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What are main factors attracting FDI in the context of ASEAN integrations - some empirical findings1

(Preliminary draft – please do not quote)

Abstract:

ASEAN's experience in the last three decades has shown that opening the economy, especially

attracting foreign direct investment (FDI) help those countries quickly gained important social-

economic achievements and become one of the promising dynamic regions in the worlds. FDI

inflow is also strongly believed to play a major role in emerging market economies, thus could

help ASEAN new members reduce development gaps with old members. Such development

gaps among Southeast Asian nation could hinder the effort of building ASEAN Economic

Community (AEC) by 2015. However, ASEAN seems to lose their "special advantages” of

potentially new market, abundant labor force, cheap labor costs and preferential investment

policies. Our paper assumes that in the process of regional integration ASEAN as a

homogeneous region and the special advantage factors such as "cheap labor cost" in this region is

assumed to be equal among its members. FDI inflows by country recognized in relation to the

total amount of FDI flows into the region. With this assumption, using regression random effects

model (REM), the paper measured a number of factors that influence FDI inflows in the region

such as cheap labor force, economic growth, population size, political stability etc. The research

results show that, beside traditional factors, institutional quality (e.g. control of corruption) need

to be paid more attention in ASEAN region in the long-run.

Key words: ASEAN integration, FDI inflows, FDI impact factors, institutional quality

JEL Classification : O12, O19, 03, P2, P3, K4

1 Paper prepared for AEC , 28 – 30, October 2013.

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Introduction

Foreign direct investment (FDI) inflows have major impact on the economic development of

ASEAN countries. Through FDI, the countries of Southeast Asia have rapidly gained important

achievements and become one of the most dynamic regions in the world. Although there are

some concern of negative effects (e.g. great competition for local businesses, adverse impacts on

environment, sensitivity and economic instability involving foreign elements), but no one could

deny the enormous benefits of FDI for the region. New FDI inflows could help ASEAN

economic development with risk sharing, trade enhancement, easy access to foreign markets and

technology transfer. Attracting FDI associated with multi-national business operations is one of

fundamental goal of ASEAN members during the process of economic integration and also as

the important objectives of the ASEAN Economic Community.

ASEAN region is considered to be an attractive destination for foreign investors as the region

has a lot of advantages to attract FDI (cheaper input factors, especially labor costs and natural

material costs, economic growth at a fair-rapid rate and many preferential investment policies).

However, considering long-term FDI attraction, based on low-cost incentives policy is not a

smart choice due to a gradual loss of this advantage. Many evidence show that China economy is

now also facing difficulties in attracting investment as its labor costs rise gradually2. At the same

time, the investment incentives policy accounted for significant expenses in the state budget in

the long term then threat macro stability 3

. Therefore, promoting FDI based on labor quality,

infrastructure and institutional quality (including contract enforcement, property rights

protection, control of corruption ...) need to be paid more attention in the new era of economic

development and integration in ASEAN. With such assumptions, the objective of this study was

to assess the level of effecting factors to FDI inflows in ASEAN region during past two decades.

The next part of our paper review factors effecting FDI in ASEAN region, then the methodology

2 The difficulty in finding work has pushed wages in some areas by 40% each year. Other costs such as compliance with

environmental regulations and labor, and commodity prices also led to increased investment in China less attractive. 3 E.g. According to the research group of the Institute of Economic Research Central Management (CIEM), the cost incurred to

implement preferential policies for foreign direct investment accounted for about 0.7% of GDP of Vietnam. "The cost of investment incentives" view 01/10/2011 (http://www.vssc.com.vn/News/2011/1/10/158601.aspx).

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and data will be provided. Some empirical findings and discussion will be presented before we

have some concluding remarks.

