UNCTAD VIRTUAL INSTITUTE TRAINING PACKAGE ON ECONOMIC AND LEGAL ASPECTS OF INTERNATIONAL INVESTMENT

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UNCTAD VIRTUAL INSTITUTETRAINING PACKAGE ON
ECONOMIC AND LEGAL ASPECTS OF INTERNATIONAL
INVESTMENT AGREEMENTS (IIAs)Module 1Concepts,
trends and economic aspects of foreign direct
investment

• Theme 3
• DETERMINANTS OF FDI
• Part I. Host country determinants of FDI
• Part II. Firm level determinants of FDI
• Kampala, 10-14 November 2008
• Zbigniew Zimny
• UNCTAD consultant

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Part IHOST COUNTRY DETERMINANTS OF FDIWhy some
countries receive more FDI than others? Why a
host countrys FDI inflows may drastically
fluctuate over time?What determines how much FDI
does a host country receive?
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Case 1. Brazils FDI inflows from 1970 to
2007Questions Why Brazils inflows were lower
during 1983-1994 than in 1983? Why they started
recovering only after 1995? Why did they peak
during 1997-2000 and then fell again?
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Case 2. India vs. China (with Brazil as a
reference) since 1980QUESTION Since China has
emerged as a host country, it has always received
much larger FDI inflows than India. Why?
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Case 3. Investors perspective what TNCs
consider important when choosing a location?
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Sorting out host country FDI determinants

• To answer these questions and explain differing
  records of countries in attracting FDI we need to
  understand key factors determining FDI inflows
  into countries
• As a rule, countries that offer what TNCs seek
  stand a greater chance to attract more FDI
• TNCs seek many things (called locational
  advantages) in host countries. Key among them are
  economic attractions including
• ? natural resources (giving TNCs access to, and
  control of, natural resources)
• ? large and dynamic domestic markets and access
  to international markets (permitting TNCs to grow
  faster than in national markets, spread the risks
  and better service the markets)
• ? lower costs of resources such as labour and
  other inputs, e.g., infrastructure services
  (permitting TNCs to reduce costs of production
  and operations)
• ? availability of firms possessing assets
  needed by TNCs (e.g., RD, brands, customers
  base, marketing or other capabilities)

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What TNCs seek in host countries determines the
types of FDI

• Access to a large domestic (Brazil, China, India)
  or regional market (EU, NAFTA, ASEAN)
  horizontal FDI

• Mining
• Tourism
• Oil and gas extraction,

Natural resource -seeking
Market-seeking
TNCs
Efficiency-seeking
Strategic-asset seeking

• Divide and specialize production
• in line with the comparative advantages
• of different locations vertical FDI
• export-oriented FDI

• primarily through MAs

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Each type of FDI has a different set of economic
requirements
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Three groups of host country FDI determinants

• Economic attractions are very important but they
  are only one group of host country determinants
• The two other groups are
• ? Policy determinants divided into two
  sub-groups
• 1. FDI policy proper including policy
  measures affecting only or mainly foreign
  investors
• 2. Policies affecting all investors. Some of
  them may be more and some less important for
  foreign investors
• ? Business facilitation, including investment
  promotion

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Policy as FDI determinant core FDI policies

• Rules and regulations governing the entry and
  establishment of foreign investors in a host
  country
• -- e.g., prohibition of entry, restrictions on
  ownership (joint venture requirement) or
  liberalization of entry
• Treatment of foreign investors concerning entry,
  establishment and operations
• -- non-discrimination in the treatment of
  foreign and domestic firms (national treatment)
  and among foreign firms (most-favoured nation
  treatment)
• -- preferential treatment of foreign or domestic
  firms (e.g., incentives only to FDI)
• -- distinguish treatment before and after entry
• Protection of foreign investors
• -- expropriation and nationalization fund
  transfers and dispute settlement are key issues
  in protection
• -- protection against regulatory takings is a
  new issue

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Key general policies that affect FDI
Tax policy
Trade policy

• tax heavens
• tax incentives
• corporate and
• personal taxes

• import-substitution vs.
• export-orientation
• membership of regional
• integration schemes

General policies affecting FDI
Privatization policy

• Monetary
• fiscal
• exchange rate policies

Policies affecting economic, political and
social stability

• can be a powerful
• determinant of FDI
• inflows

NOTE THERE ARE MANY OTHER POLICIES AFFECTING FDI
IN ONE WAY OR THE OTHER, RANGING FROM EDUCATIONAL
POLICIES THROUGH LABOUR MARKET POLICIES TO
ENVIRONMENTAL AND SECTORAL (E.G., MINING) POLICIES
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What is Investment Promotion?

