CHAPTER 3

MOTIVES AND DETERMINANTS OF FOREIGN

DIRECT INVESTMENT A THEORETICAL SURVEY

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3.0 INTRODUCTION

After the downfall of the socialist planned economy and with the beginning of

transition towards market economy attracting of foreign direct investment has been an

important objective of every economy that has long-term goals of economic welfare.

Foreign direct investment can bring positive effects such as market access,

technology, capital, and skills to developing countries. Therefore, developing country

governments are increasingly searching for best-practice policies to attract more FDI

inflows. Theoretical and empirical research in this field pays great attention to the

definition of the main factors or determinants and motives of the FDI flows.

The determinants and motives of FDI have a wide spectrum; each firm considers

certain aspects crucial from its own point of view. On the basis of orientation, most of

the FDI can be classified into 3 categories:

(i) Natural Resources oriented

(ii) Labour oriented and

(iii) Market oriented

When a country undertakes foreign investment in a natural resources oriented

industry, quite obviously, its objectives is to be able to import easy and relatively

cheaper products from the host country. The investing country may be lacking in such

a natural resource-oriented commodity or the same may be its comparatively

disadvantages industry.

In this case, the investing MNCs tend to integrate production and marketing, thereby

monopolizing or oligopolising the benefits available from the exploitation of such

natural resources. Resources like oil and copper were in this way, monopolized by a

few MNCs.

Natural resource-oriented investment is no doubt trade generating. But the net result

of the operations of the MNCs in such fields is that the countries endowed with these

resources get only marginal benefits, unless the host governments have protected their

interests at the time of signing the contract.

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The labour-oriented investment is also trade generating. In the developed countries,

capital intensive and knowledge intensive industries are being created almost every

year. Wages therefore, are becoming higher and higher with the passage of time.

MNCs find themselves unable to meet the growing wage bill in their home countries.

Therefore, they undertake FDI in those countries, where wages are relatively lower

and where the wages are very low, as in developing countries, that countries will be

the first choice for these corporations for transferring their labour intensive

operations. The products manufactured by the subsidiaries of these corporations can

be imported by the parent corporations for marketing in the home country. The

subsidiaries can also export such goods to third countries. Such foreign investment,

thus, helps in the reorganization of the international division of labour, as also in the

exposition of trade between labour abundant and labour scare nations.

The market-oriented FDI is generally induced by trade barriers imposed by the host

countries. In case the tariffs on the final product are very heavy, the MNCs would like to

export machinery, equipment technology, intermediate materials, parts and components,

etc., to the host country and undertake actual production there only. In this way, the

corporation might be helping the host country in its import substitution efforts.1

It is, however, possible that because of the protection provided to the industry, it may

not necessarily be competitive in the international market. But in case, because of the

availability of cheap labour, such an import substitution industry becomes export

oriented, then there will hardly be any differences between the trade barriers induced

investment and labour oriented investment.

3.1 THEORIES OF FDI

The importance and growing interest in the causes and consequences of FDI has led to

the development of a number of theories that try to explain why MNCs indulge in

1 - There are exceptions to this generalized observation. For instance, it is always possible that FDI is undertaken for the manufacture of new product industries, even when no trade barriers exist. The objective of such an action could be to maintain oligopolistic character of a corporation; it is also possible to internationalize production & marketing through vertical and horizontal integration.

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FDI, why they choose one country in preference to another to locate their foreign

business activity, and why they choose a particular entry mode. These theories also

try to explain why some countries are more successful than others in obtaining FDI.

Theories play an important role in shaping legal attitudes both nationally and

internationally.

At the theoretical level, the major explanations of FDI encompassing motives and

determinants can be classified into Macro and Micro economic approaches. Such

explanations are based on levels of income and development, trade parameters,

technology, theories of commercial policy, currency factors and firm specific factors

including administrative and managerial approaches, ownership advantage and

internationalization factors. In addition, there are radical approaches based on Marxist

principles and exploitation modes.

3.1.1 Macro Economic Approaches

These approaches include comparative advantages and levels of development approach.

