Endogenous determinants of fdi flows into developing countries 1

8/14/2019 Endogenous determinants of fdi flows into developing countries 1

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I. Introduction

Foreign direct investment is one of the key tools at the disposal of developing

countries to stimulate economic growth. The benefits FDI inflows bring to

developing countries are well documented. Most importantly they bring

opportunities for increased earnings through the creation of new employment

opportunities and potentially higher wages. Further to this, FDI widens

employment choices through improved working practices, as generally it is


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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 3

believed that foreign firms pay higher wages than domestic ones. FDI is also

a potentially valuable source of fiscal revenue for host countries, which in turn

can support economic and social development programmes. However at the

same time, foreign investors are often though to be deterred by high taxes,

therefore the benefits from such revenue can be marginal.

Numerous studies1 have also shown that given a certain level of

development, FDI inflows instigate technology spillovers, create a competitive

business environment, contribute to human capital formation and assist with

international trade integration. All these factors in turn contribute to higher

levels of economic growth, thus having a positive effect on poverty alleviation.

Attracting FDI is also appealing for developing countries because it is

perceived to provide long-term benefits as it is bolted down unlike short-term

debt, which is driven by speculative considerations such as changes in

exchange rate and the moral hazard-associated expectation, that

governments will be willing to bail out the banking system at the first sign of

trouble.2 In other words, there is a belief that FDI is less susceptible to boom

and bust cycles than financial liberalisation.

FDI is very unevenly spread across the world. Outflows come mainly from

developed countries. During the 1980s the UK, USA, France, Germany and

Japan were responsible from 70 percent of FDI outflows. During this period

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Foreign Direct Investment: Maximising Benefits, Minimising Costs Overview. OECD2FERNANDEZ-ARIAS, E & HAUSMANN, R. Is Foreign Direct Investment a Safer Form ofFinancing? Emerging Markets Review. 2001: 2 (1), pp.34-49


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concise answers. The research question therefore is: What endogenous

factors best explain FDI inflows into developing countries?

II. Literature Review

i. Introduction

The literature review section focuses on the theories concerning the

determinants of FDI inflows and explores previous studies that have focussed

on the areas of interest covered in this thesis. FDI discourse has been

researched and studied in various disciplines although mainly political

science, economics, development studies and business studies. The first

section provides a broad overview of the main competing theories regarding

FDI and multinational corporation (MNC) investment decisions. It then goes

on to explore the literature that debates the supposed benefits of FDI and the

regulatory policies used to attract it by governments. The final section of the

literature review examines the main studies regarding the effect of regulatory

policies, democracy, conflict, corruption, education and infrastructure upon

FDI inflows into developing countries.

ii. Theoretical Understandings of Foreign Direct Investment

Unlike the study of international trade, there has been very little to try and

quantify and compare national policies towards FDI. Given the prominence of

FDI in the global economy, it can be argued that is of equal importance to

international trade. The rationale for liberalising FDI is very similar to that of

trade; the assumption being that deregulated FDI results in more efficient

allocation of resources in line with the Ricardos theory of international free

trade. There are two main competing and somewhat complementary theories


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as to why MNCs trans-nationalise their production capabilities formulated by

Hymer and Dunning. These theories are amongst the best established in

international business studies literature and are important when addressing

the central research question of this thesis.

Hymer pioneered the study of why firms engage in transnational production.4

His theory was based on industrial organisation theory, particularly concerning

barriers to market entry with countries. He started from the assumption that

domestic firms would posses an inherent advantage over foreign firms, such

as a better understanding of a particular market, and considering such

advantages, foreign firms would need to posses some sort of firm-specific

asset in order to compete. These could be for example: market share, brand

name, technological capabilities amongst others which would allow them to

out compete rivals in their own domestic markets. This theory clearly explains

why firms may begin to trans-nationalise their operations, however it is limited

in that it has no way of illustrating the attractiveness of one country over

another as an investment opportunity. It is an explanation of this very

important issue that John Dunning has provided his groundbreaking study

which is at the heart of the research question in this study, considering its

emphasis on the locational aspects of FDI.

4 HYMER, S.H. The International Operations of National Firms: A Study of Foreign DirectInvestment. Cambridge: MIT Press. 1976.p23


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Dunnings eclectic model5 states that there at least three forms of advantage

that influence the decision of MNCs to expand their investments abroad

outside their home country. These are: Ownership, Location and

Internationalisation. This thesis is concerned specifically with the Location

aspect. By this it is meant the location specific advantages that certain

countries posses in order to attract FDI inflows. Such advantages can depend

on an individual countrys specific comparative advantage variables, which will

be examined further in the thesis. Generally these are considered to be

markets, resources, production costs, socio-political conditions and cultural

and linguistic attributes. In this sense it is a useful paradigm as it emphasises

the crucial role that geographic location or specific government policies that

are used to attract FDI for MNCs, when they decide to make their investment

decisions.

Dunning has further stated that there are three main types of FDI. These are:

Resource seeking (seeking natural, physical or human resources) market

seeking (looking to find additional markets for a product or service outside a

MNCs domestic boundary) and finally efficiency-seeking (looking to expand

into locations that are capable of producing more efficient or capable of

specialization).6 FDI inflows into developing countries are usually concerned

with the second and third of the three mentioned.

