Analyses of FDI determinants in developing countries
Recep Kok
Economics Department,Dokuz Eylul University,Izmir,Turkey,and Bernur Acikgoz Ersoy
School of Applied Science,Celal Bayar University,Manisa,Turkey
Abstract
Purpose –The purpose of this paper is to investigate the best determinants of foreign direct investment (FDI)in developing countries.
Design/methodology/approach –This paper investigates whether FDI determinants affect FDI based on both a panel of data (FMOLS-fully modified OLS)and cross-section SUR (seemingly unrelated regression)for 24developing countries,over the period 1983-2005for FMOLS and 1976-2005for cross-section SUR.
Findings –The interaction of FDI with some FDI determinants have a strong positive effect on economic progress in developing countries,while the interaction of FDI with the total debt service/GDP and inflation have a negative impact.The most important determinant of FDI is the communication variable.
Research limitations/implications –The limitations of the study are based on the development of data set which could be found uninterrupted for 30years in 24developing countries.
Originality/value –The main objective of this study is to define the main FDI determinants that show the capital flows to developing countries in a globalization framework.The secondary objective of this study is to assign countries’convergence by using the same FDI determinants.FDI flow is one of the main dynamics of globalization phenomenon thus FDI flow determinations will contribute to countries’process of political development.
Keywords Convergence,International investments,Developing countries,Globalization
Paper type Research paper
1.Introduction
Trade has traditionally been the principal mechanism linking national economies in order to create an international economy.FDI is a similar mechanism linking national economies;therefore,these two mechanisms reinforce each other.The trade effects of FDI depend on whether it is undertaken to gain access to natural resources,to consumer markets or whether the FDI is aimed at exploiting locational c
omparative advantage or other strategic assets such as research and development capabilities.Most developing countries lack technology capability and FDI to facilitate technology transfer and reduce the technology gap (TGAP)between developing countries and developed countries.In fact,it is suggested that spillovers or the external effects from FDI are the most significant channels for the dissemination of modern technology (Blomstrom,1989).spring framework表达式assign
FDI has innumerable other effects on the host country’s economy.It influences the income,production,prices,employment,economic growth,development and general
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JEL classification –F21,F47Analyses of FDI determinants 105
International Journal of Social Economics Vol.36Nos 1/2,2009pp.105-123q Emerald Group Publishing Limited 0306-8293
DOI 10.1108/03068290910921226
welfare of the recipient country.It is also probably one of the most significant factors leading to the globalization of the international economy.Thus,the enormous increase in FDI flows across countries is one of the clearest signs of the globalization of the world economy over the past 20years (UNCTAD,2006).Therefore,we can conclude that FDI is a key ingredient for successful economic growth in developing countries,because the very essence of economic development is the rapid and efficient
transfer and adoption of “best practice”across borders.
On the other hand,in general,foreign investors are influenced by three broad groups of factors:
(1)The profitability of the projects.
(2)The ease with which subsidiaries’operations can be integrated into investors’global strategies.
(3)The overall quality of the host country’s enabling environment (Christiansen and Ogutcu,2002).
A large number of studies have been conducted to identify the determinants of FDI but no consensus h
as emerged,in the sense that there is no widely accepted set of explanatory variables that can be regarded as the “true”determinants of FDI.The results produced by studies of FDI are typically sensitive to these factors,indicating a lack of robustness.For example,factors such as labor costs,trade barriers,trade balance,exchange rate,R&D and tax have been found to have both negative and positive effects on FDI.Chakrabarti (2001)concludes that “the relation between FDI and many of the controversial variables (namely,tax,wages,openness,exchange rate,tariffs,growth and trade balance)are highly sensitive to small alterations in the conditioning information set”.
The important question is “Why do companies invest abroad?”Dunning (1993)developed his theory by synthesizing the previously published theories,because existing explanations could not fully justify the existence of FDI.According to Dunning,international production is the result of a process affected by ownership,internalization and localization advantages.Dunning’s so-called OLI paradigm states that FDI is undertaken if ownership-specific advantages (“O”)like proprietary technology exist together with location-specific advantages (“L”)in host low factor costs,and potential benefits from internalization (“I”)of the production process abroad (Frenkel et al.,2004).
