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Foreign Direct Investment Dynamics In Sea Countries Economics Essay

As previously stated, compared to other European nations, SEA countries have attracted a small share of international FDI flows (Figure 1). International direct investments to SEA economies went up from US$ 39,174 billion in 1990 to US$ 134,481 in 2005. This amount represented about the 20% of the total European FDI inflows. The percentage in 1992 was much higher and reached the peak of 35%, while the worst FDI inward position has been recorded in 1999 (8%) and 2000 (9%), that is, in the period prior the launch of the single European currency.

Taking into account the GDP of the single countries, the weak performance of SEA is even more striking. Data are displayed in Figure 2. The average FDI inflows as a percentage of GDP varied between 1.3% in 1990 and 2.8% in 2005. As a group, the SEA countries are still lagging behind their European neighbors. However, among the group, there seem to be more attractive economies. During the period 2001-2005 the most important receiver of foreign investments has been Spain, with a FDI/GDP ratio equal to 3.6%, exceeding not only FDI inflows of other SEA countries, but also FDI positions of other major European economies, such as Germany, Sweden and UK. On the other hand, also France and Portugal have gradually become more interesting to foreign investors. France has recorded its highest share of FDI inflows (3.9%) in 2005, while Portugal had a peak of foreign activities in 2001 (5.8%).

At the same time, from the picture below, it clearly emerges the poor performances of the Italian and Greek economies, the lowest among the OECD countries. However, it is worth noting that while FDI to Italy more than doubled from 1990-1995 to 2001-2005 period [1] ; FDI in Greece decreased in the second half of the 90s and afterwards remained constant. This pattern suggests that foreign investments had not benefited the Italian and Greek economies in the same way as in the other three, and there is scope for further attracting foreign capitals in these territories.

Figure 2. SEA FDI Inflows (Percentage of GDP). Source: UNCTAD.

Literature Review

FDI are generally identified as “investments made by multinational business enterprises in foreign countries to control assets and manage production activities in those countries” (Padma, 1999). In the last decades different theories have been advanced to explain these forms of investments. Unfortunately none of them can boast to be a general theory that includes all aspects of MNEs’ activities (Dunning, 2008), and the main reason is that there are too many elements that can potentially drive FDI.

Despite this gap in the literature, it is widely agreed that MNEs engage in outward FDI when a set of three necessary conditions is satisfied, that is, ownership advantage, location advantage and internalization advantage. This general framework, known as the eclectic (OLI) paradigm has been introduced by John Dunning at the end of the 80s. According to the OLI paradigm, an investing firm has to own something exclusive, unique, which make it recognizable in the foreign market (O). The host market has to offer something to the foreign investor (L). The MNE has a direct advantage in carrying out the activity by itself instead of licensing it (I).

The aim of this study is focusing on one of the three necessary conditions expressed in the OLI paradigm, viz. the location advantage. Location advantage (L) refers to the host country’s quality of business environment, and it includes a wide spectrum of elements, such as factor prices, market access, trade barriers, transport costs and institutional environment (Dunning, 1988).

In the broad discussion of FDI location determinants across countries, it is useful to make a theoretical distinction between Horizontal FDI (HFDI) and Vertical FDI (VFDI). The first one pertains to market-seeking FDI and duplication of activities in the host market, in order to have a better access to that host market. The second one involves efficiency-seeking FDI since part of the production process is carried out in the host economy to take advantage of its cheap factors of production (Barba Navaretti, G. and Venables, A. J., 2007). Despite there exist practical difficulties in separating the data into HFDI and VFDI [2] , the dominance of developed economies in both FDI inflows and outflows suggests that the main strategic intent of firms investing abroad is the penetration of the foreign market. As the majority of FDI into the SEA originate from developed countries, FDI into Spain, Italy, Portugal, Greece and France are assumed to be horizontal, driven by market-seeking motives.

