Foreign Direct Investment Determinants Economics Essay

This paper provides a research proposal investigating the question of determinants of FDI in the ASEAN and the SAARC. significant relationships and differentials between potential Macro-economic, country specific and Transnational company specific determinants of Foreign Direct Investment in the ASEAN (Indonesia, Malaysia, the Philippines, Singapore, Vietnam and Thailand) and select SAARC countries (Sri Lanka and India) using data sets from 1990-2011 are identified. The paper ascertained all objectives of the study and conducted a literature review where 32 variables and 32 hypotheses were identified to test the research question. The proposal was critically centred on research design and research method but also the research conducted time frames, weaknesses and bibliographic references which are to be proposed for future research in to the author’s research topic. Finding of the study are to be conducted as per the time frame. Furthermore the Author provides definitions of all variables in the annexure 2.

Abstract

This study aims at analyzing the determinants of foreign direct investment inflows for a

group of European regions. The originality of this approach lies in the use of

disaggregated regional data. First, we develop a qualitative description of our database

and discuss the importance of the macroeconomic determinants in attracting FDI. Then,

we provide an econometric exercise to identify the potential determinants of FDI inflows.

In spite of choosing regions presenting economic similarities, we show that regional FDI

inflows rely on a combination of factors that differs from one region to another.

Design/Methodology/Approach

A mixed method approach to research is conducted gathering secondary data from the World Bank Statistics, International Financial Statistics (IFS) of the International Monetary Fund (IMF) and the Global Market Information Database (GMID). Global Market Information Database (GMID), the database of Department of Statistics for each country (Malaysia, Indonesia, Thailand, Singapore and Philippines) and the Bloomberg database. Central bank annual reports of all countries. Furthermore primary data analysis will be conducted post testing where interviews with specialists in the field of Finance and economics will help make meaning to the results.

The paper proposes to use a multiple regression analysis method where robustness of results and hypothesis are proven/disproven using ANOVA, Correlations and Model significance. This data will be tested using various statistical packages such as SPPS and visually will be shown to the reader via MS project. Then based on the variables ascertained from literature the hypothesis will be proven or disproven. Furthermore to stimulate the interest of the reader the data will be displayed as much as possible in the research report stage using graphical software such as MS project, Microsoft visio, Mind Mapping software and Matlab.

Findings:

The following paper is a research proposal and no findings have been ascertained.

Research limitations and implications:

Certain variables lacked time series data and may prove to have some level of significance on FDI. Certain countries did not have the required data to test Hypothesis.

Practical Implications:

The finding will be a guideline so that policy planners in emerging markets can use prior to making any type of investment decision related to the markets concerned. Also the paper after the finding will have section on the lessons learnt for each country or region in terms of FDI and it will be catalyst paper for future research and academia.

Originality/value

The paper extends and expands the knowledge of international capital flows and provides a more nuanced understanding of the importance of internal market dynamism in attracting FDI in the ASEAN and SAARC.

Paper type: Research

Chapter 1: Introduction

1.0 Background

One of the remarkable features of globalization in the 1990s was the flow of private capital in the form of foreign direct investment. FDI is an important source of development financing, and contributes to productivity gains by providing new investment, better technology, management expertise and export markets (Sahoor, 2004). Domestic investment still accounts for the majority of the total investment in developing economies. Foreign investment can only complement this. However, each form of foreign investment plays a distinct and important role in promoting growth and sustainable development, boosting countries’ competitiveness, generating employment, and reducing social and income disparities. Non-FDI flows may work either in association with FDI, or separately from it. As no single type of flow alone can meet investment needs, it is vital to leverage their combinations to maximize their development impact (UNCTRAD, 2011) Foreign investors are also expected to transfer intangible assets such as technology and managerial skills to the host country and provide a source of new technologies, processors, products, organizational technologies and management skills as a strong impetus to economic development (Dr Catherine S.F. et .al, 2011)

As per the Ernst & young report six factors will shape our world including, Emerging markets increase their global power, Cleantech becomes a competitive advantage, Global banking seeks recovery through transformation, Governments enhance ties with the private sector, Rapid technology innovation creates a smart, mobile world and Demographic shifts transform the global workforce. If we Identify the key emerging markets globally as per a study conducted by Ernst and Young suggests “Estimates show that 70% of world growth over the next few years will come from emerging markets, with China and India accounting for 40% of that growth. Adjusted for variations in purchasing power parity, the ascent of emerging markets is even more impressive: the International Monetary Fund (IMF) forecasts that the total GDP of emerging markets could overtake that of the developed economies as early as 2014” also other emerging markets were identified such as . “The emerging markets already attract almost 50% of foreign direct investment (FDI) global inflows and account for 25% of FDI outflows. In fact the largest The brightest spots for FDI continue to be Africa, the Middle East, and Brazil, Russia, India and China (the BRIC’s), with Asian markets(Thailand, Indonesia, Malaysia, the Philippines, Singapore and Thailand) of particular interest at the moment. By 2020, the BRICs are expected to account for nearly 50% of all global GDP growth” (Ernst & Young,2011). In fact from the top 20 FDI inflow host countries as depicted in figure 3 China, Hong Kong, Singapore, India and Indonesia are among the top recipients in the world. In fact as per the UNCTAD’s World Investment Prospectus Survey(WIPS) confirms that developing and transition economies are becoming important investors, and this trend Is likely to continue in the near future (UNCTAD, 2011) “Therefore Securing a strong base in these countries will be critical for investors seeking growth beyond them” (Ernst & Young, 2011). As depicted below in figure 2 shows the FDI inflows both global and group of economies, and it is estimated that in 2014 share of GDP growth in developing countries will surpass that of developed cuntries as shows bellow in figure 2, furthermore as Krugell, 2009 Suggets The spatial distribution of FDI depends firstly on interregional differences in factor and resource endowments. When foreign firms can choose between different regions, cities or towns, they locate in favourably endowed places. Investors also prefer to locate where other firms cluster together. Agglomeration creates a large local market and ensures diverse intermediate inputs and a thick labour market. This generates positive externalities which reduce costs and increase competitiveness and hence attracts investors.

