Determinants of FDI

THE POWER OF FDI IN REGARDS TO GLOBALIZATION: Globalization is an inevitable and irreversible process, and dealing with the imperatives of globalization capitalizing on its positive aspects and mitigating the negative ones is perhaps the most important challenge for today. Globalization has enhanced the opportunities for success, but it has also posed new risks to developing countries. Globalization has many faces; however, globalization is first and foremost comprehended in economic and financial terms. In this sense, it may be defined as the broadening and deepening linkages of national economies into a worldwide market for goods, services and especially capital. Perhaps the most prominent face of globalization is the rapid integration of production and financial markets over the last decade; that is, trade and investment are the prime driving forces behind globalization. Foreign direct investment (FDI) has been one of the core features of globalization and the world economy over the past two decades. It has grown at an unprecedented pace for more than a decade, with only a slight interruption during the recession of the early 1990s. More firms in more industries from more countries are expanding abroad through direct investment than ever before, and virtually all economies now compete to attract multinational enterprises (MNEs). This trend has been driven by the complex interaction of technological change, evolving corporate strategies towards a more global focus and major policy reform in individual countries. The past two decades have witnessed an unparalleled opening and modernization of economies in all regions, encompassing deregulation, de-monopolization, privatization and private participation in the provision of infrastructure, and the reduction and simplification of tariffs. An integral part of this process has been the liberalization of foreign investment regimes. Indeed, the wish to attract FDI has been one of the driving forces behind the whole reform process. Although the pace and scale of reform have varied depending on the particular circumstances in each country, the direction of change has not. Most developing countries were starting to look to FDI as a source of capital when flows of official development assistance (ODA) declined sharply in the 1990s. FDI usually represented a long-term commitment to the host country and contributed significantly to gross fixed capital formation in developing countries. FDI had several advantages over other types of capital flows, in particular its greater stability and the fact that it would not create obligations for the host country. FDI can play a key role in improving the capacity of the host country to respond to the opportunities offered by global economic integration, a goal increasingly recognized as one of the key aims of any development strategy.

HOST COUNTRY DETERMINANTS OF FDI: Nowadays, virtually all countries are actively seeking to attract FDI, because of the expected favorable effect on income generation from capital inflows, advanced technology, management skills and market know-how. Table below emphasizes three key determinants and factors associated with the extent and pattern of FDI in developing host countries: attractiveness of the economic conditions in host countries; the policy framework towards the private sector, trade and industry, and FDI and its implementation by host governments; and the investment strategies of MNEs.
Economic conditions Size; income levels; urbanization; stability and growth prospects; access to regional markets; distribution and demand patterns. Resources Natural resources; location. Competitiveness Labour availability, cost, skills, trainability; managerial technical skills; access to inputs; physical infrastructure; supplier base; technology support. Host country Macro policies Management of crucial macro variables; ease of remittance; policies access to foreign exchange. Private sector Promotion of private ownership; clear and stable policies; easy Host country policies entry/exit policies; efficient financial markets Trade and industry Trade strategy; regional integration and access to markets; ownership controls; competition policies; support for SMEs. FDI policies Ease of entry; ownership, incentives; access to inputs; transparent and stable policies. MNE strategies Risk perception Perceptions of country risk, based on political factors, macro management, labour markets, policy stability. Location, sourcing, Company strategies on location, sourcing of products/inputs, integration, transfer integration of affiliates, strategic alliances, training, technology
Source: Sanjaya Lall, Attracting Foreign Investment: New Trends, Sources and Policies, Economic Paper 31 (Commonwealth Secretariat, 1997).

Markets

The review of host country determinants is closely linked with the role of national policies, especially the liberalization of policies, a key factor in globalization, as FDI determinants. Location- specific determinants have a crucial influence on a host countrys inflow of FDI. The relative importance of different location-specific determinants depends on at least three aspects of investment: the motive for investment (e.g., resources, market or efficiency-seeking), the type of investment (e.g., services or manufacturing), and the size of the investors (small and medium MNEs or large MNEs). The economic determinants related to large markets, trade barriers and non-tradable services are still at work and account for a large share of worldwide FDI flows. Although FDI remains strongly driven by its traditional determinants, the relative importance of different locational determinants for competitiveness-enhancing FDI is shifting. While low-cost labour remains a locational advantage, the increasingly sought-after advantages are competitive combinations of wages, skills and productivity (UNCTAD 1998a).

