UNCTAD VIRTUAL INSTITUTETRAINING PACKAGE ON ECONOMIC AND LEGAL ASPECTS

OF INTERNATIONAL INVESTMENT AGREEMENTS (IIAs)

Module 1Concepts, trends and economic aspects of foreign direct

investment Theme 3

DETERMINANTS OF FDIPart I. Host country determinants of FDIPart II. Firm level determinants of FDI

Kampala, 10-14 November 2008

Zbigniew ZimnyUNCTAD consultant

Part IHOST COUNTRY DETERMINANTS OF FDIWhy some countries receive more FDI than others? Why a host country’s FDI inflows may drastically fluctuate over time?What determines how much FDI does a host country receive?

Case 1. Brazil’s FDI inflows from 1970 to 2007

Questions: Why Brazil’s inflows were lower during 1983-1994 than in 1983? Why they started recovering only after 1995? Why did they peak

during 1997-2000 and then fell again?

FDI inflows into Brazil, 1970-1993, $ bln and share of DCs' inflows in %

0

5

10

15

20

25

30

%

0

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2

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5

$ bln

Share of DC inflows, % FDI inflows, $ bln

FDI inflows into Brazil, 1990-2007, $ bln and share of DCs' inflows in %

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%

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10

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$ bln

Share of DC inflows, % FDI inflows, $ bln

Case 2. India vs. China (with Brazil as a reference) since 1980

QUESTION: Since China has emerged as a host country, it has always received much larger FDI inflows than India. Why?

FDI inflows to China, India and Brazil (for reference), 1980-1989, $ million

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Brazil China India

FDI inflows into China, India and Brazil (for reference), 1990-2007

$0

$10,000

$20,000

$30,000

$40,000$50,000

$60,000

$70,000

$80,000

$90,000

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Brazil China India

Case 3. Investors’ perspective: what TNCs consider important when choosing a

location?

1. FDI locational factors in developing countries, 2007, top importance (1=not at all important; 5=extremely important)

3.4 3.6 3.8 4.0 4.2 4.4 4.6

Quality of universities and research institutesQuality of international sea links

Hiring and firing regulationsQuality of life

Corporate income taxesAccess to export markets

Attitude towards foreign investorsInvestment incentives

Quality of international air connectionsQuality of banking and other financial

Supply of high-skilled labourCosts of high-skilled labour

Quality of telecommunicationsMacroeconomic stability

Political stability

2. FDI locational factors in developing countries, 2007, less important (1=not at all important; 5=extremely important)

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

Quality of rail networkCosts of low-skilled labour

Supply of low-skilled labourPersonal taxation

Costs of real estateAvailability of natural resources

Bilateral investment treaties Ability to recruit internationally

International schoolsPresence of other companies in the same

Proximity to sophisticated customersDouble taxation treatiesQuality of road network

Quality of housingEnergy costs

General costs of doing businessQuality of local suppliers of goods and services

Sorting out host country FDI determinants• To answer these questions and explain differing

records of countries in attracting FDI we need to understand key factors determining FDI inflows into countries

• As a rule, countries that offer what TNCs seek stand a greater chance to attract more FDI

• TNCs seek many things (called locational advantages) in host countries. Key among them are economic attractions including: natural resources (giving TNCs access to, and control of, natural resources) large and dynamic domestic markets and access to international markets (permitting TNCs to grow faster than in national markets, spread the risks and better service the markets) lower costs of resources such as labour and other inputs, e.g., infrastructure services (permitting TNCs to reduce costs of production and operations) availability of firms possessing assets needed by TNCs (e.g., R&D, brands, customers base, marketing or other capabilities)

Natural resource-seeking

Efficiency-seeking

Market-seeking

Strategic-asset seeking

TNCs

What TNCs seek in host countries determines the types of FDI

MiningTourismOil and gas extraction,

Access to a large domestic (Brazil, China, India) or regional market (EU, NAFTA, ASEAN) – horizontal FDI

Divide and specialize production in line with the comparative advantages of different locations – vertical FDI export-oriented FDI

primarily through M&As

Each type of FDI has a different set of economic requirements

Motive of FDI Key determinants Natural resource-seeking FDI

Abundance and cost of natural resources Physical infrastructure (ports, roads, railways, etc.) Price movements

Market-seeking FDI

Market size and purchasing power (per capita income) Market growth Access to regional and global markets Tradability of product/service Structure of markets

Efficiency-seeking, export-oriented FDI

Quality and cost of human resources Physical infrastructure (ports, roads, telecom, etc.) Trade costs Quality of suppliers, clusters, etc. Regional integration agreements

Strategic asset-seeking FDI

Presence of firm-specific assets Ease of cross-border M&As Efficiency and transparency of financial markets

Three groups of host country FDI determinants

• Economic attractions are very important but they are only one group of host country determinants

