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National and Kapodistrian University of Athens Department of Economics Master of Science in the Management

National and Kapodistrian University of Athens

Department of Economics

Master of Science in the Management and Administration of Business and Organization

Strategic Management pathway




This paper analyzes the determinants and policies to attract IB 1 & FDI 2 & ME 3 foreign direct investments, and why some country attract more than others. The scope of international transactions has changed considerably in the past thirty years with international trade in services and foreign direct investment (FDI) becoming increasingly important. As a result, the research effort into these two areas has intensified, especially in FDI. While FDI has traditionally been the domain of academics in the international business community, international trade theorists have recently moved into this area. The lack of a general model of FDI has resulted in a wide variety of approaches to answering the question of why firms would seek to locate production facilities in another country. These approaches vary in terms of their choice of independent and dependent variables. 4 The changes just described offer huge intellectual challenges both to scholars interested in the locational strategies of firms and especially those of multinational enterprises (MNEs) and to those researching into the actions of extra market actors, as each seeks to advance their economic and social goals in a global market economy. Of course, international economists have long since attempted to identify and evaluate the determinants of cross border economic activity. 5

1 International business

2 Foreign Direct Investment

3 Multinational enterprises

4 Bijita Bora Foreign Direct Investment: Research Issues, the international distribution of multinational production

5 Dunning J., Gugler P. Foreign Direct Investment 84p

1. Why some countries attract more foreign investment than others

Most of empirical analyses on the determinants of FDI use cross-country regressions to identify country characteristics such as market size, labor cost, labor skills, and political instability that attract of deter FDI. Fig 1 presents the effect of some variable that have been extensively use in the literature. 6


that have been extensively use in the literature. 6 Fig1 6 Elizabeth Asiedu On the determinants

6 Elizabeth Asiedu On the determinants of FDI to developing countries: is Africa different? University of Kansas p3

Accordant to dunning ingredients are threefold, the first is the form and content of factor endowments both natural and created possessed by the trading or investing entities. This comprises the physical environment (PE) within which firms make their locational choice. The second is the policies and institutions of the participating organizations. Together with the needs and aspirations of the various constituents of society, these make up the human environment (HE) facing firms. The third is the specific situations under which particular products can be produced and traded; e.g. whether they are subject to economies of scale or scope, and/or whether the firms producing them, benefit from being part of a geographical cluster of related firms or institutions. This I shall refer to as the contextual environment (CE) facing firms.


cluster of related firms or institutions. This I shall refer to as the contextual environment (CE)


Return on investment in the host country FDI will go to countries that pay a

Return on investment in the host country

FDI will go to countries that pay a higher return on capital. But finding an appropriate measure for the return on investment is problematic, especially for developing countries, thereby making testing this hypothesis very difficult. This is because most developing countries do not have well- functioning capital markets, and therefore it is difficult to measure the return on capital 7 .

The competition to attract inward FDI by a wide range of economies has resulted in a number of responses. First, there have been widespread policy changes more specifically, a marked trend towards the liberalization of regulatory frameworks (UNCTAD, 1999). Second, competition for FDI has contributed to the growing provision of incentives and inducements (Mytelka, 1999). Third, for a number of economies, the desire to avoid extreme competition has encouraged more Selective targeting. Ireland is an example of a country that has increased its focus on particular industries, and even particular companies within those industries. It is this area of selective targeting that is addressed in this article and, particularly, the idea that FDI varies in its “desirability”. “Desirability” appears to be generally interpreted as relating to the magnitude of likely impacts, specifically, economic impacts. A variety of bases for determining desirability have been suggested. A common feature is that they are generally built on simple dichotomies, such as the size of firm (larger firms are thought to be more desirable than smaller firms), industry (higher