• Investment promotion is undertaken by Investment
  Promotion Agencies (IPAs). WAIPA has a membership
  of 231 agencies from 156 countries.
• INVESTMENT PROMOTION FUNCTIONS
• Image-building (advertising, exhibitions,
  missions, seminars on investment opportunities ?
  marketing a host country)
• Investor generation and targeting (industry
  specific activities direct mail campaigns,
  missions, seminars, targeting individual
  investors, e.g., Intel to invest in Costa Rica)
• Investment facilitation (all types of help to new
  and existing investors counselling services,
  applications and permits, post-investment
  services)
• Policy advocacy with a view to improving the
  investment climate (policy task forces, lobbying
  activities, drafting laws and policy
  recommendations, reporting investors
  perceptions)

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Why Investment Promotion may matter?

• When choosing investment locations, TNCs
• face market failures in information due to high
  transactions costs of collecting information
  about investment locations.
• Their information base is far from perfect and
  their decision making process is often subjective
  and biased
• Most TNCs consider only a small range of
  potential investment locations and many countries
  (with real investment opportunities) are not even
  on their map
• Through investment promotion Governments can
• bridge or diminish the information gap by
  providing better information and improving the
  countrys image
• help foreign investors reduce the costs of
  entering, establishing and operating in the
  country
• better understand and meet the needs of investors
  and improve the investment climate through policy
  advocacy

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Host Country Determinants of FDI
Host country determinants
Type of FDI by motives of TNCs
Principal economic determinants in host countries

• I. Policy framework for FDI
• Economic, political and social stability
• Rules regarding entry and operations
• Standards of treatment of foreign affiliates

• Market size and per capita income
• Market growth
• Access to regional and global market
• Country specific consumer preferences
• Structure of markets

A. Market- seeking

• Policies on functioning and structure of
  markets (especially competition and MA policies)

• International trade and FDI agreements

• Availability of raw materials and natural
  resources (e.g., for tourism)
• Cost of raw materials
• Physical infrastructure (ports, roads, railways,
  power, telecom)

• Privatization policy

B. Resource -seeking

• Trade policy (tariffs and NTBs) and coherence
  of FDI and trade policies
• Tax policy
• TO NAME A FEW..

• Availability cost of skilled labor

• Low-cost unskilled labour or skilled labour
• Cost of resources and labour adjusted for
  productivity
• Other input costs, e.g. transport and
  communication costs to and from and within host
  economy
• Regional integration agreements (inter-country
  division of labour)

II. Economic determinants
C. Efficiency- seeking
III. Business facilitation

• Investment promotion

• Investment incentives

• Hassle costs or red tape (corruption,
  administrative efficiency, etc)
• Social amenities (quality of life, bilingual
  schools etc.)

• Note this type of FDI takes place through
  cross-border MAs for a variety of strategic
  reasons

• Availability of firm-specific assets
  technological, innovatory, marketing, brand
  names, etc.

D. Strategic asset- seeking

• Good infrastructure and support services e.g.
  banking, legal accountancy services

• Buying market power or new markets, spreading
  risks, lowering transaction costs

• Social capital attitude to work

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Notes on host country FDI determinants

• FDI determinants differ according to the type
  (motive) of FDI (e.g. efficiency-seeking or
  market-seeking), the mode of entry (greenfield
  vs. MAs) and the sector of investment (services
  or manufacturing)
• A number of determinants are important to all
  investors e.g., political and economic
  stability, the rules of entry, establishment and
  treatment of FDI and protection of FDI
• Typically there are many host country factors
  involved in deciding where an FDI project is
  located
• It is often difficult or impossible to pinpoint
  to the most decisive factor
• The interrelationships among the three sets of
  determinants must be borne in mind
• Economic determinants are key determinants
  countries that do not have them will not attract
  a given type of investment

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Notes continued

• Strong economic determinants (e.g., large and
  dynamic market, oil, or privileged access to
  large markets) can bring much FDI in less than
  perfect business environment
• The importance of two other sets of determinants
  should be considered under the assumption other
  things being equal
• Economic attractions being equal or similar,
  countries whose policies are most conducive to
  TNC activities, stand a better chance of
  attracting FDI
• Other things being equal, incentives or FDI
  promotion can win an investment project

