The Effects Of Clustering

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China and India, as the two largest developing economies, have experienced rapid increases in FDI flows since 1980 (World Investment report, 2010). China emerges as one of the world most attractive destination for FDI. In absolute terms, China's annual average FDI inflows rises from $3.9bn in 1985-92 to $59 bn in 2001-06 (World investment report, 2007). Since the implementation of "open door" policy in 1991, India has received more FDI into the country. FDI inflow in 2006 was $17.5 bn compared to only $2-3 bn during the 1990s (World investment report, 2007). However, its total FDI is still lagging behind China. The causes of differences in FDI flows between these two countries suggest an interesting area for further research. This literature review aims to examine the determinants of FDI inflows in China and India.

The review is structured as follows: section 1 discusses the determinants of FDI inflows. Section 2 reviews previous empirical studies on FDI determinants in China and India. Section 3 concludes.

What are the determinants of FDI?

According to Blonigen (2005), FDI inflows are determined by both endogenous and exogenous factors. Particularly, internal factors include gross domestic product (GDP), country risk and political risk while external factors range from exchange rates, taxes to trade protection and trade flows. Nonnemberg and Mendonca (2004) studied the determinants of FDI by using panel data analysis for 38 developing countries. They found that market size, the level of education; trade openness, inflation, country risk and per capita energy consumption were significant determinants for FDI flows. Although there are various determinants identified across the literature, the most important factors can be summarized as: market size, political risk, exchange rate, inflation, trade openness, human capital and infrastructure.

Market size:

Market size, as measured by GDP or GNI (Gross national income) per head, is perhaps one of the most important factors in explaining FDI (Chakrabarti, 2001). When a transnational corporation (TNC) aims to produce for the local market, the attractiveness of a particular location may be indicated by the size of a specific market. Once a country's GDP reaches a certain threshold, it offers better opportunities for TNCs to access the market, develop economies of scale and explore profitability.

A survey of literature on FDI determinants, including that of Dunning (1973), Kobrin (1976), Ramirez (2006) and Vijayakumar (2010), had all found evidence about the correlation between FDI and the host countries' market sizes. A study by Ang (2007) on the factors affecting inward FDI in Malaysia also emphasized, along with other determinants, the significance of market size. The analysis suggested that a larger domestic market resulted in more FDI inflows, owing to the benefits of economies of scale.

Agarwal (1980) supported the positive relationship between market size and FDI by reviewing several empirical studies and summarizing the basic factors determining FDI in the host countries. However, this linkage is challenged by Lucas (1993) in an analysis of 7 Asian countries including Indonesia, Philippines, Singapore, Malaysia, South Korea, Thailand and Taiwan. Lucas considered two measures of market size: one focuses on the export market and the other relates to the domestic market. The results showed a weak positive relationship between the size of "domestic consumption spending" and the rate of inbound FDI (in comparison to Agarwal, 1980) and high degree FDI responsiveness to earnings in the main export markets. This probably indicates the outward orientation of foreign firms in these areas.

Political risk

An unstable political environment could be a deterrent to investment, for instance; TNCs prefer a stable government since their investment is more secure. According to Butler and Joaquin (1998), "political risk" is the risk that a sovereign host government will suddenly alter "the rules of the game" under which businesses are operated. Changes in policies and political institutions could make investment unfavourable. Therefore, this would affect the location decision and investment behaviour of TNCs. Some indicators of political risks identified by Sinha (2007) are: currency inconvertibility, negative attitude of the government towards TNCs, non-allowance of fund transfer, corruption, war, coup and threat of a takeover of TNC assets.

Many empirical studies have pointed out the relationship between political stability and FDI inflows. In particular, Wei (2000) concluded that if China and India could reduce red tape and corruption to a level comparable to Singapore, FDI inflows would be 218% and 348% higher respectively for these countries. In contrast, Egger and Winner (2005) found a positive association between corruption and FDI in 73 countries over the period of 1995-99. They suggested that with excessive regulation and administrative controls on hand, corruption may serve as a catalyst for the encouragement of FDI.