7 Elizabeth Asiedu On the determinants of FDI to developing countries: is Africa different? University of Kansas p4

value-added is preferred to lower value-added), the functional focus of an affiliate (higher order functions such as research and development (R&D) or regional headquarters are preferred to assembly operations), the form of entry mode (greenfield investment is superior to mergers and acquisitions), or the orientation of a firm (Poynter and White, 1984). While the simplicity of such distinctions may appeal to policymakers, they are unlikely to provide meaningful insights into the complex issue of assessing the impact of FDI. 8

Some stylized facts about FDI assisted development strategies

Although inward FDI is not the only option available to promote economic catching-up, it may be the most efficient option (Dunning and Narula, 2004). FDI, however, is not a sine qua non for development. There are at least four main preconditions that need to be satisfied:

1. The FDI being attracted must generate significant spillovers.

2. The domestic sector needs to develop the capacity to absorb these Spillovers.

3. The FDI being attracted should be complementary to domestic industry, rather than substitutive.

4. A regulatory and institutional environment must be developed in Order to facilitate the

integration of the foreign affiliates into the domestic economy. These conditions tend to make FDI more sticky and sustainable in particular locations. It is true that the determinants of economic development are similar to the determinants of FDI, but this does not mean that there is a simple cause and effect between them. Particular types of FDI tend to be attracted to countries with certain levels of economic development and appropriate economic structures. But simply to “pump” a country full of FDI will not catapult it to a higher stage of development. In other words: there are no automatic gains from FDI (see e.g. Mencinger, 2003). For instance, FDI may not compensate for the low ratio of domestic savings in the host countries;

nor do we know whether inward FDI will generate sufficient externalities.

It is generally acknowledged that there are four main motives for foreign investment: 1) to seek natural resources; 2) to seek new markets; 3) to restructure existing foreign production through rationalization; and 4) to seek strategically related created assets. These, in turn, can be broadly divided into two types. The first three represent motives which are primarily asset-exploiting in nature: that is, the investing company’s primary purpose is to generate economic rent through the use of its existing firm-specific assets. The last is a case of asset-augmenting activity, whereby the

8 Transnational Corporations August 2005 united nation new York and Geneva 2005 p95

firm wishes to acquire additional assets that protect or augment their existing created assets in some way. In general, developing countries are unlikely to attract much asset-augmenting FDI, but tend to receive FDI that is primarily resource seeking, market-seeking or efficiency-seeking. Empirical evidence (e.g. Bellak et al., 2009a) shows that in the CEE countries, besides market size, the level of infrastructure plays a crucial role for attracting FDI, while unit labour costs are comparatively less important

The point here is that not all affiliates provide the same opportunity for spillovers. A sales office or an assembly unit may have a high turnover, or employ a large number of staff, but the technological spillovers will be relatively fewer than, say, those from a manufacturing facility (figure 2). Likewise, resource-seeking activities can be capital- intensive, but also provide fewer possibilities for spillovers than say, a market-seeking type of FDI. Prior to economic liberalization and EU integration, TNCs responded to investment opportunities primarily by establishing truncated miniature replicas of their facilities at home, although the extent to which they were truncated varied considerably between countries. The extent of truncation was determined by a number of factors, but by far the most important determinant of truncation and thereby the scope of activities and competence level of the subsidiary were associated with market size, and the capacity and capability of domestic industry (Dunning and Narula, 2004). There is thus a hierarchy of the quality of FDI activity in Europe which reflects the stage of industrial development. At the “bottom” are countries that are at an early stage of transition (and furthest away from convergence with the EU norm), with a very limited domestic sector and with low domestic demand. Such countries have been host to the most truncated subsidiaries, often single- activity subsidiaries, primarily in sales and marketing, and in natural resource extraction. The most advanced economies with domestic technological capacity (such as the core EU members) have hosted the least truncated subsidiaries, often with R&D departments. Cohesion countries (with the exception of Greece) have been in the middle. 9

2. Factors affecting foreign direct investment

Foreign direct investment is a kind of private investment aimed at maintaining control Capital holds at least 10% of voting shares in a foreign company. Factors Effective in attracting capital

