/80 was followed by a reduction of about 3.1 % per annum between
l980/81 and l984/85 and 3.8% per annum from 1985/86 to 1988/89( Ethiopian Industrial
Development Strategic Plan 2013-2025).

After the fall of the Derg regime in 1991 the new transitional government of Ethiopian claimed
for increased participation of private investment to give new life to socio economic condition of
the country. The economic system has been transformed from command to market based system
through decentralized planning, privatization of public enterprise, promoting investors and the
introduction of market based planning. The economy policy which adopted and implemented
under Structural Adjustment programs(SAP)during the transitional period and thus followed by
Agricultural development–Led Industrialization (ADLI), in which enhanced agricultural growth
and expanding agricultural surpluses provide the necessary savings for financing structural
transformation and rapid industrialization. The industry sector in general and the manufacturing
sector in particular were given due national importance following the formulation of the national
industry policy in 2002 by the FDRE (Ethiopian investment climate assessment report, 2004).

The central focus of industrial development strategy in Ethiopia is the development of micro and
small scale enterprise. As a result in 2010/11 a comprehensive development strategy was devised
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and approved by government in consolation with all relevant actors .extension services and
support were accorded to small business to create productive jobs in the industrial sector during
the fiscal year .in 2010/11, around 542000 jobs were created of which 53% were accounted for
women (MOFED, annual progress report, 2020/11).

About USD 409 million foreign exchange earning was generated from the manufacturing sector
in 2014/15 were only 22.5%of the 1.82billion USD target set for the final year of GTP 1.the
export earnings from the textile and garment industry sub sector stood at USD 98.1 million and
the total export revenue of the leather and leather product over the GTP 1 period totaled USD
596.2 million. During the GTP 1 period the agro processing industry sub sector registered USD
196 million export earnings. On the other hand during the plan period USD 416.56 million was
generated from the export of meat, milk and honey .the pharmaceuticals industry has also
registered USD 20.92 million in export earnings during the plan period. (Ethiopian national
planning commission, may, 2016).

1.2 Statement of the problem

The Ethiopian economy is dominated by the agriculture and services sectors –with each
accounting for about 45 percent of gross domestic product (GDP),leaving only about 10 percent
for industry, of which manufacturing accounts for about 6-7 percent. Exports are highly
concentrated, with coffee alone accounting for more than 60 percent of the total. (Investment
climate assessment report , 2004).

during the last five years (2010/11_2014/15) with respective annual average value added growth
rate of 6.6% agriculture ,10.8 % service and 20.2% industry . The manufacturing accounts for
about 14.6 %during the same period. The share of agriculture, service and industry in GDP
averaged 41.5%, 45.6% and12.9, in 2014/15, respectively. Generally the share of the
manufacturing subsector was remained below 5%. This showed that the contribution of
Ethiopian manufacturing sector to the economy is still at low level (Growth and Transformation
Plan II, 2015/16_2019/20).

Moreover, Ethiopia could hardly be located in the international market for manufacturing
exports, having an industrial export share much less than the already minuscule median for
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Africa. The limited change in the structure of the economy, especially with regard to
manufacturing, is partly explained by the low levels of investment flows and the sluggish growth
of the private sector, which was too little to affect its historically low share in labor- intensive
manufactures. Indeed, even after more than a decade of reforms by the current Government of
Ethiopia (GOE) private economic activities in the Ethiopian manufacturing sector remain very
small, even by African standards. (IBID)

Investing in manufacturing sector is a very essential over the other sector of the economy in
many world countries because of the manufacturing sector capability to provide important
material support for national economy, huge potential for employment creation, to create wealthy
economy, and to help developing nations to alleviate their balance of payments problems by
generating more foreign currency as compared to the other sector. In addition if industrial
development is directed to use local raw materials, it can create strong linkages among the
different sectors of the domestic economy. But many LDCs lack this opportunity because of low
level income, capital deficiency, technological backwardness and lack of skilled manpower to
exploit their resource and many socio economic and political related problems including
Ethiopia.

The stagnation of manufacturing sector could be attributed to less than optimal investment levels
in manufacturing sector. The reason for this could be credited to Ethiopian business environment
being suitable for investments in the service sector. Both the government and the private sector
invest in the service sector. The reason for low concentration of investment in manufacturing can
be attributed to lack of access to finance due to bank policy. In addition investors are happy to
engage in making easy money which contradicts with manufacturing sector which has high risk.
Manufacturing sector is also susceptible to fluctuations in prices and exchange rates which make
it less attractive to prospective investor. (BerihuAssefa, 2010).

Despite the importance of manufacturing industries in sustainable economic growth, the sector
encountered with a series growth problem that leads to insignificant contribution to GDP due to
the immediate results of this challenge is high production cost, severely constrained supply and
poor quality raw materials and technology, low level of investment, financial constraints (i.e.
loan, saving and others), and low capacity utilization, facility provision related problem (i.e.
area), lack of skilled man power, and other policy and social related factors limit the investment
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in the sector (MuluGebreeyesus ,2007).

According to many related papers entails that most of these problems are derived essentially
from inadequate infrastructure (i.e. electricity, road etc.), lack of executive capacity, poor
utilization of available man power and absence of a sound technological base (Umudike et.al,
2015). And also according to (Belayneh, 2010), the difference in prices and qualities of imported
raw materials and technologies along with inadequate supply also makes investment challenges
in the manufacturing sector. (Kefyalew, 2011); entails that the problem of this also drive from
inadequate infrastructure, access to formal source of finance is not easy due to high value
collateral requirements, tax and tax administration related constraints, institutional services more
specifically that of the municipal, and power interruption are the main one. This is also supported
by many other related empirical views. For an economy sustained industrial growth play a great
role in international computing. Without growth, industrial expansion in general and
competitiveness in the international market in particular will not be possible.