5 DUNNING, J. The Eclectic Paradigm of International Production: A Restatement and Some

Possible Extensions. Journal of International Business Studies.1988: 19 (1), pp.1-316 DUNNING, J. Toward An Eclectic Theory of International Production: Some EmpiricalTests. Journal of International Business Studies. 1980: 11, pp.9-11


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Central to this study is the relationship between governments and

international businesses. Peter Dicken provides a broad summary of the

relationships between MNCs and states in his textbook Global Shift.7 He

argues that this relationship is one that contains both rivalry and collusion. In

this sense the goals of both actors are fundamentally divergent in their aims

and goals. The goal of an MNC is to maximise profits and shareholder value

while minimising the cost base. For a state, the ultimate aim of FDI is to

maximise the growth of their GDP and create as many employment

opportunities for the population within its boundaries. In regards to developing

countries, the greater the number of countries vying for investment, the

weaker their particular bargaining positions will be as MNCs are capable of

playing one state off against another in order to attain the highest return on

their investment.8

Advocates of FDI maintain that its benefits for developing countries include

injecting new capital within a host economy, which can provide additional

investment in both physical and human capital. However many academics

argue that the rapid growth of MNCs is marginalising the role of the state in

the global economy. Susan Strange argues9 this is part of a structural change

in the international system of world politics, which has in part been

responsible for a tide of economic liberalisation around the world. According

to Strange this is largely due to the rapidly rising power of MNCs in the

preceding few decades to the point where they are now major actors in North-

7DICKEN, P, Global Shift: Mapping The Changing Contours of The World Economy. London:SAGE Publications. 2007. p.2368ibid.p.2389STRANGE, S. States, Firms and Diplomacy. International Affairs. 1992: 68 (1), pp.1-15


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South relations. This now means that developing countries have become

economic competitors amongst each other to attract MNCs looking to further

internationalise their production capabilities. Accordingly this has resulted in a

seismic shift where states compete amongst each other for world market

shares in their constant pursuit to sustain economic growth. Her research

based on a series of interviews in Turkey, Brazil and Malaysia with MNC

directors, public officials and politicians. This study is particularly well known

as it represented one of the first attempts to merge business studies and

international political economy discourse together in examining the rise of

MNCs as powerful non-state actors in the international system.

iii. Economic and Regulatory Policies for attracting Foreign DirectInvestment

Amongst the very first empirical studies in the area of FDI was conducted by

Root and Ahmed. They examined10 several policy variables that were

considered to be conducive to FDI inflows. In their study they tested 44

economic, social and political and policy variables against the FDI inflows of

41 developing countries. They found that tax laws and relative level of

economic freedom were not significant variables, while increases in corporate

tax levels, had a negative association with FDI inflows. This study had

important policy implications for developing countries during its publication in

the 1970s as it advocated a neoclassical economic policy as an incentive to

attract foreign investment.

10 ROOT,R & AHMED, A. The Influence of Policy Instruments on Manufacturing DirectForeign Investment in Developing Countries. Journal of International Business Studies. 1978:9, pp.81-93


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More recently, Golub11 has gone about categorising various government

policies towards FDI using a multivariate cross-sectional regression.

Considering that many of these policies and restrictions are often specific to a

particular industry, a high level of disaggregation was used. 73 developed and

developing countries were used in the regression. The results indicated that

developing countries on average are more restrictive than developed

countries concerning their investment regulations. Specifically, the European

Union states and Latin America has amongst the lowest entry restrictions

while the Middle East and South Asia tended to have higher restrictions.

Using time-series data, there is evidence that these restrictions have been

relaxed. The one exception in these results was that the USA was amongst

the least restricted economies in the 1980s but by the mid 1990s was firmly in

the middle of the pack, thus indicating that there has been almost no changes

in liberalising investment restrictions since then.

Busse and Groizard also examined the effects of government regulations on

FDI inflows.12 Their findings suggest that highly regulated economies are less

likely to be able to utilise the benefit of an MNC presence within their borders

as regulations hinder the potential for profits to be made, thus leading to lower

economic growth within a country. This study corresponds well the to

investment theories of Hymer. However a strong counter argument to this

assertion is that the removal of FDI related restrictions does not create

additional attractive factors for MNCs. Instead it merely allows them to take

11 GOLUB, S. Openness to Foreign Direct Investment in Services: An International

Comparative Analysis. The World Economy. 2009: 32 (8), pp.1245-126812 BUSSE, M & GROIZARD, L. Foreign Direct Investment and Growth. The World Economy.2008: 31 (7), pp.861-886


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advantage of the existing capabilities more freely, thus it has been argued that

liberalisation of investment restrictions needs to be complimented by strong

endogenous capabilities within countries.13

One of the most often cited work on the topic of the relationship between

economic growth and FDI is Borensztein et al14, which emphasised the

positive impact of FDI inflows on economic growth in a cross-country study of

69 developing countries over the 1970-89 period. They found that this growthwas totally dependent on the relative level of human capital within a country.

For countries with very low levels of human capital, FDI could even have a

negative impact on economic growth. This fits with one of the main

hypotheses of this study that; that greater levels of education and a skilled

workforce subsequently results in increasingly FDI inflows.

Balasubramanyam15et alhave argued that the type of trade regime (import-

substituting or export promoting) within a state is crucial to understanding the

impact of FDI inflows. The rationale here is that import-substituting strategies

incur various distortions within the economy such as factor prices. They found

that export-promoting countries better utlilised the effects of FDI on economic

growth rates between 1970 and 1985 while the effects of import substituting

were insignificant. Therefore the export orientation of a country is one of the

13LALL, S & NARULA, R. Foreign Direct Investment and its Role in Economic Development:Do We Need A New Agenda? The European Journal of Development Research. 2004: 16 (3),pp.447-46414 BORENSZTEIN, E., DE GREGORIO, J & LEE, J. How Does Foreign Direct Investment

Affect Economic Growth? Journal of International Economics, 1998: 45 (1), pp.115-13515 BALASUBRAMANYAM, V, SALISU. M & SAPSFORD, D. Foreign Direct Investment andGrowth EP and IS Countries. Economic Journal. 1996: 106 (434), 92-105


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main exogenous variables that explain a particular countrys attractiveness to

foreign investors.

