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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