ORIGINAL ARTICLE The foreign aid–foreign direct investment relationship in Africa: The mediating role of institutional quality and financial development Olufemi Adewale Aluko Department of Finance, University of Ilorin, Kwara State, Nigeria Correspondence Email: olufemiadewale6@gmail.com Abstract The interaction of foreign aid and foreign direct invest- ment is an important issue for developing countries in Africa. I probe into the mediating role of institutional quality and financial development using a panel data set of 47 countries over the period 1996–2016. I find that the effectiveness of foreign aid in attracting foreign direct investment is greater in countries with better institutional quality and sound financial development. The implications for policy are outlined. KEYWORDS financial development, foreign aid; foreign direct investment, institutional quality JEL CLASSIFICATION F21; F35; G20; O55 1 | INTRODUCTION Unarguably, developing countries experience a shortfall in domestic financial resources to finance the investment needed to ensure economic growth. Hence, they require external finance to overcome this shortcoming. Foreign direct investment (FDI) is the most significant source of external finance for developing countries to reduce their financing gap. This has com- pelled developing countries to strategise ways to increase FDI inflows. However, for the most part, developing countries receive less FDI than developed countries. The share of FDI flows to developing countries in global FDI inflows averaged approximately 31 per cent over the period 1970–2018 (UNCTADstat, 2019). Only in one year, 2018, did the total of FDI inflows to develop- ing countries exceed that of developed countries, when it represented 54.4 per cent of global FDI. DOI: 10.1111/ecaf.12386 Economic Affairs. 2020;40:77–84. wileyonlinelibrary.com/journal/ecaf © 2020 Institute of Economic Affairs 77