However not all academics are convinced of the benefits of FDI inflows to

developing countries. Andrew Summer has argued16 that the debate

concerning whether FDI has a positive or negative impact on economic

growth and poverty reduction is misguided and the focus should be on the

terms that FDI is accepted in developing countries. As he correctly argues, for

FDI to have a positive impact, there must be a net positive transfer of capital

into the recipient country, allowing local firms to crowd in through joint

ventures and local spillovers.17 Greenfield investments for example are far

more likely to have a positive impact on the economy as they create new

employment sectors, bring in new forms of capital and are more likely to result

in spillovers. The character of a host economy is also important too as

economically developed countries are more likely to benefit from FDI. The

effectiveness of FDI is thus attached to the FDI policy regime of a particular

country. This viewpoint can be seen in opposition to neoclassical assumption

that the state should not interfere with potential external private investment

opportunities.

More recently he has suggested18 that many countries in the developing world

have reached a tipping point, as the conventional wisdom during the 1990s

16 SUMNER, A. Is foreign direct investment good for the poor? A review and stocktake.Development in Practice, 2005: 15 (3&4), pp.269-28517

ibid.pp.269-28518 SUMNER, A. Foreign Direct Investment in Developing Countries: Have we reached apolicy tipping point? Third World Quarterly, 2008: 29 (2), pp.239-253


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that FDI is an essential precondition for economic growth is no longer

unconditionally accepted by developing countries. Evidence of this can be

seen through the tightening of investment regulations in many countries and

the renationalisation of key industries in states such as Venezuela and Bolivia

and the increasing political swing to the left in many other Latin American

countries as they look to endogenous ways to develop their economies.

Mayer has also pointed out that implementing policies to attract FDI is notwithout cost,19 especially for poor countries with limited public funds and

resources. Tax breaks, subsidies and improvements in infrastructure are

example of this. Money on such projects that could be well spent on improving

education, health care and other public provisions. However this ties into the

work Sumner has done, which emphasises that developing countries need to

ensure they attract the right kind of FDI which can enhance economic growth.

Therefore high value greenfield investments are to be encouraged. It could be

argued that this presents a dilemma for developing countries, as without FDI it

is often hard to instigate significant economic and social development yet the

very policies that governments use to attract MNCs to invest are often at the

expense of welfare provisions, thus leading to increased income inequality.

Therefore it is important to be sure of a clear causal link between FDI and

subsequent economic growth. Hansen and Rand conducted research20 on

this topic and found a strong causal link between FDI inflows and economic

19MAYER, T. Policy Coherence for Development: A Background Paper on Foreign Direct

Investment. OECD Development Centre, 2006: 253, pp.1-6020 HANSEN, H & RAND, J, Causal Links Between FDI and Growth in Developing Countries.The World Economy, 2006: 29 (1), pp.21-41


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growth. Furthermore they found that the effects of FDI on economic growth

were the same irrespective of the region in the globe or level of economic

development.

Shah and Slemrod found21 that international investors were attracted to lower

corporate tax rates in Mexico, therefore recommending that Mexico aim for

taxes that were lower than the rate in the US as a way to provide incentives

for investment within the country. However such a viewpoint negates other

important variables as how to attract FDI with its narrow focus on structural

adjustment policies. However such recommendations were typical of the early

1990s when the World Bank and International Monetary Fund were attaching

structural adjustment conditions to their aid and loans, which involved far

reaching macroeconomic reforms in line with the neoliberal economic

consensus of the time.

The OECD has provided specific guidelines22 as to the policies host

governments should pursue to attract FDI. They can be summed summarised

into three key points: First and foremost is a general improvement in

macroeconomic and institutional framework, secondly creating a regulatory

framework conducive to the needs of international investors and finally

ensuring infrastructure, technology and human capital whereby international

21 SHAH, A & SLEMROD, J. Do Taxes Matter for Foreign Direct Investment? The WorldBank Economic Review. 1991: 5 (3), pp.473-491

22 CHRISTIANSEN, H & OGUTCU, M. Foreign Direct Investment For Development:Maximising Benefits, Minimising Costs. Global Forum On International Investment. 5/6December 2002, Shanghai, p.9


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firms can recognise their benefits. An OECD working paper23 concerning FDI

in sub-Saharan Africa concluded that the region had lagged behind other

regions in the world. Although the 1990s brought increasing levels of

investment as a result of political and economic reforms, this one-size-fits-all

approach was now inappropriate for many of the countries in the region due to

their individual circumstances. Several policy recommendations were

prescribed in this report. The first regarding macroeconomic conditions within

a country states that countries such as Uganda and Mauritius have had astable environment, yet this alone is not sufficient. An adequate physical and

social infrastructure is also an important factor in determining the investment

appeal of a country. One of the strongest arguments for the lack growth in

inward FDI to sub-Saharan Africa is that investment has been concentrated in

primary industries with little added value for economic growth.24

Nunnenkamp argues25 that for FDI to be affective in alleviating poverty in

developing countries. Firstly governments need to ensure their country is

attractive to foreign investors and secondly the environment of the country

must be conducive to the potential spillover effects that FDI can bring.

