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W H A T A T T R A C T S F O R E I G ND I R E C T I N V E S T M E N T:A C L O S E R L O O K ecaf_1925 81..86

Nabamita Dutta and Sanjukta Roy

It is rational to assume that minimal trade barriers (tariffs and quotas), a bigger

trade sector, lower interest rate regulations, freer international capital market, lower

credit and labour market regulations will make investment in a country more

lucrative for foreign investors. We confirm this and show the prevalence of

non-linearity in the relationships.

Keywords: Foreign direct investment, institutions, labour market regulations,trade barriers.

Why concerns about boostingforeign direct investments?

Economists largely favour free flow of capitalsince that allows capital to seek the highestreturn. International movements of capitalhave many advantages they allow investorsto diversify their investments and minimiseassociated risks, leading to efficient practicesin corporate governance and restrictingexpropriation policies by governments. Yet,one of the main advantages of foreign directinvestment (FDI) over equity investments andother private capital inflows is that it is highlydurable in the context of financial crisis. Thisadvantage of FDI makes it more beneficial tohost countries. In addition, FDI can providegains to host countries in various other forms,ranging from technological advancement to

generation of tax revenues and alsoimprovement of institutions.1 The developingworld and the transition economies have beenquick to realise the importance of FDI inflows.

Over the years 1981 to 1996, the recipientcountries have focused on increasing FDIinvestments to a greater extent thandeveloping trade relations. During the 1990s,foreign investment grew substantially,reaching a peak in 2000, when FDI inflowsreached US$1.3 trillion (OECD InternationalDirect Investment Statistics). According to

Cable and Persaud (1987

), a huge amount ofFDI flows from OECD to non-OECD countrieswent to Latin American countries such asBrazil and Mexico, and Asian nations such asIndonesia, Malaysia and Singapore. More

recently, China and India have become majorrecipients.

What matters for FDI inflow:the literature so far

During the 1990s, international cross-countrystudies investigated the impact of policyvariables on FDI inflows to a country. Onestudy investigated the association betweeninstitutional uncertainty and privateinvestment and found the association to benegative (Brunetti and Weder, 1998). Someother studies under this frameworkestablished a positive relationship betweenFDI and intellectual property rights (Lee andMansfield, 1996) and a negative impact ofcorruption on FDI inflows (Wei, 1999).

Gastanga et al. (1998) found that lesscorruption, efficient contract enforcement andlow nationalisation2 risks attract greater FDIto a country. Along with the increase in theflow of FDI to the developing nation, therehas been also a spread of democracy aroundthe world. Usually, foreign investors prefer tochoose nations who follow democratic norms,encourage free-market policies and fosterprospective business climates.

In this context, many studies explored therelationship between democracy and FDI

inflows. It has been shown by Rodrik (1996

)that a country attracts less US capital if it hasweak democratic rights. Busse (2004), Harmsand Ursprung (2002) and Jensen (2003) alsoconfirmed the positive association between

Other articles

2009 The Authors. Journal compilation Institute of Economic Affairs 2009. Published by Blackwell Publishing, Oxford

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democratic institutions and FDI inflows. Yet, Li and Resnick(2003) suggest that the association between the two is notstraightforward. Democratic institutions lead to better securityof property rights which, in turn, attracts greater foreigncapital. But democracy itself has a negative direct impact onFDI inflows. Busse and Hefeker (2007) studied the impact of

political risks on FDI inflows. They showed that absence ofinternal conflicts and ethnic tensions, efficient law and order,and maintenance of democratic order are crucial determinantsof FDI inflows to a country. Furthermore, Kapuria-Foreman(2007) investigated the relationship between FDI andeconomic freedom using cross-country regression analysis.Bengoa-Calvo and Sanchez-Robles(2003) established theassociation to be positive between the two for 18 LatinAmerican countries.

What else can be important?

Though studies have investigated the impact of overallinstitutional quality in successfully attracting FDI, not muchhas been done to study specific factors which might affect theflow of foreign funds. To be specific, we argue that trade,financial and labour market conditions in a country shouldhave a significant impact in determining the extent of FDIinflows. Factors like high tariffs, foreign exchange marketdistortions, and regulation of interest rates, credit markets andlabour markets can have important implications for foreigninvestors making decisions about investments in hostcountries.

