Foreign Direct Investment and the Business Environment

Direct investment abroad is a complex venture. As distinct from trade, licensing or investment, Foreign Direct Investment (FDI) involves a long-term commitment to a business endeavor in a foreign country. It often involves the engagement of considerable assets and resources that need to be coordinated and managed across countries and to satisfy the principle of successful investment, such as sustainable profitability and acceptable risk/profitability ratios. Typically, there are many host country factors involved in deciding where an FDI project should be located and it is often difficult to pinpoint the most decisive factor. However, it is widely agreed that FDI takes place when three sets of determining factors exist simultaneously; the presence of ownership-specific competitive ages in a transnational corporation (TNC), the presence of locational advantages in a host country, and the presence of superior commercial benefits in an intra-firm as against an arm’s-length relationship between investor and recipient.

The ownership-specific advantages (e.g. proprietary technology) of a firm if exploited optimally can compensate for the additional costs of establishing production facilities in a foreign environment and can overcome the firm’s disadvantages vis-a-vis local firms. The ownership-specific advantages of the firm should be combined with the locational advantages of host countries (e.g. large markets or lower costs of resources or superior infrastructure). Finally, the firm finds greater benefits in exploiting both ownership specific and locational advantages by internalization, i.e. through FDI rather than arm’s length transactions. This may be the case for several reasons. For one, markets for assets or production inputs (technology, knowledge or management) may be imperfect, if they exist at all, and may involve significant transaction costs or time-lags. For another, it may be in a firm’s interest to retain exclusive rights to assets (e.g., knowledge) which confer upon it a significant competitive advantage (e.g. monopoly rents). While the first and third conditions are firm-specific determinants of FDI, the second is location-specific and has a crucial influence on a host country’s inflows of FDI. If only the first condition is met, firms will rely on exports, licensing or the sale of patents to service a foreign market. If the third condition is added to the first, FDI becomes preferred mode of servicing foreign markets, but only in the presence of boa specific advantages. Within the trinity of conditions for FDI to occur, locational determinants are the only ones that host governments can influence directly.

To explain differences in FDI inflows among countries and to formulate inbound investment, it is necessary to understand how MNCs choose investment locations. The relative importance of different location-specific determinants depends on at least four aspects of investment: the motive for investment (e.g. resource seeking or market seeking FDI), the type of investment (e.g. new or sequential FDI), the sector investment (e.g. services or manufacturing) and the size of investors (small and medium sized MNCs or large MNCs). The relative importance of different determinants also changes as the economic environment evolves over time. It is therefore entirely pos that a set of host country determinants that explains FDI in a particular country at a given time changes as the structures of its domestic economy and of the international economy evolve. At the same time, there are also location determinants remain constant. Therefore, there is need to review the location-specific (host-country) determinants of FDI flows and stocks and to analyse how these have changed in a liberalizing and globalizing world economy. The review of host country determinants begins with the role of national policies and especially the liberalization of policies key factor in globalization as FDI determinants. Then follows a review of business facilitation measures: as the world economy becomes more open to international business transactions, countries compete increasingly for FDI not only by improving their policy and economic determinants, but also by implementing pro-active facilitation measures that go beyond policy liberalization. While not as important as the other two determinants, these measures are receiving increased attention. Economic determinants and, in particular, their changing significance in the context of liberalization, global and issues related to the impact of international investment frameworks have bet all the more topical as discussions and negotiations whether at the bilateral, regional or multilateral levels have gathered momentum and the possibility of a multilateral framework on investment has raised questions as to whether, why and how international investment agreements matter for the location of FDI and the activities of MNCs. In particular, a key question is what effect, if any, a multilateral framework on investment might have for the growth and pattern of FDI.

Foreign Direct Investment Policy

As a general principle, host countries that offer what MNCs are seeking, and/or host countries whose policies are most conducive to MNC activities, stand a good chance attracting FDI. But firms also see locational determinants of ownership-specific and internalization advantages in the broader context of their corporate strategies. These strategies aim, for example, at spreading or reducing risks, pursuing oligopolistic competition, and matching competitors actions or looking for distinct sources of competitive advantage. In the context of different strategies, the same motive and the corresponding host country determinants can acquire different meanings. For example, the market-seeking motive can translate, in the case of one MNC, into the need to enter new markets to increase the benefits arising from multi plant operations; in the case of another MNC, it can translate into the desire to acquire market power; and for another MNC, it can aim at diversifying markets as part of a risk strategy.

Core FDI policies consist of rules and regulations governing the entry and operations of foreign investors, the standards of treatment accorded to them, and the functioning of the markets within which they operate. These policies can range from outright prohibition of FDI entry to non-discrimination in the treatment of foreign and domestic firms and even preferential treatment of foreign firms. They typically satisfy various objectives reducing or increasing FDI, influencing its sectoral composition or geographical origin, encouraging specific contributions to the economy and affecting ways in which these contributions are made. To achieve these objectives, FDI policies are usually accompanied by other policies that also influence investors decisions.

Among these supplementary policies used to influence locational decisions, trade policy plays the most prominent role. For example, to attract FDI and to maximize its contributions to their import-substituting development strategies, countries in Latin America used a mix of protectionist trade policies combined with policies allowing FDI in manufacturing. Asian countries, in contrast, used both FDI and trade policies (e.g. exemptions from import duties) to encourage MNCs to contribute to their export oriented economic strategies. For example, Hong Kong, China pursued laissez-faire trade and FDI policies. On the other hand, the FDI policies of such economies as the Republic of Korea, Taiwan Province of China and Japan were embedded in a broader set of industrial policies guiding and selectively inducing MNCs to link up with local firms to help increase local innovative and export capacities.

Other related policies may include Privatization policies and policies determined by the international agreements a country has signed:

  1. Privatization is a special case of acquisition, as it involves purchases of firms from the state. It has two dimensions: an FDI policy dimension and a competition policy dimension. If privatization welcomes foreign investors, it broadens the scope of FDI. The competition-policy dimension becomes relevant if, in industries characterized as natural or near-natural monopolies, the sale of a privatized company to a domestic or foreign investor only means the transfer of a monopoly from the state to a private agent.
  2. International investment agreements provide an international dimension to national FDI policies. Some of them focus on insurance and, protection, while others deal with broader issues.

Policies used intentionally to influence FDI and its location constitutes the “inner ring” of the policy framework for FDI. The features of such a framework vary among countries and also vary over time in the same country. This has become obvious since the broad-front advance of more market-based economic policies. Core FDI policies themselves have become more liberal and, coupled with more liberal trade policies; have contributed to a more cohesive policy framework.

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