.

Figure 1 : Top 20, Host recipients of FDI (Source: UNCTAD, based on annex table I.1 and the FDI/TNC database (www.unctad.org/fdistatistics).

a Ranked on the basis of the magnitude of 2010 FDI inflows. Note: The number in bracket after the name of the country refers to the ranking in 2009. British Virgin Islands, which ranked 12th in 2010, is excluded from the list)

Figure 2: World GDP forecast (World Economic Outlook, Business Source Monitor, 2010)

To secure strong base as advised by Ernst & Young for investors require an understanding on the history, policy, trends, important lessons learnt from a global context with an emphasis in the South, East and South East Asian regions to understand its investment environment prior to understanding FDI determinants, which will be covered in section 1 of the report. Then the essay will conduct a literature review looking at various benchmark indices that measure FDI performance together with other literature which will help in understanding the location or regional FDI determinant factors at a country specific and regional level. Then the determinants will be tested by model creation for its significance by using data from a variety of reputed sources and testing panel data using OLS regression and a unit root equation using panel data from 1xxx-2010. Then the findings will be done both for a country specific angle and at a regional level. Then a TOPSIS analysis will be conducted to see if FDI promotes competitiveness. Then the findings will be interpreted and finally the dissertation will be concluded with some considerations for investors/Policy Makers.

1.0.1 History, policy, Trends and Lessons learnt through Global FDI and FDI in the ASEAN and SAARC

1.0.1.1 Global trends and directions in FDI

As stimulus packages and other public fiscal policies fade, sustained economic development fade, sustained economic recovery becomes more dependent on private investment, at present Trans National Corporations (TNC) have taken a customary role as private investors (UNCTRAD, 2011). Global FDI rose to $ 1.24 Billion in 2010 from $1.185 Billion, but were 15% below pre-crisis averages. This in contrast global industrial output and trade, which were back to pre-crisis levels. UNCTAD estimates that Global FDI, will recover to pre-crisis level in 2011, increasingly to $1.4 Trillion-1.6 Trillion, approaching its 2007 peak(as per UNCTAD econometric model), this is baring any global economic shocks, that may arise due to a number of risk factors (UNCTRAD, 2011) risk factors especially for TNC’s have become critical as unpredictability of global economic governance, possible widespread sovereign debt crisis, fiscal & financial sector imbalances, rising inflation, apparent signs of overheating certain economies; might derail global FDI. Therefore investors have changed there preferences as the global FDI trends depict below:

Developing (including ASEAN and SAARC) and transition economies contributed more than half(52%) of Global FDI flows while its outward flows were also the highest, while intra-regional flows of FDI between developing countries plus TNC were also high. Figure 3 depicts the transition of FDI flows over 3 decades from developed to developing and transition economies (UNCTRAD, 2011). TNC are actively in those countries due to its cost effectiveness and to remain competitive in the global production networks and also since the consumption patterns in the world are shifting (UNCTAD, 2011).

52% to developed and transition countries

figure 3: World FDI inflows, global and by group of economies(Source: UNCTAD, based on annex table I.1 and the FDI/TNC database (www.unctad.org/fdistatistics)

In the South, East and South East Asia inflows rose in the region by 24% in 2010, reaching $300 Bn, as a result of economic growth, good macro-economic fundamentals and higher commodity prices spurred FDI, figure 4 depicts FDI inflows to the developing economies in the region and it is clear that most FDI flows are flowing to South, East and South East Asia.

Figure 4: FDi inflows to developing and transition economies, by region, average of 2005-2007 and 2008 to 2010 (Source: UNCTAD, FDI/TNC database (www.unctad.org/fdistatistics).

International production expansion in foreign sales, assets and employment TNC’s account for 1/10 of global GDP and 1/3 of world exports. TNC contribute largely as global presence sustains price advantage, cost effectiveness and make them remain competitive with global production networks. Furthermore state owned TNC’s account(650 in number) with its affiliate network (8500 in number), their outward investments account for 11% of global FDI flows. Therefore the governance of state owned TNC’s have raised concerns of late, the level playing field, national security, regulatory implications for international expansion becomes important for these companies. Understanding their incentives for capital flows is important to understand FDI flows.

In 2010, 70% projects(Cross border merger and acquisition (M&A) and Greenfield FDI projects) from these were invested in these regions. Mainly FDI’s were inherited by BRIC countries in which China and India have gained ground In recent years following rapid economic development in home countries, abundant financial resources are strong motivations to acquire resources and strategic assets abroad. Infact Chinese and Indian companies saw large capital investment beyond their own regions. In fact in 2010, there were seven mega deals(12% of the total inward FDI came from these deals as shown below in table 1 in appendix 2 of this report were done by Chinese companies mainly to the Latin American Region.