Therefore the challenges for developing countries are similar in that their

policy goals include developing a policy and regulation framework that is

capable of attracting foreign investment. However as he correctly asserts,

these factors are no guarantee of encouraging investment conducive to

23 ODENTHAL, L. FDI in sub-Saharan Africa. OECD Development Centre, 2001: 173, pp.1-5524

ibid.pp.1-5525 NUNNENKAMP, P. To What Extent Can Foreign Direct Investment Help AchieveInternational Development Goals? The World Economy, 2004: 27 (5), pp.657-677


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respect for human rights. The neoclassical economic approach stresses the

benefits that FDI can bring to a state. According to this logic, developing

countries that liberalise their economies, along with the benefits of increasing

levels of economic growth, will benefit from the added knock on effect of an

increasingly stable political environment, which has respect for human rights.

In stark contrast to this view, advocates of dependency theory regard FDI as a

threat to the economic and social wellbeing within a state. The rationale

behind this is that one of the ways that developed states are able to ensuretheir dominance over weaker developing states is through economic

penetration which is based on a fundamentally unequal exchange of goods

and services.29 This approach therefore would view FDI, as a tool for wealthy

states to ensure their enduring influence over the economic policies in

developing states.

Countries with democratic institutions are associated with higher levels of FDI

inflows. For example, it has been argued30 that democratic governments,

even after other domestic variables are controlled for, account for as much 70

percent more FDI as a percentage of GDP than authoritarian governments.

According to his logic, one of the key advantages for MNCs operating in

countries with democratic institutions is the credibility the host governments

offer to businesses. Thus, once investments have been made, there are

considerable political risks for firm such as nationalisation and expropriation.

29 CAPORASO, J, Introduction to the special issue of International Organization ondependence and dependency in the global system, International Organization, 1978: 32 (1),

pp.1-1230 JENSEN, N. Democratic Governance and Multinational Corporations: Political Regimesand Inflows of Foreign Direct Investment. International Organization, 2003: 57 (3), pp.587-616


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However these potential risks involved are accordingly minimised in

democratic countries. Jensens study involved a set of four tests. The first

involved an OLS regression for 79 countries over the period 1990-97. The

dependent variable in this study was net inward FDI as a percentage of GDP,

which was taken from the World Bank Development Indicators in 1999.

Another controlled variable used is Government consumption. This is used

because the degree of consumption can be used as a way of possibly

correlating the type of government regime within a certain country.

Budget deficits is another variable that is controlled for, the assumption here

being that governments with large deficits maybe more attracted to FDI as a

way of balancing the books. In his regression government expenditure had a

negative relationship with FDI. More importantly his findings indicate that a

move from an authoritarian regime to a democratic one increases FDI flows

by 60 percent.31 His analysis shows that countries move from one standard

deviation below the mean to the mean level of democracy. A move to full

democracy would increase FDI as a percentage of GDP by 1.2 percent. He

asserts the most significant advantage of democratic government is that it

increases the legitimacy of political leaders from the perspective of

international financial markets. The assumption is that democratic systems

produce leaders who are less likely to implement policies unfavourable to

MNCs.32 His OLS regression indicates a statistically significant positive

relationship between levels of democracy and country risk ratings. This study

has important policy implications for developing countries and supports one of

31 ibid.pp.587-61632 ibid.pp.587-616


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the hypotheses of this study; that democratic countries receive higher levels

of FDI inflows than authoritarian governments.

Li and Resnick also conducted research33 into the effects of democratic

governments on the amount of FDI inflows into countries around the world.

Their conclusion was that the effect of democratic institutions on FDI inflows

into developing countries, were conflicting and often quite complex. They

argue that improving protection for property rights in developing countries wasmore likely to inspire confidence in international investors, however this in

itself is directly related to country regime type since democracies generally

provide superior property rights protection. They used a times series OLS

regression using Freedom House data as the independent variable. Their

output found that a one unit increase in democracy results in a decrease of

88-94 million dollars in FDI inflows to a country. In contrast a one-unit

increase in property rights protection leads to an increase of 52 million dollars

in FDI inflows.

Richards, Gelleny and Sacko have looked at the relationship between FDI

and government respect for human rights using a logit model of analysis.34

They used cross sectional time series data across the period of 1981-1995.

The results indicated that FDI and portfolio investments both have a positive

33RESNICK, R, & LI, Q. Reversal of Fortunes: Democratic Institutions and Foreign DirectInvestment Inflows to Developing Countries. International Organization , 2003: 57 (3), pp.175-211

34 RICHARDS, D, GELLENY, R & SACKO, D. Money with a Mean Streak? ForeignEconomic Penetration and Government Respect for Human Rights in Developing Countries.International Studies Quarterly, 2001: 45, pp.219-239


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impact on increasing government respect for human rights. Therefore these

results support the neoclassical economic theory that increased financial and

economic liberalisation results in greater democratisation and respect for

human rights. These findings therefore contradict the pessimistic assertions of

dependency theory regarding the consequences of FDI inflows in the

developing world.

v. Political Stability and Its Effect on Foreign Direct Investment

I hypothesise that political stability and the absence of violent conflict within a

state increases the potential for FDI inflows, as international investors are

attracted to states with minimal risk. Therefore countries with stable rule of

law will increasingly benefit from external investments, as MNCs will have

greater levels of confidence in receiving a return on their investment. This

area of study is also intrinsically linked to the studies on democratic

governance and FDI. Democracies are associated with lower levels of internal

and external conflict as states in the democratic peace theory.35 This

hypothesises that democracies do not go to war with other democracies, as

the citizens and electorate are unwilling to bear the potential costs of such

conflicts.