One of the key aspects of global integration has beencomplementarities between FDI and trade relations amongcountries. It is not important whether there is a chicken andegg relation between trade and FDI or whether both growtogether. The main issues to consider are the factors that makeparticular locations advantageous for particular activities, forboth domestic and foreign investors. Thus, the presence oftrade barriers like tariffs and quotas as well as internationalcapital controls is likely to affect FDI inflows. A bigger tradesector will always attract greater FDI since a larger part ofworld trade is comprised of foreign investments in the form ofintra-firm trade.

Limiting freedom of exchange is another major barrier to

FDI inflows. Credit market regulations are big hindrances forFDI. Absence of credit market regulations implies that there isenough competition in the banking industry due to thedominance of private firms. It also suggests the presence offoreign banks, substantial amounts of credit being supplied tothe private sector and also fewer controls on interest rates.Less availability of credit and higher interest rate regulationsare not desirable for investors. Moreover, minimal businessregulations mean investors face fewer constraints and, thus,they are more willing to set up their businesses in locationscharacterised by low levels of government intervention. Theyprefer the business environment to be friendly as their sole

aim is to generate substantial profit from activities in the hostcountries. Thus, FDI flows will be negatively affected if thereare restrictions of entry into a new business, if starting a newbusiness is time consuming, or if complicated bureaucraticprocedures are involved with the functioning of the market.

While the minimal presence of certain basic regulationsmay be desirable, this may not be true for the labour market.It seems obvious that initially high regulations would implylower FDI inflows. However, as regulations are relaxed, FDIflows go up but only up to a certain point. As Palokangas(2003) shows, a minimal amount of labour market regulation

may result in less negotiation power for the foreign investorswith labour unions, which may not be advantageous for theformer. In the absence of stable labour market organisations,binding wage contracts and other institutional arrangementsthat support the reliability of wage contracts, a greater portionof FDI profits can be expropriated by the local elites. Thefewer the labour market regulations, the greater can be theinstitutional inefficiencies leading to unreliable wage contractswhich may not be preferred by foreign investors. Thus, anoptimal amount of regulation may be preferred by foreigninvestors. Beyond a certain threshold less regulation mayactually lower FDI inflows to a country.

Experiences across the globe

Looking into raw data and experiences of countries across theglobe we find support for our argument.

Bangladesh

Bangladesh experienced really low FDI inflows in themid-1980s. This corresponds with the period when the countryhad extreme trade restrictions tailored towards inwardorientation and policies towards export promotion and importsubstitution. Since 1992, however, the economy embarked onits liberalisation regime and accordingly FDI flows started.This is reflected in the data of components of the EconomicFreedom Index from the Fraser Institute which shows thatsince 1992 the score for the index of tariff restriction went upfrom 0.6 to nearly 5,3 while FDI inflows as a percentage of GDPwent up from 0.11 to nearly 1. The score for the trade sector4

has gone up from 0 to 3.5. However, we do not find impressiveimprovements in the scores for international capital marketrestrictions, interest rate regulations and credit marketregulations. This is supported by country-specific problemslike lack of transparency and the presence of high levels ofcorruption that have led to the dismal situation. These have

made the country inefficient in reaping the benefits of theincreased inflow of foreign funds. Furthermore, the WorldBank still rates the country as having the highest trade barriersin South Asia.

Senegal

Looking at the data for Senegal, we find that over the period1984 to 2002, restrictions have not been relaxed significantlyso as to make the country more attractive for foreigninvestment. As the data show, FDI inflow as a share of GDPhas gone up slightly from about 1.2% to 1.5%, with intermittent

years showing negative numbers. Accordingly, indicators ofregulations in trade, credit and labour markets show littleimprovement over the 19-year period. The facts from the rawdata are supported by the observations of the World Bank(2005) which points outs that Senegal has the lowest levels of

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FDI among sub-Saharan African countries. It lacks theinfrastructure to engender investor confidence and suffersfrom serious constraints on the investment climate, high levelsof corruption, as well as a lack of adequate educational andtraining facilities to develop human capital. Thus, althoughSenegal has undertaken various reforms in the past decade, it

still needs to go a long way to reap and sustain the resultingbenefits.