The Comparative Advantage Approach has been developed by Kojima (1973-78) which

establishes correspondence between comparative costs (affecting international trade) and

comparative profitability (affecting international investment) stressing that both trade and

investment should be guided by a common theory. A firm will choose to invest abroad by

extending its operations rather than investing in a domestic company operating in the

country in which it is interested as long as the income it expects to earn is greater. This

will occur whenever the investing company possesses some advantages over its foreign

competitor which are not readily available to it and are sufficient to compensate for the

disadvantages of operating a subsidiary at a distance.

These advantages as described by kindleberger (1969) may take various forms and

include superior technology, patterns, access to markets, and entrepreneurial expertise

and experience and economies of integration and so on. A firm will wish to fully

exploit these benefits rather than share them with potential competitors and this

encourages that firm to undertake direct investment rather than portfolio investment.

The more significant the advantages, the greater the likelihood of monopoly profits

being earned, and the more a firm is encouraged to engage in direct investment. The

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traditional theory suggests that where the cost of producing a certain quantity of

output for export to a particular country, plus distribution and marketing costs is

greater than the cost of producing the same product in the country is concerned; it will

pay the exporting company to set up local production facilities. FDI follows this

principle because such type of investment raises income both in home and host

countries. Thus this theory is an important determinant of FDI.

The level of development is another important determinant of FDI. This approach is

developed by Dunning. It explains how net outward investment position of a country

is related to the various stages of development. Using data on the flows of FDI and

per capita GDP of 67 countries covering the period 1967-75, Dunning has shown that

after a "threshold" per capita income has been reached, further increases are

associated with rising gross outward and gross inward investment but the shape of net

outward investment takes a U or J type shape.

Earlier the countries were divided into four stages of development defined by the

average per capita income range.2 However, the concept of the investment

development path (IDP) has been revised and extended in several papers and books

(Dunning 1986, 1988, 1993, Narula 1993, 1995; Dunning & Narula 1994, 1996).

According to the revised studies there are five stages of development outlined below.

Stage 1: There is no gross outward investment either because the country's own

enterprises have no specific advantages, or are exploited by minority direct

investment. Smallness of gross inward investment may be due to small market size,

poor infrastructure facilities and lack of trained and educated work force.

Stage 2: Inward investment is more which leads to expand "Domestic market" in such

an environment where infrastructural facilities are; MNCs tend to invest there.

Outward investment is small as the domestic enterprises are yet to develop fully the

ownership specific advantages. Frequently inbound FDI is stimulated by host

government's imposing desirable tariff and non-tariff barriers. A country must possess 2 - The overlapping income ranges in stages 3 and 4 suggest that in more developed stages, investments behaviour cannot be explained by per capita income.

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some desirable locational (L) characteristics to attract inward direct investment,

although the extent to which foreign firms are able to exploit these will depend upon

its development strategy and the extent to which it prefers to develop technological

capabilities of domestic firms.

The extent to which outward direct investment is undertaken will be influenced by

home country indeed push factors such as subsidies of exports and technology

development or acquisition, as well as the changing (non-government induced) L

advantages such as relative production costs.

Stage 3: In this stage, a country begins to get specialization in direct investment. The

country seeks to attract inward direct investment in those sectors in which the

comparative location advantages are strongest and comparative ownership advantages

of its enterprises are weakest. Countries in stage 3 are marked by a gradual decrease

in the rate of growth of outward direct investment, and an increase in the rate of

growth of outward direct investment, and an increase in the rate of growth of outward

direct investment that results in increasing NOI (Net Outward Investment).

Comparative advantages in labour incentive activities will deteriorate, domestic

wages will rise, and outward direct investment will be directed more to countries at

lower stage in their investment development path. The original O advantages of

foreign firms also begin to be eroded, as domestic firms acquire their own

comparative advantages and compete with them in the same sectors. The role of

government induced advantages is likely to be less significant in Stage 3, as those of

FDI induced ownership advantages take on more importance.

Stage 4: It is a situation in which local firms develop strong ownership advantages to

be reaped best through internationalization of foreign investment abroad. Firms are

induced to invest abroad due to rising domestic labour costs, lower rates of

productivity.