Recent studies have considered the linkage between FDI and fundamental democratic rights. Applying different econometric techniques and data, Jesen (2003) and Busse (2004) found that TNCs prefer democracies over dictatorships. However, other studies could not find democracy, political instability or political and economic risk as important FDI determinants (Assiedu, 2002; Li and Resnick, 2003). This lack of significance in those findings could be due to the fact that the outcome of a certain political or economic event's risk appraisal is dependent on the country's FDI portfolio (Busse and Hefeker, 2006). Each country affects this directly by differentiating in guarantees against political risk. Additionally, it is arguable that while political risk is an important consideration, the location decision is also based on many other factors.

Exchange rate:The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk

Exchange rate is the price of domestic currency in terms of a foreign currency. This impacts both the total volume of FDI and the allocation of investment across a range of countries. Depreciation in the value of a currency would have two implications for FDI inflows. Firstly, it reduces the country's wages and production costs compared to those of its foreign counterparts. The real currency devaluation makes the country more attractive towards productive capacity investments. Therefore, the diminished currency value would improve the rate of returns to foreign investors.

Secondly, the depreciated currency in the destination market increases the relative wealth of source country agents and lowers capital costs. This allows investors to make significantly larger investments abroad. Goldberg and Klein (1997) examined the connection between exchange rate and outward FDI from Japan and the US to Southeast Asia and Latin America. Their empirical results suggested that the appreciation of the Yen did stimulate direct investment from Japan to these regions. This was also boosted by the decrease of the Southeast Asian real exchange rate.

In addition to the effects of exchange rate levels, the volatility of exchange rate is also significant. Arguments for volatility effects are broadly divided into "production flexibility" and "risk aversion". The first approach argues that increased volatility is associated with increased FDI and more potential excess for capacity. Goldberg and Kolstad (1995) looked at the link between FDI and short-term exchange rate variability. They supported this hypothesis of the contribution of exchange rate instability to the internationalization of production. On the other hand, the "risk aversion" argument suggests that if the exchange rate is highly volatile, the expected returns of investments are reduced. Cushman (1985) studied the impacts of real exchange rate risk and anticipations on FDI. The results indicated that increases in the current real foreign exchange value reduced the US FDI significantly and the expectations of appreciated real foreign exchange reduced this further. The two approaches mentioned provide different predictions of exchange rate volatility implications for FDI. Which one is better at explaining the influence of exchange rate movements on FDI requires further evidence.

Inflation:

The stability of macroeconomic policy, especially price stability is fundamental for investment and growth (Rogoff and Reinhart, 2003). In its absence, the risks of conducting business increases intensely and external and internal trades are hindered significantly.

A high and unpredictable rise in price level indicates the instability of the macroeconomic policy of the host country. This consequently creates a form of uncertainty that hampers potential investment (Razafimahefa and Hamori, 2005). More specifically, higher inflation will drive up prices and curb investment due to increases in interest rates. Therefore, TNCs' decision of investing in the host country can be adversely affected by the price volatility which raises the costs of doing business.

Estrin et al. (1997), Majeed and Ahmad (2009) found that high inflation reduced the interest of TNCs in the host country as it raised the relative costs of production. Glaister and Atanasova (1998) looked at the impact of inflation on employment in Bulgaria. Their analysis showed that although inflation did not have a direct impact on FDI, it did influence factors such as wages, unemployment and economic growth. These factors formed important criteria for firms when making investment abroad, therefore affecting FDI.

To contest the above, Akinkugbe (2000) found that inflation rate was not significant in explaining FDI in developing countries. However, Udoh and Egwaikhide (2008) challenged this result by applying the data in the case of Nigeria. Their finding was consistent with others that high inflation contracted FDI inflows. One possible explanation for the lack of significance in Akinkugbe (2000) model is that the inflation rate was used instead of inflation rate uncertainty as employed by Udoh and Egwaikhide (2008); this may lead to inaccurate inference on the link between FDI and inflation. Hence, another finding would probably be obtained if the inflation rate uncertainty was adopted.