Turkey

After Bangladesh and Senegal, we examine the case of Turkey.As noted in a study documented by Ayalp et al. ( 2004), Turkeyhas suffered from low levels of FDI inflows compared with itspotential. This can be attributed to political instability,macroeconomic volatility, corruption and bureaucratic hurdles to name a few. The study estimates that though Turkey hasthe potential to draw in FDI worth US$35 billion, it is merely

able to attract US$1 billion. This loss is primarily attributed toapathetic government policies which fail to give adequateattention to the importance of making Turkey attractive toforeign investors. The data also support these facts. FDI inflowas a share of GDP in Turkey rose from 0.18% in 1984 to 0.62%in 2002. At the same time, policies on trade, credit market andlabour market regulations have improved significantly,although there is scope for substantial further improvement.

Iran

As for Iran, the data depict that it has a very low share of FDIinflow relative to its GDP. Though it has low levels of tariffrestrictions, its situation with respect to international capitalmarket controls and credit market regulations is depressing.As documented by Ilias (2008), Iran banned foreign banks andnationalised all its indigenous banks after the 1979 revolution,and to date Irans financial market continues to be heavilydominated by large national banks. These state-ownedinstitutions have a record of poor performance as financialintermediaries and are burdened with excessive regulations.Moreover, Irans financial market is still dominated byinformal trust-based transactions or Hawala.5 The poor stateof Irans financial market is also often attributed to thecountrys strained relations with the USA. Overall, the low

levels of FDI in Iran are due to the political instability,stringent domestic regulatory environment, reluctance of thegovernment to allow foreign investors and Irans poorinternational relations.

A simple regression analysis

Data sources

The data on FDI are taken from United Nations Conference onTrade and Development (UNCTAD, 2002). The measure usedis FDI inflow as a percentage of GDP. The control variables

include GDP growth, inflation rate, exchange rate, populationand trade openness.6 The data source for these is the WDIdatabase (World Bank, 2006) and Penn World Tables.

In this study we consider the contribution of specificcomponents of economic freedom in attracting FDI into an

economy. The components considered are pertaining to trade,labour and credit market regulations and are taken from theFraser Institute (2002). The reason for isolating these threecomponents lies in the simple intuition that foreign investorsfind a country lucrative for investment when the country has afree-trade policy with lower levels of trade restrictions, alabour market free from regulations and other governmentalpolicy restrictions and a well-developed, creditor- andinvestor-friendly financial sector. Each of the above-mentionedcomponents consists of an aggregate score broken down intoseveral sub-categories. The components of trade marketregulations considered are non-tariff trade barriers, size of the

trade sector relative to the expected size, and internationalcapital market controls. Credit market regulations consist ofownership of banks, foreign bank competition, credit providedto the private sector and interest rate controls. Hiring andfiring regulations, conscription (i.e. military service) costs andminimum wages are the major components of labour marketregulations.

We have used sub-components from these components orthe aggregated score of the components themselves, basedpurely on the availability of data. The analysis is based on apanel of97 countries over a period of19 years (19842002).7

Results

Before running the analysis, the raw data for some countrieshave been plotted graphically (see Figures 13). They clearlyshow the presence of non-linearity.

14

12

15

10

5

0

5

10Credit regulations

10

8

6

FDIinflow

overGDP

FDIinflowo

verGDP

4

2

0

0 2 4 6

Tariffs

8 10

0 2 4 6 8 10

2

Figure 1: The impact of tariffs and credit market regulations on FDI

for Bolivia

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Our regression results8

indicate that, across the board, theratio of FDI inflows to GDP has a strong relation withRegulations. The implication is that as restrictions arelowered (a higher score), more FDI flows in to the respectivenations. The first sets of components pertain to theregulations in the trade sector. Of this the first componentTaxes on International Trade (comprising revenue from taxeson international trade as a percentage of exports and imports,mean tariff rate and standard deviation of tariff rates9) has asignificant impact on FDI inflows. Similarly, we find that Sizeof the Trade Sector Relative to Expected, International CapitalMarket Control and Interest Market Regulation also matter

for FDI inflows. Credit Market Regulations and Labour

Market Regulation, though they have the expected sign, donot achieve statistical significance. We investigate the FDIinflowregulations linkage further by looking for any possiblenon-linearity in their association.10 A non-linearity (concave orconvex) would mean that for similar changes in restrictions,the change in the rate of FDI inflows varies. The square of