Stage 5: During stage 5, the NOI position of a country first falls and later fluctuates

around the zero level. At the same time, both inward and outward FDI are likely to

continue to increase. This is the scenario which advanced industrial nations are now

approaching. Stage 5 of IDP represents a situation in which no single country has an

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absolute hegemony of created assets. Moreover, the O advantage of MNCs will be

less dependent on their country's natural resources but more on their ability to acquire

assets an on the ability of firms to organize their advantages efficiency and to exploit

the gains of costs border common governance.

3.1.2 Micro Economic Approaches

Micro economic theories are mainly theories of market structure imperfections and

market failure imperfections. In market structure imperfections, there are theories in

which the behaviour of the firm deviates from that assumed under conditions of

perfect competition, through their ability to influence market prices. Under market

failure imperfections we will consider theories which depart from the technical

assumption behind the model of perfect markets that is the assumptions about

production technique and commodity properties. This category will deal basically

with those phenomena which lead to market failure or cases where "the decentralizing

efficiency of that regime of signals, rules and built in sanctions which define a

"market system" will fail.

A. Industrial Organization Approach

The recognition that FDI belongs to the realm of industrial organization, goes back to

Hymer's writings in 1960s and the 70s. Since then, it has received much attention and

has become the most popular approach to date. The industrial organization approach

has come to be favored by Lemfalussy (1961) and Kindleberger (1969) and an

impressive array of scholars like, Knickerboker (1973); Caves (1948) and Dunning

(1974). There are two essential characteristic which set oligopolistic industries apart

from competitive ones. First the former are industries where maximising decisions

whether profit or growth are inter dependent, each firm much speculates on the

reactions of the few other firms in the industry. Second barriers to entry are essential

in order to prevent a surge in competition.

Notable barriers to entry lend themselves to direct expansion abroad leaving aside

vertical foreign investments which respond to barriers of a different kind. Caves

(1971) considered product differentiation in the home market as being the critical

element giving rise to foreign investment.

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Why corporations undertake horizontal investments abroad to produce the same

general level of goods as they, produce at home has been explained in several ways.

Hymer (1976) and Giddy and Rugman (1979) have suggested the importance of some

unique asset of the firm, a patented invention or a differentiated product on which it

can earn maximum profit in foreign markets only through foreign production. For the

possession of some special asset to lead the firm to invest abroad two conditions must

be satisfied. First the asset must partake the character of a public good within the firm

such as knowledge fundamental to the production of a profitable sale able commodity.

Any advantage embodied in knowledge, information or technique that yields a

positive return over direct costs in the market where it is first proven can potentially

do the sunk costs associated with its initial discovery. Knowledge would seem to be

the hypothetical asset displaying the character of a public good propriety to the firm

but it is not the only one.

The essential feature of an asset conducive to foreign investment is not that its

opportunity cost should be zero but that it should be low relative to return available via

foreign investment. Second, the return attainable on a firm's special asset in a foreign

market must depend at least somewhat on local production. Thus the firm investing

abroad must not only enjoy enough of an information advantage in its special asset to

offset the information disadvantage of its alien status; it must also find production abroad

profitable to any other means of extracting this rent from a foreign market.

These requirements, taken together, point to a particular trait of market structures-

product differentiations as one necessary characteristic of industries in which

substantial direct investment occurs. A differentiated product is a collection of

functionally similar goods produced by competing sellers, but with each seller's

product distinguishable from its rivals by minor physical variations, brand name and

subjective distinctions created by advertising or differences in the ancillary terms and

conditions of sale.

In the nature of differentiation, a successful variety is protected from exact imitation

by trademarks, high costs of physical imitation or both. The successful firm producing

a differentiated product, control knowledge about servicing the domestic market that

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can be used at little or no cost in other national markets. This provides the motivation

for investing abroad; as long the means to protect the market exist; such as patents

and copyright.

Survey evidence shows that firms very frequently test a foreign market by exports and

then switch over to local production through a subsidiary for better adaptation of the

product to the local market or superior or lower cost of ancillary service that can be

provided. These advantages of local production hold for producer as well as consumer

goods; although the highest of differentiation are found in the latter; they are not

necessarily absent in the former and marketing advantages of having production

goods. MNCs are always keen to maintain oligopolistic character. They cannot

survive this position, if they continue operating within the home country. Even if their

oligopolistic nature survives in the short run, it will not be there in the long run.

