Foreign Direct Investment

FDI is the investment activities of MNEs that operates overseas. According to IMF/OECD (2008), ³ “FDI is the investment in a foreign country where foreign investor owns at least 10% of the ordinary shares undertaken with the objective of establishing a lasting interest in the country.” According to Economy Watch (2010.6.30), “FDI is a type of investment that involves injections of foreign funds into an enterprise that operates in a country of origin different from the investor.”⁴

FDI is the flow of capital across national boundaries for maintaining control over production activities conducted by the firm’s overseas subsidiary, and for establishing service facilities and conducting business activities in a foreign market (Teng et al., 2001; Park, 2003).

Lagendijk & Hendrikx (2009) considered FDI as prevailing form of corporate governance for gaining control over assets in a foreign country that are being achieved through property rights to foreign firms, whereby companies can exploit their ownership-specific advantages through a combination with location-specific advantages in a foreign country.

Borensztein et al. (1998) regarded FDI in the presence of advanced technology as a tool used for transferring technology to increase economic growth of the host country rather than increase investment in the domestic market, thus having a negative effect on the economic growth of the home country. At the same time, due to poor absorptive capacity, FDI will crowd out domestic investment, external vulnerability and dependence, and destructive competition leading to concentration of power in the industry (Agosin & Mayer, 2000;

Aitken & Harrison, 1999; Blomstrom & Kokko, 1995).

The choice of choosing correct mode of entry into a foreign country is one of the very

3 http://www.oecd.org/dataoecd/26/50/40193734.pdf (2010.11.29).

4 http://www.economywatch.com/foreign-direct-investment/definition.html (2011.12.05).

important strategic decisions that MNEs have to make. They can either choose to enter a market through Greenfield investment or Brownfield investment or FDI (Horizontal and Vertical). Beugelsdijk et al. (2008) separated FDI into two forms: (1) Horizontal FDI refers to production of goods in a foreign market that possesses some similarities with goods produced in the home market for the purpose of reducing transportation cost and trade barriers; (2) Vertical FDI refers to the fragmentation of production activities by outsourcing some of the production stages.

In addition other authors like Klaus & Estrin (2001) defined another type of FDI: (1) Brownfield investment is a special type of acquisition whereby investor’s transferred resources will dominate over acquired firm resources; (2) Greenfield investment or project will provide investors an opportunity to create a completely new organization as per their requirements.

2.2 The Motivation behind FDI

For the purpose of attaining high return on economic rent, MNEs are driven to adopt FDI as an entry mode to gain access into foreign countries to seek for a new market, physical and/or human resources, technological know-how, and economies of scale and scope. These factors are the results of push and pull considerations.

A. Push Factors

The three motivating factors that drive MNEs to engage in FDI are market-seeking, efficiency-seeking, and resource-seeking (Dunning, 1977, 1993).

1) Market-seeking is undertaken by firms in emerging economy to sustain the present market or to promote new market in countries that are in close proximity with each other to reduce transaction cost.

2) Efficiency-seeking is undertaken mainly to take advantage of different factor endowments, cultures, institutional arrangements, economic policies and market structures by concentrating the firm’s location only to a specific area to reap returns on the economies of scale and economies of scope.

3) Resource-seeking involves search for physical resources such as mineral oils and human resource, this also includes seeking specific technology like R&D for sustaining or advancing the firm’s global competitiveness.

MNEs often choose investment locations that best meet their requirements. For penetrating into a foreign market MNEs would choose to opt for FDI in advanced industrial nations for increasing import level in host country. But if it is for procurement of resource advantages that can be exploited in export markets to increase trade surplus MNEs would prefer to endeavor in FDI in developing countries (Brouthers et al., 1996). In addition, maximization of profit MNEs would often take on illegal transactions like “capital flight” and

“money laundering” (Perez et al., 2011).

B. Pull Factors

Countries after having signed international trade agreements that provide certain investment provisions like tax incentives, tax holidays, tariff wall has been able to attract MNEs that are escaping from double taxation and or tariff jumping in their home country.

Blonigen & Davies (2004) in their panel studies comprising of 88 countries between the years 1980-1999 on the Bilateral Tax Treaties on U.S inward and outward found due to tax reduction by tax authority such treaties are the driven force behind MNEs endeavoring in FDI.