TNC ROI on FDI is approximately 7.3%, where leverage has shown decline, as proxy by outward FDI stock over foreign assets.

Sales over foreign affiliates increased by 9.1%, reflecting strong revenue in developing and transition economies, employment continued to expand, as efficiency seeking investments increased.

A new recent development is that TNC’s account for nearly 80% of global FDI and TNC’s are in the developing world account for 70% of global FDI flows.

Strong profits of TNC’s in emerging markets were incentives for further investments. Infact 100 of the largest TNC companies of Anglo-American origins gained 93% of their profits from these economies, this includes high EBIT positions for Coca-Cola, Toyota Motor, Unilever, SABMiller, Nestle, Barrick gold, Holcim, British American Tobacco, Nissan Motor, BASF, Honda Motor and Bayer.

Even state owned TNC’s became important to global FDI contributing largely to global FDI inflows and outflows, the 15 largest state owned TNC’s account for large chunk of global FDI. Geographically 56% of State owned TNC’s are located in China (50), Malaysia (50) and India (20) are among some top participants. Among them include Volkvagen group, GDF suez, General Motors, CITI group, Tata steel to just name a few.

If we consider FDI by sector wise classification, FDI towards manufacturing sector increased while services and primary sector saw declines. Within manufacturing business cycle sensitive industries such as metal and metal products, electronics and wood products saw declines while chemicals, food, beverages & tobacco, textile, automobiles showed rapid increases in emerging economies. In fact manufacturing related FDI rose to 23% in 2009 to $554 Billion, this as seen made TNC’s more receptive to restructuring in to more profitable and productive units FDI in the primary sector decreased in 2010 despite growing demand for raw materials and energy resources, and high commodity prices. FDI projects (including cross-border M&A and Greenfield investments) amounted to $254 billion in 2010, raising the share of the primary sector to 22 per cent, up from 14 per cent in the pre-crisis period(UNCTAD, 2011).

Natural resource-based companies with sound financial positions, mainly from developing and transition economies, made some large acquisitions in the primary sector. Examples include the purchase of Repsol (Brazil) by China’s Sinopec Group for $7 billion, and the purchase of the Carabobo block in the Bolivarian Republic of Venezuela by a group of investors from India for $4.8 billion. The value of FDI projects in the services sector continued to decline sharply in 2010, with respect to both 2009 and the pre-crisis level of activity. All main service industries (business services, finance, transport and communications and utilities) fell, although at different speeds(UNCTAD, 2011).

Business services declined by 8 per cent compared to the precrisis level, as TNCs are outsourcing a growing share of their business support functions to external providers, seeking to cut internal costs by externalizing non-core business activities Transportation and telecommunication services suffered equally in 2010 as the industry’s restructuring is more or less completed after the round of large M&A deals before the crisis particularly in developed countries (UNCTAD, 2011).

Figure 5 depicts the breakdown of Sectoral distribution of FDI projects during the 2009-2010 period.

Figure 5: Sectoral Distribution of FDI projects (Source: UNCTAD. a Comprises cross-border M&As and Greenfield investments. The latter refers to the estimated amounts of capital investment.)

In terms of mode of entry Greenfield investment has become much larger that cross-border M& A, however TNC’s. Recovery of FDI flows in 2011 reliant on the rise of both Greenfield and M&A. as depicted in figure 6 M&A and Greenfield projects have increased by 36% to $ 339 Bn as a result of higher stock prices increased the purchasing power of investors to invest abroad, the higher the values of corporate assets in 2010 raised the leverage of investors to undertake M&A by using shares in part payment. At the same time the ongoing corporate and industrial restructuring is creating new oppertunies for for cash rich TNC’s including those from emerging markets. However the total project value of Greenfield Investments over M&A is not surprising as varying conditionality has tilted the favor towards Greenfield projects

Figure 6: Greenfield Vs Mergers and Acquisitions (Source: UNCTAD, based on UNCTAD cross-border M&A database and information from the Financial Times

Ltd, FDI Markets (www.fDimarkets.com).

Note: Data for value of Greenfield FDI projects refer to estimated amounts of capital investment.

If we consider FDI by component; reinvested earnings grew fast, while equity capital investments and intra-company loans declined, cash reserves of foreign affiliates grew substantially. For example the profits to sales ratio of the United States S&P 500 firms, Japanese Firms, Korean firms and developing country firms rose in 2010.

However the rise in reinvested earning brought a decline in equity capital, intra-company loans declined as loans were paid back and capital was held for future investments. Given the fact the foreign affiliates hold large retained earning’s on their balance sheet, repatriation to their parents become important role in determining the investment flows. Here government policymakers need to take steps.

FDI flows in developing economies and transition economies should be treated with caution due to containing some short-term volatile flows, “hot money”, stabilization of capital flows represents an important challenge to many developing countries.

As private foreign capital flows-portfolio investment, bank loans and FDI all contribute to development. But due to the nature of the crisis, official development assistance (ODA) is less prone to fluctuations and is as important to developing countries. But there effectiveness has been questioned on actual development.