Therefore, they want to invest abroad so that their oligopolistic character is not only

strengthened but also expanded.

B. The Product Life Cycle Approach

This hypothesis was developed by Vernon (1966) to explain the expansion of US

MNCs after the Second World War. According to this hypothesis, 'products go

through a cycle of initiation, exponential growth, slow-down and decline a sequence

that corresponds to the process of introduction, spread, maturation and senescence`.

This hypothesis is useful because it offers another interpretation of FDI, particularly

for manufactured products that are characterized by advanced technology and high

income elasticity of demand.

FDI takes place as the cost of production becomes an important consideration, which

is the case when the product reaches maturity and standardization. FDI is thus a

defensive move to maintain the firm's competitive position against its domestic and

foreign rivals. The product life cycle hypothesis predicts that, over time, the home

country where the innovative product first appeared switches from an exporting to an

importing country. This prediction is consistent with the pattern of dynamic changes

observed for many products. For example, personal computers were first developed

by US firms (such as IBM and Apple Computers) and exported to foreign markets.

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When personal computers became standardized, the USA became a net importer from

producers based in Japan, Korea and Taiwan. The exporters include foreign firms as

well as subsidiaries of US companies located in these countries.

Gruber (1967) found a strong association between the propensity to invent new

products, export performance, FDI and the ratio of local production to exports on the

one hand, and R&D expenditure of the US industries on the other. The association

between the ratio of local production to export and R&D expenditure is interpreted as

an indication of the substitution of FDI for exports in host countries in the final stage

of a product cycle.

It is noteworthy that Vernon's original theory was developed in the 1960s, when the

USA was the unquestioned leader in R&D and product innovation. Now, product

innovation takes place outside the USA, and new products are introduced

simultaneously in many advanced countries. Thus, production facilities may be

located in several countries right from the beginning, and the international system of

production is becoming too complicated to be explained by a simple version of the

product life cycle hypothesis.

This is why the hypothesis has been extended to take into account not only labour costs

but also other factor costs, and has been generalized to apply to the FDI of all developed

countries. One has to admit that the applicability of the product cycle hypothesis is

restricted to highly innovative industries, and that it is an oversimplification of the firm's

decision-making process. However, it should be borne in mind that the hypothesis was

based originally on the US experience, and offered a useful explanation for the interaction

between production, exports and FDI during the 1950s and 1960s.

C. The Eclectic Theory

The eclectic theory was developed by Dunning (1977, 1979, and 1988) by integrating

the industrial organization hypothesis, the internalization hypothesis and the location

hypothesis without being too precise about how they interrelate. The eclectic theory

aims at answering the following questions. First, if there is demand for a particular

commodity in a particular country, why is it not met by a local firm producing in the

same country, or by a foreign firm exporting from another country?

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And, second, supposed that a firm wants to expand its scale of operations, why does it

not do so via other channels? These other channels include the following: (i)

producing in the home country and exporting to the foreign country; (ii) expanding

within the home country; (iii) indulging in portfolio investment in the foreign country;

and (iv), licensing its technology to foreign firms that carry out the production. It

seems that the answer to these questions is that a foreign subsidiary can out-compete

other potential suppliers in the foreign market, and that FDI is more profitable than

other means of expansion. The eclectic theory attempts to answer to this question and

the related questions.

According to this theory, three conditions must be satisfied if a firm is to engage in

FDI. First, it must have a comparative advantage over other firms arising from the

ownership of some intangible assets. These are called Ownership (O) advantages,

which include things like the right to a particular technology, monopoly power and

size, access to raw material, and access to cheap finance. Second, it must be more

beneficial for the firm to use this advantages that rather than to sell or lease them.

These are the Internalization (I) advantages that refer to the choice between

accomplishing expansion within the firm and selling the rights to the means of

expansion to other firms. Third, it must be more profitable to use these advantages in

combination with at least some factor inputs located abroad. If this is not the case,

then exports would do the job. These are the Locational (L) advantages, which pertain

to the question of whether expansion is best, accomplished at home or abroad.

The eclectic theory suggests that all forms of FDI can be explained by reference to its

conditions. It recognizes that advantages arising from Ownership, Internalization and

Location (OIL) may change over time, and accepts that if country-specific

characteristics are important determinants of FDI, it may be invalid to generalize from

one country's experience to another.