9 Transnational Corporations August 2005 united nation new York and Geneva 2005 p 71-75

can be divided into four parts: natural, ecological, supportive and encouraging factors Politics. Obviously, countries with a tense foreign policy are very unsuccessful in attracting foreign investment. A fundamental force of globalization is the rising level of attractiveness of different countries and geographical locations. Traditionally, factors such as market potential and size, relative labor unit costs, exchange rate, and relative endowments have been seen as important determinants for the location decision and investment activity of MNEs (Caves, 1974: dunning. 1980). While the view that good institutions such as non-corrupt bureaucracy, security of property rights, and political freedom are conductive to economic growth, and in the same spirit may attract direct investments from MNEs, is intuitively compelling, the findings of empirical research have not fully confirmed this impression. In general, institutions seem to have an influence on FDI. According to dunning, MNEs invest abroad because of three distinct advantages deriving from aspect of ownership, internationalization, and location. 10 Foreign Direct Investment has increased significantly in past few decades. This is because:

Lower transport costs

Improved technology which has helped increase low capital intensive startups

Increased global trade and lower tariff costs 11

Barrier to FDI

1. Level of restrictions on foreign ownership 2. Ease of doing business vs red tape (screening& approval procedures) 3. Constraints on foreign personnel and operational freedom

Other factor that affect FDI

1, Political stability and property rights 2. Size of economy and potential for Growth 3. Safety and security concerns 4. FDI incentives: tax breaks/ tax reductions and rates 5. Labor productivity and skills 6. Cost of wages 7. Transport links, costs and infrastructure 8. Levels of infrastructure (such as internet 1 Wage rates 9. Access to free trade areas. Connectivity, and existence of commodities10. Exchange rate11. Clustering effects


Author: p3

11 World Bank, Statistics analysis of FDI

Institutions and Inflows of Foreign Direct Investment: A Fuzzy-Set Analysis

Potential for productivity improvements

Hence, the potential for productivity improvements is positively related to the technology gap between local and foreign firms in an industry. A stream of theoretical models demonstrates that, for a given level of foreign presence, spillovers increase with the technology gap between foreign and domestic firms (Findlay, 1978; Wang and Blomström, 1992; Perez, 1997). John Dunning (1977; 1981; 1993). Dunning proposed that there are three conditions needed for firms to have a strong incentive to undertake DFIs.

1. Ownership advantage: the firm must have a product or a production process such that the firm

enjoys some market power advantage in foreign markets. 94 James R. Markusen

2. Location advantage: the firm must have a reason to want to locate production abroad rather

than concentrate it in the home country, especially if there are scale economies at the plant level.

3. Internalization advantage: the firm must have a reason to want to exploit its ownership

advantage internally, rather than license or sell its product/process to a foreign firm. 12

The crucial question then is, why should knowledge capital be associated with multinationals while physical capital is not? I have suggested that the answer lies in two features of knowledge capital. These will appear as assumptions in theoretical models. First, the services of knowledge capital can be easily transported to foreign production facilities, at least relative to the services of physical capital. Engineers and managers can visit multiple production facilities with some ease (although stationing them abroad is costly) and communicate with them in a low-cost fashion via telephone, fax, and electronic mail. This property of knowledge capital is important to firms making either horizontal or vertical investments.

According to empirical evidence leads us to make three assumptions. A. Transportability: the services of knowledge-based assets are easily supplied to geographically separate facilities.

b. Jointness: the services of knowledge-based assets are (at least partially) joint (“Public”) inputs

into geographically separate production facilities.

c. Factor intensity: Knowledge capital is skilled-labor intensive relative to final Production. 13

12 Bijit Bora 2002, Foreign Direct Investment: Research Issues p 95

13 Bijit Bora 2002, Foreign Direct Investment: Research Issues p 96

One of the important theory for international industry is Porter’s diamond model for analysis of competitive advantage. According this theory we can obtain some variable by factors in market segmentation. For example Japanese car manufacturing, technique Korea, electronics, Switzerland in pharmaceuticals, Britain Chocolate and biscuit industry US is expert in weapons and internet business. If we considered these countries for analysis, we can conclude that they have different factor of production, labor cost, and government policies but although, they have got competitive advantage in that particular industry.