Trade Openness:

Trade reforms have been historically given much attention with regards to the role of economic freedom in attracting FDI. The degree of openness to trade is generally measured by the proportion of exports and imports to GDP. This ratio is usually clarified as "quantification of trade restrictions".

The effects of trade openness on FDI were examined by Kokko and Blomstrom (1997). The study showed that fewer restrictions on investment and more trade liberalization had different impacts on FDI, depending upon the motives of firms involved. Particularly, horizontal FDI is "market seeking" and TNCs, instead of exporting from the home country, may prefer direct investment in the host country to avoid trade barriers. Conversely, vertical FDI is "efficiency seeking" where TNCs may invest in a relatively open economy as trade openness enables multinationals to operate more effectively across borders.

Lee (2005) found that trade restrictions such as quotas and tariffs affect multinationals' behaviour in host countries. Import tariffs, in particular, would force TNCs to conduct manufacturing in the host country. Belderbos (1997) analyzed the correlation between FDI and trade barriers in the case of Japanese firms in the electronics sector. The findings showed that protectionist measures taken by the US and the European Union induced Japanese "tariff jumping" FDI. This is where trade protection tends to boost FDI as firms try to lower their costs through shifting production rather than exporting from home. Culem (1988) and Bolonigen and Feenstra (1997), however; found a negative relationship between FDI and trade control. Their explanation is that trade limitation may be taken as a sign of policy imperfections such as "exchange rate control", resulting in a contraction of FDI inflows.

Liberal trade policies mirrored by the openness of an economy are an important factor driving export-oriented FDI. Openness makes the transfer of goods and capital in and out the host country easier in the absence of restrictions, and thus stimulates production and reduces costs (Singh and Jun, 1995). Balasubramanyam et al. (1996), using cross-country data for 46 developing economies concluded that trade openness is essential for gaining the potential growth benefit from FDI. They argued that countries more open to trade attracted higher amount of FDI and better utilized the investment than closed economies.

Human capital:

Since the 1980s, there have been considerable changes in the sectoral composition and location determinants of FDI. As a result of great advances in technology, FDI inflows have shifted towards more capital, knowledge and skill-insensitive manufacturing. Comparative location advantage is not limited to "tangible location" factors but also consists of "intangible assets" such as infrastructure, institutional framework and human capital which become increasingly important to competitiveness. The quality of human capital in a country is crucial for technology transfer, managerial techniques and spill-over effects of FDI.

The important role of human capital in determining FDI has been embodied in literature. For instance, Zhang and Markusen (1999) identified skilled human capital as a prerequisite and a significant determinant of FDI inflows. Sinha (2007) maintained that efficiency-seeking FDI or vertical FDI took place only when there was enough efficient labour in specific host countries. Sinha states that the recent "Business process outsourcing" boom in India occurs thanks to the qualified workforce well-skilled in English-speaking and technologically educated in "IT enabled services".

Narula (1996) examined the determinants of FDI in 22 developing countries during the periods of 1975, 1979, 1984 and 1988. He showed that while the technology capacity was significant but concluded with an unexpected negative relationship, the correlation to human skills was insignificant. Narula implied that the level of a country's economic structure better explained the extent of FDI activities in developing countries. These results were different from those received for 18 industrialized countries, where skills of human and technological competency were highly significant. Narula argued that FDI into industrialized economies was planned to seek complementary "created assets" and also that the existence of human capital played an increasingly essential part when countries progressed along their development path.

Infrastructure:

Infrastructure is a vital factor for growth and globalization. It is known to be a parallel process to development as its dynamic incentive and association to the economy are diversified and intricate. It also influences manufacturing and consumption directly, and creates spill-over and developmental effects.