MNEs that are cost sensitive would often prefer to undertake investment in both developed and developing countries that have a high and low National Corporate Responsibilities (NCR) levels to search for low cost, skilled labor, better corporate governance infrastructure. Peng & Beamish (2007) by performing least squares regression (OLS) and random effect regression on 28 developing countries and 22 developed countries between the time period 1999-2003, examined the relationship between Japanese foreign direct investment (JFDI) and NCR environment in host countries found that, NCR level possess a positive relationship with FDI inflow into developing countries. However, MNEs with high Corporate Social Responsibilities wouldn’t prefer their investment in countries with weak environmental regulations, whereas MNEs with low CSR are more likely to go for

investment (Dam & Scholtens, 2008).

2.3 The Significant Determinants of FDI

The decision making of MNEs with regard to investment in a particular country or region is determined by various factors and policies that differ in accordance with the country characteristics and the foreign investors’ requirements. How a host country can attract FDI depends on various factors such as abundance in physical and natural resource, government policies and so on. At the same time, the requirements of MNEs also play a significant role as they bring in advanced technology, skilled labor, and resources. MNEs to increase their chances of survival in a foreign country will utilize specific advantages such as product differentiation, managerial and marketing skills, innovation and technology and agglomeration economies to compete with rival firms so as to reimburse their cost of investment in a foreign country. The behaviors of MNEs for endeavoring in FDI are determined by heuristics behavioral rules such as herding, anchoring, and mental accounting (Pinheiro-Alves, 2011).

MNEs to endeavor in FDI must satisfy the three conditions stated in the OLI paradigm (Dunning, 1993).

(1) Ownership-specific advantages (O): are intangible assets such as property rights that tend to increase firms wealth and asset value.

(2) Location-specific advantages (L): may favor either home or host countries such as spatial distribution of natural resources and markets, hence leading to an increase in the competitive advantages of firms.

(3) Internalization advantages (I): reflect the ability of firms to exercise monopoly power over assets under their governance.

A. Home Country’s Perspectives

Governments for enhancement of their country’s FDI level have become a member in international agreements like FTAs, PTAs, BITs, Customs Unions (CUs), and North

American Free Trade Agreement (NAFTA) that are under the flagship of GATT/WTO.

Taking active participation in international agreements will enable country’s government to provide a channel for early movers or late movers to gain entry into a foreign market. As stated by Buthe & Milner (2008) in their statistical analyses for 122 developing countries from 1970-2000, developing countries memberships in PTAs under the WTO has enabled them to received greater FDI inflow.

In addition other scholars like Raff (2004) stated that creation of the European Customs Union in 1968 had led to significant inflows of FDI into US and Japan as well as FDI level in Mexico due to her active participation in NAFTA. Investment provisions agreements like BITs provide certain favorable treatments to foreign investors such as expropriation risk;

disputes settlement and strong protection on property right will implant a positive impact on outward FDI as put forward by Egger & Pfaffermayr (2004) in their panel study on OECD countries outward stock of FDI.

Developing countries being signatories in BITs have drawn in high amount of foreign investment (Tobin & Ackerman, 2011) and trade liberalization policies under NAFTA prompted several countries like the Latin American countries to open their market for foreign competition (Javalgi et al., 2010). The investment provision under NAFTA was mainly established to encourage FDI among member countries, as found by MacDermott (2007) in their examination on the relationships between RTAs and NAFTA on panel studies of OECD countries between the years 1982-1997.

B. Host Country’s Perspectives

i. Geographical Distance

Distance should be regarded as a measure of transaction cost for undertaking business activities in a foreign country (Bevan & Estrin, 2004). It is one of the most important factors considered by MNEs since market accessibility is one of the main motives in deciding location choice of FDI (Wei & Liu, 2001). Geographical proximity reduces managerial risk by lowering informational and managerial uncertainty, transportation, and monitoring cost (Davidson, 1980; Wei, 2004). Countries in proximate time zones with other countries are

more adverse to competition as compared with countries that are at distant time zones (Stein

& Daude, 2007). FDI flows are inversely related to the distance between home and host country as stated by Frenkelet et al. (2004) in their empirical studies on bilateral flows of 22 emerging industrial countries through application of gravity model. According to Wei (1995) a 1% increase in geographic distance will lead to a reduction in FDI by 0.39 %. It is one the most important factor considered by MNEs engaged in sourcing activities as pointed out by Pan (2003) in his study on FDI inflow in China between the years 1984 and 1996.