Thus, investing the level land growth rate of industrial manufacturing and its contribution to
GDP are of paramount importance for an assessment of its potentiality. The Ethiopian
manufacturing as described earlier is not growing from time to time.

Though there are some studies on the determinant of investment in manufacturing industries of
Ethiopia, A study by the center for the Study of African Economies (1997) shows that there is
very low level of investment in Africa’s manufacturing sector. Moreover a positive effect from
profits onto investment is identified in a flexible accelerator specification of the investment
function controlling for firm fixed effects.

UrgaiaRissa (2007) in his thesis on “growth of industrial manufacturing in Ethiopia, using time
series analysis”. Industrialization plays an important role in economic development. The analysis
indicates that the long-term growth rate of investment in manufacturing sector is positively
related to the weight placed on growth of the sector. While that of labour engaged in production,
is the short-run effect. he showed the sector growth is negatively influenced by total factors of
production that represent the obsolete uses technological level in manufacturing activities
accounts for the sector’s stagnant growth.

Mulu Gebreeyesus. (2006) ; the main focus of this paper was to determine the relationship
between firm size and the economic growth to investigate this relationship ordinary least square
5
econometric model and data from 1996 to2003 was used. They tried to show the relationship
between firm growth and firm attitude such as firm size, age productivity and firm size is defined
by employment. He also used the model called general method of moment for unobserved
heterogeneity. He investigates that firm growth decrease with size and it is not affected by
transitionary fluctuation or measurement errors.

The study of Mulu Gebreeyesus 2007, the study lacks detail analysis of other factors of
manufacturing productivity growth, such as cost of capital, raw material and financial factors it
mainly focused on the policy side of entry and exit.

Constraints and opportunities of manufacturing investment in Rwanda studied by Kamarudeen

and Soderbom 2013, the study does not show the long run effects of social and cultural change
that come through foreigner’s, and it does not show the fate of the domestic firms when the
foreign owned firms become dominant leading the sector.

The study of Hannibal birhane .(2011), on his paper “ Determinants of investment in

manufacturing sectors ; micro level analysis and results that indicate while education level of the
investor, relative price and initial capital have a positive significant effct on the decision to invest
in manufacturing average power of blackout per weeks have a negative significant effects.

As this paper is the first attempt the important macroeconomic variable included such as capital
expenditure and credit for manufacturing sectors were incorporated so in addition to this the
model use real effective exchange rate, real interest rate, inflation rate, real GDP and multiple
linear regression model and current reliable data will help the existing gap. So the main
determinants of investment in the manufacturing sector in Ethiopia are tried to be explained with
relevant and update data.

1.3 Research Question

The research conducted on the title of the determinant of investment in manufacturing

investment in Ethiopia was primarily intended to answered the following question

 What are the trends of investment in manufacturing industries in Ethiopia?

 What are the factors that affect investment in manufacturing industries in Ethiopia.
 Are there any significant relationship between investment in manufacturing industry
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 and its determinant?

1.4 Objectives of the Study

1 .4.1 General Objective of the Study

The general objective of the study is to examine the determinant of investment in manufacturing
industries in Ethiopia.

1.4.2 Specific Objective of the Study

The specific objectives of this research are:

To show the trends of investment in manufacturing industries in Ethiopia.

To examine the relationship between investment in manufacturing industry and on

its determinant.

To examine factor that affect investment in manufacturing industries in Ethiopia.

1.5 Significance of the Study

It is not new for all that investment in manufacturing industries will provide an important role
for economic growth which further leads to development. In addition to this the need of this
study will to give current and relevant information about the determinants of Investment in
manufacturing industries in the country. This paper tries to attempt the factors that determine in
manufacturing sector relative to other sectors. Thus, the paper I hope that the result will help to
formulate policies that facilitate the investment in the manufacturing industries, attracts investors
from domestic and foreign, to find some solutions, and in view of the fact that the problem are
wide and needed multi-disciplinary survey this paper also can serve as a basis for fellow
researchers.

1.6 Scope the study

The main focus of the paper were to identify factors that affect investment directly or indirectly
in the manufacturing industries in the period from 1990-2017 by using secondary data.

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 1.7 Limitation of the study

There are certain constraints that faced while conduct the study. Among those are constraints of
time, lack of finance and lack of organized information are the major problems in this paper.
Having this limitation the study will use the possible capacities to make the findings more real
and acceptable as much as possible.

1.8. Organization of the study

The paper will be organized in to three chapters. The first chapter focuses mainly on the
background, statement of the problem, objectives of the study, significance of the study, scope of
study, limitation of the study and organization of the study. Relevant literature reviews related to
the study were reviewed in chapter two. Chapter three includes methodology used in the study
some analysis and estimation techniques.

CHAPTER TWO

2. LITERATURE REVIEW

2.1 Theoretical Review

2 .1.1 Basic Concept and Definitions

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An investment can be defined generally as spending for the production and accumulation of
capital and addition to inventories. In economics, investment is the value of all goods produced
during a period for use in the production of other goods and services. So all the things that go in
to the production process of consumer goods, such as the manufacturing equipment at a product
factory or buildings that house business along with the equipment that businesses use to supply
goods and services to consumers (JonNash ,2015).

2.1.2 An Overview of Investment theory

A. Keynesian Theory of Investment

As Keynes stated in his book, entitled as “the general theory of employment, interest and money,
1963” (as cited in encyclopedia of economics, 1982) he was the first to call attention to the
existence of independence on the prospective marginal efficiency of capital which is the
expected yield from new investment and some interest rate reflecting the opportunity cost of
investment funds. He suggested that investment could be raise either by increasing the marginal
efficiency of capital or by reducing the rate of interest. In addition to the above variables, he
introduce expectation of future demand for firms output, violating of investment, uncertainty and
other non-economic variables such as political environment as possible determinant of
investment. These factors determine investment decision because rational assessment of them is
impossible.