The popular gravity model, whose first economic version was suggested by Tinbergen in 1962, has been widely used as a reference point to explain both home and host countries FDI determinants (e.g. Ledyaeva and Linden, 2006; De Santis and Vicarelli, 1999; Bénassy-Quéré et al., 2007; Leibrecht and Scharler, 2008; Galego et al., 2004). In a very simple form, it suggests that bilateral FDI are directly proportional to GDP levels in both host and source countries, and inversely proportional to the geographical distance between them. However, despite the undoubted validity of the approach, the FDI literature has agreed to move beyond its simple form and include additional explanatory variables (Barba Navaretti, G. and Venables, A. J., 2007). The existing literature usually considers two broad set of location-related variables. The first one pertains to countries’ supply-side factors, such as market size, labor force and R&D. The second one consists of institutional factors, such as fiscal conditions, quality of bureaucracy, government’s influence and level corruption (e.g. Wheeler and Mody, 1996; Wei, 1997; Habib and Zuravicki, 2002; Nicoletti et al., 2003; Bénassy-Quéré et al., 2007). Our choice of FDI determinants follows this theoretical distinction.

3.1 Supply-side factors

Market size has been widely considered as the most important FDI determinant. As suggested by the theory, the larger is the host country the higher is the probability that MNEs will prefer to serve locally the foreign market instead of exporting – since they will easier recoup the fixed costs of setting up a foreign plant (Barba Navaretti and Venables, 2007). Therefore, market size directly affects the return of an investment (Zheng, 2009). In line with the theory, empirical works have extensively supported these predictions (Globerman et al., 2004).

As market accessibility is one of the fundamental motivations to invest abroad, the geographical distance is seen as a critical factor when choosing a foreign location. Davidson (1980) highlights that geographical proximity reduces uncertainties and costs of obtaining information. Solocha and Soskin (1994) argue that this proximity is determinant since raw materials and intermediates are often provided by the home country. In other words, the higher is the geographical distance between home and host country the higher will be the costs of managing foreign affiliates, hence smaller the volume of FDI inflows (Wei and Liu, 2001).

Trade openness is usually measured as the sum of a country’s imports and exports divided by its Gross Domestic Product (GDP). It captures the liberalization of trade in a given economy, and it is widely agreed that it is most likely to be positively correlated with inward FDI (Caves, 1996).

Since labor costs represent a large component of total production costs, the literature has always brought them into the analysis of factors affecting FDI location. Despite some studies did not find any significant effect (e.g. Owen, 1982; Wheeler and Mody, 1992), empirical results have usually supported the main theoretical expectation that higher wages have an adverse effect on inward FDI (e.g. Fung et al., 2005; Culem, 1988).

In the analysis of multinational firms’ behaviors, Dunning (1998) emphasizes that FDI may be driven by the search of strategic assets. Empirical and anecdotal evidence supports this view. Firms may use foreign investments to acquire location-specific assets and set up activities in Research and development-rich countries (Barba Navaretti and Venables, 2007; Fosfuri and Motta, 1999; Siotis, 1999).

Finally, corporate taxation in the host country is expected to have a clear and unambiguous effect on FDI, despite some studies, such as Brainard (1997), produced abrupt (but insignificant) results – with high corporate taxes increasing affiliate sales relative to exports. Ample evidence is provided by more recent works (e.g Hines, 1999; Basile et al., 2009 and Bénassy-Quéré et al., 2007) which pointed out that corporate tax regimes influence the choice of where to locate investments.

3.2 Institutional factors

The very first attempt to study the effect of quality of institutions on inward FDI has been made by Wheeler and Mody in 1992. Taking into account 13 different country-related risk factors, such as quality of bureaucracy, level of corruption and political stability, they did not find a significant correlation with US firms’ location choices. However, this result is partly conditioned by the fact that they also considered non-institutional-related factors as inequality and living environment of expatriates (Bénassy-Quéré et al., 2007). Later studies have often tried to identify the relationship between formal institutions and volumes of FDI inflows, but results are often controversial and contradictory due to difficulties of measuring qualitative variables such as institutions and due to the different methodologies and samples employed (Bloningen, 2005).

Despite these contradictions, empirical investigations on FDI determinants consider the quality of bureaucracy as a first order determinant (Lankes and Venables, 1996; Habib and Zurawicki, 2002). Efficiency of public administration can condition MNEs’ location choices (Jun and Singh, 1996). Existence of sluggish bureaucratic procedures can generate a surge of operating costs and increase uncertainty, thus reducing expected profitability of investments and discouraging the entrance of foreign investors (Basile et al., 2009).