Private equity sponsored FDI has regained momentum, although it fell of its pre-crisis level. It is directed more towards developing and transition economies as secondary buyouts and smaller acquisitions.

Sovereign Wealth Funds FDI declined substantially because of severely reduced investment from the Gulf region. However its long term potential as a source of investment remains.

Poorest countries saw declines in FDI flows such as landlocked countries, small island developing countries or certain regions in south Asia.

(UNCTRAD, 2011)

Figure 5: FDI inflows by component (Source: UNCTAD, based on data from FDI/TNC database (www/unctad.org/fdistatistics).

a Based on 106 countries that account for 85 per cent of total FDI inflows during the period 2007-2010.

1.0.1.2 Policy reform in terms of FDI and Macro-economic reform in East, South, South-East Asia

The People’s Republic of China (PRC) and East/Southeast Asian countries have made rapid enhancement in their macroeconomic situations, investment, exports and employment over the decade of 1980s and 1990s through the use of large amounts of Foreign Direct Investment. Similarly private capital, which was long seen with concern and suspicion, is now regarded as source of investment and economic growth in South Asia. Like other developing countries, South Asian economies focus their investment incentives exclusively on foreign firms. Over the last twenty years, market reforms, trade liberalization and intense competition for FDI have led to reduced restrictions on foreign investment and expanded the scope for FDI in most sectors. However, the South Asian countries have been largely unsuccessful in attracting FDI. These countries, jointly and also individually, receive low FDI compared to PRC, Brazil, Singapore and other East/Southeast Asian countries. South Asia received the smallest FDI flows among developing Asian countries, accounting for around 3 percent of the total FDI inflows to developing countries in the region. All the countries in the South Asian region except India have received very little attention and negligible FDI inflows. South Asian policymakers realize that credible efforts for economic reforms in South Asia must involve an upgrading of technology, scale of production and linkages to an increasingly integrated globalise production system chiefly through the participation of Multi National Corporations (MNCs). South Asian countries have many advantages to offer to potential investors, including high and steady economic growth, single-digit inflation, vast domestic markets, a growing number of skilled personnel, an increasing entrepreneurial class and constantly improving financial systems, including expanding capital markets. On top of these advantages, South Asian countries have been designing policies and giving incentives to foreign direct investment in several ways (Sahoor, 2006)

Till the late 1960s, most of the developing economies, including those of East Asia, adopted closed macroeconomic policies with import substitution industrialization policies, under which self-reliance and indigenous efforts were encouraged. At the same time, a dominant role was assigned to the state in the development process. These import substitution strategies, coupled with the large public sectors, resulted in rent seeking activities and uncompetitive production processes (Bhagawati and Srinivasan, 1975). Therefore, export-led industrialization and liberalization was advocated to make the production process efficient and competitive. Following the export-oriented growth argument (Bhagawati and Srinivasan, 1975 and Kruger, 1975), and the success of East Asian countries with higher exports and economic growth during the period from the early seventies to mid nineties, most of the South Asian countries started opening up their economies from the early eighties. The South Asian economies are currently enjoying the benefits of economic reforms, particularly reforms related to trade and investment. These countries undertook reform processes and opened up their economies after having experienced sluggish growth rates throughout the seventies and eighties (Sahoor, 2006 ). Please see appendix 1 for the types of reforms undertaken by SAARC countries.

1.0.1.3 Current trends in the ASEAN and SAARC

* to understand the Policy, policy framework or related public institutions for FDI then foreign policy in terms of its automatic routes, government approval, FDI in attractive zones, repatriation of profit, labour regulations applicable to the South, East and South-East Asian Countries have been shown in appendix 1 of this report.

ã‡½ç™Œç£»Ó±ìŒ›

Figure 6: Various Tables and Graphs (Source UNCTAD, 2011)

In 2010, FDI inflows to South, East and South- East Asia increased by 24 per cent, to $300 billion (Figure A of Figure 6). inflows to the ASEAN countries more than doubled; those to China and Hong Kong (China) enjoyed double-digit growth; while those to India, the Republic of Korea and Taiwan Province of China showed decline (table B of figure 6). FDI to ASEAN increased to $79 billion in 2010 breaking 2007’s previous record of $76 billion recorded at pre-crisis level times. The boost was driven by large magnitude of FDI inflows to Malaysia (537 per cent), Indonesia (173 per cent) and Singapore (153 per cent) (table A ; annex table I.1). Positive policy at country level fuelled good performance within region, and seem likely to continue to do so: in 2010, Cambodia, Indonesia and the Philippines liberalized more industries; Indonesia improved its FDI-related administrative procedures; and the Philippines strengthened the supportive services for public private partnerships.

Singapore the global financial centre and a regional hub of TNC headquarters, has benefited greatly from increasing investment in developing Asia, this accounted for half of ASEAN’s FDI, recorded record FDI levels of $39 billion in 2010. Due to rising production costs in China, some ASEAN countries, such as Indonesia and Viet Nam, have gained ground as low-cost production locations, especially for low end manufacturing.

FDI to East Asia rose to $188 billion, thanks to growing inflows to Hong Kong (China) (32 per cent) and China (11 per cent) (table A). Benefiting greatly from its close economic relationship with mainland China, Hong Kong (China) quickly recovered from the shock of the global financial crisis, and FDI inflows recorded a historic high of $69 billion in 2010. However, inflows to the other two newly industrializing economies, namely the Republic of Korea and Taiwan Province of China, declined by 8 per cent and 11 per cent, respectively.