Factors attracting foreign direct investment in ASEAN region

Reviewing previous studies, there are many authors analyzing the determinant factors of the

level of FDI inflows (Artige & Nicolinie 2006, Meon and sekkai 2007, Bevan & Estrin 2000 and

Peter (2001). As the objective of our paper is to determine the specific factors that attract FDI in

general and FDI in ASEAN, we use the approach of Peter (2001) to draw those factors as the

basis for FDI competitiveness as below:

Country indicators Market size

The level of Openness

Infrastructure

Distance with home country

Regional market link

Natural resources

Institution indicators Law and social norms

Regulation enforcement

FDI incentives related policies

Education and human capitals

Political stability

Economic indicators Labor costs and productivity

Macro economic stability

Economic growth rate

Level technology

Balance of payments

Inflation

Sector indicators Scale industrial sectors

Competitiveness

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Level of subsidy for domestic sectors

Many studies show that cost saving is the most important factors for the decision of FDI

enterprises (Yoon, 2007) into the ASEAN region. In the past decades, international investors are

attracted by the abundant large natural resources and cheap labor forces in the ASEAN countries.

For example, considering a few case studies of Malaysia, the foreigners have been flocking to

the country to exploit the abundance of oil, gas, rubber, wood, etc. (Nguyen Manh Toan, 2010).

However, in recent years the trend seems to have faded. Natural resources factors appear weak

compared to the other factors such as political stability, market potential, and preferential tax

policies.

Most ASEAN countries except Singapore and Burney are countries with relatively low or very

low labor costs. For example, wages in the two major cities in Vietnam, Hanoi and Ho Chi Minh

City respectively only about 60 and 70% of salary and wages in Beijing, China (Phuc, VH,

2005). Wages and salaries in Jakarta even half the amount of that in Beijing (JETRO, 2002).

Therefore, compared with China (especially with the pace of rapid economic development of

China) labor costs in Vietnam and Indonesia are now much cheaper.

Some recent empirical studies did not only focus on low cost incentives but a set of factors

attracting FDI in Southeast Asia. Normaz (2009) used a model of attraction factors to consider

major factors attracting FDI inflows during the period 1995-2003. Using data of 18 countries to

invest into 09 ASEAN countries (except Cambodia), Normaz shows that besides economic

factors, market size, exchange rate, quality of infrastructure and labor costs affect FDI inflows.

He also found other significant institutional factors such as trade policy and transparency

contribute to FDI development in ASEAN. Tajul and Hussin (2010) carried out a study on the

effect of institutional quality on FDI flows to ASEAN region from 1996-2008 also showed an

improvement of institutional quality is an important factor to attract new FDI flows. Most

recently, Hong Hiep Hoang (2012) reviewed FDI in ASEAN countries during the period of

1991-2009 and found that, beside the traditional factors as market size, openness of the

economy, infrastructure and exchange rate, political risk and institutional quality also play an

important role on attracting foreign investors.

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Apart from above mentioned factors, market size with high purchasing power, abundant labor is

an important advantage of ASEAN region which help attracting foreign direct investment

(Benacek Gronicki, Holland, and Sass, 2000). A total population of 10% of the world population

along with rapid economic growth (even during financial crisis period from 2008 to 2009, many

countries in the ASEAN region remains a growth rate of 6% - 8 %)4 could make ASEAN to

become an ideal investment location for any international company seeking to dominate new

markets.

Regarding policy incentives to attract FDI into ASEAN region, the policy of tax incentives,

credit support with governmental guarantee, and free trade policies were among the most

important strategy of ASEAN countries. Research by the World Bank also shows the same trend

of improving investment incentives in all over the world (World Investment Report, 2012) in last

decade. Especially, the WB researchers show the trends toward liberalization and promotion was

always superior to the trends of regulation/restriction as in the diagram bellows:

4 According Finance and Macroeconomic Suveilance ASEAN and IMF World Economic Outlook Database (2009), the economic

growth rate in 2008 of the entire ASEAN region which is 4.4% of Cambodia's growth is 6%, Indonesia 6.1%, Laos is 8.4%.

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Figure 1: Investment regulatory change 2000 - 2011

Source: UNCTAD 2012.

Such a trend of study focusing on institutional quality and environment could be explained by

the fact that institutional conditions are important in order to minimize the risks when business

operating in the region beyond the control of foreign investors. Any regulatory and policy

instability as same as political conflict will also psychologically affect the decision of investors

that could not only prevent new investment flows but also make the out flows of FDI to a better

location.