• The two other groups are: Policy determinants divided into two sub-groups:1. FDI policy proper including policy measures affecting only or mainly foreign investors2. Policies affecting all investors. Some of them may be more and some less important for foreign investors Business facilitation, including investment promotion

Policy as FDI determinant: core FDI policies

• Rules and regulations governing the entry and establishment of foreign investors in a host country-- e.g., prohibition of entry, restrictions on ownership (joint venture requirement) or liberalization of entry

• Treatment of foreign investors concerning entry, establishment and operations-- non-discrimination in the treatment of foreign and domestic firms (national treatment) and among foreign firms (most-favoured nation treatment)-- preferential treatment of foreign or domestic firms (e.g., incentives only to FDI)-- distinguish treatment before and after entry

• Protection of foreign investors-- expropriation and nationalization; fund transfers; and dispute settlement are key issues in protection-- protection against “regulatory takings” is a new issue

General policies affecting FDI

Policies affecting economic,

political and social stability

Trade policy

Privatization policy

Tax policy

Monetaryfiscal exchange rate policies

import-substitution vs. export-orientationmembership of regional integration schemes

can be a powerful determinant of FDI inflows

tax heavens tax incentives corporate and personal taxes

Key general policies that affect FDI

NOTE: THERE ARE MANY OTHER POLICIES AFFECTING FDI IN ONE WAY OR THE OTHER, RANGING FROM EDUCATIONAL POLICIES THROUGH LABOUR MARKET POLICIES TO

ENVIRONMENTAL AND SECTORAL (E.G., MINING) POLICIES

What is Investment Promotion?Investment promotion is undertaken by Investment

Promotion Agencies (IPAs). WAIPA has a membership of 231 agencies from 156 countries.

INVESTMENT PROMOTION FUNCTIONS: Image-building (advertising, exhibitions, missions, seminars on

investment opportunities marketing a host country) Investor generation and targeting (industry specific activities:

direct mail campaigns, missions, seminars, targeting individual investors, e.g., Intel to invest in Costa Rica)

Investment facilitation (all types of help to new and existing investors: counselling services, applications and permits, post-investment services)

Policy advocacy with a view to improving the investment climate (policy task forces, lobbying activities, drafting laws and policy recommendations, reporting investors’ perceptions)

Why Investment Promotion may matter?When choosing investment locations, TNCs

o face market failures in information due to high transactions costs of collecting information about investment locations.

o Their information base is far from perfect and their decision making process is often subjective and biased

o Most TNCs consider only a small range of potential investment locations and many countries (with real investment opportunities) are not even on their map

Through investment promotion Governments cano bridge or diminish the information gap by providing

better information and improving the country’s imageo help foreign investors reduce the costs of entering,

establishing and operating in the countryo better understand and meet the needs of investors and

improve the investment climate through policy advocacy

Host country determinants

Host Country Determinants of FDI

• Policies on functioning and structure of markets (especially competition and M&A policies)

• Privatization policy

• Good infrastructure and support services e.g. banking, legal accountancy services

• Note: this type of FDI takes place through cross-border M&As for a variety of strategic reasons

• Availability of firm-specific assets: technological, innovatory, marketing, brand names, etc.

• Buying market power or new markets, spreading risks, lowering transaction costs

• Availability & cost of skilled labor

A. Market- seeking

• Market size and per capita income

• Market growth

• Access to regional and global market

• Country specific consumer preferences

• Structure of markets

• Availability of raw materials and natural resources (e.g., for tourism)

• Cost of raw materials

• Physical infrastructure (ports, roads, railways, power, telecom)

• Low-cost unskilled labour or skilled labour

• Cost of resources and labour adjusted for productivity

• Other input costs, e.g. transport and communication costs to and from and within host economy

• Regional integration agreements (inter-country division of labour)

B. Resource -seeking

C. Efficiency- seeking

D. Strategic asset- seeking

I. Policy framework for FDI• Economic, political and social stability• Rules regarding entry and operations• Standards of treatment of foreign affiliates

II. Economic determinants

• Hassle costs or red tape (corruption, administrative efficiency, etc)• Social amenities (quality of life, bilingual schools etc.)

• Social capital; attitude to work

• International trade and FDI agreements

• Trade policy (tariffs and NTBs) and coherence of FDI and trade policies• Tax policyTO NAME A FEW……..