Gartzke, Li and Boehmer conducted research into the relationship between

international investment, economic interdependence and international conflict.

Their dependent variable was the onset of militarised interstate disputes.

Their findings suggested that interdependent states avoided increasing

35OWEN, J. How Liberalism Produces Democratic Peace. International Security, 1994: 19(2), pp.87-125


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threats to military hostilities. As part of their study, monetary independence

was measured through whether a state has pegged its currency to that of

another state and whether it was part of a joint monetary zone. The

measuring of capital investment impact was measured through economic

restrictions in place within a state. Their overall findings link in further with the

larger democratic peace theory.

Busse and Hefeker also researched

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this area, instead examining the effectsof perceived political risk and institutions upon FDI inflows using a cross-

sectional regression analysis using time series data from 1984 2003. Like

other academics, they also found a statistically significant relationship

between democratic institutions and increasing FDI inflows. They concluded

that MNCs are highly sensitive to changes in political stability within a country

and therefore, their results contradict those found by Li and Resnick.

Additionally they assert that MNCs are concerned by external and internal

conflicts in the host countries they have invested in to ensure minimal risk.

Easterly and Levine37 looked the reasons for sub-Saharan Africas failures in

sustaining economic growth, arguing its ethnic diversity has impeded

economic development and researched this using a cross-sectional OLS

regression analysis. They concluded that continent has such as dismal record

in economic growth and attracting investment due to low educational

36BUSSE, M & HEFEKER. Political Risk, Institutions and Foreign Direct Investment.

European Journal of Political Economy, 2005: 23 (2), pp.397-41537EASTERLY, W & LEVINE, R. Africas Growth Tragedy: Policies and Ethnic Divisions. TheQuarterly Journal of Economics, 1997: November. pp.1204-1250


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Wei also came to a similar conclusion as that of Habib and Zurwacki as he

found that the incidence of corruption within a country has a similar effect to

that of raising corporate taxes41, which in turn deters potential foreign

investors. He used a linear OLS regression with net FDI inflows as the

dependent variable and tax rate and corruption as independent variables.

However, one notable finding was that MNCs tended to invest in countries

that possessed a similar level of corruption as that of the home country of aparticular MNC.42

vii. Infrastructure and Its Effect on Foreign Direct Investment

Burnside and Dollar have found43 that low level of communication related

infrastructure and trade repels foreign investors thus making local firms less

likely to become exporters. They compared various large cities in developing

countries such as Brazil, China, Honduras, India and Nicaragua. The

variables they used included time taken to clear customs, time to get a fixed

telephone line and power losses. For example their results imply that

Karachis share of foreign invested firms in certain sectors would jump from 1

percent to about 20 percent if it could raise its infrastructure standards to that

of Shanghai in the above-mentioned variables.

41WEI, S. How Taxing Is Corruption on International Investors? The Review of Economicsand Statistics. 82 (1). pp.1-1142

ibid.pp.1-1143DOLLAR, D, BURNSIDE, C. If you Build it, Will They Come? Foreign Aids Effect onForeign Direct Investment. MPSA National Conference, 2007: 14/04, pp.1-20


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have. Countries that rely on solely on low skilled labour or natural resources

are unlikely to entice high value FDI into a country thus leading to slower

economic growth.

ix. Conclusion

To conclude, the literature concerning FDI is extremely broad and attracts

study from researchers across various academic disciplines in the social

sciences. There is no clear consensus across all the disciplines regarding the

benefits of FDI to the economic growth in developing countries. Business

studies and economics scholars generally tend emphasise the positive

aspects of FDI for growth thus associating with the neoclassical-school of

thought. Therefore maintaining the benefits of creating and economic and

regulatory framework conducive to needs of international investors. However

other such as Sumner are more cautious as to the immediate benefits.46

The main body of literature suggests that endogenous factors such as

democratic governance, corruption, infrastructure, political stability and

education are important variables in explaining the attractiveness of particular

countries for international investors. Having considered the literature on FDI,

the following hypotheses have been formulated for analysis in this study:

Hypothesis I:Lack of corruption within a country positively affects itslevels of FDI inflows.

46

SUMNER, A. Foreign Direct Investment in Developing Countries: Have we reached apolicy tipping point? Third World Quarterly, 2008: 29 (2), pp.239-253


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allows for comparison of countries regardless of population size. This data is

converted from three-year periods to offset annual fluctuations within the

dataset. This data is compatible with the central research question, which is

What are the endogenous determinants of FDI inflows into developing

countries? The dataset omits various small countries associated with tax

haven status as they have the potential to skew the data. Several emerging

market countries were also omitted due to the large fluctuations in data

associated with them. It is an average value, which is normalised to yield ascore between 0 to 1.

FDI includes the three following components: equity capital, reinvested

earnings and intra company loans. The coefficient does not provide actual

aggregate data on FDI, but instead provides a solid indication of countries

attractiveness to foreign investors. Therefore providing a good estimate of

how much FDI a country receives proportional to its population size. This

measure, more importantly, provides a solid indication of the attractiveness of

a particular country to foreign investors. Using annual net FDI inflow data has

problems with reliability due to considerably large annual fluctuations in the

data set therefore potential inward FDI is a more appropriate dependent

variable.

ii. Independent Control Variables

GDP per Capita: The first independent variable used is Gross Domestic

Product per capita using the purchasing power parity method (GDP per capita

PPP). Using the PPP data allows for the data to be adjusted for the individual


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costs of living within each country measured although this is based upon an

estimate. The data was taken from the International Monetary Fund 2006

statistics.48 The variable is used to control for the other independent variables

as this study is not attempting to try and prove a correlation between GDP per

capita and FDI inflows as the link between the two is obvious. The variable is

measured in United States dollars.