Keynesian analysis is the observation that although savings and investment must be identical ex-
post, different decision makers in general, take savings and investment decisions and there is no
reason why ex-ante savings should equal ex-ante investment.

B. Accelerator theory

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, profitability and capital costs play no role. Keynesians have traditionally favored
the accelerator theory of investment while disregarding the role of factor costs.

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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 = j (K* - K_1)

Where I = net investment, K* = desired capital stock, K_1 = last period’s capital stock, and
j=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.

C. The Neoclassical Theory

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).

D. The HarodDomar Model

Theory of investment after Keynes was linked to simple growth model based on HarrodDomar
growth model (a model used as economic analysis to project some macro variables) and he
accelerate the theory of saving and investment. These models are used to determine the rate of
saving and hence investment required to achieve a given target of economic growth rate with a
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given technology. In these theories, investment is simply made to ascertain proportion of
changes of output. These models therefore sail to have much relevant for developing countries
because they do not have cost of capital and profitability of investment decisions (Mankiw,
2007).

E. Tobin’s

According to world book encyclopedia, Tobin, 1969, pointed out that investment decision is a
function if the ratio of the addition to value of the firms due to extra units of capital installed to
its replacement cost. If this ratio called Tobin’s q1 is greater or less than unit the firms would
want to increase or decrease their capital stock. In a disequilibrium context, investment is viewed
as dependent on both profitability and demand for output (N.GregoryMankiw, 2007), as cited by
Mohammed, 2011).

F. The profit theory of investment

The central theme of the Profit Theory of Investment is, “greater the gross profits, greater will be
the availability of internal funds for investment”. Some empirical studies have found significant
correlation between profit and investment. They conclude profit as a major determinant of
investment. They found that there exists a positive relationship between profitability and
investment. As we know it’s mainly profit that derives investment in rich capitalist nations
(Suresh, 1997 as cited in Hannibal, 2005).

G. Structural Change Models

Structural change theory focuses on the mechanism by which underdeveloped economies

transform their domestic economic structures from a heavy emphasis on traditional subsistence
agriculture to a more modern, more urbanized, and more industrially diverse manufacturing and
service economy. It employs the tools of neoclassical price and resource allocation theory and
modern econometrics to describe how this transformation process takes place. This section will
discuss some of the renowned structural change models which can be helpful in understanding
how a country transforms itself from agrarian into industrialized nation.

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 1) The Lewis Theory of Development;One of the best known early theoretical models of
development that focused on the structural transformation of a primarily subsistence
economy was that formulated by Nobel laureate W. Arthur Lewis in the mid-1950s and
later modified, formalized, and extended by John Fei and Gustav Ranis. (Todaro, 2012).

In the Lewis model, the underdeveloped economy consists of two sectors: a traditional,
overpopulated rural subsistence sector characterized by zero marginal labour productivity; a
situation that permits Lewis to classify this as surplus labor output and a high productivity
modern urban industrial sector into which labor from the subsistence sector is gradually
transferred. The primary focus of the model is on both the process of labor transfer and the
growth of output and employment in the modern sector.

In conclusion Lewis two-sector model is a theory of development in which surplus labor from
the traditional agricultural sector is transferred to the modern industrial sector, the growth of
which absorbs the surplus labor, promotes industrialization, and stimulates sustained
development.

2) Patterns of Development

This model was developed by Hollis B. Chenery. Like the earlier Lewis model, the patterns of
development analysis of structural change focuses on the sequential process through which the
economic, industrial, and institutional structure of an underdeveloped economy is transformed
over time to permit new industries to replace traditional agriculture as the engine of economic
growth.

However, in contrast to the Lewis model and the original stages view of development, increased
savings and investment are perceived by patterns of development analysts as necessary but not
sufficient conditions for economic growth. In addition to the accumulation of capital, both
physical and human, a set of interrelated changes in the economic structure of a country are
required for the transition from a traditional economic system to a modern one. These structural
changes involve virtually all economic functions, including the transformation of production and
changes in the composition of consumer demand, international trade, and resource use as well as

12
changes in socioeconomic factors such as urbanization and the growth and distribution of a
country’s population( Todaro, 2012).

Empirical studies, both cross-sectional and time-series of countries at different levels of per
capita income led to the identification of several characteristic features of the development
process. These included the shift from agricultural to industrial production, the steady
accumulation of physical and human capital, the change in consumer demands from emphasis on
food and basic necessities to desires for diverse manufactured goods and services, the growth of
cities and urban industries as people migrate from farms and small towns, and the decline in
family size and overall population growth as children lose their economic value and parents
substitute what is traditionally labeled child quality (education) for quantity with population
growth first increasing and then decreasing in the process of development.

H. Three Sector Growth Hypothesis (Petty-Clark law)

Three-sector Growth hypothesis is an economic theory which divides economies into three
aggregated sectors of activity: agriculture and extraction of raw materials (AGM), and
manufacturing (MNF) and services (SRV). In was initially developed by Clark (“Conditions of
Economic Progress", 1940, 1951, 1957). Clark has stressed the dominance of different sectors
(Agriculture + Mineral Industry, Manufacturing and Services) of economy at different stages of
its development and modernization.

Clark introduced the analysis of comparative performance in three main sectors of economy and
initiated the discussion by quoting what he called the Petty's Law; "There is more to be gained by
manufacture then husbandry, and by merchandise than manufacture." He stressed the
significance of the three sector breakdown and structural change in interpreting economic
growth.