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Back to the Brazil, China and India how
determinants can make a difference?
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Brazil in the 1970s and 1980s loss of stability

• Debt crisis hit Brazil in 1983
• Severe macroeconomic and political instability
  followed large budget deficit, hyperinflation
  (3,000 in 1990!) and low growth (GDP per capita
  fell)
• The Real Plan in 1994 restored stability
• In 1995 FDI inflows exceeded pre-crisis level and
  started growing again

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Brazils peak in 1997-2000 privatization

• Brazils privatization programme was among the
  biggest in the world, valued at 105 bln from
  1991 to 2002
• Largest sales, 65 bln, took place in 1997-1998,
• With big privatizations of utilities completed,
  unprecedented FDI inflows proved to be
  unsustainable until 2007 due to large FDI in
  metal mining

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China vs. IndiaMarket size and growth

• The size of population is not much different but
  China has much higher income per capita, more
  than two times larger market and has grown much
  faster than India

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Type of investment

• CHINA
• Both market-seeking and export-oriented FDI
  mainly into manufacturing
• The share of FDI in exports 1989 9 gt 2002 50
  (91 in technologically quite advanced products)

• INDIA
• Mainly market-seeking with the exception of IT
  services (call centres, back-office services,
  RD)
• The share of FDI in exports 3 in the 1990s gt 10
  now

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Strategies and policies

• CHINA
• Opened to FDI in 1979 and liberalized
  progressively
• In spite of restrictions and requirements it
  favoured FDI over domestic firms
• Privileges to foreign firms led to FDI
  round-tripping estimated at 25 of FDI

• INDIA
• Permitted FDI long before China did but started
  liberalizing seriously since 1991
• India pursued for a long time import-substitution
  strategy relying on domestic resources and firms
• Trying to encourage FDI only in high-tech

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Less red tape in China?

• China has higher literacy and education rates and
  better physical infrastructure in coastal areas
• Procedures are easier, decisions taken more
  rapidly, business laws more flexible, labour
  climate better and entry and exit of firms easier
• India has (a narrow) advantage in skilled IT
  manpower and language skills
• Overseas Chinese in Asia invest much more in
  China than overseas Indians do in India
• CHINA COMES UP MUCH HIGHER THAN INDIA AS AN FDI
  DESTINATION IN INVESTORS SURVEYS

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Part IIFIRM LEVEL DETERMINANTS OF FDIWhat
explains FDI? Why firms invest abroad?What are
their underlying motivations and strategies?SO
FAR WE HAVE DISCUSSED WHAT FIRMS ARE SEEKING WHEN
INVESTING ABROAD IGNORING THE QUESTION WHY THEY
INVEST INSTEAD OF EXPORTING OR SELLING THE
TECHNOLOGYFOR NON-TRADABLE SERVICES THE ANSWER
IS SIMPLE FDI IS THE ONLY WAY TO SELL SERVICES
ABROAD. BUT IT IS NOT SO FOR MANUFACTURING GOODS
WHERE THERE ARE OTHER OPTIONS TO SERVICE FOREIGN
MARKETS
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Early macro-level theories not helpful in
explaining the internationalization of economic
activity through TNCs/FDI

• In the world assumed by trade theory TNCs could
  not exist gt immobile production factors
  (including capital) and no scale economies
• FDI as a capital flowing from countries with
  capital surplus to countries with deficit. Wrong
  most FDI in the world is among capital-rich
  areas
• FDI and trade as substitutes (Mundell, 1957) gt
  FDI as a capital flow replaces home country
  exports. Later empirical evidence has proved it
  wrong. FDI and trade are largely complementary

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Micro-level approach Hymers contribution

• Inspiration from industrial organization theory
• Starting point in serving a particular market,
  domestic firms have an intrinsic advantage over
  foreign firms. They have better local connections
  and a better understanding of the local business
  environment, the nature of the market, business
  customs and legislation and the like
• Consequently foreign firms wishing to produce in
  that market have to possess some kind of a
  firm-specific advantage to offset the advantage
  held by the domestic firms

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Sources of firm-specific advantages

• Firm size and economies of scale
• Market power
• Marketing skills (e.g., brand names or
  advertising strength)
• Technological expertise (either product, process
  or both)
• Managerial expertise
• Access to cheaper sources of finance
• Once established, the control of productive
  assets abroad multinationality itself
  becomes a source of competitive advantage