In recent years, ASEAN gain important development process toward common FDI policies with

the foundation of ASEAN Investment Area (AIA) Agreement signed in October 1998. This

agreement is a significant milestone to promote FDI in ASEAN member countries, from both

internal and external sources. It also help to transforming ASEAN into the most competitive and

attractive region for doing investment and business. Besides, ASEAN Free Trade Area

Agreement (AFTA) is the most important and advanced tool of the ASEAN Economic

Community (AEC) to strengthen economic integration and also increase incentives for FDI

inflows. It is the fact that FDI inflows into ASEAN region increase dramatically recent years as

shown as table below

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Table 1: FDI net inflows to ASEAN region from selected partners

Partner country/region Value

2009 2010 20112/ 2009-2011

ASEAN

6,300.2

14,322.7

26,270.7

46,893.6

USA

5,704.3

12,771.6

5,782.7

24,258.5

Japan

3,789.9

10,756.4

15,015.1

29,561.4

European Union (EU)

8,063.1

17,012.1

18,240.5

43,315.7

China

1,852.6

2,784.6

6,034.4

10,671.6

Republic of Korea

1,794.0

3,764.2

2,138.3

7,696.5

Australia

993.0

2,584.9

1,338.0

4,915.9

India 616.4

3,351.5

(1,848.5)

2,119.4

Canada

720.3

1,393.0

985.4

3,098.8

Russian Federation

139.8

60.3

21.6

221.6

New Zealand 98.9 3.4

13.4

115.7

Pakistan

14.3

30.0

13.5

57.9

Total selected partner

countries/regions

30,086.7

68,834.8

74,005.1

172,926.6

Others

16,810.0

23,443.8

40,105.5

80,359.4

Total FDI inflow to ASEAN

46,896.7

92,278.6

114,110.6

253,286.0

Source: ASEAN FDI Statistics Database

In each ASEAN countries, regulatory and policy framework was also very supportive for FDI

inflows. Singapore is one best example where issued the investment legislation earliest in1965 to

attract FDI inflows. The law was amended in 1967, 1971 in order to institutionalize policy

incentives for foreign investors in the key industries. By the early 80s, Singapore was amended

and supplemented laws to encourage large FDI investment and tax exemption for the loss-

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making company. Thailand investment law was issued in 1970 and the government improved

this law in 1986 with the exemption for corporate tax and export tax for FDI project having

export oriented production. In order to encourage foreign investment, Malaysia has also set

many referenced conditions and policies in its law during the years of 80s. Since 1987, when the

first Law on Foreign Investment was promulgated, Vietnam has undergone five of its revisions

(in 1990, 1992, 1996, 2000 and 2005). Law on Foreign Investment in Vietnam has improved

gradually, creating a legal framework based on the new guidelines and policy to open market

economy into international economic integration of the Communist Party that significantly

attracting foreign investment into Vietnam.

Beside policy incentives, control of corruption became an important issue in research on

institutional factors influencing FDI recently. Wei Research (2000a) considers the effects of tax

and corruption to FDI flows using bilateral FDI data from 12 countries to 45 host countries. The

author pointed out the high tax rate on multinational companies and high levels of corruption

will decrease in FDI flows. Wei also pointed out that the decline of FDI inflows caused by

corruption is greater than the negative impact of corruption on the other capital inflows (Wei,

2000b). Using data of 18 countries investing in 9 ASEAN countries (except Cambodia) Normaz

(2009) concluded that besides economic factors, market size, exchange rate, quality of

infrastructure and labor costs affecting FDI inflows to the region, there is also other factors such

as trade policy and transparency (related with control of corruption) also encourage investment

in ASEAN. Therefore to measure institutional quality that effect FDI in the long-term, it is

rationale to consider control of corruption rather than policy and regulatory incentives that only

have short-term impact.

In general, a number ASEAN advantages such as market expansion, cost reduction, the

availability of natural resources have play an important role in the past to motivate FDI inflows.

That motivation could be explained by a set of factors attracting FDI flows into ASEAN region:

political stability, market size, economic growth, abundant labor force, labor costs, and cheap

input factors. In the next part of our paper, these factors will be considered as endogenous factors

in the modeling explain FDI inflows in ASEAN region in comparison with regulatory and policy

incentives as well as institutional quality with the focus of corruption control.