According to Fourastie's the main focus of an economy activity shifts from the primary activity
(Agriculture and mineral industry) through to the secondary activity (Industry) and finally to the
tertiary activity (service). Fourastie (1949) saw the process as essentially positive and writes of
the increase in quality of life, social security, blossoming of education and culture, higher level
of qualifications, humanization of work and avoidance of unemployment. To formalize it let be
13
the average multiplicative rate of change for of these sectors; over time. The three-sector growth
hypothesis, including the Petty' Law means the following ordering: This process of structural
transformation has been followed by current developed countries. But many developing
countries including Ethiopia are following processes that are very distinct from the above
process. The share of services in output is high at relatively low income per capita in many
developing countries in Africa and Latin America. This is not the case for Asian countries that
are mostly following the path of developed countries.

Figure2.1: Three Sector Growth Hypothesis

The structural transformation we see in Ethiopia is not consistent with the Petty-Clark law which
predicts that the center of gravity in economic activities shifts (through inter-sectorial resource
allocations by the market) from agriculture to the industrial sector, and further, to the service
sector as average per capita income continues to rise (BerihuAssefa; blog ,2010).

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Though all sectors of the economy are important and indispensable there are some peculiar
characteristics of manufacturing sector which makes it very important for a big and poor country
like ours. These characteristics direct to the idea that manufacturing sector should be given
priority over the other sectors in developing world.

2.1.3 The Role of Manufacturing Sector in Economic Growth

Economists have for a long time discussed the causes of economic growth and the mechanisms
behind it. In the last two decades, in particular, a revived interest on this topic arose with the
upsurge of ‘new growth’ (or ‘endogenous’ growth) models, after Romer (1986, 1990) and Lucas
(1988).

Manufacturing sector plays a major role for economic growth in the developed as well as in
developing countries. It is now well established in the growth and development literature that
there is a strong causal relation between the growth of manufacturing output and the growth of
GDP (Pacheco-Lopez and Thirlwall, 2013). The link between the growth of manufacturing
output and the growth of GDP is sometimes referred to as Kaldor’s first growth law (Pacheco-
López and Thirlwall, 2013).

Kaldor’s First law (1966), an important stylized fact in the growth trajectory of developed
economies in the post war period is the relationship between industrial growth and the
performance of the economy as a whole. This observation is the origin of Kaldor’s first law,
which states that there is a close relation between the growth of manufacturing output and the
growth of GDP. Kaldor’s first law can be summed up in the expression “manufacturing is the
engine of growth”, and was first estimated by Kaldor in a cross section of developed countries
over the period 1952-54 to 1963-64. The law can be represented by following regression:

qi = ai +bi mi………………………………………………...(1)

Where: - q and m refers to growth of total output and manufacturing output, respectively.

It is important to note that the correlation between the two variables is not only due to the fact
that industrial output represents a large component of total output. The regression coefficient is
expected to be positive and less than unity, which means that the overall growth rate of the

15
economy is associated with the excess of the growth rate of manufacturing output over the
growth rate of non-manufacturing output. This proposition implies that high growth rates are
usually found in cases where the share of manufacturing industry in GDP is increasing, and it
can be tested using the equation:

qi= ci +di (mi- nmi) (2)

Where: - nm refers to the growth of non-manufacturing output.

As additional evidence supporting the statement that “manufacturing is the engine of growth”,
Kaldor has argued that the growth is non-manufacturing output also responds positively to the
growth of manufacturing, as described in the following equation:

NMI = u i+ vi mi………………………………………………………….. (3)

The explanation for the correlation between the growth of manufacturing output and the overall
performance of the economy is to be found on the impact of the former on the growth of
productivity in the economy. There are two possible reasons for such effect. The first relates to
the fact that the expansion of manufacturing output and employment leads to the transfer of labor
from low productivity sectors (or disguised unemployment) to industrial activities (that present
higher productivity levels). The outcome is an increasing overall productivity in the economy
and little or no negative impact on the output of the traditional sectors, given the existence of
surplus labor. According to Kaldor, this process is characteristic of the transition from
“immaturity” to “maturity”, where an “immature” economy is defined as one in which there is a
large amount of labor available in low productivity sectors that can be transferred to industry.

The second reason for the relation between manufacturing growth and productivity relates to the
existence of static and dynamic increasing returns in the industrial sector. Static returns relate
mainly to economies of scale internal to the firm, whereas dynamic returns refer to increasing
productivity derived from learning by doing, ‘induced’ technological change, and external
economies in production.

Kaldor’s Second Law (Verdoorn’s Law) Law refers to the statistical relation between the growth
of manufacturing output and the growth of labor productivity in manufacturing, where causality

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runs primarily from the former to the latter. These gains, in turn, allow for further output
expansion through increasing exports, which reinitiate the cycle. In conclusion, once a country or
region acquires a growth advantage, it will tend to keep it through the process of increasing
returns and consequent competitive gains that growth itself induces. (Libanio and Moro, 2009)

Different empirical studies has confirmed kaldor’s first and second law (Libanio and Maro for
Latin American countries) there by confirming statement that manufacturing sector is the engine
of growth. So for developing countries to have robust economic growth, a manufacturing sector
growth is necessary condition.

2.1.4 Factors that affects investment in manufacturing industries

The central core of economic growth of any nation is influenced by the growth rate of the
industrial sector specially manufacturing industries. The major components of this activity
involve labor productivity, capital formation, improvements in technology and the market
environment (UNIDO, 1996). (As cited by Hannibal Birhane)

Labor productivity: Labor productivity in economic growth refers to how much output per
hour, week and so on, results from labor-input. Labor productivity depends upon a number of
factors including the population size (quantity) and degree of education and skills (quality) of
labor supply, the capital stock other resources; each laborer has to work with and the technology
available for production.