For foreign investors, the host country policies on the repatriation of profits and capital and access to foreign exchange for the import of intermediaries, raw materials and technology are particularly important. The pattern of recent FDI flows supports the conclusion that liberal policies on technology, which tend to go hand in hand with more liberal policies in general, serve to attract more and better foreign investments. The economic slowdown has intensified competitive pressures, forcing companies to search for cheaper locations. This may have resulted in increased FDI in activities that benefit from relocation to low-wage economies. FDI outflows may also have risen from countries in which domestic markets have been growing slower than foreign markets. There are signs that both factors have contributed to the recent increase of Japanese FDI in China. In general, there has been a redistribution of FDI towards developing countries, where growth has reportedly been higher than in developed countries. The rise in developing countries shares may also reflect the further liberalization of their FDI regimes, which was reinforced by the growth in the number of bilateral investment promotion and protection treaties. In todays highly competitive world economy, the ability to attract FDI, especially high quality FDI, increasingly needs an investment product. One implication of this is that countries that want to attract high-quality FDI and benefit from it need to develop differentiated and efficient clusters that offer real and identifiable localizational advantages to international investors and eventually become brand names recognizable to any national or international investor seeking this particular configuration of advantages. INVESTMENT COUNTRY DETERMINANTS OF FDI: Companies become interested in FDI for one or more of the following reasons:

Market seekers interested in producing in foreign markets either to satisfy local demand or export to markets other than their own Looking for raw materials search for cheaper or more raw materials outside their own market Looking for production efficiency want to produce in countries where one or more of the factors of production are cheaper Looking for new knowledge gain access to new technologies or managerial expertise Looking for political safety want to establish operations in countries considered unlikely to expropriate or interfere with private enterprise

The most fundamental question about FDI activity is why a firm would choose to service a foreign market through affiliate production, rather than other options such as exporting or licensing arrangements. The standard answer revolves around the presence of intangible assets specific to the firm, such as technologies, managerial skills, etc. Such assets are public goods within a firm to the extent that using such assets in one plant does not diminish use of the asset in other plants. This explains why firms with such assets are more likely to have multiple plants but not necessarily why they would be multinational. To explain why such assets lead to an MNE decision, we often note the potential for market failure connected with these assets. A standard hypothesis is that it

is difficult to fully appropriate rents from such assets through an arrangement with an external party. For example, a licensee will not offer full value in negotiations over a contract if the intangible asset is not fully revealed, but the licensor will not want to reveal the asset fully until a contract is finalized. In such situations, the optimal decision may be for the firm to internalize the market transaction, which would mean establishing its own production affiliate in the market.

General Determinants of FDI Positive: Political and Institutional Stability Low Corruption Levels Intellectual Property Rights Pro-business Policies Openness to Trade Economic stability Stable Exchange Rate Low and stable inflation Similar economic structure Market liberalization Stable Financial Markets Level of Infrastructure Labour Productivity High Levels of Education Capital Per Worker Pro-business Labour Policies Low Minimum Wage Negative: Tariffs Unions High Payroll Taxes Satisfy Local Demand Positive: Political and Institutional Stability Population Growth Income Growth Threat of New Entrants Negative: Competition Domestic Incumbents Foreign Incumbents Threat of New Entrants Export to Other Markets Low cost of production Low unit-cost of labour Low unit-cost of inputs Availability of raw material Dealing with the Effects of Exchange Rates