ii. FDI Promotional Measures

To attract foreign investors government that enter into tax sparing agreements provided under international agreements as discussed in the above sections and give certain incentives like tax incentives, tax holidays and imposition of tariff wall and corporate tax regime to their foreign counterparts will signal a favorable investment condition (Raff & Srinivasan, 1998;

Simmons, 2003). The tax provisions under these agreements will have a positive influence on location choice of FDI as stated by Azémar et al. (2007) in their panel study of Japanese outbound FDI comprising of 26 developing countries between 1989 and 2000 found that high tax rate of 1% have decreased flow of FDI into Japan by 2.63%. This is an indication that tax rate imposed is one of the factors considered by Japanese firms while deciding on their location choice. Conversely, Egger et al. (2009) in their study on outbound FDI among OECD countries between the years 1991-2002 found that tax burden in home and host country are positively related to outbound FDI whereas it is negatively related with bilateral effective tax rates.

For further enhancement of countries attractiveness as location of FDI, host country’s government has set up several FDI promotional measures like setting up of SEZs,⁵ Export Processing Zones (EPZs)⁶ and promotion of industrial parks. The coming up of such zones will serve as a promotion of economic growth (Ge, 1999) leading to overall economic

5 SEZs are duty free enclaves that are considered to be foreign territory for the purposes of trade operations and duties and tariffs (Ge, 1999).

6 EPZs are areas set up inside developing countries to attract FDI meant for export-oriented production through provision of incentives, and a barrier free environment to improve economic growth (Papadopoulos & Malhotra, 2007).

development (Chaudhuri & Yabuuchi, 2010). Moreover, the presence of labor and capital in EPZs in developing countries will allows a country to be connected with the global economy and have the opportunity to attract FDI with minimum impact on the local economy. The presence of these zones (Wu, 2009) along with industrial parks will help in speeding up the economic growth of developing countries (Walcott, 2009) as foreign investors are drawn towards such areas to reap economic benefits like ease in communications, facilities that meet their requirement as well as access to labor pools.

iii. Regime Types

Host countries characteristics or regime types also play a key role in attracting foreign investors. Countries with democratic regimes are able to increase FDI level by giving strong protection of property right, reduction in transactions cost and risk incurred by foreign investors while holding back on MNEs oligopolistic or monopolistic behaviors, will assist MNEs to pursue for protection from foreign capital, thereby hampering FDI inflows (Li &

Resnick, 2003). Other authors, Asiedu & Lien (2011) uses linear dynamic panel data model of 112 developing countries in the years 1982-2007 found that 90 countries due to their democratic regimes have received greater amount of FDI while others have a lower levels of FDI. This is an indication that democratic countries can receive either high or low level of FDI.

iv. Governance Infrastructure

A country with good governance will receive higher level of FDI (Morrissey &

Udomkerdmongkol, 2011) whereas country with poor governance will deter both domestic investment and FDI due to high rates of return borne by companies; this was observed by Louie & Rousslang (2008) in their studies on 7,500 largest subsidiaries of US parent company in the years 1992, 1994 and 1996. Additionally, Seyoum (1996) based on empirical finding of 27 countries found that protection of intellectual property rights (IPRs) are one of the strong determinant when inward FDI is concerned. Other authors pointed out that strengthening of IPRs in developing countries will promote technology transfer particularly in large economies, and thus have a positive impact on FDI as found by Titus & Yin (2010) in

their panel on 38 diverse countries from 1992-2005, followed by Yang & Cheng (2008) who through application of cournot duopoly model showed that either a strong IPRs protection or a higher tariff will attract FDI.

A country is said to have good governance infrastructure if it can provide good communication facilities such as internet. Internet plays a very important role in bilateral FDI by enhancing transparencies in host country (Vinod, 1999). A 10% usage of internet is said to increase FDI inflow by 2% as observed by Choi (2003) on bilateral FDI of 14 source and 53 host countries. The network externalities created by internet have a two sided effect as observed by Ko (2007) in a two stage game model, the existence of negative network effect in developing countries discourages inward FDI whereas positive network effect reduces the distance effect on FDI and will attract more FDI. Of it internet is the most important channel of network effect especially for industries dealing with manufacturing and service (Lee, 2012).

v. Financial Reforms

Financial reforms that provide local capital at low interest rates draw in foreign investors (Tolentino, 2010; Takagi & Shi, 2011; Yang & Cheng, 2008; Biglaiser & Karl, 2006).Takagi

& Shi (2011) studied Japanese FDI flows to Asian economies and found that devaluation in host country currency will increase FDI inflow whereas high exchange rate discourages it.