Capital formation: The promise to invest capital on some activity. It is the initial stage of
accumulation of money either through savings domestically or borrowing from financial
institution. Capital formation is one of the integration of growth in size and quality of capital
stock and the quantity of fixed assets consisting of building, machineries, inventories and
equipment use in production. Labor productivity is enhanced when capital stock available to
labor growth faster than the labor supply. This capital is said to be deepening capital (urgaia,
2007).

Improvements in technology: Technological growth and invention, improvements in methods

by which goods and services are produced and sold is another key to economic growth. The
contemporary high living standard of the developed world is unthinkable without the invention
17
of items such as steam engine, assembly line production and etc. globalization has enabled the
developed countries to access new idea and technological which improve living standard, but
many African countries still have not exploited it because of structural barriers and other factors
such as poor education and infrastructure. Technology and invention have been responsible for
nothing less than the modern world.(OluAjakiaiye and John Page, 2012).

The market environment: Most economists believe that the market environment surrounding
the growth in natural resources, labor productivity, capital formation and so on, are a large
contributing factors to economic growth. A competitive market system may encourage invention
and rapid innovation. All private and public restraints on competition, including excessive or
unnecessary regulation or tariffs or quotas on goods exchanged in an international and trade, will
trend to reduce the rate of growth in real per capital GNP.(UrgaiaRissa Worku,2007).

Industrial Policy: Industrial policy concerns with the effective and coherent implementation of
all policies, which enhance the structural adjustment of industry to promote competitiveness.
Then after, the infant industries (like Ethiopian manufacturing case) can develop and prosper by
remedying the structural deficiencies and addressing areas where the market mechanism alone
fails to correct. Though industrialization in Ethiopia was initiated three -quarters of a century
ago, manufacturing sector is still in an incipient stage characterized by unbalanced and distorted
internal and external structural linkage, backward technology and lack of technological
capability (Kibre and Worku, 2003/04).

Infrastructural provision: Easy access to quality infrastructure is vital for the development of
the manufacturing sector. But many LDCs are lacked this opportunity such as provision of
electricity, transport etc. that are affecting the performance of manufacturing sector.

2.1.8 The Determinants of Investment in manufacturing sector

There exist a lot of studies on what to determine investment in manufacturing sector. Some are
controversial while others give a clear cut answer to the problem. Here, it is tried to look the
major factors which have been investigated by many research paper repeatedly.

18
Interest rate; there are computing views about the effect of interest rate on investment. such as
some researchers say that there exist negative relationship between investment and interest rate
while others say relationship is positive .the first group, negative stat that, lower interest rate
makes funds available through low cost of borrowing while the second group (positive) states if
there is no high interest rate savers are not motivated and fund for investment cannot be easily
obtained. Mankiw 2007, stats that the quantity of investment goods demanded depends on up on
the interest rate, which measures funds used to finance investment.

Banks credit for manufacturing sector

Gerschenkron(1962) suggested, in a moderately developed country like Nigeria, there is need for
some special institution to supply long term funds for industrial capital, since the enterprise have
no substantial prior ploughed back profits, and the average plant size is assumed to be large ,
making the banks to be prime source of capital and entrepreneurship for type of industrialization,
indicating a kind of supply-leading tendency. The implication of Gerschenkron analysis is
finance is considered critical for investment in manufacturing industries contribute to economic
growth. This means that the financial sector must developed and function efficiently to speedily
cheaply mobilize the needed funds for productive investment, while earning reasonable returns
for financial institution.

The rental price of capital: Mankiw 2007, analyses the relationship between rental price of
capital and output produced from the renting firm. the firm rents capital at a rental rate R and sell
its output at price P, the real cost of a unit of capital to the production firm is R/P .the real
benefit of a unit of capital is the marginal product of capital MPK the extra output produced
with one more unit of capital. The more capital the firm uses the less an addition capital will add
to its output.

Limited to access to raw material: raw material are the main ingredient in the production of
any economic activity .the availability of wide alternative of raw materials are the primary
question of firm to produce and supply their output timely.in other word the presence of well-
functioning input market and early access to imported raw materials help for the growth of
private investment.

19
Inadequacy of infrastructural facilities: infrastructural facilities in Africa are the main barriers
for computation, intercontinental trade and others. Infrastructure access indicators rose between
1990 and 2000s.but this was mainly in communication technology led by cellular revolution and
water supply and sanitation (Jhon Page, 2012)

Exchange rate devaluation: exchange rate fluctuation are not favorable to economic activities
in the manufacturing sector specifically and the whole economy in general. Exchange rate can
adversely affect the ability of import and therefore manufacturing output fluctuation in exchange
rate will result the instability of purchasing power and hence .negative impact on manufacturing
inputs. (Opaluwa, and others, 2010)

High inflation rate: high rate of inflation adversely affect (but not necessarily) investment
activity by increasing the risk of long term investment project, reducing maturity of commercial
lone, and distorting the information conveyed by price in the economy.

2.1.9 PERFORMANCE OF MANUFACTURING INDUSTRIES IN

ETHIOPIA

Ethiopia has a long tradition in the development of handcrafts and cottage manufacturing
activities such as weaving, blacksmithing, pottery, and woodwork. But the introduction of
modern industries began at the end of the 19th century (History of Ethiopian economy textbook).
Particularly, the following two major early 20th century events contributed to the introduction of
modern manufacturing industries in Ethiopia:

 The emergence of a strong central government, which resulted in political stability and
 The construction of the Ethio-Djibouti railway.