China continues to experience rising wages and production costs, so the widespread offshoring of low-cost manufacturing to that country has been slowing down and divestments are occurring from the coastal areas.

Meanwhile China has seen structural transformation shifting FDI inflows towards high technology sectors and services. For instance, FDI in real estate alone accounted for more than 20 per cent of total inflows to China in 2010, and the share was almost 50 per cent in early 2011. Mirroring similar arrangements in some developed countries, China established a joint ministerial committee in 2011 to review the national security implications of certain foreign acquisitions.

FDI to South Asia declined to $32 billion, reflecting a 31 per cent slide in inflows to India and a 14 percent drop in Pakistan, the two largest recipients of FDI in the subcontinent. In India, the setback in attracting FDI was partly due to macroeconomic concerns, such as a high current account deficit and inflation, as well as to delays in the approval of large FDI projects;10 these factors are hindering the Indian Government’s efforts to boost investment, including the planned $1.5 trillion investment in infrastructure between 2007 and 2017. In contrast, inflows to Bangladesh increased by nearly 30 percent to $913 million; the country is becoming a major low-cost production location in South Asia.

Cross-border M&As in the region declined by about 8 per cent to $32 billion in 2010. M&As in manufacturing rose slightly while they declined by 8 per cent in services. Within manufacturing, the value of deals surged in industries such as chemical products ($6.0 billion), motor vehicles ($4.2 billion) and metal products ($1.6 billion), but dropped in industries such as food and beverages ($2.9 billion) and electronics ($920 million) (table D). Greenfield investment remained stable in 2010, after a significant slowdown due to widespread divestments and project cancellations in 2009 (annex table I.8).

FDI inflows to East Asia should continue to grow in the near future, and those to South Asia are likely to regain momentum. The competitiveness of South- East Asian countries in low-cost production will be strengthened, and further FDI increases can be expected. Prospects for inflows to the LDCs in the region are promising, thanks to intensified South-South economic cooperation, fortified by surging intraregional FDI. Indeed, countries in the region have made significant progress in their regional economic integration efforts (within Greater China, and between China and ASEAN, for example), which will translate into a more favourable investment climate for intraregional FDI flows. To get a closer picture of the emerging trends in terms of its industrial patterns please refer appendix 2 of this report.

(UNCTAD, 2011)

1.2 Problem Statement

2.0 Litreature Overview

The literature consists of a multitude of research, therefore to create sound policy paradigms, initially the literature will identify the definition of FDI,The benefits and costs of FDI, the micro-level theories of FDI,the Macro-Economic determinants will be asctained via th help of benchmark global indicators. Furthermore the literature reiew will take it one step further by gathering all studies based on the indicators and see various scholars and their view on FDI both at regional and country level. Understanding the benefits and the drawbacks of FDI is imperative to formulate a sound policy. Even if, in recent times, the policy that favors FDI dominates, there are two opposing views as to the role of FDI in developing economies. On the one hand, it is argued that FDI benefits the host country, for instance by creating employment opportunities and bringing new technologies. In contrast, the other group argues that the adverse effects of FDI outweigh its benefits.

2.2.1 Pro-FDI Views

Economic growth depends on the rate of investment which in turn largely depends on savings. However, gross domestic savings are too low in the least developed countries (LDCs). Foreign direct investment is an alternative source to fill the gap between savings and the required investment. Foreign firms bring not only financial capital but also managerial techniques as well as, entrepreneurial and technological skills that lack in LDCs and these skills can be transferred to domestic firms through different channels. The government’s budget deficits can also be filled by profit-tax may be collected from transnational companies (Todaro, 1992; Woldemeskel, 2008).

The total amount of foreign exchange that can be obtained from export and net public foreign aid falls short of foreign exchange that is required by LDCS. FDI can help to fill this gap by reducing part or the entire deficit in the balance-of-payments. Moreover, multinational companies manufacturing products that can be exported are able to generate net positive export earnings (Todaro, 1992 Woldemeskel, 2008). FDI can also play important role by creating employment opportunities and by integrating the host-country economy in to the world economy (OECD, 2002).

2.2.2 Anti-FDI Views

However, there is a group of scholars that strongly disagrees with the positive view on FDI that has been explained above. Their arguments are presented in the following.

The first counter argument says that Multinational Corporations (MNCs) increase income for low income groups, which have low propensity to save. If individuals do not save enough, the gap between savings and investments cannot be closed. Besides, foreign firms may also fail to reinvest the profit they generate in the host country; hamper the growth of domestic enterprises and domestic investment by importing the input and intermediate product from their subsidiaries in other countries. FDI might also inhibit the development of indigenous skills as the result of multinational companies’ dominance over local enterprises (Todaro, 1992; Woldemeskel, 2008).

Certainly, initial investment of foreign firms improves the current and the capital account of the host country. However, in the long run, substantial import of intermediate and capital goods, repatriation of profit, interest, royalties and management fees may harmfully affect the foreign exchange position of the host country (OECD, 2002; Woldemeskel, 2008).

