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

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


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 countrys FDI inflows may drastically
fluctuate over time?What determines how much FDI
does a host country receive?
3
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?
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., RD, 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 MAs

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
    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

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 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

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. 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

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
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

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
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

22
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

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 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

26
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

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 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

31
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

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
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
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
Toyotas 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
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