The latter is the most important:the factors based on which an investor selects a location for a project.These include the factors affecting the availability of local inputs such as natural resources,the
size of the market,geographical location,the position of the economy,the cultural and political environment,factor prices,transport costs and certain elements of the economic policy of the government (trade policy,industrial policy,budget policy,tax policy,etc.).
The main objective of this study is to define the main FDI determinants that show the capital flows to developing countries in a globalization framework.The secondary objective of this study is to assign countries’convergence by using the same FDI determinants.FDI flow is one of the main dynamics of globalization phenomenon thus FDI flow determinations will contribute to countries’process of political development.
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2.The determinants of FDI:theory and evidence
FDI has been regarded in the last decades as an effective channel to transfer technology and foster growth in developing countries.This point of view vividly contrasts with the common belief that was accepted in some academic and political spheres in the1950s and1960s,according to which FDI was harmful for the economic performance of less developed countries.The theoretical discussion that permeated part of the development economics of the second half of the twentieth century has been ap
proached from a new angle on the light of the New Growth Theory.Thus,the models built in this novel framework provide an interesting background in order to study the correlation between FDI and the growth rate of GDP(Calvo and Robles,2003).
In the neoclassical growth model technological progress and labor growth are exogenous,inward FDI merely increases the investment rate,leading to a transitional increase in per capita income growth but has no long-run growth effect(Hsiao and Hsiao,2006).The new growth theory in the1980s endogenizes technological progress and FDI has been considered to have permanent growth effect in the host country through technology transfer and spillover.There is ongoing discussion on the impact of FDI on a host country economy,as can be seen from recent surveys of the literature (De Mello,1997,1999;Fan,2002;Lim,2001).
According to the neoclassical growth theory model,FDI does not affect the long-term growth rate.This is understandable if we consider the assumptions of the model,namely:constant economies of scale,decreasing marginal products of inputs, positive substitution elasticity of inputs and perfect competition(Sass,2003).Within the framework of the neo-classical models(Solow,1956),the impact of FDI on the growth rate of output was constrained by the existence of diminishing returns in the physical capital.Therefore,FDI could only exert a level effect on the output per capita, but not a rate eff
ect.In other words,it was unable to alter the growth rate of output in the long run(Calvo and Robles,2003).
As a consequence,of endogenous growth theory,FDI has a newly-perceived potential role in the growth process(Bende-Nabende and Ford,1998).In the context of the New Theory of Economic Growth,however,FDI may affect not only the level of output per capita but also its rate of growth.This literature has developed various hypotheses that explain why FDI may potentially enhance the growth rate of per capita income in the host country(Calvo and Robles,2003).However,the endogenous growth theory,which dispenses with the assumption of perfect competition,leaves more scope for the impact of FDI on growth.In this theoretical framework,investment, including FDI,affects the rate of growth through research and development(R&D)or through its impact on human capital.Even if the return on investment is declining,FDI may influence growth through externalities.These may include the knowledge “leaking”into the local economy through the subsidiary(organization forms, improvement of human capital,improvement offixed assets),as well as effects through the various contacts of the subsidiary with local companies(joint ventures, technical-technological links,technology transfer,orders,sale of intermediate products,market access,improvedfinancing conditions,more intense competition generated by the presence of the subsidiaries,etc.).These factors increase the pro
ductivity of the subsidiary and of the connecting companies in the host economy. Technology transfer and the local ripple effects prevent the decline of the marginal productivity of capital,thus facilitating longer term higher growth rates induced by Analyses of FDI determinants
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endogenous factors.Thus,the existence of such externalities is one of the preconditions of the positive effect of FDI on the host economy (Sass,2003).The various theoretical schools attribute different impacts to FDI on economic growth.On the other hand the literature examines a large number of variables that have been put forward to explain FDI.Some of these variables are encompassed in formal hypotheses or theories of FDI,whereas others are suggested because they make
sense intuitively.Most of the studies reporting a significantly negative coefficient on the labor cost (wage rate)combine the theory with the growth rate,inflation and trade deficit.Those reporting a positive coefficient combine wages with taxes and openness.The growth rate has been found to have a significantly positive effect on FDI if it is combined with inflation,trade deficit and wages.Findlay (1978)postulated that FDI would promote economic growth through its effect on technological progress.Empirical studies such as those by Blomstrom et al.(1992)and Borensztein et al.(1998)found
that FDI is positively correlated with economic growth.Empirical studies relating economic growth to capital formation have concluded that gross domestic investment (GDI)exerts a major influence on economic growth.For instance,Levine and Renelt (1992)and De Long and Summers (1991)concluded that the rate of capital formation determines the rate of economic growth.On the other hand,Graham (1995)surveys the theoretical and empirical literature on the determinants of FDI and the economic consequences of FDI for both host (recipient)and home (investor)countries.The paper concludes that FDI can have both positive and negative economic effects on host countries.Positive effects come about largely through the transfer of technology and other intangible assets,leading to productivity increases and improvements in the efficiency of resource allocation.Negative effects can arise from the market power of large foreign firms (multinational corporations)and their associated ability to generate very high profits or from domestic political interference by multinational corporations.However,empirical research suggests that the evidence of negative effects from FDI is inconclusive,while the evidence of positive effects is overwhelming.