D. Business Administration Approach

This theory concentrates on the growth of the firms. It views the activities of direct

foreign investment as a natural consequence of the growth of a firm. This theory is

based on the logic that when a corporation expands, it tries to capture as much of the

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domestic market as possible. When the corporation can no longer expand within the

confines of the domestic market, it undertakes exportation. And thus, an export division is

established. When export business expands, export division is converted into an

international business with relation to a particular country or region becomes very large,

subsidiaries are established in the concentrated country or region. In the course of time,

for the same region, subsidiaries are established all over the world. And, although some

autonomy is granted to its subsidiaries, in respect of a number of maters, there is central

control from the corporate head quarters based in the parent country.

Consequently the firm faces new problems such as negotiation with foreign

government, the handling of foreign currencies and other assets, dealing with foreign

laborers, arbitrations of international conflicts and so forth.

There are many proponents of the business administration approach. Mention may

be made of Penrose (1959), Fayerweather (1969), Stopford and Wells (1972),

Robinson (1973).

Elementary, as it may seem in its nature, the business administration approach was the

first to tackle the problem of direct foreign investment and still is most influential. It

may, however, be pointed out that this theory is based on the assumption of

prevalence of perfect competition both in domestic and foreign market.

E. International Division of Labour Approach

Many attempts have been made to suggest an International Division of Labour based

theory of direct foreign investment. The theory defines managerial resources as the

specific factors. These managerial resources include capital, technology and

managerial know-how. These factors are specific to the individual industries. As

against this, labour is a general factor.

While specific factors can move not only domestically but also internationally within the

same industry, the general factor can move freely between industries but only domestically.

Since, managerial resources are specific factors and do not move between industries

within a country, the rate of profits differs from industry to industry. This will certainly

result in differences in the profit rate for the same industry in different countries.

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Kojima (1978) is not in full agreement with the thesis developed by Ikemoto and

others that production technology and industry specific capital stocks may be treated

as specific factors. According to him, if it is assumed that managerial resources are

specific factors, then it means that we are justifying "enclave type direct foreign

investment of monopolistic or oligopolistic enterprises. This obviously is not the

intention. Therefore, whether the factors of production are "specific" or "general" may

depend upon the length of time horizons. It seems to be more reasonable to suppose

that general factors move domestically as well as internationally to the place where

immobile or specific factors are located. For instance, managerial resources tend to

move to those places, where rich natural deposits are located or to those places where

cheap labor is available. Hence, while managerial resources should be treated as

general factors, other production factors like labour and natural resources may be

treated as specific factors.

According to the international division of labour based theory of direct foreign

investment suggested by Kojima, the Hecksher Ohlin model may be formulated, using

labour and managerial resources in place of labour and capital. These managerial

resources include "not only material capital but also human capital such as technology

and skills". The comparative cost difference emerges as a result of differences

between the two countries in the labour/managerial resources ratio. Comparative

profit rates are directly related to comparative cost differences. International trade

tends to move in the direction dictated by comparative costs, which is also the

direction dictated by comparative profit rates.

Foreign direct investment, too, tends to move to the direction indicated by

comparative profit rates. So, Kojima suggests that both international trade and FDI

should be discussed and analysed under the same principle of international division of

labour based on the principle of comparative costs or comparative profit rates.

F. Tariff Wall Jumping Approach

The proponents of this theory of foreign investment suggest that in case the host

country had levied tariffs indeed heavy tariffs on the goods it was importing from the

investing country, the latter was bound to set up manufacturing facilities in the firm.

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That is to say, FDI is bound to take place behind a tariff wall. In order to cross the tariff

wall, the investing country replaces its export to the host country by undertaking FDI.

G. The Differential Rates of Return Approach

The differential rates of return represent one of the first attempts to explain FDI flows.

This theory postulates that capital flows from countries with low rates of return to

countries with high rates of return move in a process that leads eventually to the

equality of real rates of return. The rationale of this hypothesis is that firms

considering FDI behave in such a way as to equate the marginal return on and the

marginal cost of capital. The hypothesis obviously assumes risk neutrality, making the

rate of return the only variable upon which the investment decision depends. Risk

neutrality in this case implies that the investor considers domestic and FDI to be

perfect substitutes, or in general that direct investment in any country, including the

home country, is a perfect substitute for direct investment in any other country. One

problem with the differential rates of return approach is that it is not consistent with

the observation that countries experience inflows and outflows of FDI simultaneously.

