Journal of Economics and Behavioral Studies (ISSN: 2220-6140) Vol. 10, No. 5, pp. 244-254, October 2018 244 The Impact of Financial Sector Development on Foreign Direct Investment: An Empirical Study on Minimum Threshold Levels Kunofiwa Tsaurai, Daniel Makina University of South Africa, Department of Finance, Risk Management and Banking, South Africa tsaurk@unisa.ac.za, kunofiwa.tsaurai@gmail.com Abstract: Using panel data of 21 emerging economies, the paper investigates the financial sector development threshold levels that would influence foreign direct investment (FDI) inflows. The threshold levels we identified are 41.27% of stock market capitalization for stock market turnover, 53.55% of gross domestic product (GDP) for stock market value traded, 121.53% of GDP for stock market capitalization, 114.43% of GDP for domestic credit to private sector by banks, 144.06% of GDP for domestic credit provided by financial sector, 0.22% of GDP for outstanding domestic private debt securities and 41.26% of GDP for outstanding domestic public debt securities. Our results show that higher stock market and banking sector development above the threshold level positively and significantly influence FDI inflows whilst the influence of lower stock market and banking sector development on FDI inflows was weak and not significant. Levels of private bond market development equal to or greater than the threshold level are found to have a positive but non-significant impact on FDI inflows whilst private bond market development levels less than the threshold have a weaker positive and non-significant influence on FDI inflows. On the other hand, public bond market development levels equal to or greater than the threshold level negatively influenced FDI inflows whilst levels of public bond market development less than the threshold positively but non-significantly attracted FDI inflows into emerging markets. Keywords: Foreign Direct Investment; Financial Sector Development; Endogeneity; Threshold; Emerging Markets 1. Introduction Empirical literature recently observed that FDI influences economic growth on condition that absorption capacities are not just present in the host country but have reached a minimum level needed to make use of the technology, knowledge and other skills associated with FDI (Vita and Kyaw. 2009). According to Asong (2014), financial sector development is among the absorption capacities that must be present in the host country to ensure significant FDI inflows. Focusing on Sub-Saharan African countries, Sghaier and Abida (2013) suggested that these countries could only benefit from technological diffusion that comes with FDI if their financial systems reach a certain minimum level of development. Choong (2012:828) acknowledged that financial sector development must reach a certain minimum threshold point before FDI inflows positively and significantly influence economic growth in the host countries. In a panel study of BRICS (Brazil, Russia, India, China and South Africa) countries, Kaur et al. (2013) reported that developed financial markets enable host countries to benefit from FDI through better provision of financial support in terms of quicker transactions, provision of loans, good foreign currency services and optimal allocation of capital to more deserving projects. Furthermore, Balasubramanyam et al (1996:96) showed that well developed financial markets guarantee that the environment in which FDI operates is competitive, free from market distortions and promotes knowledge transfer among firms. Supporting this view are Huang and Xu (1999) who argue that financial institutions influence the FDI by increasing the speed of technological innovation that arises from different channels of FDI technology spill-overs. In our study we hypothesize that there is a certain threshold level of financial sector development that influences significant inflows of FDI. Given that UNCTAD (2012) reported that FDI flow over the years has proven to be a major source of economic growth and development especially for emerging markets, the research problem of our study centres on the empirical question: What minimum threshold levels must financial sector development reach to trigger FDI inflows in emerging markets? This empirical question is far from being conclusively addressed in emerging markets and other countries in the world.