Transnational companies contribute to close the gap between locally collected tax and targeted revenue. However, governments often enter in to exclusive agreements with foreign firms and provide tax holidays, tariff protections, and investment allowances. Due to these reasons, the taxes that can be collected become quite small. Moreover, these firms can avoid local taxation by transfer pricing techniques -a method used to reduce local profit level by paying artificially inflated prices to the intermediate products purchased from abroad subsidiaries (Thomas A. andPeter H. 2000; Woldemeskel, 2008).

2.3 Theories of FDI

Theories of FDI can be split into two groups: micro-level determinants of FDI and macro-level determinants of FDI. The micro-level theories of determinants of FDI try to provide answer the questions why multinational companies prefer opening subsidiaries in foreign countries rather than exporting or licensing their products, how MNCs choose their investment locations and why they invest where they do. The macro-level determinants deal with the host countries situations

that determine the inflow of FDI.

2.3.1 Micro-level Theories of FDI

2.3.1.1 The Early Neoclassical and Portfolio Investment Approaches

According to the early neoclassical approach, interest rate differentials are the main reason for the firms to become a multinational company. In this line of arguments, capital moves from a country where return on capital is low to a place where return on capital is high. This approach is based on perfect competition and capital movement free of risk assumptions (Harrison et al, 2000). “The portfolio approach to FDI reacted to this early theory of FDI by emphasizing not only return differentials but also risk” (Almayehu, 1999). However, the movement of capital is not unidirectional. Capital moves from countries where return on capital is high to countries where return on capital is low and vice versa (Woldemeskel, 2008).

2.3.1.2 The Product Life Cycle Theory of FDI

This theory was first developed by Vernon in 1966. A new product is first produced and sold in home market. At the early stage, the product is not standardized. i.e. per unit costs and final specification of the product are not uniform. As the demand for the product increases the product will be standardized. When the home market is saturated, the product will be exported to other countries. The firm starts to open subsidiaries in locations where cost of production is lower, when the competition from the rival firms intense and the product reaches its maturity. Therefore, FDI is the stages in the product lifecycle that follows the maturity stage (Dunning, 1993). Vernon’s product life cycle theory is a dynamic theory because it deals with changes

overtime. However, it seems that the theory is not confirmed by empirical evidence, as some multinational companies start their operations at home and abroad simultaneously (Chen, 1983).

(Woldemeskel, 2008).

2.3.1.3 Internalization Theory of FDI

To increase profitability, some transactions should be carried out within a firm rather than between firms and this is one of the reasons why multinational companies exist. In other words, there are transactions that should be “internalized” to reduce transaction costs and hence increase profitability. This theory may answer the question why production is carried out by the same firm in different locations. One of the reasons of internalization is market imperfection. Any kind of economically useful knowledge can be called technology. Mostly, technologies or knowhow can be sold and licensed. However, sometimes, there are technologies that are embodied in the mind of a group of individuals and not possible to write or sale to other parties.

This difficulty of marketing and pricing know how forces multinational companies to open a subsidiary in a foreign country instead of selling the technology. In addition, a number of problems may arise if an output of a firm is an input to other firm in other country. For instance,”if each has a monopoly position, they may get into a conflict as the buyer of the input tries to hold the price down while the firm that produces input tries to raise it”(p.173). Nevertheless, these problems can be avoided by integrating various activities within a firm rather than subcontracting the activities (Krugman and Obstfeld, 2003).

(Woldemeskel, 2008).

2.3.1.4 The Eclectic Theory of FDI

John Dunning developed an eclectic theory of FDI, which is called OLI paradigm. O, L and I refer ownership advantage, location advantage and internalization conditions, respectively. Operating in a foreign country market has many costs and these “costs of foreignness” include a failure of knowledge about local market conditions, cultural, legal and many other costs. Therefore, foreign firms should have some advantages that can offset these costs. Ownership advantage is a firm specific advantage that gives power to firms over their competitors. This includes advantage in technology, in management techniques, easy access to finance, economies of scale and capacity to coordinate activities. Unlike ownership advantages, location advantages are country specific advantages. Transnational Companies (TNCs) in order to fully reap the benefit of firm specific advantages, they should consider the location advantage of the host country. This includes accessibility and low cost of natural resource, adequate infrastructure, political and macroeconomic stability. As a consequence, the location advantage of the host country is one essential factor that determines the investment decision of TNCs. Internalization is multinational companies’ ability to internalize some activities to protect their exclusive right on tangible and intangible assets, and defend their competitive advantage from rival firms. Accordingly, all the three conditions must be met before transnational companies open a subsidiary in a foreign country (Soderstein (1992), Laar(2004)).

(Woldemeskel, 2008).

2.3.2 Motives of FDI

Assefa and Haile (2006) assert that the ownership and internalization advantages as developed in Dunning (1993) eclectic theory are firm specific advantages, while location advantages are regarded as host country qualities. Firms choose locations where all these advantages can be combined together to advance the firms’ long-term profitability. Asiedu (2002) and Dunning (1993) distinguish the motives of FDI as either market seeking or non-market seeking (efficiency and resource seeking). According to Dunning (1993), a market seeking FDI is that which aims at serving the domestic and regional markets. This means that goods and services are produced in the host country, sold and distributed in the domestic or regional market (Asiedu, 2002). This kind of FDI is therefore, driven by host country characteristics such as market size, income levels and growth potential of the host market and so on. A non-market seeking FDI can either be classified as resource/asset seeking and/or efficiency seeking. Resource seeking FDI aims at acquiring resources that may not be available in the country of origin.