Regulations is introduced to gauge its potential non-linearimpact on FDI inflows. Our results suggest that whenrestrictions are high (lower value of the indices), the level ofFDI inflow is low. However, when the restrictions are relaxed(implying higher values of the indices), the inflow of FDI goesup and at an increasing rate.

We find the presence of non-linearity as expected. Thecoefficients for the linear term are negative while that for thesquared Regulations is positive. The results are very significantfor all types of regulations considered here, except for theindex for labour market controls. The labour marketregulation, however, is significant when we consider

alternative robust regression techniques.11

For these we find aconcave relationship12 between labour market restrictions andFDI inflows. This means that while decreasing labour marketregulations do raise FDI inflows into a country, after athreshold the relation turns negative. This could primarily beexplained by the fact that while too many regulations in thelabour market would make a country unattractive to foreigninvestors, an optimal level of regulation is still desirable. Thiswould keep the sector organised, yet flexible for foreignplayers. Absolutely no regulation in the labour market wouldmake it unorganised and be a more difficult environment forforeign investors.

This can be substantiated by the views of Whyman andBaimbridge (2006) who explain through an example that

decentralisation of wage formation may facilitate pay structures best

suited to the incentive structures sought by individual managers, yet the

rise in pay diversity in the labour market as a whole, together with the

removal of the moderating effect of peak level bargaining partners,

might provoke increased industrial unrest and hence damage

macro-flexibility.

This is also supported by raw data. Countries such asAustralia, China, Colombia and the Dominican Republic showhigh ratios of FDI inflow to GDP and a moderate-to-low score

for labour market regulation. Interestingly, for all thesecountries, the other indices of regulations have significantlyhigher scores.

Conclusion

Our analysis reveals that liberalised trade, financial and laboursectors greatly influence the inflow of FDI into an economy. Aconvex relation reveals that not only is the impact on FDIpositive, but also exhibits increasing returns to reducedregulation. While higher restrictions would increasingly pulldown the FDI inflow, lower levels of restrictions bring in

increasingly higher levels of FDI. The results demonstrate thatwhile trade and some financial regulations have a convexrelationship with respect to FDI inflow to a nation, labourmarket regulations have a concave relationship. Thus, theresults imply that though investors prefer almost no form of

3

2.5

2

1.5

FDIinflo

wo

verGDP

FDIinflowoverGDP

1

0.5

0

3

2.5

2

1.5

1

0.5

0

0 1 2

0 0.5 1 1.5 2 2.5 3 3.5

3

Tariffs

Credit regulations

4 5 6

Figure 2: The impact of tariffs and credit market regulations on FDI

for Sri Lanka

0 1

2.5

2

1.5

1

FDIinflowo

verGDP

0.5

0

0.5

1

2 3 4

Labour regulations

5 6

Figure 3: The impact of labour market regulations on FDI for Niger



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trade and financial regulations, they are attracted by somedegree of labour regulation.

The implications are important for policy-makers,especially in the current era of global integration. This isparticularly true for developing economies that would benefitfrom FDI for their process of development. Policies should be

targeted towards the trade, financial and labour sectors tomake them friendly for foreign investment. Accordingly,countries should free themselves from unnecessarygovernment regulations, bring in transparency in bureaucracy,tackle corruption, improve the investment climate, generateinvestor confidence, invest more in human capital andencourage a work-ethic among the population in general.

Appendix: detailed description of theproxies for regulations

Source: Economic Freedom of the World2008

Annual Report

Taxes on international trade

(i) Revenue from taxes on international trade as a percentageof exports and imports. A score of 10 is given to nationswith no taxes.

(ii) Mean tariff. A score of10 implies no tariff imposed.(iii) Standard deviation of tariff rates: a score of10 implies the

country imposes uniform tariffs.