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Research Methodology and Data

Consideration of a set of factors that impact on the ability to attract foreign direct investment

from countries with similar economic conditions in the ASEAN region, we adopt a model based

on the panel data of the 7 countries in the region (including Cambodia, Laos, Indonesia,

Thailand, Malaysia, Vietnam, Philippines) during the period of 1996 - 2011. Four countries in

ASEAN namely: East-Timor, Brunei, Singapore and Myanmar are not included in the model due

to the lack of data from East-Timor and Brunei. Singapore and Myanmar are the two countries

with its characteristics relatively different compared to other countries in the region. Singapore is

the country's with impressive economic conditions and is also the most developed countries that

attracted nearly 50% of FDI inflows in ASEAN region.

Figure 2: Share of FDI stock in ASEAN

Sources: UNCTAD Statistic quoted in Hoang Hiep Hong (2012)

Therefore, considering the extent of those countries with similar economic conditions in

ASEAN, Singapore has a relatively large difference conditions.

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With panel data, our paper use impact assessment model as follows:

Log(FDI)it = β0 + β1 CCit + βj +uit

In particular, i represent the unit of observation (7 countries in the ASEAN region), t represents

time (from 1996 to 2011). The dependent variable is FDI in each country in each year are

expressed as logarithm.

As analyzed in above section, the most important factor reflecting institutional quality effecting

long-run FDI inflows in ASEAN is Control of Corruption (CC). Therefore we use CC (Control

of Corruption) as measured by the rank of the ability to control the country's corruption with

level 0 is the lowest and 100 is the highest. With the assumption of a negative impact of

corruption on FDI, CC is expected to have an impact with same direction with FDI inflows.

To assess the authenticity of the impact of corruption on FDI inflows into ASEAN region

especially with higher level of regional integration (e.g. with the establishment of AEC ), our

study considers to control the impact of low-cost advantage by assuming that, in seven selected

ASEAN countries, cheap-cost factors (including costs of labor and raw material) are identical.

That means these countries are considered to have the same relative cheap-cost factors.

Meanwhile, our paper also considered some other factors into our modeling as control variables

namely: economic growth, size of population (population growth), the average longevity

(variable representing a relative market size), labor force, openness of the economy (the ratio of

export turnover/GDP), infrastructure (telephones per 100 people), labor quality (Enrolment of

secondary school), and political stability. They are expected to have a positive impact (on the

same way) to the scale of FDI inflows.

We also considered inflation as a meaningful explanatory variable, especially in Vietnam

situation, which causes macroeconomic instability and may increase uncertainty of business.

Consequently, inflation is expected to have an impact on FDI flows in the opposite side. The

ASEAN integration still keeps silent on an issue of having common currency so that the

exchange rate also affects FDI at least in medium term. The increase in the exchange rate

corresponding to the depreciation of the domestic currency in each selected ASEAN countries

which lead to encourage export activities as well as stimulate foreign investment. Thus, the

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impact of exchange rates on FDI flows is expected to be in the same way. Table below lists all

considered factors and variables and its data sources being integrated into our model.

Table 2: List of explanatory variables, expected signs and sources of data

Variables Explaining of Variables Expectation of

variable sign

Data Sources

(GDP) Economic Growth + WGI database

Corruption (CC) Control of Corruption by P-Rank

(Percentile rank among all

countries (ranges from 0 (lowest)

to 100 (highest) rank)

+ WGI database

Political Stability

(PS)

Political Stability and Absence of

Violence by P-Rank (Percentile

rank among all countries (ranges

from 0 (lowest) to 100 (highest)

rank)

+ WGI database

Labor force

(log(LAB))

Total labor force + WDI database

Openness Total of export and import

volume/ GDP

+ WDI database

Infrasture (INFRAS) Telephone per 100 people + WDI database

Inflation (CPI) Consumer price index - WDI database

Labor skill School enrolment, secondary (%

Gross)

+ WDI database

Exchange rate (EX) Official Exchange Rate + WDI database

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Population Growth Population growth (annual %) + WDI database

Life expectation

(LIFEEX)

Life expectancy at birth, total

(years)

+ WDI database

Source: compiled by the authors via WB and other Secondary data

Regression of panel data is likely to remain group effects and/or time effects which may be fixed

or random one. Our paper therefore conducted Hausman test to find whether to use the fixed

effects model (FEM) or random effects model (REM). The results showed that the use of REM

model is more appropriate than the FEM model with our research.