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The focus on the internal ownership-specific
characteristics of TNCs has become an accepted
part of the theoretical literature and has laid
ground for the theory of international production
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Better understanding of FDI/TNCs

• FDI is a mechanism by which TNCs maintain control
  over productive activities abroad
• It means international production rather than
  international exchange or merely a capital flow
• FDI is primarily about the transfer of
  non-financial assets (such as knowledge or
  technology) across different countries by TNCs
  while still retaining the property or control of
  such assets

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OLI paradigm (Dunning) a framework integrating
various explanations of international production

• O ownership-specific (or competitive)
  advantages, discussed earlier, permitting to
  overcome the firms disadvantages vis-à-vis local
  firms
• L locational advantages of host countries, or
  host country determinants of FDI, discussed
  earlier, such as natural resources, large and
  dynamic markets, lower costs of labour and/or
  superior infrastructure
• I internalization advantages

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I-advantages are benefits of exploiting OL
advantages through FDI rather than arms length
transactions

• Markets for assets or production inputs
  (technology, knowledge or management) may be
  imperfect and involve significant transactions
  costs or time lags
• The major incentive for internalization of
  markets is uncertainty over the availability,
  price or quality of supplies or of the price of
  firms product
• A firm may prefer to retain exclusive right to,
  or at least control of, assets, called core
  assets (especially a new technology or a brand
  name), which confer upon it a significant
  competitive advantage resulting in higher profits
  or monopoly rents
• Internalization is especially likely to occur in
  the case of knowledge

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FDI takes place when three sets of OLI advantages
exist simultaneously

• If only the first condition is met (O
  condition), firms will rely on exports, licensing
  or a sale of patents to service a foreign market
• If the third condition (I) is added to the
  first (O), FDI becomes the preferred mode of
  servicing the foreign market (or undertaking
  efficiency-seeking investment), but only in the
  presence of location-specific advantages

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Notes on OLI paradigm

• The paradigm is sometimes criticized as a list of
  factors explaining a TNC rather than the
  explanation itself
• Theoretical relations between the different
  factors too often remain un-theorized
• It is however widely used as a conceptual
  structure within which specific cases of FDI can
  be examined
• How the three conditions for FDI are satisfied
  varies according to the type of FDI

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TNC as a sequential process (Vernon, Swedish
school). TNCs move to FDI gradually
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Changing strategies and structures of TNCs

• From stand-alone to integrated strategies (or
  from horizontal to vertical FDI)
• From simple integration to complex integration
• From multi-domestic to regional and global
  structures
• CHANGING STRATEGIES AND TYPES OF INTERNATIONAL
  PRODUCTION LEAD TO SHIFTS IN LOCATIONAL
  DETERMINANTS OF FDI

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Towards integrated production
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Stand-alone, multi-domestic
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Simple integration -- outsourcing
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Complex, vertical integration
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From shallow to deep integration between parents
and affiliates
Shallow Integration
Deep Integration
FINANCE
FINANCE
FINANCE
FINANCE
PRODUCTI0N
PRODUCTI0N
PRODUCTI0N
PRODUCTI0N
RD
RD
RD
RD
ACCOUNTING
ACCOUNTING
ACCOUNTING
ACCOUNTING
PROCUREMENT
PROCUREMENT
PROCUREMENT
PROCUREMENT
TRAINING ETC.
TRAINING ETC.
TRAINING ETC.
TRAINING ETC.
COUNTRY B
COUNTRY A
COUNTRY B
COUNTRY A
INTER- AND INTRA-FIRM EXCHANGE OF GOODS,
SERVICES, PERSONNEL BASED ON DIVISION OF
LABOUR AND AS PART OF INTEGRATED PRODUCTION, WITH
COMMON GOVERNANCE OF TNCs OVER MOST FUNCTIONS
INTER-FIRM ARMS LENGTH TRADE IN GOODS AND
SERVICES BASED ON DIVISION OF LABOUR BETWEEN
INDEPENDENT PRODUCERS
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REAL LIFE EXAMPLES OF INTERNATIONAL INTEGRATED
PRODUCTION
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Ford network in Europe in the 1960s economies of
scale and specialization
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Toyota from exports to multi-domestic affiliates
to regional networks
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Toyotas domestic and international production,
2004
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Toyota global supply network of finished
products (vehicles)
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Toyota regional supply network of finished
products, components and services