According to Sanjaya and Streeten (1977),FDI had a net positive effect on national economic welfare.The main determining factor of the remaining negative social income effects was the extent of effective protection granted firms.According to Sun (1998),FDI has significantly promoted economic gr
owth in China by contributing to domestic capital formation,increasing exports,and creating new employment.In addition,FDI flows to China have tended to improve the productive efficiency of resource allocation of the Chinese domestic sectors by transferring technology,promoting exports,and facilitating inter-regional and intersectional flows of labor and capital.However,FDI flows to China have had also some negative side effects by:.Worsening of environmental pollution.
.Exacerbating inter-regional economic disparities as a result of the uneven distribution of FDI.
.Transfer pricing.
.Encouraging round tripping of the capital of Chinese domestic firms recent literature has also raised concerns about the harmful effects of flows of capital on the recipient countries.
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Particularly,FDI displaces domestic savings(Papanek,1973;Cohen,1993;Reinhart and Talvi,1998).In a seminal paper,Papanek(1973)showed the significant negative impacts of different types of capital on national savings.Based on a sample of85 developing countries,Papanek found that foreign capital displaced domestic savings. Specifically,he showed that foreign aid,private investment and other capit
al crowded out national savings,and a reduction in domestic savings could lead to further increase on the dependency on foreign capital(Baharumshah and Thanoon,2006).
Another determinant,tariffs,has a positive effect on FDI if they are combined with the growth rate and openness,but they produce a negative effect when combined with wages.The real exchange rate produces a positive effect when it is combined with openness,domestic investment and government consumption.When domestic investment is excluded,the effect becomes negative.
This supports the argument that an efficient environment that comes with more openness to trade is likely to attract foreignfirms.This conclusion is also supported by Asiedu(2002)and Edwards(1990).In this model,investment tax and wages have a negative impact on FDI,while infrastructure and market size have a significantly positive impact on FDI.Generally,only in the case of export oriented FDI,cheap labor in terms of lower wages works as an incentive(Wheeler and Mody,1992).On the other hand Tomiura’(2003)study confirms that the positive association between FDI and R&D is robust even iffirms undertaking no FDI and/or no R&D are included.In this respect,Morck and Yeung(1991)hypothesize and provide evidence that FDI creates wealth when an expandingfirm possesses intangible assets,such as superior production and management skills,marketing expertise,patents and consumer goodwill.
FDI determination effects in most of the studies can be seen from Table I.
The UNCTAD’s classification of FDI determinants can be seen from Table II. 3.Data definition
The indicators tested in this study are selected on the basis of FDI theories and previous empirical literature.The indicators tested in the panel study and cross-section SUR,are the FDI determinants for which the data have been found for developing countries for at least30years.Data sets related to a number of developing countries are sometimes discontinuous for some available for all30years).For that reason while defining the main determinants of FDI in this study,24developing countries for which uninterrupted data sets for30years at some variables could be used Developing countries list is reported in the Appendix.Hence,the forecasts related to main determinants of FDI in this study were obtained under these constraints.At the same time,some variables referred as FDI determinants by UNCTAC and used in literature were used in the same sampling.These are:
3.1Gross foreign direct investment(GFDI)
The gross inflows of investment to acquire a lasting management interest(10percent or more of voting stock).A business enterprise operating in a country other than that of the investor.Data source:World Development Indicators(2007).Analyses of FDI determinants
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