Political stability has a positive relationship to FDI inflows (Henley 2004). This is because companies need to be confident that the government will not nationalize their investments, that their agreements will be honored, and that conflict will not destroy their investments or make business prohibitively expensive (Henley 2004). Political instability does not prohibit all FDI inflows, however it does reduce the flow of FDI into a country and also changes the nature of FDI from an investment in the countrys future into a drain on a countrys future (Henley 2004). FDI made in countries with high political instability tend to be involved in the extraction of natural resources, such as lumber, coal, diamonds, oil, and other natural resources (Henley 2004). Investments in the extraction of natural resources tend to yield high return, with relatively low and flexible investments. This allows companies to have flexibility and still make a high return on their investment, which lowers the risk that political instability will destroy an investment. However, this depletes the country of its natural resources without a lasting positive impact on the economy. Political stability, thus, has a positive impact on FDI and encourages investment in long-term businesses that bring resources and opportunities into a country instead of extracting resources and opportunities from the country (Henley 2004). Low corruption levels, intellectual property rights, pro-business government policies, and openness to trade are all institutional characteristics. Corruption has had a significant negative impact on FDI inflows, because corruption makes the business environment less certain and also decreases returns on investment by making investments and operations more expensive. Strong intellectual property rights have a positive impact on FDI because FDI often involves the investment of information, technology, processes, knowledge, research and other forms of intellectual property. If a companys intellectual property is stolen or nationalized then their competitors could eliminate the companys major competitive advantages and make their investments in intellectual property worthless. Pro-business policies have a positive impact on FDI because they make investments and doing business simpler and more predictable (Henley 2004). Openness to trade with other countries and also within the country is important for both, production for local markets and export to markets outside of the country. Companies need access to foreign and domestic markets in order to gain access to inputs and to distribute their products. Political stability and institutional characteristics make business more predictable, simpler and less expensive and economic stability has similar effects on business (Canfei 2006; Henley 2004). The exchange rate, low inflation, economic structure and established and stable financial markets are all factors of economic stability. A stable exchange rate has a positive impact on FDI because it decreases the risk that an investment and the profits from that investment will not be devalued relative to the FDIs source country. Low and stable inflation has a positive impact on FDI by lowering the risk that profits and investments will be devalued within the host country and that the cost of doing business will not become prohibitively expensive. The economic structure of a country also has an impact on the sources of FDI (Canfei 2006). It has been shown that FDI tends to be made between countries with similar economic structures because potential investors are able to better understand the economic system of the host country. This is one reason why market liberalization has been shown to have a positive impact on FDI (Henley 2004). Countries with high levels of market liberalization are able to attract more FDI from developed countries because the majority of developed countries have market economies. Established and stable financial markets have a positive impact on FDI because most companies need to raise capital either thru equity