Michael porter diamond model

in that particular industry. Michael porter diamond model Description of explanatory variables and return on

Description of explanatory variables and return on investment in the host country

1 Countries will tend to interact by direct investment when (A) they are relatively similar in size and in relative endowments (horizontal investment), or (B) when one country is smaller but skilled- labor abundant (vertical investment).


Investment liberalization can reverse the direction of trade when one country is small and

skilled-labor abundant. Such a country substitutes the export of services for the export of X.

3 Investment liberalization can decrease the volume of trade in X if trade barriers are relatively high and countries are similar (horizontal investment), but can increase the volume of trade if trade barriers are low and the countries differ in relative endowments (vertical investment).

4 Trade liberalization (in the presence of relatively liberal investment) will tend to reduce investment for relatively similar countries (horizontal investment) but tend to increase investment for relatively dissimilar countries (vertical investments).

5 Investment liberalization has a skilled-labor bias for source countries, but may also have a

skilled-labor bias for host countries. The latter occurs when branch plants of foreign multinationals draw factors from less skilled-labor intensive sectors rather than from competing,

skilled-labor intensive local firms. 14


The rise in FDI is based upon a combination of both ‘technology push’ and ‘market pull’ factors. As the world economy grows, the increase in the size of worldwide markets has enabled many international firms to set up new businesses in foreign countries that achieve similar cost structures to those achieved in their own countries. For some countries that they have lack of capital potential or monetary, financial policy problems, and they forced to borrow capitals from countries and international organizations or banks, for this countries the FDI is an opportunity to invest, to increase work place, sustainably economy for long-term or macroeconomic period. According to Paulo Elicha Tembe 2012, Mwilima (2003) the reason and theory for the developing countries in FDI sector more or less is the same factors or close each other’s. Southern Africa, China, Latin America, East Asia countries want to attract FDI is just because they see FDI as an important source of capital formation; the second reason is the transferring of technology; another reason is argued that FDI will lead to employment creation; the reason number four, the government expect FDI to transfer management skills to local managers and the last one is the

14 Bijit Bora 2002, Foreign Direct Investment: Research Issues p 108

increase of export competitiveness. 15 Investment incentives to attract FDI are widespread and used

by governments in both high-income and developing countries. Developing country policy makers often

view incentives as necessary for their countries to compete for FDI. (Fig 4 p28)


for their countries to compete for FDI. (Fig 4 p28) Fig4 Duty-free imports, tax holidays, and

Duty-free imports, tax holidays, and VAT exemptions are the top three most important incentives

for investors fig5 p29


15 Paulo Elicha Tembe, Attracting Foreign Direct Investment in Developing Countries: Determinants and Policies-A Comparative Study between Mozambique and China

Where there is a potential for developing standardised products for the global market place, realizing

Where there is a potential for developing standardised products for the global market place, realizing considerable economies of scale, firms may prefer a global strategy. This involves forgoing some of the benefits of a multidomestic strategy, preferring the cost savings of scale economies to any demand advantages of product differentiation. Global strategy may involve dispersing elements of the production process around the world on the basis of cost minimization, with subsidiaries exchanging parts and products with other subsidiaries in the MNC’s global system. Coordination of such an interdependent global production system necessarily involves a high degree of control over the operations of subsidiaries 16


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16 Bijit Bora 2002, Foreign Direct Investment: Research Issues p 35

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Transnational Corporations August 2005 united nation New York and Geneva 2005 p95

World Bank, Statistics analysis of Foreign Direct Investment (FDI)