This is because a rate of return differential implies capital flows in one direction only,

from the low-rate country to the high-rate country, and not vice versa.

Another problem is that testing is based on the rate return calculated from reported

profit, which is different from expected profit and actual profit. Furthermore,

accounting profit cannot produce a reliable and objective measure of the rate of

return, since it can be influenced by many subjective and procedural factors, such as

the method used for writing off fixed assets, inventory accounting (FIFO versus

LIFO), and inflation accounting.

The validity of the differential rates of return hypothesis can be questioned on

theoretical grounds. First, MNCs may indulge in FDI for reasons other than profit; the

objective may be to maximize sales revenue in accordance with market penetration

objective. In general, MNCs are faced with a multiplicity of objectives for their

international operations, and these objectives are likely to change with the passage of

time. More importantly, however, risk aversion implies that the FDI decision does not

only depend on return, but also on risk.

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H. The Portfolio Diversification Approach

Risk is another variable upon which the FDI decision is made. If this proposition

is accepted, then the differential rate of return approach becomes inadequate, in

which case we resort to the portfolio diversification approach to explain FDI. The

choice among various projects is therefore guided not only by the expected rate of

return but also by risk. The idea of reducing risk via diversification that is relevant

to portfolio investment is also used here. Because of risk aversion, a rate of return

differential will not induce capital flows in one direction until the differential

disappears via arbitrage. The problem with this hypothesis is that; first, risk and

return are calculated from reported profit that is unlikely to be equal to actual

profit for several reasons, including transfer pricing and accounting procedure.

Second, the risk variable cannot be measured accurately from historical data if it is

taken to be the variance or standard deviation.

However, it remains true that the diversification approach, which takes risk into

account, is superior to the differential rates of return approach, for the following

reasons. First, the diversification approach offers the main advantage that it can be

generalized. Second, it considers risk, which constitutes a very important element in

FDI decisions. Like the differential rates of return approach, the portfolio

diversification does not explain why MNCs are the greatest contributors to FDI, and

why they prefer FDI to portfolio investment. One explanation, perhaps, is financial

market imperfections. Since in DCs, financial markets are not only imperfect but also

making portfolio investment less attractive than FDI. Another factor is the degree of

control which MNCs prefer FDI over portfolio investment because FDI gives more

control over foreign investment.

3.2 HOST COUNTRY PULL FACTORS

Most of the theories explained above mention only the hose country macro-economic,

industry specific and firm specific push factors. But it is also necessary that host

country must possess certain locational advantages to attract FDI. The push factors

explain the outward investment by different countries while the pull factors explain

the uneven distribution of FDI among the recipient countries.

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The decision of an enterprise in an industrial country to invest directly in a developing

country is motivated by a higher expected profitability as compared to the alternative

investment possibilities at home or in other industrialized countries. The relative

advantage of such investment depends upon both economic and non-economic

influences. Even if present economic conditions seem satisfactory and suggest good

prospects for the future, it is entirely possible that they will not materialize due to

unfavorable non-economic conditions. It is therefore necessary to consider both

economic and non-economic determinants of investment decisions. Host country pull

factors can be grouped under two heads i.e. economic and non-economic factors.

3.2.1 Economic Factors

The economic factors have been discussed under the following sub-factors:

A. The Market Size and Characteristics

Market size is one of the most important considerations in making investment location

decisions. Indeed, larger economies have attracted the bulk of world wide FDI.

According to the market size hypothesis, the volume of FDI in a host country depends

on its market size, which is measured by the sales of a MNC in that country, or by the

country's GDP (that is, the size of the economy). As soon as the size of the market of

a particular country has grown to a level warranting the exploitation of economies of

scale, the country becomes a potential target for FDI inflows.

The relationship between direct investment and output can be derived from

neoclassical models of domestic investment. The rationale for the hypothesis that

firms increase their investment in response to their sales is based on neoclassical

domestic investment theories.