or debt (Henley 2004). Tariffs also have a significant influence on FDI inflows, because most companies involved in FDI need to be able to import equipment and supplies that they are familiar with. Import Tariffs can make importing the proper equipment and supplies prohibitively expensive and thus discourage total investment (Henley 2004). Export Tariffs hinder the exports to other countries by making exporting products prohibitively expensive. However, Export Tariffs can encourage producing for local markets by making it the most profitable form of FDI. Economic agglomeration allows companies to take advantage of economies of scale for production and for infrastructure, and reduce the cost and uncertainty in regions with high levels of government corruption, government intervention in the private sector and weak protection of property rights (Heley 2004; Julan Du et al. 2007). Economic agglomeration can be divided into two categories: horizontal agglomeration and vertical agglomeration (Julan Du et al. 2007). Horizontal agglomeration is the concentration of Foreign Invested Enterprises (FIEs) from the same country of origin engaged in the same industry in the same region (Julan Du et al. 2007). Horizontal agglomeration allows firms to gain collective bargaining power against local governments (Julan Du et al. 2007). It also allows companies to gain and share information about industry trends and markets, gain economies of scale, gain access to specialized labor and intermediate inputs, increase competitive pressures and gain better access to infrastructure (Julan Du et al. 2007). Vertical agglomeration is when there is a network of domestic firms that are able to provide FIEs with intermediate products for production and with distribution channels to reach markets (Julan Du et al. 2007). Vertical agglomeration allows firms access to a variety of goods at low costs and access to markets that would otherwise be inaccessible (Julan Du et al. 2007). Local governments often erect barriers that prevent the entry of goods from provinces (Amiti and Javorcki 2005; Bai et al. 2004). If FIEs werent able to use vertical agglomeration then they would have to invest in multiple regions to overcome the regional protectionism (Julan Du et al. 2007). The potential production capacity of a country is also a determinant of FDI. High levels of infrastructure and labor productivity are two components of a countrys potential production capacity, and they have a positive impact on FDI. High levels of infrastructure allow FDI to be fully utilized (Henley 2004). For example a modern factory needs a stable supply of electricity, water, and supplies in order to operate at full capacity and maximize return on investment. However, it is not uncommon in some developing countries for factories to be forced to shut down for a period of time because they are unable to receive utilities or supplies required for operation. Labor productivity is another determinant that allows companies to fully utilize their investments. Education levels and capital per worker are all factors of labor productivity. A persons education level determines the tasks that they can perform. Typically the more educated the workforce, the higher the value-added activities that can be done. While education determines what activities a worker can do the capital per worker determines the production capacity of a single worker. The determinants of FDI are applicable to both, producing for the local market and producing for exports to other countries. By understanding the determinants of producing for local markets, FDI policy makers can create policies to encourage foreign companies to invest in producing products for the domestic market. Likewise by understanding the determinants of producing to export to other countries, FDI policy makers can create policies to encourage foreign companies to invest domestically to produce products for export. Thus if policy makers wanted to increase the variety of

products offered domestically they could adopt policies to encourage this production of FDI, and if they wanted to encourage exports then they could adopt policies to encourage for that level of FDI. The next several paragraphs focus on the factors that are specifically relevant to either producing for local markets or producing to export. Producing for local markets FDI is invested for the purpose of taking advantage of a foreign market and as a result, the future predictions about the growth of the market are important determinants. If the domestic market is growing then the company has a growing number of future consumers for their products, this lowers the risk that the local market wont be able to support the investment (Henley 2004). A growing market also increases the potential return on an investment. The market can grow through population growth, increasing income per capita, or both (Henley 2004). If population grows then there are more potential customers, if income per capita increases then individuals are able to consume more and if both increase then there are more people with more ability to consume. While potential opportunities for market growth have a positive impact on producing for local markets, competition from incumbent domestic firms, incumbent foreign firms or the threat of new entrants tend to have a negative impact (Henley 2004). For producing for local markets to be a profitable investment the company needs to be able to gain a significant share of the market through a competitive advantage. If no competitive advantage exists then producing for local markets will be discouraged. Export Tariffs, the cost of transportation, and long shipping distances can encourage producing for local markets by increasing the cost of production to a point where producing for local markets is the only profitable form of FDI. Export tariffs, the cost of transportation and long shipping distances can also increase the cost of production to the point where producing for local markets becomes the most profitable form of FDI. So if a country is already invested in a country or wants to make an investment then their only profitable alternative for the FDI is the local market. Producing for export to other countries is determined by a companys ability to produce at a relatively low-unit-cost, through low unit costs of labor and materials. However, in the long-run, this strategy tends to be temporary because labor and materials continually move toward global equality. This is because producing for export to other countries takes advantage of inequalities in the labor and materials market between two countries and the increase in global corporations, the Internet and global trade organizations such as the World Trade Organization (WTO) have increased the mobility of labor and materials around the world. This mobility has allowed production inputs, such as materials and labor to gravitate toward the highest paying jobs and this has decreased labor and price inequalities between countries. However, it is important to note that perfect mobility does not exist and as a result wages and prices will never be perfectly equal. The availability of the raw materials and labor necessary for production is an important determinant of producing for export to other countries, because raw materials are necessary for production (Henley 2004). Also producing for export can be a profitable strategy when the FDI source country doesnt have the necessary raw materials but the host country does. Thus the FDI source country can utilize the raw materials for production at the source instead of having to ship them elsewhere for production.