Such resources may comprise natural resources, availability and productivity of both skilled and unskilled labour forces as well as availability of raw materials. Efficiency seeking FDI aims at reducing the overall cost of factors of production especially when the firm’s activities are geographically scattered (Dunning, 1993). This allows the firm to exploit scale and scope economies as well as diversify risks. Apart from the economic factors that are believed to be the major motivation for FDI, the host country’s FDI policy also plays a major role in attracting or deterring FDI. This therefore, suggests a need for the host country to develop policies that provide a conducive environment for business if the authorities believe in the benefits of FDI. This necessitates a regular monitoring of the activities of TNCs and an acceptance by the host government that, if FDI is to make its best contribution, policies that were appropriate in the absence of FDI may require amendments in its presence. For example, macroeconomic policies may need to be altered in order to provide a favourable climate for FDI. Stronger competition as a result of FDI may also induce a host government to operate an effective and efficient competition policy.

î†»ç-»ä€Ÿî‹´ìˆ

2.4 Common Macro-economic determinants of FDI

The literature has identified numerous push and pull-side determinants of FDI. Push side factors include intangible assets, internalization, product life cycle, oligopoly reaction and economies of scale, among others. Examples of pull-side determinants are market size, economic growth, labour cost, levels of competition, technology level, infrastructure, cultural distance, political and legal environment, government policy, and so forth. Empirical studies by Lim (1983) and Tonisi (1985) have demonstrated the crucial importance of pull-side factors in determining FDI (Wang, Clegg, & Kafouros, 2011). However many authors have identified many variables with variety of views on their effect on country or region. However to narrow down the variables to ascertain the best variables for the study The world Investment Report 2011 depicted in the introduction is a global conference on trade and development discussing integral issues in relation to FDI and its development policies in the global context.

These are “traditional” determinants, but the current globalization process is likely to induce important changes to location determinants (UNCTAD, 1996). The theoretical argument for explaining these changes is that technological advances, increasing openness to trade, FDI and technology inflows, and the subsequent competitive pressure on firms, would result in a reconfiguration of the strategies pursued by TNCs to achieve their objectives (resources-, markets- and efficiency-seeking FDI). The two possible consequences on the location determinants are: first, host countries would be assessed by TNCs on the basis of a wider set of variables than before; and, second, the relative importance of FDI determinants would be rebalanced.5 Although the “traditional” economic determinants and the type of FDI associated with these would not disappear, their relevance is likely to decrease, giving a greater weight to the determinants related to efficiency-seeking and created assets-seeking FDI. Since the aim of this index is to be a useful tool for analysing the relative advantages of countries for FDI inflows, we adopt Dunning’s eclectic paradigm as theoretical framework. This paradigm encompasses, as location advantages, a wide range of factors, including those related to policies regulating FDI (and policies that affect FDI indirectly), those of an economic nature, and those related to the “climate” in which foreign investors operate in host countries. Dunning (1993) provides a long list of factors that may be considered as determinates. In WIRs (UNCTAD, 1998a and 2001), these same factors are included, ordered according to the main objectives that transnational corporations (TNCs) seek when they invest abroad. In these works, mainly in WIR 1998, an extensive review of empirical studies on the determinants of FDI inflows is undertaken. The synthesis of all the literature is that the most significant variables are those related to market-seeking and resources-seeking FDI (in the case of the less developed countries) such as GDP, income per capita, labour costs, etc (Carlos Rodríguez, 2009).

These are “traditional” determinants, but the current globalization process is likely to induce important changes to location determinants (UNCTAD, 1996). The Although the “traditional” economic determinants and the type of FDI associated with these would not disappear, their relevance is likely to decrease, giving a greater weight to the determinants related to efficiency-seeking and created assets-seeking FDI is interpreted by UNCTAD as a sign that institutional characteristics of the countries have a positive influence on FDI inflows (Carlos Rodríguez, 2009).

Recent studies concur with the findings of UNCTAD. Stein and Daude (2001) find that the “quality of institutions”, as defined by the Governance Indicators of the World Bank, has positive effects on FDI. Globerman and Shapiro (2002) conclude that, for the period 1995-1997, the attractiveness of a country (for both developed and developing countries) is strongly conditioned by “National Political Infrastructure”. Moreover, although the Human Development Indicator is not a significant indicator, the level of education is important. Busse and Hefeker (2005) find that the 12 indicators used to proxy political risk have a significant negative impact on FDI inflows. Regarding the institutional framework, Bengoa and Sánchez-Robles (2003) find, using panel data for 18 Latin American countries over the period 1970-1999, that economic freedom (as defined by the Fraser Institute Index) in host countries is a positive determinant of FDI inflows. Addison and Heshmati (2003) conclude that the wave of democratization9 and, mainly, the spread of technologies of information and communication positively affect FDI inflows in developing countries. Asiedu and Lien (2004), in a study of 96 developing, transition and emerging economies, that almost all the indicators for capital control have a significant negative effect in a fixed panel specification (Carlos Rodríguez, 2009).