The World development report (1994) classified infrastructure into physical and social-institutional infrastructure. The former comprises services such as transport, roads, water system, electricity and communication, whilst the latter consists of health facilities, education and other forms. The report also emphasized the significance of infrastructure as an integral factor for: expense reduction, better utilisation of potential resources and factors of production, enhancing the distribution networks and coordinating the market forces. It is, therefore, an important location determinant of FDI.

Studies on the relationship between infrastructure and FDI seem to show a highly positive correlation. The empirical evidence demonstrates that countries possessing adequate levels of infrastructure facilities tend to attract more FDI. Considering FDI determinants in American TNCs in electronics and manufacturing, Wheel and Mody (1992) found that the quality of infrastructure is an important predictor of FDI in less developed countries. They also suggested that taxes and other short-term incentives only had limited impact on FDI since transfer pricing and foreign tax deduction provided different ways to lower the total taxes paid.

Belderbos et al (2001) verified the importance of the size of regional component industry and infrastructure base for Japanese multinational corporations' vertical linkages of FDI. Mohan (2004) analysed FDI in the Association of Southeast Asian Nations (ASEAN) and found that transportation services including all modes of transport such as see, air, land, internal gateways and related support service are a determinant of FDI in this region.

FDI determinants in China and India - Empirical evidence:

China:

China has emerged as one of the world main host of FDI in recent years. Its significant market reforms combined with rapid economic growth have created great investment opportunities for foreign corporations. Many empirical studies have attempted to find out the determining factors for FDI inflows in China. An example is the study by Wei (2005) exploring determinants of FDI from OECD countries to China in the period between 1987 and 2000. The analysis found significant correlation between FDI and relative market size, real exchange rate and "international trade ties". Among these indicators, domestic market size appeared as the major driving force for outward FDI from OECD countries to China. This seems to be convincing as China has a huge domestic market with a mass-production system, which considerably reduces production costs. This factor coupled with "business-oriented" and "FDI friendly" policies consequently increases the attractiveness of China to multinationals. The results provide background explanations for FDI inflows in China, however, it should be taken into account that the source of FDI from OECD countries does not take up a large proportion of China's inward FDI. Therefore, the finding should be considered with caution.

Matthew et al. (2008) analysed the determinants of inward FDI distribution among provinces in China from 1993 to 2003. Their focus was on the indicators of political risks including "province corruption level" and "governance". They found that provinces which provided better efforts to tackle corruption and possessed effective local governments tended to receive more FDI. The analysis also suggested that if provinces with "anti-corruption effort" below the average level could improve their efforts to the average, they would be able to attract more FDI. For instance, a 10 % increase in the "anti-corruption effort" would boost FDI to more than $ 40 million in the following year.

Another study on the determinants of FDI is by Xi et al. (2008) focusing on a particular region of China. They found that FDI in Eastern China was positively related to market size and labour quality, whereas; education and infrastructure were statistically insignificant in explaining FDI. Wei et al. (2010) analyzed the location factors and "network relations" of TNCs in Nanjing, China. This research confirmed the importance of government policy and infrastructure in the location decision of TNCs. Specifically, government intervention through investment policies was considered as one of the key factors determining FDI since it indicates the significant role of government in the expansion of FDI. Moreover, infrastructure factors such as access to ports and industrial lands also contributed to the location attractiveness for FDI.

The two studies above provide a better understanding of FDI determinants in specific regions of China but only at a micro-state level. The chosen explanatory factors may generate different results when applied to different regional analyses. Therefore, it does not give a full picture of FDI and its determinants in China.

India:

India's policies towards FDI have gone through remarkable transformation since 1991. The country has opened its door to encourage more FDI and as a result of this, India has enjoyed considerable increases in inward FDI over the last decade. What has driven the growth of FDI in India is of important and has raised the interest for further investigation. However, there are only a decent number of empirical studies trying to indentify major determinants of FDI in India, compared to divergent analyses for China.