One way to test the market size hypothesis is to find out whether or not the share of FDI of

a given country going to a group of host countries is correlated with the individual income

level of the host country. The empirical studies seem to support the hypothesis that higher

levels of sales and the host country's income are related positively to FDI.

A number of survey studies have also dealt with market size as a determinant of FDI.

The majorities of empirical studies of the determinants of FDI include some measures

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of market size in the host country, typically using real GDP as a proxy and found it to

be a significant determinant of FDI. But studies based on Australian data, failed to

find a relationship between FDI flows and GDP. According to this study the growth

rate of GDP may be regarded as a measure of the future potential of the host country's

domestic market, while per capita income may be used to represent the level of host

country's economic development. Finally, size does matter, according to a recent

survey by A.T. Kearney, the results of which were summarized in The Economist

issue dated 17 February 2000. This survey is based on the views of 135 executives of

the world's 1000 largest companies. The ranking of countries from the top to bottom

of the list did not exactly match the ranking of countries in terms of size, because of

the influence of other determinants of FDI.

B. Availability of Cheap and Skilled Labour Force and Raw Material

The continued expansion of transnational corporation was, in the past, a response to

the differential availability of factor endowments in various countries. In the case of

labour intensive industry, the availability or non availability of labour is an important

factor. Cheap labour availability reduces the cost of production and yields high

profitability. Low wage rate in developing countries encourages the inflow of FDI.

The availability of well trained human resources may be a powerful incentive for

investment, especially in the manufacturing and service sector which often require

access to skilled labour and technical and managerial personnel. This presupposes a

certain educational infrastructure and facilities for vocational training. If these

resources are not available locally, the freedom to employ needed foreign nationals is

necessary. The degree of discipline in labour/management relationship in the host

country may also prove to be an important factor, especially in industrial and labour

intensive investment.

The availability of raw material for the manufacturing industry is an important factor

in making the investment decision. If the raw material is available locally the cost of

production remains low, as the transportation of the raw material from the other

places, which would entail huge expenses, is saved. It is only the availability but the

sustained availability of raw material at a place with matters in investment decisions.

In case of planned and long term industrial investments the availability of raw

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material for short period is not considered favourable. The search of reliable sources

of raw material to feed the growing industrialization had motivated industry to move

beyond the national boundaries right from the middle of the nineteenth century.

C. Economic Policy of the Host Country

Industrial policy of the host country is also one of the important determinants of FDI.

Industrial policy encouraging private sector investment, having liberal attitude

towards mergers, conglomerates and industrial concentration increases the inflow of

FDI. Clarity of policies and rules and predictability in their application are more

important than special incentives to foreign investors. Accurate and up-to-date

information on investment opportunities as well as data on general economic trends,

are of great relevance to any prudent investor. Clearly defined development programs

which elaborate priorities and identify sectoral opportunities are also useful. A

government can significantly improve its national investment climate by adopting

macro economic policies to encourage efficient utilization resources.

Every foreign investor wants to take home the profits he earns from investment

abroad as well as the capital which he has invested. But foreign investor's choice most

of the times, regulated by the rules of the host country in respect of repatriation of

profit and capital. Restriction on the transfer of dividends to foreign investors or loan

payments impairs confidence in the long term viability of investments. Freedom to

remit profits and dividends and repatriate capital is clearly an essential ingredient in

an attractive climate for foreign investment.

Many countries impose limitations on the operations of foreign companies. A

government may introduce regulations restricting foreign investment in certain sectors

to ensure its conformity with development priorities. Entry into politically sensitive

industries, such as public utilities, the media, banking and insurance, has been

restricted in most developing countries. Industries with relatively small technology or

modest financial requirements have also been reserved for local enterprises. Other

restrictions relate to the access to local capital market etc. Specific performance

requirement on foreign investors are also common especially in association with an

offer of incentives. They include domestic content minima, export obligations,

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employment quotas, establishment of research and development facilities, and

appointment of host country national to senior managerial positions, and limits on the

duration of technology licensing agreements.