However, Nunnenkamp (2002) questions whether a change in the relevance of determinants amongst developing countries has really taken place. Using data from a survey of companies including 33 questions on a set of economic and political factors related to FDI in 28 developing countries, he concludes that between 1987 and 1999, no important changes took place regarding location determinants. The traditional determinants related to host markets (population and GDP per capita) are still dominant, and the only new determinant with a higher relevance is the skill level of the labour force. Noorbakhsh et al. (2001) also conclude that human capital is a statistically significant determinant of FDI inflows, having a growing relevance, and that other traditional variables (the growth of the domestic market, a stable macroeconomic situation, liberalization policies, a sustaining business framework, etc.) are also significant. Chakrabarti (2001) also reject the hypothesis of a change in the determinants, and argues that the market size and the degree of openness of the host country are more stable than other determinants (wages, net exports, rate of growth, taxes, trade tariffs and exchange rates). (Carlos Rodríguez, 2009)

Hallward-Driemeier (2003), making an econometric study of bilateral flows in the OCDE countries over a 20 year period, concludes that there is no solid evidence that BITs stimulate additional FDI flows, although they would act as complement to the institutional framework of the target country by offering sufficient guarantees on property rights to foreign investors. However, Banga (2003), analysing 15 Asian countries using a panel data analysis, concludes that BITs play a significant positive role. Although there are a large number of studies on the effects of taxation on FDI, this is not the case of DTTs. Blonigen and Davies (2001) conclude, by making a regression analysis of bilateral inflows of FDI between the United States and 65 countries, that these treaties do have a positive impact on FDI in the medium and long term (Carlos Rodríguez, 2009)

2.4.1 Problems with current indices

The United Nations Conference on Trade and Development has developed several indices to evaluate and compare the location advantages of the countries and their relative success in attracting FDI. Some of the indices include Improved Inward FDI Potential Index (IIFPOI), Inward FDI Potential Index of UNCTAD for 140 countries (IFPOIUN140), Inward FDI Potential Index of UNCTAD, re-caluclated for the 49 countries in our sample (IFPOIUN49), Reverse ranking of the Competitiveness Index of Global Competitiveness Report (GCR), World Competitiveness Yearbook (WCY) Index and Economic Freedom Index (ECFREE) However, these indices suffer from several limitations but it has been used as a benchmark for assessing policy in relation to FDI and it posses as a severe limitation. Therefore Carlos Et.al constructed an improved inward FDI potential index that can solve some of those limitations, making use of 70 variables for 49 countries and data reduction techniques. The correlation analysis shows that it fits better with the Inward FDI Performance Index, and thus this new index explains more precisely countries’ FDI inflows. Moreover, the larger number of variables included allows us to rank the countries for different kinds of FDI and to assess countries’ strengths and weaknesses for policy purposes. Furthermore the Index uses not only variables from model but also encompasses a variety of theoretical literature. Infact the choice of the variables included in IIFPOI is justified by the following criteria: the theoretical analysis of the determinants of FDI; the empirical studies testing the validity of the theoretical analysis; the availability of quantitative data on the potential determinant factors and their geographic scope; and finally, the correlation between these criteria and IIFPI (Carlos Rodríguez, 2009).

Since the aim of this index is to be a useful tool for analysing the relative advantages of countries for FDI inflows, we adopt Dunning’s eclectic paradigm as theoretical framework while also recognising the pro view of FDI and also we adopt the product life cycle theory as well in to the analysis. This paradigm encompasses, as location advantages, a wide range of factors, including those related to policies regulating FDI (and policies that affect FDI indirectly), those of an economic nature, and those related to the “climate” in which foreign investors operate in host countries. Dunning (1993) provides a long list of factors that may be considered as determinats. In WIRs (UNCTAD, 1998a and 2001), these same factors are included, ordered according to the main objectives that transnational corporations (TNCs) seek when they invest abroad. In these works, mainly in WIR 1998, an extensive review of empirical studies on the determinants of FDI inflows is undertaken.The synthesis of all the literature is that the most significant variables are those related to market-seeking and resources-seeking FDI (in the case of the less developed countries) such as GDP, income per capita, labour costs, etc (Carlos Rodríguez, 2009)

At this point, however, we must stress that the number of variables included in an index of this nature is constrained by the availability of data. We must stress that the UNCTAD’s decision to include only 13 variables in her potential index is not guided by this restriction, although it is proposed as such. Furthermore, the difficulty in quantifying some qualitative determinants related to the political and institutional framework, which UNCTAD cites as the reasons for their omission in its index, is a problem which can be solved, as most of the above mentioned studies do, with indicators produced by a number of bodies. However, this solution involves that, with the data available at the time of writing, we cannot include all countries in the world, and, therefore, there is a trade-off between geographical scope and the depth of analysis. For this paper, we opted to improve the quality of the index, leaving aside the issue of limited geographic scope. This option allows this index to fulfil better than the current UNCTAD’s potential index the objectives of being a tool, first, to evaluate the countries’ competitiveness to attract certain kinds of FDI inflows, and, second, to design policies to improve, or change, the location advantages of host countries. Compared to the correlation analysis done by Carlos et.al 2007 shows that it fits better with the Inward FDI Performance Index, and thus this new index explains more precisely countries’ FDI inflows. Moreover, the larger number of variables included allows us to rank the countries for different kinds of FDI and to assess countries’ strengths and weaknesses for policy purposes (Carlos et.al, 2007)

Order Now