Results and discussion

With the method of estimating random effects model (REM), our regression results shown in

Table 3 below:

Table 3: Results of regression random-effects model (REM)

Dependent variable: Log(FDI)

Log FDI= F(GDP growth, CC,PS, log(LAB), Openness, Infras,

log(EX), CPI, Population growth, Lifeex, labour skill)

Random effect

Economic Growth (GDPgrowth) 0.150614

(0.0001***)

Control of Corruption (CC) 0.037985

(0.0048***)

Political Stability (PS) 0.016729

(0.0247**)

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Labor force total ( log(LAB)) 0.873525

(0.0000***)

Openness 0.001805

(0.7579)

Infasture (INFRAS)= Tell/100 people 0.087085

(0.0042***)

Consumer price (CPI) 0.028018

(0.1227)

Labor skill (school enrollment of secondary) -0.021487

(0.1781)

Exchange rate (log(EX)) 0.000174

(0.0000***)

Population growth 0.547872

(0.0444***)

Life expectation (LIFEEX) 0.225472

(0.0309**)

R2

= 0.84

* Significant at 10%; ** significant at 5%; *** significant at 1%

The table shows the results for the explaining variables included in the model is fairly good

explanation for the dependent variable (R2 = 0.84 means that the variable FDI is explained of

about 84% by the independent variables in the model).

The factors like market scale (represented by GDP), economic openness (OPEN), and labor force

(log (LAB)), political stability (PS) is on the same way with FDI inflows. Among them, labor

force expressed the strongest impact on attracting FDI which is reflecting in the regression with

relatively high coefficient. Total labor force increased 1% led to increased FDI growth rate

average of 0.873525 percentage points. Variable representing the quality of human resources

(Labor skill) is not statistically significant, meaning that human resources quality in ASEAN is

less attractive to investors. It confirmed our previous argument that FDI inflow in ASEAN has

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been motivated by cheap but low skill labor forces. Our result is also consistent with the results

of some previous studies (e.g. PCI Vietnam Report, 2011).

Our study pay attention on institutional quality with the focus of corruption control (CC) to the

FDI in ASEAN and found that, higher level of corruption (i.e. ability to control of corruption fell

1 ranking) will lead decrease of FDI with an average of 0.037985 percentage points. This results

well demonstrates our hypothesis that corruption negatively impacts on FDI inflows into the

ASEAN region. The regional institutions as well as individual government in ASEAN thus

should more actively control of corruption. Our research result is also entirely consistent with the

work of Normaz Wana Ismail (2009) and Tajul Aiffin Masron and Hussin Abdullah (2010).

Conclusion

According to the OECD (2002), FDI is a major catalyst for economic development with the

potential of contributing towards both economic growth and improved living standards. FDI

Inflow has had a major impact on the economic development of the countries in the ASEAN

region and ASEAN nowadays becomes one of the most dynamic economic regions in the world.

However, the causal link that is often depicted between FDI inflows and economic development

condition is not necessarily straight forward.

Our study included a review of the impact of identical factors affecting the scale of FDI in the

ASEAN region. Using regression random effects model (REM) for 7 selected ASEAN countries,

our paper measured the negative impact of institutional quality represented by level of corruption

on FDI inflows to ASEAN in nearly past two decades. We also confirmed that there are a

number of factors that positively affect FDI in the region, most notably is the labor force,

economic growth, population size, political stability. Our research results show that to attract

FDI in the long-term, ASEAN need pay more attention to institutional quality rather than other

traditional factors and policy incentives. In the process of ASEAN integration and as

consequences of economic growth in the region, the advantages of cheap-cost factors and

investment policy incentives will fade while the impact of institutional quality related to business

transaction costs will increase more obviously.

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