According to the International Standards for Industrial Classification (ISIC), the Ethiopian
industrial sector is composed of mining and quarrying, manufacturing, electricity, water supply,
and construction. The performance of the manufacturing industries can be measured, among
other things, by:

 Gross value of output (GVO), which refers to the total output produced during a given
period of time;

20
  Value added at factor cost (VAFC), which is the difference between the gross value of
output and the value of intermediate inputs, such as the cost of raw materials;
 Value added at current market price (VACMP), which is the sum of value added at factor
cost and indirect taxes, regardless of any subsidies
 GDP contribution: the share of manufacturing sector in the total output of a country

2.2 Empirical Literature Review

2.2.1 Determinants of Investment in the Manufacturing sector in America

According to Everett M.(1995), in his thesis “engine of growth manufacturing industries in the
U.S economy”. A well-established body of theoretical and empirical research supports the
conclusion that manufacturing industries are engines for growth. These industries are by far the
economy’s most prolific generators and disseminators of new technology. In addition,
manufacturing integrates more numerous and varied inputs of goods and services and cultivates a
greater variety of production skills than other kinds of production activity.

The new face of American manufacturing reflects a process of continuously change in the
composition of production, the mix of skills required, and the organization of U.S.
manufacturing firms:

Though manufacturing industries have supplied a relatively constant share of GDP for decades,
the direct link between growth in manufacturing output and the spread of economic opportunity
is now more tenuous. Manufacturing accounts for a steadily declining share of total U.S.
employment (though in many manufacturing industries, productivity, output, and employment
have grown in rapidly). Proportionately fewer jobs are concentrated in blue collar categories.
And erosion in the average wage of manufacturing workers relative to service workers
contradicts the common assumption that manufacturing jobs are, by definition, good jobs.

2.2.2 Determinant of Investment in the Manufacturing sector in Africa

Arne.B et.al(1997) study on “Investment in Africa’s manufacturing sector :a four country panel
data analysis” by using panel logit model shows that the most important factor adversely
affecting investment is the high capital costs facing the firms associated with uncertainty and
21
high risk, not the availability of finance to the firms. They also show that there is very low level
of investment in Africa’s manufacturing sector.

Mbugua (2000) analysed the micro and macro determinants of private investment in the
manufacturing sector in Kenya, using OLS technique, for macro level determinants and
descriptive statistics for micro level determinants of private investment. His findings showed that
high interest rate, inefficient infrastructure, corruption, insecurity, weak institutional framework
and inefficient and bureaucratic public serves are the greatest hindrances to investment in
manufacturing sector.

2.2.3 Determinant of Investment in the Manufacturing sector in Ethiopia

Investment in manufacturing sector in Ethiopia is not adequate from the perspective of the past
decades. Especially the private sector investment in manufacturing sector is at low stage. In
addition manufacturing sector remains by far the least attractive sector to indigenous investors.
Although there is no sufficient data, some researchers have been done on the aspects of
investment in manufacturing industries in Ethiopia. In this section will deal on some studies
related with investment in manufacturing industries in Ethiopia.

Investment climate assessment report in Ethiopia surveyed by World Bank (2004) reveals three
pivotal features of the Ethiopian manufacturing sector. First, labour costs in Ethiopia are very
low compared with those of potential competitors in and outside Africa (for example, labour
costs in Ethiopia are almost one-third of those in China). Second, despite this huge cost
advantage, exporting Ethiopian firms account for less than 8 % of the population of firms which
is very small by any standard. Third, the Ethiopian manufacturing is also dominated by small
private firms, which suggests limited firm growth. The manufacturing firms also identified
access to land, access to reliable infrastructure service, banks’ cumbersome credit allocation and
the favourable treatment given to state-owned enterprises (SOEs) as a major business
impediment.

UrgaiaRissa (2007) in his thesis on “ growth of industrial manufacturing in Ethiopia, using time
series analysis”. Industrialization plays an important role in economic development. In this
regard, the manufacturing sector plays the key role in the growth process. Despite the importance
22
of industrialization in Sustainable Economic Growth, the sector has encountered with a serious
growth problem that leads to insignificant contribution to GDP, due to financial constraint,
shortage of supply raw materials and lack of skilled manpower. The analysis indicates that the
long-term growth rate of investment in manufacturing sector is positively related to the weight
placed on growth of the sector. While that of labour engaged in production, is the short-run
effect. Hence the manufacturing sector in Ethiopia is characterized as labour intensive. In the
meantime, he showed the sector growth is negatively influenced by total factors of production
that represent the obsolete uses technological level in manufacturing activities accounts for the
sector’s stagnant growth.

Kefyalew, (2011); in his thesis on ‘’Investment Climate and Manufacturing Performance in

Ethiopia” he conducted a survey to understand the effect of investment climate on business
performance. The survey covered 360 manufacturing firms over 15 cities of Amhara, Oromia,
Tigray, SNNP, Addis Ababa and Diredawa. His sample sizes followed by World Bank are
stratified and proportional to number of firms in each city. About 47% of the samples are from
Addis Ababa alone. Mekele ranked second in terms of large numbers of samples with 10% share
while other cities have a share below 10%. He found that the problem of this also drive from
inadequate infrastructure, access to formal source of finance is not easy due to high value
collateral requirements, tax and tax administration related constraints, institutional services more
specifically that of the municipal and power interruption are the main one. This is also supported
by many other related empirical.

MuluGebreeyesus 2006; the main focus of this paper was to determine the relationship between
firm size and the economic growth. to investigate this relationship ordinary least square
econometric model and data from 1996 to2003 was used. They tried to show the relationship
between firm growth and firm attitude such as firm size, age productivity and firm size is defined
by employment. He also used the model called general method of moment for unobserved
heterogeneity. He investigates that firm growth decrease with size and it is not affected by
transitionary fluctuation or measurement errors. The paper also suggested that policies that
aimed at encouraging small firm might have significant effect on both employment and output
growth. As the paper discovers the relationship between productivity and growth is positive

23
which implies more productive firms grow faster than others .this is the result of passive learning
model which predicts that firms get to know their true efficiency level after entry by experience
and adjust their size after that. The researcher also raises other factor that affects firm growth,
capital intensity, where firm with high capital grow faster than firm with low capital intensity.