• Investment promotion

• Investment incentives

III. Business facilitation

Type of FDI by motives of TNCs

Principal economic determinants in host countries

Notes on host country FDI determinants

• FDI determinants differ according to the type (motive) of FDI (e.g. efficiency-seeking or market-seeking), the mode of entry (greenfield vs. M&As) and the sector of investment (services or manufacturing)

• A number of determinants are important to all investors: e.g., political and economic stability, the rules of entry, establishment and treatment of FDI and protection of FDI

• Typically there are many host country factors involved in deciding where an FDI project is located

• It is often difficult or impossible to pinpoint to the most decisive factor

• The interrelationships among the three sets of determinants must be borne in mind

• Economic determinants are key determinants: countries that do not have them will not attract a given type of investment

Notes continued• Strong economic determinants (e.g., large and

dynamic market, oil, or privileged access to large markets) can bring much FDI in less than perfect business environment

• The importance of two other sets of determinants should be considered under the assumption “other things being equal”

• Economic attractions being equal or similar, countries whose policies are most conducive to TNC activities, stand a better chance of attracting FDI

• Other things being equal, incentives or FDI promotion can win an investment project

Back to the Brazil, China and India: how

determinants can make a difference?

Brazil in the 1970s and 1980s: loss of stability

• Debt crisis hit Brazil in 1983• Severe macroeconomic and

political instability followed: large budget deficit, hyperinflation (3,000% in 1990!) and low growth (GDP per capita fell)

• The Real Plan in 1994 restored stability

• In 1995 FDI inflows exceeded pre-crisis level and started growing again

FDI inflows into Brazil, 1970-1995, $ mln, and 5-years trendline

0.0

500.0 1 000.0

1 500.0

2 000.0

2 500.0 3 000.0

3 500.0

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5 000.0

1970

1971

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1995

Brazil’s peak in 1997-2000: privatization

• Brazil’s privatization programme was among the biggest in the world, valued at $105 bln from 1991 to 2002

• Largest sales, $65 bln, took place in 1997-1998,

• With big privatizations of utilities completed, unprecedented FDI inflows proved to be unsustainable until 2007 due to large FDI in metal mining

FDI inflows into Brazil, 1995-2007, $ billion and 5-years average trendline

0.0

5 000.0

10 000.0

15 000.0

20 000.0

25 000.0

30 000.0

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40 000.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

China vs. IndiaMarket size and growth

The size of population is not much different but China has much higher income per capita, more than two times larger market and has grown much faster than India

China vs. India, population, GDP and GDP per capita, 2005

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Population,mln

GDP, $bln GDP percapita, $

China

India

China vs. India, annual rate of GDP growth, 1980-2005, %

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2

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12

1980-1989 1990-2000 2001-2005

China

India

Type of investmentCHINA• Both market-

seeking and export-oriented FDI mainly into manufacturing

• The share of FDI in exports: 1989 9% > 2002 50% (91% in technologically quite advanced products)

INDIA• Mainly market-

seeking with the exception of IT services (call centres, back-office services, R&D)

• The share of FDI in exports: 3% in the 1990s > 10 % now

Strategies and policiesCHINA• Opened to FDI in 1979

and liberalized progressively

• In spite of restrictions and requirements it favoured FDI over domestic firms

• Privileges to foreign firms led to FDI round-tripping estimated at 25% of FDI

INDIA• Permitted FDI long

before China did but started liberalizing seriously since 1991

• India pursued for a long time import-substitution strategy relying on domestic resources and firms

• Trying to encourage FDI only in high-tech

Less red tape in China?• China has higher literacy and education rates

and better physical infrastructure in coastal areas

• Procedures are easier, decisions taken more rapidly, business laws more flexible, labour climate better and entry and exit of firms easier

• India has (a narrow) advantage in skilled IT manpower and language skills

• Overseas Chinese in Asia invest much more in China than overseas Indians do in India

CHINA COMES UP MUCH HIGHER THAN INDIA AS AN FDI DESTINATION IN INVESTORS’ SURVEYS

Part IIFIRM LEVEL DETERMINANTS OF FDI

What explains FDI? Why firms invest abroad?What are their underlying motivations and

strategies?SO FAR WE HAVE DISCUSSED WHAT FIRMS ARE

SEEKING WHEN INVESTING ABROAD IGNORING THE QUESTION WHY THEY INVEST INSTEAD OF EXPORTING

OR SELLING THE TECHNOLOGY

FOR NON-TRADABLE SERVICES THE ANSWER IS SIMPLE: FDI IS THE ONLY WAY TO SELL SERVICES ABROAD. BUT

IT IS NOT SO FOR MANUFACTURING GOODS WHERE THERE ARE OTHER OPTIONS TO SERVICE FOREIGN

MARKETS

Early macro-level theories not helpful in explaining the internationalization of economic activity through TNCs/FDI

• In the world assumed by trade theory TNCs could not exist > immobile production factors (including capital) and no scale economies

• FDI as a capital flowing from countries with capital surplus to countries with deficit. Wrong – most FDI in the world is among capital-rich areas

• FDI and trade as substitutes (Mundell, 1957) > FDI as a capital flow replaces home country exports. Later empirical evidence has proved it wrong. FDI and trade are largely complementary