Regulatory trade barriers

(i) Non-tariff trade barriers.(ii) Compliance cost of importing and exporting: data source

used is World Banks Doing Business data. Higher ratingsare assigned to countries where less time is required.

Size of the trade sector relative to expected

Actual size of the trade sector was compared with expected,which was derived based on regression analysis. Higher ratingsare allocated to countries with larger trade sectors.

International capital market controls

(i) Foreign ownership/investment restrictions: extent offoreign ownership and whether laws favour FDI in thecountry.

(ii) Capital control: source is the IMF which reports up to 13different types of controls. The 0 to 10 rating is based onthe percentage of capital controls not levied as a share ofthe total number of capital controls listed by us.

Credit market regulations

This index is composed of the following categories:

(i) Ownership of banks is comprised of the percentage ofbank deposits held in privately-owned banks. Countries

whose privately-held deposits ranged between 95% to100%, received a rating of10. This index varied between 0and 10.

(ii) Foreign bank competition: countries which approvedalmost all foreign bank applications and have adominance of foreign banks in their banking sector

receive a higher rating.(iii) Private sector credit: this is based on the percentage of

domestic credit consumed by the private sector. As thepercentage increases, the rating gets closer to 10.

(iv) Interest rate controls/negative interest rate: a country withinterest rate determined by the market, stable monetarypolicy, and positive real deposit and lending rates receivedhigher rating. This ranged between 0 and 10.

Labour market regulations

This component is based on the following categories:

(i) Minimum wage: countries with higher mandatedminimum wages relative to average value added perworker are given lower ratings.

(ii) Hiring and firing regulations: the index ranges from 1(if regulations are impeded) to 7 (if determined byemployers).

(iii) Centralised collective bargaining: the index ranges from1 (if wages are set by a central bargaining process) to 7(if they are set by individual companies).

(iv) Mandated cost of hiring: this is based on hiring cost as apercentage of salary. The index ranges from 0 to 10 with

higher values representing lower hiring costs.(v) Mandated cost of worker dismissal: this is based ondismissal cost. The index ranges from 0 to 10 with highervalues representing lower dismissal costs.

(vi) Conscription: countries with longer conscription periodsreceived lower ratings.

Acknowledgement

We are thankful to Russell Sobel for indispensable commentsand suggestions.

1. To quote Douglass North (1991), Institutions are humanly devised

constraints that shape human action. He continues to emphasise that

institutions reduce uncertainty by establishing a stable infrastructure which,

in turn, facilitates enhanced human interaction.

2. Nationalisation refers to the act of transferring an industry or asset into

public ownership, generally against the will of the owner.

3. On a scale of 0 to 10, 10 reflects no tariff restrictions.

4. Here also the scale is from 0 to 10 with higher ratings being given to

countries with a larger trade sector.

5. This system exists in the Middle East and other Muslim countries. It does

not involve any record of transactions, and no promissory instruments are

exchanged between the parties involved.

6. The choice of control variables are based on the studies by Froot and Stein

(1991), and Garibaldi et al. (2001) and Nonnenberg and Mendona

(2004).

7. Using a pooled ordinary least squares (OLS) approach.

8. The benchmark equation is FDIit = b0 + b1Regulationsit + b2Xit + b2Regional+

b4Zt + et. Here FDIit is the ratio of FDI inflow over GDP for country i at time

t. Xit represents the covariance matrix of control variables. The controlvariables are annual growth of GDP, inflation, exchange rate, trade

openness and population. Regionalrepresents the vector of regional

dummies and Zt is the vector representing the time dummy.

9. A detailed description of each of the sub-components is provided in the

Appendix.

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10. The regression for explaining non-linearity is: FDIit = b0 + b1Regulationsit.

11. We run feasible generalised least square (FGLS) estimates for robustness of

our results. This is done to render more efficient results (the need for which

is confirmed by the DurbinWatson test, which verifies the presence of

autocorrelation). We also run robust regression to take care of possible

outliers.

12. See Figure 3 for validation.

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Nabamita Dutta is joining the University of Wisconsin-La Crosse asan assistant professor of economics in Autumn 2009([email protected]).

Sanjukta Roy is a final year PhD student at the College of Businessand Economics at West Virginia University([email protected]).



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