CHAPTER THREE
3 .METHODOLOGY OF THE STUDY

3.1. Type and source of Data

24
For the purpose of analyzing the determinant of investment in manufacturing secondary data
source will be uses. The main data Minister of finance and Economic development (MOFED),
National bank of Ethiopia (NBE), Ethiopian Investment Agency (EIA) and Central statistical
Agency (CSA).

3.2 Method of Data analysis

3.2.1 Descriptive Method of Analysis

According to the nature of data which the researcher will have collect, both descriptive and
econometric techniques have been employed to study the different variables. The descriptive part
of my study helps us to describe the effects of different variables with respectively to desired
characteristics. The descriptive statistics that were included in this study are quantitative
measures such as graphs. The econometrics part of my study used econometrics model to shothe
relationship between investments in manufacturing sector with different determinant relevant
variables. The model estimation technique will be estimated by multiple linear regression model
estimation technique using STATA econometric software.

3.2.2 Econometric analysis

Model specification refers to mathematical demonstration of the relationship between variables

that is dependent variable and independent variable. One approach to identification of the basic
forces influencing investment is to start with the firm level neoclassical model of optimal capital
accumulation (Jorgenson) where net worth (N) of the firm is given by:

∞
S N= ∫𝑜 𝑒-rt[p(t)Q(t)-w(t)l(t)–q(t)i(t)]

Where: p= price of production

Q= quantity of output produced W= price of variable inputs L=quantity of inputs used

q=price of capital i=investment in durable goods r=discount rate

Since investment is based on expected future income streams which are not known with
certainty, expected income is probabilistic in nature. To reflect the fact that operators may value
non uniform probabilistic income streams differently, the model must be placed in a utility
25
framework. Thus, the utility of expected income becomes a basic factor which may influence
investment.

From this model, it is clear that investment is a function of the prices of output, inputs and
capital, the production function which establishes the level of output as a function the amount of
inputs and capital used and the time value of money or discount rate. This model is theory of
optimal investment capital (Jorgensen, 1966).

This model is very helpful in explaining the working of the economic environment especially the
investment environment. But this doesn’t mean I am totally depend up on this model to explain
the entire real world phenomenon on investment. In addition to this, the paper is not concerned
with the decision to invest or not or how much to invest. My concern is more related with which
sector to invest in the economy to promote economic growth. This means this paper would not
use the model as it is. There would be changes to the optimal investment theory of Jorgensen in
this paper. Some variables will be rejected and other variables would be added. Therefore my
model will be as follows

IMFG =F (RLIR, EXR, INFR, CEXP, GDP, BD, CM) Hence, the model is specified as follow:

IMFG=αo+β1RLIR+β2REX+β3INFR+β4CEXP+β5RGDP+β6BD+ Βc7M +Ut

Where IMFG=investment in the manufacturing sector

RLI=lending rate EEER = exchange rate INFR = inflation rate

DB = budget deficit GDP = gross domestic product CM = credit for manufacturing sector

CEXP = capital expenditure α= constant β’s=coefficient of the variable Ut=error term

3.3 Description of variables and expected signs

26
The data for the analysis the paper covers about27 years ranging from 1990-2017.time serous
data are collected on the variable and expected currently available data and use current data but
they depend on availability of data. Precise discussions on the variables are given below.

A. Dependent Variable

It is a single variable which its entire values depends on other explanatory variables. In this
model the dependent variable is the investment in manufacturing industries (IMS).it includes a
range of human activity, from handicraft to the practical application of science to commerce or
industry. Although there are many variables which affect (IMS) in this study will be the Maine
factors tried to be raise. While some of the variables have positive relation with IMS, others will
have negative relation with it.

B. Independent Variables

The real GDP; is the market value of the final goods and services produced by an economy
overtime. It is conventionally measured as the percent rate of increase in Real Gross Domestic
Product. Since most economists argue that economic growth can be measured using growth in
real GDP, it is will collect from the national bank of Ethiopia (NBE) will be used in the
regression analysis. the coefficient of the term real GDP is expected to have positive relation
with investment in manufacturing industries .this is because ;as real GDP increase aggregate
demand will increase thereby stimulating an increased production of goods and service by
undertaking investment activities.

The Inflation Rate; it is growth rate of price. The general inflation obtained from national bank
of Ethiopia will be used in the regression analysis. According to Mundel-tobin effect it is pointed
that higher expected inflation leads to lower interest rate, which will result to portfolio
adjustment away from real money toward real capital. This implies that higher expected inflation
will induce an increase in the real investment activities by economic agent. In this case expected
inflation is will see to have a positive impact on investment (Kibrom, 2008).

Real Effective Exchange Rate; Real Effective Exchange Rate (REER) is a measure of the trade-
weighted average exchange rate of a currency against a basket of currencies after adjusting for
inflation differentials with regard to the countries concerned and expressed as an index number
27
relative to a base year. REER is also defined as the average of the bilateral Real Exchange Rates
(RER) between the country and each of its trading partners, weighted by the respective trade
shares of each partner (Mankiw, 2007). The coefficient is expected to have negative sign. This is
because depreciation /devaluation of domestic currency. Since the majority of developing
countries constitute imported machineries, this leads to an increase of cost of investment which
results reduction of investment. (Opaluwa, 2010).

Capital expenditure: CEXP capital expenditure to the manufacturing sector will be used as one
factor to the growth of manufacturing productivity growth. It is expected that capital expenditure
will have positive relation with the dependent variable investment manufacturing industries. This
is because as more investment funds are available for the sector economic agents are initiated to
enter in to activities. Many investment projects in developing countries are constrained with
initial beginning capital of the project. If there is not sufficient beginning capital for investment,
then investors may not be willing to undertake the activity because of risk associated with further
operation of the investment activity (Brthow, 2012).