Micro-level approach: Hymer’s contribution

• Inspiration from industrial organization theory• Starting point: in serving a particular market,

domestic firms have an intrinsic advantage over foreign firms. They have better local connections and a better understanding of the local business environment, the nature of the market, business customs and legislation and the like

• Consequently foreign firms wishing to produce in that market have to possess some kind of a firm-specific advantage to offset the advantage held by the domestic firms

Sources of firm-specific advantages • Firm size and economies of scale• Market power• Marketing skills (e.g., brand names or

advertising strength)• Technological expertise (either product,

process or both)• Managerial expertise• Access to cheaper sources of finance• Once established, the control of productive

assets abroad – “multinationality” – itself becomes a source of competitive advantage

The focus on the internal ownership-specific characteristics of TNCs has

become an accepted part of the theoretical literature and has laid

ground for the theory of international production

Better understanding of FDI/TNCs• FDI is a mechanism by which TNCs

maintain control over productive activities abroad

• It means international production rather than international exchange or merely a capital flow

• FDI is primarily about the transfer of non-financial assets (such as knowledge or technology) across different countries by TNCs while still retaining the property or control of such assets

OLI paradigm (Dunning) – a framework integrating various explanations of

international production • O – ownership-specific (or competitive)

advantages, discussed earlier, permitting to overcome the firm’s disadvantages vis-à-vis local firms

• L – locational advantages of host countries, or host country determinants of FDI, discussed earlier, such as natural resources, large and dynamic markets, lower costs of labour and/or superior infrastructure

• I – internalization advantages

I-advantages are benefits of exploiting O&L advantages through FDI rather than arm’s

length transactions • Markets for assets or production inputs (technology,

knowledge or management) may be imperfect and involve significant transactions costs or time lags

• The major incentive for internalization of markets is uncertainty over the availability, price or quality of supplies or of the price of firm’s product

• A firm may prefer to retain exclusive right to, or at least control of, assets, called “core assets” (especially a new technology or a brand name), which confer upon it a significant competitive advantage resulting in higher profits or monopoly rents

Internalization is especially likely to occur in the case of knowledge

FDI takes place when three sets of OLI advantages exist simultaneously

• If only the first condition is met (“O” condition), firms will rely on exports, licensing or a sale of patents to service a foreign market

• If the third condition (“I”) is added to the first (“O”), FDI becomes the preferred mode of servicing the foreign market (or undertaking efficiency-seeking investment), but only in the presence of location-specific advantages

Notes on OLI paradigm• The paradigm is sometimes criticized as a

list of factors explaining a TNC rather than the explanation itself

• “Theoretical relations between the different factors too often remain un-theorized”

• It is however widely used as a conceptual structure within which specific cases of FDI can be examined

• How the three conditions for FDI are satisfied varies according to the type of FDI

TNC as a sequential process (Vernon, Swedish school). TNCs move to FDI gradually

Changing strategies and structures of TNCs

• From stand-alone to integrated strategies (or from horizontal to vertical FDI)

• From simple integration to complex integration

• From multi-domestic to regional and global structures

CHANGING STRATEGIES AND TYPES OF INTERNATIONAL PRODUCTION LEAD TO SHIFTS IN LOCATIONAL DETERMINANTS OF FDI

Towards integrated production

Stand-alone, multi-domestic

Simple integration -- outsourcing

Complex, vertical integration

FINANCE

PRODUCTI0N

R&D

ACCOUNTING

PROCUREMENT

FINANCE

PRODUCTI0N

R&D

ACCOUNTING

PROCUREMENT

FINANCE

PRODUCTI0N

R&D

COUNTRY B COUNTRY A COUNTRY BCOUNTRY A

From shallow to deep integration between parents and affiliates

INTER- AND INTRA-FIRM EXCHANGEOF GOODS, SERVICES, PERSONNEL

BASED ON DIVISION OF LABOURAND AS PART OF INTEGRATEDPRODUCTION, WITH COMMONGOVERNANCE OF TNCs OVER

MOST FUNCTIONS

Shallow Integration

ACCOUNTING

PROCUREMENT

INTER-FIRM ARM’S LENGTH TRADE IN GOODSAND SERVICES BASED ON DIVISION OF LABOUR

BETWEEN INDEPENDENT PRODUCERS

FINANCE

PRODUCTI0N

R&D

ACCOUNTING

PROCUREMENT

TRAININGETC.

Deep Integration

TRAININGETC.

TRAININGETC.

TRAININGETC.

REAL LIFE EXAMPLES OF INTERNATIONAL INTEGRATED

PRODUCTION

Ford network in Europe in the 1960s: economies of scale and specialization

Toyota: from exports to multi-domestic affiliates to regional networks

Toyota’s domestic and international production, 2004

Toyota: global supply network of finished products (vehicles)

Toyota: regional supply network of finished products, components and services