The determinants of FDI inflows
Introduction: Benefits of FDI
The advance of the globalization process and the progress of science and technologies have broughtthe world closer together than ever before, facilitating the movement and spread of information,capitals, goods and products, raw materials and human capital from countries around the world. Onone hand, transnational companies are quick to realize these new potential investment destinationsand markets and start moving their resources to even the furthest corners on Earth to capitalize onthese new opportunities. Directly investing in these locations helps companies gain easy access tothe local markets, reduce transportation costs, and take advantage of the local workforce andnatural resources.
On the other hand, countries, especially developing ones, also recognize the importance andcontribution of FDI inflows to their economic growth. FDI inflows increase the existing pool ofcapitals and speed up the transfer of new technologies and knowhow to host countries. Also, thepresence of FDI enterprises increases competition in the host countries' business environment,forcing domestic enterprises to innovate and catch up with their foreign competitors and createsother positive spillover effects.
Trends in FDI flow in recent years
In recent years, the prospects for overall global FDI flows have been very positive. According to thestatistics of UNCTAD, after falling from the height of $2 trillion in 2007 due to the world economicrecession, the global FDI inflow showed signs of recovery. In 2013, it increased by nearly 9 percentto reach more than $1.45 trillion, and the increasing trend was observed across all 3 categories ofthe economy - developed, developing and transitional economies. Many experts predicted that thisrising trend would continue for the next 3 years.
Among all global destinations, with the exception of the year 2009, FDI inflow to developingcountries kept increasing, making up for more than 54% of the total global inflows in 2013 ($778billion), among which, emerging Asian economies accounted for nearly one third of the total globalshare ($426 billion), significantly higher than that of African economies ($57 billion). China arose asthe most attractive developing-economy destination, ranking 2nd among the top host economies forFDI and receiving a total of $124 billion in 2013, up 2.5% compared with 2012. As for developedcountries, after reaching a peak of $1.3 trillion in 2007, the total amount of FDI inflow to the regiondeteriorated and stood at $566 billion in 2012, only slightly greater than that of 2012 ($517 billion).North America attracted $250 billion while the European countries received $246 billion.
In terms of FDI outflows, developed countries maintained their lead, contributing more than $857billion or more than 60% of the total global outflows. The United States and Japan were the mostactive investors, investing $338 billion and $126 billion abroad respectively.
Determinants of FDI inflows
As the role of FDI in economic development has been increasingly acknowledged and emphasized,competition among countries and regions to attract the global FDI inflows to their locations has alsointensified, leading to the big question as to which factors encourages or discourages foreigninvestors from investing in a location. According to various researches, these followings factors areidentified as crucial in influencing investors' location decisions.
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Market size, which is usually decided by the host country's population, GDP and per capita income,is one of the most important factors in FDI location decision. Market size gives investors an ideaabout the host location's general economic and demographic conditions, the potential demand fortheir products, local sales and profitability. Zheng (2009) argued that foreign investors who areseeking new markets for their output are most likely to be interested in market size, customers'potential purchasing power and growth. In addition, Scaperlanda and Mauer (1969) pointed out thatmarket size would positively affect the level of FDI if it was large enough to allow the companies totake advantage of economies of scale and effectively allocated resources. It is no coincidence thatChina and the United States, the two biggest economies in the world, are also the two largest FDIrecipients, accounting for approximately 13% and 9% respectively of global FDI inflows in 2013.
It is generally believed that openness and market freedom encourages FDI and economic growth.Many studies show that trade openness promotes export-oriented FDI inflow into an economy ingeneral and companies often prefer host countries that are close to their export markets, havepolicies supporting import-export activities and participate actively in many regional or global tradeagreements. Countries that undergo trade liberalization are expected to receive more FDI. Forinstance, after Vietnam officially joined the World Trade Organization, signing various agreements toopen its economy and loosen the state's control in many areas, the country witnessed the largestwave of FDI companies flocking to the country with a peak in 2008 with 1,171 new FDI projects anda total registered capital of $71 billion.
Although researches have demonstrated that tax incentives are not the deciding factors in drawingforeign investors' attention, it does prove to have some impacts on investors' decision, especiallywhen they compare among locations with relatively similar investment conditions. For example, from1985 to 1994, as Caribbean and South Pacific countries amended their tax policies, making thembecome tax havens, total foreign direct investment to these locations increased more than five times.Similarly, countries and territories such as Hong Kong, British Virgin Islands etc. with lucrativeeffective corporate tax rates are also able to attract a steady stream of foreign investments.Moreover, tax incentives enable the host government to influence the structure of FDI inflow. Infact, most governments give more incentives to a certain type of investment or a certain sector toencourage investors satisfying specific conditions.
Labor cost has always been identified as a major FDI determinant and many developing countriesclaim low labor cost as their competitive advantage in attracting foreign companies. Labor is onecomponent of the total production cost; therefore, labor-intensive industries and companies whichhave labor costs constitute a large proportion of their total costs are most appealed to cheap labor.Besides, export-oriented FDI companies are even more sensitive to labor cost and they tend to movetheir production to the place offering low tax rates and cheap inputs including labor, raw materialsand energies to cut down on production cost. A study by Wheeler and Mody (1992) found out that for
US firms, labor cost played an important role in their global investment location decisions and lowerlabor cost associated with higher level of FDI inflow. According to a research by Baskaran, Nasrin,and Muchie (2010), low labor cost is the most significant determinant of FDI inflow to Bangladeshand 71% of the foreign investors surveyed indicated that cheap labor was the main factor motivatingtheir investment decisions.
Economic and political stability
Foreign investors pursuing long-term and sustainable investment take economic and politicalstability of the host country into serious consideration before making investment decision. A stableand reasonably sound economic and political climate enhances the certainty and predictability offuture events or changes, increases investors' trust and makes them feel more secure about theoutcome of their investment. In addition, perception of stability adds to investor's perception of riskand the greater level of instability drives away risk-averse investors, thus reducing the incoming FDIflow. A report by OECD (2002) cited macroeconomic instability, nonenforceability of contracts, andarmed conflicts as the biggest risks of capital loss of foreign investors when investing in Africa,which ultimately discourages them from investing in this region despite the high potential rate ofreturn on investment. Another example is the China - Japan's political dispute over islands in SouthChina Sea which caused much tensions and hostile attitudes towards Japanese investors in China,forcing many Japanese companies to redirect their investments from China to other surroundingcountries in recent years.
In addition to the above-mentioned factors, there are other factors that are potentially thedeterminants of FDI inflow such as natural resource availability, investment regulation, institution,cultural traits, ease of doing business, infrastructure and so on. Each country has its owncomparative advantages in FDI attraction and pursues different goals in order to maximize benefitsand minimize risks from FDI. As the competition among countries in attracting FDI becomes fiercer,there will be more factors that companies will take into account before deciding where they wouldlike to invest.
Baskaran A, Nasrin S, and Muchie M. (2010), "A Study of Major Determinants and Hindrances ofFDI inflow in Bangladesh", DIR Department of Culture and Global Studies, Aalborg University.
OECD (2002), "Foreign Direct Investment for Development: Maximizing benefits, Minimizing costs"
Scaperlanda A, Mauer L. (1969), "The Determinants of US Direct Investment in the EEC", AmericanEconomic Review 59, 558-568.
Wheeler, D and A. Mody (1992), "International Investment Location Decisions: The Case of USFirms," Journal of International Economics, Vol. 33.