Real interest rate; The quantity of investment goods demanded depends on the interest rate,
which measures the cost of the funds used to finance investment. For an investment project to be
profitable, its return (the revenue from increased future production of goods and services) must
exceed its cost (the payments for borrowed funds). Another distributive share that Marshall
considered is interest. A rise in the rate of interest diminishes the use of machinery, because the
business person avoids the use of all machines whose net annual surplus is less than the rate of
interest. Lower interest rates increase capital investments. The demand for the loan of capital is
the aggregate of the demands of all individuals in all trades. As with final commodities, the
higher the price, the less capital demanded; the lower the price, the more capital demanded. This
relationship is based on diminishing marginal productivity associated with an increase in the
quantity of the factor, just as the demand for consumer goods is based on diminishing marginal
utility from successive quantities consumed. If the interest rate rises, fewer investment projects
are profitable, and the quantity of investment goods demanded falls. It is collected from national
bank of Ethiopia .the coefficient of real interest rate is expected to have negative or positive
(Borenzstein, 1990).

28
Credit for manufacturing sector (CM); Availability of credit facility for manufacturing is very
important since most of manufacturing sector need huge beginning capital for investment.
According to Rizov.M. (2004) there is a link between credit accesses and profitability and again
according to to Gerschenkron (1962) external finance is considered critical for investment in
manufacturing sector. this means CM has direct effect for investment in manufacturing
industries. Therefore credit for manufacturing sector expected to generate direct effect (Mekdes
,2018) .

3.3 Estimation techniques

3.3.1. Tests for Stationary and Co-integration

One of the basic ideas in time series econometrics is a steady state relationship between
economic variables overtime. This leads to the concept of stationary and non-stationary
economic variables. A time series data is said to be stationary if its mean, variance, and
autocorrelation (at various lags) remain the same no matter at what point we measure them; that
is, they are time invariant. In other words the probability distribution of the variables of interest
is time independent. Augmented-Dickey-Fuller test is used to test whether the data is stationary
or not. If the absolute value of computed t value is greater than DF absolute critical t value the
time series under consideration is stationary

Economically speaking, two variables will be co integrated if they have a long term or
equilibrium relationship between them. Economic theory is often expressed in equilibrium terms,
such as Fishers theory of money, or the theory of purchasing power parity(PPP), just to name a
few. The valuable contribution of the concept of unit root, co integration, etc. is to force us to
find out if the regression residuals are stationary. As Granger notes, “a test for co integration can
be thought of as a pre-test to avoid spurious regression situations’’. Co integration simply means
that despite being individually non stationary, a linear combination of two or more-time series
can be stationary.

. 3.3.2 Multicollinearity Test

29
Existence of no exact linear relationship among the regressors or the independent variables is one
of the classical linear regression model (CLRM) assumptions. This assumption technically is
known as the assumption of collinearityormulticollinearity. Generally, no collinearity means
none of the regressors can be written as exact linear combinations of the remaining regressors in
the model. If two linearly dependent variables are included in the model there will be perfect
collinearity. The solution to multicollinearity problem is including only those variables that are
not exact linear functions of one or more variables in the model. Gujarati(2004) puts two
important notes here. First, the assumption of no multicollinearity pertains to a theoretical model.
In practice, when data is collected for empirical analysis there is no guarantee that there will not
be correlations among the repressors. As a matter of fact, in most applied work it is almost
impossible to find two or more economic variables that may not be correlated to some extent.
Second, keep in mind that it is being talked only about perfect linear relationships between two
or more variables. That is multicollinearity does not rule out nonlinear relationships between
variables.
Measurements or tests of mulicolleanirty are variance inflation factor (VIF) and condition valid
number (Maddala, 1992) whiles this research used VIF. Multicollinearity with VIF of less than
or equal to 10 is tolerated as if there is no multicollinearity. But if it is above 10 multicollinearity
became serious.

3.3.3 Test forHetroscedastisity

It is the test of the variance of Ui whether to have a constant variance or not. If the error term
does not have a constant variance, there is Hetroscedastisity problem. It makes estimate
parameters consistent but inefficient. In this study, the brush-pagan testing method will be use. If
p –value is greater the given level of significance not reject the null –constant variance.

3.3.4 Test of autocorrelation by Durbin-Watson test

The most celebrated test for detecting serial correlation is that developed by statisticians Durbin
and Watson. It is popularly known as the Durbin-Watson d statistic, which is defined as simply
the ratio of the sum of squared differences in successive residuals to the RSS. A great advantage
of the d statistic is that it is based on the estimated residuals, which are routinely computed in

30
regression analysis. If there is no serial correlation, d is expected to be about 2. Therefore, as a
rule of thumb, if d is found to be 2 in an application, one may assume that there is no
autocorrelation, either positive or negative (Ibid).

WORK PLAN

Time schedule

The time that the researchers will take considers all activities so as to achieve the research
objective. As time is an important resource to do any research, the researchers want to run the
study according to the following time schedule.

Table 1 - Time schedule

Months

Activities Nov Dec Jan Feb Mar Apr. May Jun

Review previous findings  

Prepare concept note 

Prepare proposal first draft  

Prepare proposal second draft 

Prepare proposal final draft  

Data collection and organization 

Data analyzing 

Prepare research first draft 

31
Prepare research second draft  

Submitting final report 

Presentation of final report 

Budget schedule

Budget schedule is a plan that the researchers predict what should be the expenditure in running
the proposal. It is one of the requirements to conduct a research. Therefore, by considering the
budget constraint, the researchers set the following budget schedule.

Table 2 – Budget schedule

Description of cause of expenditure Cost (in birr)

Paper and pen expenditure 300

Printing and typing expenditure 500

Internet service fee 250

Transportation expenditure 150

Telephone expenditure 300

Contingency 150

Total 1500

32
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