Economic Freedom: The data for levels of economic freedom was taken

from the 2009 Index of Economic Freedom published by the Heritage

Foundation.49 This ranking is created from a composite of 10 independent

data sources. These are: Business freedom, trade freedom, fiscal freedom,

government size, monetary freedom, investment freedom, financial freedom,

property rights, freedom from corruption and labour freedom. Each of these

components, are equally weighted in determining the country scores. The

2009 data was compiled from the second half of 2007 through to the first

quarter of 2008. Much of this data was taken from surveys whose

respondents included business with investments in countries included in the

index and regional experts.

Corruption: As it would be a nigh on impossible task to actually measure

global corruption in all countries as there is a lack of empirical data. Therefore

it is operationalised through Transparency Internationals Corruption

Perception Index, which is regularly used in academic studies to quantify

48IMF World Economic Outlook Database [online]. [accessed 7th June 2009]. Available From

World Wide Web: 49 Heritage Foundation 2009 Index of Economic Freedom [online]. [accessed 14 th June2009]. Available From World Wide Web:


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perception of corruption.50 This is a ranking of perceived corruption amongst

public officials and politicians within 180 countries. The data is gathered

through surveying those who are directly affected by corruption using cross-

sectional methods. This method of measurement has obvious weaknesses,

as it does not measure actual corruption per se but the perception of

corruption within a given country. This is still significant given that the thesis

hypothesises that increasing levels of corruption will be associated with

diminishing levels of FDI inflows. Therefore it is expected that countries thatare perceived to be corrupt are likely to be associated with diminishing FDI

flows.

Education: This is operationalised through the UN Education Index,51 which

further makes up part of the Human Development Index. The index is

compiled through creating a coefficient score for each country. This score

includes a two thirds weighting for adult literacy rate combined with the gross

enrolment ratio for primary, secondary and tertiary education. The latest data

was released in December 2008 and this particular data source is used in the

regression. Higher levels education, are expected to yield increasing levels of

FDI inflows within a country. The rationale behind this is that MNCs are

attracted to invest in areas with a skilled and adaptable workforce as this can

potentially provide higher rates of return in production and efficiency.

50 Transparency International 2009 Corruption Perception Index [online]. [accessed 10 th June2009]. Available From World Wide Web:

51UNDP World Development Indicators 2007/08 [online]. [accessed 5th June 2009]. AvailableFrom World Wide Web:


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Considering this thesis explores government capability to attract FDI. The

dependent variable is a coefficient score for potential FDI inflows, this is

analysed and researched using a cross-sectional OLS regression with the

eight endogenous independent variables. The first empirical test uses a

sample size of 139 countries including developed, emerging market and

developing economies and runs an OLS regression against the seven

independent variables. This sample size includes most countries in the world

of significant size and omits various states associated with tax haven status

due to their potential to skew the results.

The second test removes all countries with a Potential FDI inflows coefficient

score of 0.2360 or higher, leaving a sample size of 81 developing and

emerging market economies. The purpose of this is that developing countries

are often fundamentally different in their economic, political and social

structure from industrialised countries therefore the determinants of FDI

inflows to these countries could vary from that of developed countries. This

should provide a set of results that are more specific to developing countries.

One of the main reasons for this is that developing countries often attract

different MNC investment usually associated as efficiency seeking or

resource seeking. To mitigate to problems of reverse causality or

autocorrelation, all the variables used are lagged or use weighted averages

from the 2000s to ensure appropriate time order with the dependent variable.

One of the weaknesses of a pooled model is that countries that are very

different in their structural makeup are pooled together and by virtue of


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exhibiting similar rankings in the dependent variable coefficient. Cross-country

variations in data thus present a dilemma, as regional differences may well be

significant and require a qualitative case study related method of research for

concise results specific to the context of individual states. One of the

weaknesses of using an OLS regression is that it may yield an inconsistent

estimate of the causal effects being examined in this thesis. However since

the purpose of this study is to examine which endogenous contemporary

factors prevalent within a country contribute to greater levels of FDI inflowstherefore an OLS regression and provide clear and concise results, as the

data used in the dependent and independent variables is empirical. More

specifically, an OLS regression provides an estimate of the effect of y on

unexplained changes inx.

This approach is the most widely used the literature concerning determinants

of FDI inflows and government policies that attract it. This methodological

approach is therefore appropriate. Due to limitations in data availability, a time

series regression was also not possible. Internal validity is accounted for, as

the statistical inferences are valid for the countries in the study. There is

appropriate time order sequencing between the dependent and independent

variables. The sample size in both models is sufficiently large including most

countries of sufficient size to eliminate the threat of selection bias. The study

possesses construct validity, as all the variables are appropriately

operationalised.


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IV. Results/Findings

In this study, two OLS regressions were run. Table 1 shows the cross

sectional output from model one, which included 139 countries in the sample

population. Table 2 shows the output from model two, which included a

sample size of 82 developing and emerging market economies.

i. Model One

Unstandardized Coefficients

Standardized

Coefficients

Model B Std. Error Beta t Sig.

(Constant) .104 .048 2.176 .0

GDP 08 PPP 3.769E-6 .000 .520 7.308 .0

Corruption .016 .005 .308 3.083 .0

Economic Freedom Index -.002 .001 -.148 -1.881 .0

Freedom House Ranking .000 .000 .076 1.353 .1

Political Stability 8.644E-5 .000 .071 1.317 .1

Oil Exports 1.713E-8 .000 .163 4.173 .0

Education .084 .018 .204 4.595 .0

1

Regulatory Quality .000 .000 .101 1.168 .2

a. Dependent Variable: Inward Potential FDI.04.06


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ii. Model Two

Unstandardized Coefficients

Standardized

Coefficients

Model Two, Table 2. B Std. Error Beta t Sig.