One of those studies is that by Pradhan (2010), examining the role of trade liberalization on FDI inflows in India between 1980 and 2007. He found that trade openness had a positive relationship with FDI and that this association was much stronger after the economic reforms since 1991. This implies the necessity of maintaining an "open door" policy to attract more FDI into the Indian economy. The analysis also found the significant impacts of other factors including real exchange rate and terms of trade on inward FDI in India during this period.

In a current study of FDI determinants in India, Resende (2010) found the evidence supporting the positive impacts of exchange rate instability, trade openness and market size on FDI. In particular, domestic market size and the attractiveness of the market appeared to be the most significant factors determining the inflows of FDI into India. Poor infrastructure, on the other hands, deterred multinationals from investing in the country.

Green (2005) explored FDI in a specific Indian industry sector: telecommunications from 1993 to 2003. Econometric tests were applied to evaluate factors influencing the volume of FDI. The results showed that FDI would gain more traction if the government take actions to reduce the limits on investment, maintain transparent regulations and improve physical infrastructure in the telecommunications sector. This conclusion seems to be appropriate as the evidence of FDI performance in this sector during the chosen period showed that foreign firms entering the telecommunications industry did not stay in the business for a long time. The reasons behind this were that FDI in telecommunications had long suffered from poor infrastructure, non-transparent regulatory and legal environment.

Among infrequent macro-level studies on FDI in India, Mukim and Nunnenkamp (2010) investigated factors determining the location decision of TNCs to invest in 447 districts of India. The analysis suggested that infrastructure and the availability of skilled workforce played important roles in the location choice of foreign enterprises. However, the study suffered from data limitations with regards to FDI determinants at district-level. This consequently reduces the reliability of its results and hence cannot be applied generally.

Conclusion:

This paper has reviewed the important literature on the determinants of FDI in China and India as well as related countries. In particular, the main factors have been identified as market size, political risk, exchange rate, inflation, trade openness, human capital and infrastructure. These key elements by and large determine the forms and geographical locations of FDI.

Market size reflects the attractiveness of a specific market, which provides opportunities for TNCs to develop economies of scale and realize potential profits. Most of empirical studies seem to agree that the size of a host country market has a positive impact on FDI. Similarly, infrastructure is considered as a driving force for growth and investment. Its significant effect on FDI inflows has been confirmed in numerous studies.

There is a general consensus on the role of human capital as a positive indicator of FDI due to significant changes in the sectoral composition and location determinants of FDI. Many studies have sought to show the correlation between human capital and FDI, but no large positive impact has really been observed. Most of the findings are inconclusive and some are unreliable.

The directions of exchange rate and trade openness effects on FDI are uncertain as there are divided views among the literature. For the former factor, it is suggested that the real currency devaluation would make a country more attractive to FDI, although; exchange rate instability comprises both negative and positive impacts. Similarly, how trade openness affects FDI depends on the type of FDI and motives of firms for investment. Specifically, horizontal FDI is encouraged by trade restriction while vertical FDI would be stimulated by trade liberalization.

Political risk and inflation generally tend to have negative linkages to FDI. There are a few studies resulting in positive or no correlations between those factors and FDI. However, majority of those studies do not always apply or exhibit some problems in the adopted models.

In spite of divergent studies on FDI determinants, there are gaps in the literature regarding FDI for individual countries. Many studies focus on groups of countries with India and China included, but there is limited literature concerning the two countries separately, especially from India. There are a few analyses such as that by Anantarm (2004) investigating determinants of FDI in India at a micro- state level and his result cannot be applied to a macro-scale analysis. Wei (2004) attempts to explore FDI in India and China, however; his research focuses predominantly on China. There are inadequate numbers of studies considering FDI in India by Kurma (1990) and Venkatachalam (2000) compared to various studies on East Asia, China and ASEAN countries. This provides a starting point for further research exploring the determinants of FDI in India to eventually compare and justify the differences in total FDI between China and India.

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