According to the World Bank (2004), a country’s business climate, identified by specific regulation and policies, can promote or discourage foreign investments. The business climate is measured by four variables, that is, procedures necessary to set up an activity, associated time, cost and minimum capital requirement. The ease of entry in a foreign location is a factor that influences the decision to undertake an investment (Root and Adned, 1978; Habib and Zurawicki, 2002). Bitzenis et al. (2009) argues that the average time to register property in OECD countries is 34 days; longer registration time may discourage foreign activities.

Political stability is another element that strongly influences MNEs’ preferences (Kobrin, 1976). Basi (1963), with an extensive survey of international executives, highlighted that, along with market potential, political stability is the most important aspect in foreign investments decisions. Aharoni (1966) obtained similar findings interviewing international personnel in more than 30 multinational companies. On the other hand, Bennett and Green (1972), analyzing a sample of 46 countries, found out that political instability is not a decisive FDI obstacle. They did not find any significant correlation and concluded that US firms’ investment decisions are taken on the basis “other overriding factors”. However, these findings have been methodologically doubted by Kobrin (1976) who pointed out the contradiction between the emphasis they give to the political climate in the survey responses and in the findings. In line with Kobrin, Aristidis et al. (2009), Jun and Singh (1996) and Habib and Zurawicki (2002) conclude that political stability is an imperative for profitability and long-run success.

Local governments play a key role in forming the overall economic environment of a country (Barba Navaretti and Venables, 2007). Their economic policies are implemented to secure domestic interests and/or employment. In some cases they are intended to improve the national welfare, in others they are used to bring advantages to some domestic interest groups (Barba Navaretti and Venables, 2007). According to De Santis and Vicarelli (1999) and Aristidis et al. (2009), Government interference in business operations discourages foreign investments. Also Li (1998) and Canfei He (2006) obtain similar statistical results and conclude that, among Chinese provinces, a higher degree of local authorities’ interference on the market is negatively related to foreign investments’ flows.

Corruption is generally defined by the literature as the “abuse of public power to obtain private benefits” (World Bank, 2006). Whereas corruption in the public sector is the dominant theme, Coase (1979) sustains that it is a widespread phenomenon also between private parties. Despite some studies (Leff 1964, Leys 1965 and Huntington 1968) have demonstrated that in some cases corruption may confer beneficial effects to the economy by acting as an “efficient grease”, the majority of the literature seems more orientated toward the moral and economic condemn. The consensus is reinforced by the bulk of studies that investigate the outcomes of corruption. Effect of corruption on FDI is relatively a new area of interest. Theoretically, it is advanced that it may hinder FDI inflows for several reasons. First, it may be an obstacle when foreign investors consider corruption as morally wrong and decide to stay away from contexts where it is an extensive problem (Habib and Zurawicki, 2002). Second, as corruption hampers the development of a fair market, it does not guarantee equal treatment and equal access among the economic forces which operate in the country (Boatright, 2000). Finally, corruption can be considered as a “tax on profits” since foreign investors have to pay extra costs in the form of bribes in order to get licenses or government permits to conduct investments (Bardhan, 1997).

Aspects regarding the labor legislation are often considered since their effects can more than offset advantages arising from differences in factor endowments and factor costs (Parcon, 2008). According to Görg (2005), labour market regulations played a pivotal role for the location of US firms’ outward activities during the period 1986-1996. In his research he reveals that nations with less stringent labour regulations receive a higher share of American investments. Benassy-Quere, Coupet and Mayer (2007) include three different measures of the degree of labour regulation in their study [3] , and conclude that in general terms strict labour market regulations deter FDI inflows. Similar results are also reached by Javorcik and Spatareanu (2005) and Haaland et al. (2002). Nicoletti et al. (2003) suggest that employment protection legislation (EPL) and labour income taxation can affect FDI patterns in the same way than increasing product market regulations do, that is, by augmenting the relative prices of different products or by lowering the expected return of investing in a given country. Parcon (2008) makes a distinction between wage and non-wage costs [4] . He argues that the mainstream literature frequently measures labour costs using only wage costs; in such a way, the fact that labour costs are formed by wage and non-wage costs is neglected.

Testable Hypothesis

To explain the relatively low attractiveness of SEA countries, the following hypothesis are put forth:

We expect a positive relationship between FDI and market size, trade openness, R&D expenditures, quality of bureaucracy and absence of government interference.

We expect a negative relationship between FDI and geographical distance, labour costs, corporate taxation, political instability, corruption, employment protection legislation and labour income taxation.

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