(Constant) .101 .041 2.477 .0

GDP 08 PPP 6.549E-6 .000 .599 6.171 .0

Corruption -.009 .005 -.185 -1.608 .1

Economic Freedom Index 7.858E-5 .001 .013 .105 .9

Freedom House Ranking -5.374E-5 .000 -.018 -.192 .8

Political Stability 8.772E-5 .000 .158 1.976 .0

Oil Exports 1.514E-8 .000 .181 2.300 .0

Education .046 .013 .319 3.475 .0

1

Regulatory Quality -3.689E-7 .000 .000 -.005 .9

a. Dependent Variable: Inward Potential FDI.04.06

GDP per Capital PPP: As expected the relationship between GDP per capita

and FDI inflows is highly significant and important in its substantive impact in

both models holding all other variables constant. It would of course be a gross

over simplification to suggest a countrys FDI inflows are a function of its GDP

per capita. The relationship between the two variables is highly complex as it

is the case that FDI inflows contribute to a countrys wealth so it very hard to

say whether one is a linear function of the other.


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Corruption: Lack of corruption is correlated with positive increase in FDI

inflows thus corresponding to most of the conclusions of the literature in the

field in the Model One output. For a one unit increase in lack of corruption

perception there is a 0.16 increase in FDI Potential inflows controlling for all

other variables. This is significant to the 0.005 level. In Model Two the

statistical significance no longer holds as it is only to the 0.112 level. Also

there is interestingly a slightly negative relationship between lack of corruption

and increasing FDI inflows. This corresponds well the study by Egger and

Winner56 mentioned in the literature review, who conducted a similar study

using the same data from Transparency International. Therefore the output

seems to suggest international investors in developing countries are attracted

to countries where there is potential to bribe politicians and public officials.

The results therefore seem to suggest that on the whole, the perceived

presence of corruption within a society is deterrent to international investors,

however when considering developing countries, the potential to bribe officials

could act as an incentive to invest on terms favourable to an MNC. However,

this is not to suggest corruption in developing countries is something to be

encouraged.

Regulatory Quality and Economic Freedom: Two of the most striking from

the Model One output is the lack of a statistically significant relationship

between regulatory quality, economic freedom and FDI. Model One actually

56EGGER, P & WINNER, H. Evidence on corruption as an incentive for foreign directinvestment. European Journal of Political Economy, 2005 21, pp.932-952


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increases human capital through knowledge and technology spillovers in host

countries. The findings in both Model One and Two provide strong indications

that international investors are highly attracted to locations, which provide an

educated and skilled workforce this reinforcing the findings of previous

studies. The rationale behind this being that MNCs will invest overseas to

utilize a skilled labour force at lower cost than available in their home country,

thus conducting efficiency seeking FDI.

Political Stability: Another surprising result from the regression is the

absence of statistical significance concerning the relationship between

political stability and FDI inflows. This is particularly interesting given the

broad array of literature that stresses the importance of stable political system

and the culture of political risk analysis that many MNCs engage in. Model

One indicates that the relationship is only significant to the 0.191 level

meaning the null hypothesis cannot be rejected. However for Model Two the

results are remarkably different with a sig column score of 1.976 giving even

less confidence in this relationship regarding developing and emerging market

economies

Democracy: Model One finds no relationship between democratic

government, political freedoms and FDI inflows. This is another surprising

result. The findings in Model Two present a similar output from the regression,

although the statistical significance is far weaker. The findings of this study


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The results from this study have several policy implications for developing

countries. Firstly, creating a regulatory framework conducive to attracting

investment from foreign firms and implementing liberalizing reforms within a

country does not appear to be entirely sufficient to attract FDI. This alone

does not create the value added determinants that attract foreign firms to

invest in a particular location. As has been mentioned in the past, the benefits

of FDI to countries which are still at a low level of development is marginal

due to threshold externalities, meaning they have yet to reach a certain levelof educational, technological and infrastructure related level of development

and therefore do not reap the full benefits of FDI.61

The results from the regression clearly indicate the crucial role of education in

attracting investment. It is also often the case that FDI provides knowledge

spillovers into host countries as well, once it has been attracted through on-

the-job training therefore creating a further positive effect from sound

government educational policies. Corruption is also endemic problem, which

appears to impede FDI inflows to a country. Although the two models used,

resulted in different directional relationships, it is clear that corruption either

impedes FDI inflows or nullifies the potential positive impact the may have on

socio-economic conditions within a country.

Surprisingly the findings suggest no significant relationship between political

stability/lack of violence and FDI inflows considering the amount of literature,

which has concluded there is a relationship between the two. However, since

61Foreign Direct Investment: Maximising Benefits, Minimising Costs Overview. OECD


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however build upon previous literature to give a broad overview of the key

endogenous determinants of FDI inflows into developing countries and the

key characteristics that are shared by them to successfully attract value

added foreign direct investment.