The purpose of this model is to provide countries and companies a better understanding of the determinants of FDI. FDI flows have become essential for economic development and have provided companies with opportunities for increased profitability and growth. Having a better understanding of the determinants of FDI is essential for growth. It allows countries to adopt policies that encourage capital and knowledge inflows through FDI. It also allows companies to understand which countries to invest in and what type of investments are best for a specific country.

Other Factors Affecting FDI Decisions

Location Institutions: The quality of institutions is likely an important determinant of FDI activity, particularly for less-developed countries for a variety of reasons. First, poor legal protection of assets increases the chance of expropriation of a firms assets making investment less likely. Poor quality of institutions necessary for well-functioning markets (and/or corruption) increases the cost of doing business and, thus, should also diminish FDI activity. And finally, to the extent that poor institutions lead to poor infrastructure (i.e., public goods), expected profitability falls as does FDI into a market. Trade protection: The hypothesized link between FDI and trade protection is seen as fairly clear by most trade economists higher trade protection should make firms more likely to substitute affiliate production for exports to avoid the costs of trade production. This is commonly termed tariff-jumping FDI. Trade Effects: One can think of exports as involving lower fixed costs, but higher variable costs of transportation and trade barriers. Servicing the same market with affiliate sales from FDI allows one to substantially lower these variable costs, but likely involves higher fixed costs than exports. This suggests a natural progression from exports to FDI once the foreign markets demand for the MNEs products reach a large enough scale (size). THE IMPORTANCE OF FDI: FDI is important because it: - supplements low domestic savings - provides substantial parts of the shortfall in capital needed to finance economic growth and development FDI DETERRENTS: The following factors deter FDI: - hostile policy frameworks - civil strife and political instability - high-perceived risks - high transaction cost - fear of policy reversals - high degree of economic volatility POSSIBLE INSTRUMENTS FOR ATTRACTING FDI: Possible instruments for attracting FDI include: - political stability - steady economic growth - high returns on investment

attractive and profitable locations for FDI SDIs and transport corridors (focus on stimulating investment potential and opportunities of different transport routes and areas)

CHARACTERISTICS OF COUNTRIES THAT ATTRACTED FDI: It is difficult to generalize about factors that promoted positive FDI trends in SADC countries. However, the countries that have attracted large amounts of foreign capital have: - sustained economic policy reforms - improved their macroeconomic environment towards greater stability and predictability of policies - maintained political stability - implemented effective privatization programs MINERAL RESOURCES REMAIN A DOMINANT ATTRACTION: Mining has been a major FDI determinant in a number of SADC countries including South Africa, Angola, Botswana, Zambia, Zimbabwe and Namibia. The discovery of huge gold deposits around Lake Victoria has made Tanzania an attractive site for gold exploration and development activity. WHY IS MINING IN AFRICAN COUNTRIES ATTRACTING FDI? The boom in mineral exploration is due to: - improved political stability - better mining codes - privatization - aggressive promotion activities - reasonable production costs, particularly the cost of power and labour - legal and regulatory reform

Amiti M, Javorcki BS. (2000) Trade costs and location of foreign firms in China. International Monetary Fund, Working paper Bai C, Du Y, Tao Z, Tong SY. (2004) Local protectionism and regional specialization; evidence form Chinas industries. Journal of International Economics, 63, pp. 397-417. Campa, Jose M. (1993) Entry by Foreign Firms in the U.S. Under Exchange Rate Uncertainty,Review of Economics and Statistics, 75(4): 614-22. Canfei, He. (2006) Regional Decentralization and Location of Foreign Direct Investment in China. Post-Communist Economies, Vol. 18, No. 1, March 2006, pp. 33-50 Henley, John S. (2004) Chasing the Dragon: Accounting for the Under-Performance of India by Comparison with China in Attracting Foreign Direct Investment. Journal of International Development, J. Int. Dev. 16, pp. 1039-1052. Du Julan, Yi Lu and Zhigan Tao. (2008) FDI Location Choice: Agglomeration vs. Institutions. International Journal of Finance and Economics, 13, pp. 92-107.

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