Theme 3 DETERMINANTS OF FDI Part I. Host country determinants of FDI Part II. Firm level determinants of FDI Kampala, 10

1. 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

2. Part IHOST COUNTRY DETERMINANTS OF FDIWhy some countries receive more FDI than others? Why a host country’s FDI inflows may drastically fluctuate over time?What determines how much FDI does a host country receive?

3. Case 1. Brazil’s FDI inflows from 1970 to 2007Questions: Why Brazil’s 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?

4. 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?

5. Case 3. Investors’ perspective: what TNCs consider important when choosing a location?

6. 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., R&D, brands, customers base, marketing or other capabilities)

7. 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 M&As

8. Each type of FDI has a different set of economic requirements

9. 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

10. 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

11. 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

12. 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)

13. 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 country’s 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

14. 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 M&A 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 • Trade policy (tariffs and NTBs) and coherence of FDI and trade policies • Tax policy • TO NAME A FEW…….. B. Resource -seeking • 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 III. Business facilitation C. Efficiency- seeking • 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 M&As for a variety of strategic reasons D. Strategic asset- seeking • Availability of firm-specific assets: technological, innovatory, marketing, brand names, etc. • 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

15. 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. M&As) 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

16. 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

17. Back to the Brazil, China and India: how determinants can make a difference?

18. 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

19. Brazil’s peak in 1997-2000: privatization • Brazil’s 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

20. 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

21. CHINA Both market-seeking and export-oriented FDI mainly into manufacturing The share of FDI in exports: 1989 9% > 2002 50% (91% in technologically quite advanced products) INDIA Mainly market-seeking with the exception of IT services (call centres, back-office services, R&D) The share of FDI in exports: 3% in the 1990s > 10 % now Type of investment

22. 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 Strategies and policies

23. 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

24. 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

25. 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 > 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) > FDI as a capital flow replaces home country exports. Later empirical evidence has proved it wrong. FDI and trade are largely complementary

26. Micro-level approach: Hymer’s 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

27. 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

28. 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

29. 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

30. OLI paradigm (Dunning) – a framework integrating various explanations of international production • O – ownership-specific (or competitive) advantages, discussed earlier, permitting to overcome the firm’s 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

31. I-advantages are benefits of exploiting O&L advantages through FDI rather than arm’s 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 firm’s 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

32. 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

33. 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

34. TNC as a sequential process (Vernon, Swedish school). TNCs move to FDI gradually

35. 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

36. Towards integrated production

37. Stand-alone, multi-domestic

38. Simple integration -- outsourcing

39. Complex, vertical integration

40. From shallow to deep integration between parents and affiliates Shallow Integration Deep Integration FINANCE FINANCE FINANCE FINANCE PRODUCTI0N PRODUCTI0N PRODUCTI0N PRODUCTI0N R&D R&D R&D R&D ACCOUNTING ACCOUNTING ACCOUNTING ACCOUNTING PROCUREMENT PROCUREMENT PROCUREMENT PROCUREMENT TRAINING ETC. TRAINING ETC. TRAINING ETC. TRAINING ETC. COUNTRY A COUNTRY B COUNTRY A COUNTRY B INTER-FIRM ARM’S LENGTH TRADE IN GOODS AND SERVICES BASED ON DIVISION OF LABOUR BETWEEN INDEPENDENT PRODUCERS 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

41. REAL LIFE EXAMPLES OF INTERNATIONAL INTEGRATED PRODUCTION

42. Ford network in Europe in the 1960s: economies of scale and specialization

43. Toyota: from exports to multi-domestic affiliates to regional networks

44. Toyota’s domestic and international production, 2004

45. Toyota: global supply network of finished products (vehicles)

46. Toyota: regional supply network of finished products, components and services