Clegg & Scott-Green (1999) using comparable US and Japanese data on new FDI flows between the years 1984-89 found that, real depreciation in host country currency will have a positive effect on host country inward FDI due to an appreciation in home country currency.

Similarly, Nagubadi & Zhang (2011) by using panel analysis between the years 1989-2008 for U.S. and Canadian forest industry found that bilateral FDI have a positive effect on the exchange rates and exchange rates volatility of host country.

vi. Political Environment

In countries, corruption and difference in level of corruption have a huge effect on both home and host countries (Habib & Zurawicki, 2002). Countries that have signed the OECD Convention on Combating Bribery of Foreign Public Officials in International Business

Transactions⁷ attract relatively less FDI, as highly corrupted host countries are unlikely to receive FDI from home countries governed by laws against bribery, whereas countries with high level of corruption have higher level of FDI, as MNEs being exposed to high level of corruption at home country will seek for investment in countries with high corruption level (Cuervo-Cazurra, 2006).

MNEs before going in for any kind of investment must take into account the perceived corruption level as found by Voyer & Beamish (2004) in their 29,546 investment sample studies investments of Japanese FDI in 59 countries industrialized and non-industrialized countries found that, absence of comprehensive legal and regulatory frameworks to curb deceitful activity would reduce FDI due to corruption. MNEs are also more likely to engage in such activity if and only if they posses social ties with government officials as stated by Collins et al. (2009) in their sample studies on Indian executives. Such falsified activities will slow down developing countries economic growth due to a reduction in investment level. On the other side, such activity has increased the investment level of newly industrialized economies in East Asia (Rock & Bonnett, 2004). It is one of the hindrances faced by developed countries and not less developed countries, but only under FDI as observed by Wei (2000) through sample studies of bilateral investment between 12 source countries to 45 host countries showed that the corruption level in host country will generate a negative impact on MNEs. Egger & Winner (2006) in their studies on 21 home and 59 developed and less developed host countries also found similar impact.

Another group of scholars in their studies on the developed countries and developing countries found that corruption is also positively correlated with FDI (Egger & Winner, 2005).

An increase of Corruption Perceptions Index (CPI) by 1 unit will result in an increase of per capita annual GDP growth rate of 1.7% for all countries between the years 1999-2004 (Podobnik et al., 2008). Asiedu (2006) in their panel study of 22 countries between the years 1984-2000 found a positive impact of corruption on FDI level in Africa. In general, corruption will hamper international trade, whereas paying of bribe to custom officer will

7 This convention seeks to assure a functional equivalence among the measures taken by parties to sanction bribery of

foreign officials, without requiring uniformity or changes in fundamental principles of a party’s legal system.

enhance import (Jong & Bogmans, 2011).

Cross-border investment between home and host countries has also been affected by corruption distance between two countries. Karhunen & Ledyaeva (2012) utilizing dataset comprising of 1,341 firms with foreign ownership in Russia found that corruption distance and anti-corruption legislation are positively related to the shares ownership in home country.

Corruption alone is not to be blame, both corruption and FDI are correlated. Robertson &

Watson (2004) from results obtained from Corruption Perceptions Index (CPI) for the years 1999 and 2000 has shown that a rapid change in FDI has increased corruption level.

Besides the above stated factors there are also other factors such as openness to international trade, interest rates, exchange rates (Tolentino, 2010), institutional quality (Buchanan et al., 2012), and respect for human right (Shannon & Robert, 2007), visa regulations (Neumayer, 2011; Song et al., 2012), strict environmental laws and regulations (List & Co, 2000), natural resources, large market, inflation, an educated population, openness to FDI, and political stability (Asiedu, 2006) need to be considered.

C. MNEs Perspectives

i. International Experience

MNEs during their initial stage of entrance into a foreign market often face substantial

“liability of foreignness” due to insufficient knowledge or lack of information about host market environment. Therefore MNEs in order to succeed must possess experiential knowledge since experiential learning will influence the location choice within host country (Zhu et al., 2012), especially general international experience (Li & Meyer, 2009).

ii. Psychic Distance

The decisions of MNEs to enter a foreign market crucially depend on their knowledge of the market in the host country. MNEs prefer to invest in countries that are psychologically close with their own. As put forward by O’Grady & Lane (1996): “There is an implicit assumption that psychically close countries are more similar and that similarity is easier for firms to manage than dissimilarity, thereby making it more likely that they will succeed in