Trade policy of the host country is one of the important factors determining the flow

of FDI. Protectionist policies provide a stimulus to import substituting FDI and at

least in countries with large and medium sized home markets, this type of FDI is

likely to be predominant until import substitution possibilities are exhausted. But

protection makes it difficult to export and to attract FDI in export activities. Import

liberalization, export promotion measures and establishing of free trade zones or

export processing zones play a significant role in attracting export oriented FDI. Both

theory and experience have combined to show that other things being equal, countries

pursuing export promotion strategies rather than import substitution, attract more FDI

and in more economically valuable ways.

Tax structure in the host country also influences the inflow of FDI. There is some

empirical evidence to show a negative correlation between tax rates and FDI flows.

Bilateral agreements between the host and home country governments, signals the

government's commitment to a stable investment environment and thereby enhances

the investor's confidence. Liberal banking activities, developed and stabilized call

market, good and reliable capital markets also encourage the inflow of FDI.

Intellectual property protection is one of the important factors influencing technology

transfer and investment decisions. The weakness of a developing country's system of

intellectual property protection discourages the inflow of FDI in certain industries.

Appropriate exchange rate policy is of great importance in attracting foreign

investment once private firms an individual can shift assets among currencies legally,

they can hedge against perceived risks of policy deterioration. When governments

engage in policies which are judged by the public to be unsustainable, flight from

local currency will occur, this will bring down the level of international reserves.

Thus, foreign direct investors want exchange rates and interest rates to be allowed to

adjust to changing inflation rates. If exchange rates, in particular, are not allowed to

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reflect cross national differences in inflation rates, investors are exposed to price

distortions in their cost and revenues that can threaten their long run competitive

position. Although, they prefer stable exchange rates in the short run, they do not

want exchange rates to be inflexible and insensitive to basic price and income forces

in the long run. Currency convertibility, unified and stable exchange rate is expected

to bring in more FDI.

D. Infrastructure Facilities

The establishment of industry requires a highly developed infrastructure. The

development of roads, rail transport system, electricity and communication system are

important infrastructural elements which are vital for the development of industry.

These factors are responsible for the attracting of FDI. The lack of such facilities in a

country hinders the inflow of FDI.

3.2.2 Non- Economic Factors

The political and socio-cultural factors are considered in non-economic factors.

Investor's costs and revenues are not only affected by economic conditions, they are

also dependent on political conditions, including the stability of the political system.

A country in which there is political unrest or in which there is a threat of having the

investment nationalised without adequate compensation is more of a risk and less

attractive to invest in, than in a country offering political stability and a guarantee of

property rights. The political attitudes of the stable government becomes known to the

world at large over a period of years and the investment decisions become easy to take.

On the other hand, if the government is not stable, the investors tend to keep away.

Perceptions of political risk can greatly discourage foreign investments in

developing countries. Investors may screen out some host countries as too risky

at the preliminary stage of the decision making process, thus preventing the

identification of investment opportunities in those countries. Direct investment

decisions, which are long term by nature, are particularly vulnerable to the

prospect of political instability, especially if investment would be susceptible to

major damage or interruption.

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There are quantitative and qualitative costs attached to perceptions of instability in

developing countries. Qualitatively, if the risk profile is perceived to be too high, the

projected investment will not be too high; the projected investment will not be made,

thus decreasing the overall welcome of capital inflows into the host country.

Qualitatively, uncertainty about the medium and long time horizon may limit

investors to ventures that yield high rates of return over a short period, neglecting

important investment opportunities involving longer gestation periods.

The behaviour of the legislative, executive and judicial branches of the host country

also affects the inflow of FDI. Frequent changes in legislation, breaches of contractual

arrangement and unavailability of a credible and independent judicial system

represent important shortcoming in the legal aspects of the investment climate for

local and foreign investors alike which cannot be rectified merely by issuing a

favourable investment code.

If the consumer's tastes and culture are similar to those in the home country, if there is

acceptance of advertising or other persuasive marketing method, if the attitude of the

public is friendly towards foreign investment, then there is more possibility of FDI

coming into the country. Consumerism and demonstration effect in the host country

also influence the flow of international direct investment in that country.

To conclude, the relative significance of the motives and determinants as contained in

the above theories differs not only between firms and regions but also from time to

time for a particular firm or region. The differences in the strength of the determinants

are most marked between developed and developing countries which differ radically

with regard to economic structure, development characteristics and socio-economic

structure, development characteristics and socio-economic profiles.