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VI. Bibliography

i. Books and Academic Journals

BALASUBRAMANYAM, V, SALISU. M & SAPSFORD, D. Foreign Direct Investment andGrowth EP and IS Countries. Economic Journal. 1996: 106 (434), 92-105

BLOMSTRM, M & KOKKO, A. Human Capital and Inward FDI. Stockholm School ofEconomics Working Paper. 2003: 167, pp.1-16

BORENSZTEIN, E., DE GREGORIO, J & LEE, J. How Does Foreign Direct Investment AffectEconomic Growth? Journal of International Economics, 1998: 45 (1), pp.115-135

DOLLAR, D, BURNSIDE, C. If you Build it, Will They Come? Foreign Aids Effect on ForeignDirect Investment. MPSA National Conference, 2007: 14/04, pp.1-20

BUSSE, M & GROIZARD, L. Foreign Direct Investment and Growth. The World Economy.2008: 31 (7), pp.861-886

BUSSE, M & HEFEKER. Political Risk, Institutions and Foreign Direct Investment. EuropeanJournal of Political Economy, 2005: 23 (2), pp.397-415

CAPORASO, J, Introduction to the special issue of International Organization on dependenceand dependency in the global system, International Organization, 1978: 32 (1), pp.1-12

CHRISTIANSEN, H & OGUTCU, M. Foreign Direct Investment For Development: Maximising

Benefits, Minimising Costs. Global Forum On International Investment. 5/6 December 2002,Shanghai

DEAN, J, LOVELY, M & WANG, H. Are foreign investors attracted to weak environmentalregulations? Evaluating the evidence from China. Journal of Development Economics, 2009:90, pp.1-13

DICKEN, P, Global Shift: Mapping The Changing Contours of The World Economy. London:SAGE Publications. 2007

DUNNING, J. Toward An Eclectic Theory of International Production: Some Empirical Tests.Journal of International Business Studies. 1980: 11, pp.9-11

DUNNING, J. The Eclectic Paradigm of International Production: A Restatement and SomePossible Extensions. Journal of International Business Studies.1988: 19 (1), pp.1-31

EASTERLY, W & LEVINE, R. Africas Growth Tragedy: Policies and Ethnic Divisions. TheQuarterly Journal of Economics, 1997: November. pp.1204-1250

EGGER, P & WINNER, H. Evidence on corruption as an incentive for foreign directinvestment. European Journal of Political Economy, 2005 21, pp.932-952

FERNANDEZ-ARIAS, E & HAUSMANN, R. Is Foreign Direct Investment a Safer Form ofFinancing? Emerging Markets Review. 2001: 2 (1), pp.34-49

GOLUB, S. Openness to Foreign Direct Investment in Services: An International Comparative

Analysis. The World Economy. 2009: 32 (8), pp.1245-1268


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HABIB, M & ZURAWICKI, L. Corruption and Foreign Direct Investment. Journal ofInternational Business Studies. 2002: 33, pp.291-307

HANSEN, H & RAND, J, Causal Links Between FDI and Growth in Developing Countries.The World Economy, 2006: 29 (1), pp.21-41

HYMER, S.H. The International Operations of National Firms: A Study of Foreign DirectInvestment. Cambridge: MIT Press. 1976

JENSEN, N. Democratic Governance and Multinational Corporations: Political Regimes andInflows of Foreign Direct Investment. International Organization, 2003: 57 (3), pp.587-616

LALL, S & NARULA, R. Foreign Direct Investment and its Role in Economic Development: DoWe Need A New Agenda? The European Journal of Development Research. 2004: 16 (3),pp.447-464

MAYER, T. Policy Coherence for Development: A Background Paper on Foreign Direct

Investment. OECD Development Centre, 2006: 253, pp.1-60

NOORBAKSH, F., PALONI, A. & YOUSSEF, A. Human Capital and Foreign DirectInvestment Flows into Developing Countries: New Empirical Evidence. World Development.2001: 29 (9), pp.1593-1610

NUNNENKAMP, P. To What Extent Can Foreign Direct Investment Help AchieveInternational Development Goals? The World Economy, 2004: 27 (5), pp.657-677

ODENTHAL, L. FDI in sub-Saharan Africa. OECD Development Centre, 2001: 173, pp.1-55

OWEN, J. How Liberalism Produces Democratic Peace. International Security, 1994: 19 (2),pp.87-125

RESNICK, R, & LI, Q. Reversal of Fortunes: Democratic Institutions and Foreign DirectInvestment Inflows to Developing Countries. International Organization , 2003: 57 (3), pp.175-211

RICHARDS, D, GELLENY, R & SACKO, D. Money with a Mean Streak? Foreign EconomicPenetration and Government Respect for Human Rights in Developing Countries.International Studies Quarterly, 2001: 45, pp.219-239

ROOT,R & AHMED, A. The Influence of Policy Instruments on Manufacturing Direct ForeignInvestment in Developing Countries. Journal of International Business Studies. 1978: 9,pp.81-93

SHAH, A & SLEMROD, J. Do Taxes Matter for Foreign Direct Investment? The World BankEconomic Review. 1991: 5 (3), pp.473-491

SINGH, H & JUN, K, W. Some New Evidence on Determinants of Foreign Direct Investmentin Developing Countries. World Bank Policy Research Working Paper. 1995: 1531.pp.1-37

STRANGE, S. States, Firms and Diplomacy. International Affairs. 1992: 68 (1), pp.1-15

SUMNER, A. Foreign Direct Investment in Developing Countries: Have we reached a policytipping point? Third World Quarterly, 2008: 29 (2), pp.239-253

SUMNER, A. Is foreign direct investment good for the poor? A review and stocktake.Development in Practice, 2005: 15 (3&4), pp.269-285

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World Investment Report UNCTAD, August 2003, New York. Geneva: United NationsConference on Trade and Development

ii. Websites

CIA World Factbook 2009 [online]. [accessed 27 th June 2009]. Available From World WideWeb:

Freedom House, 2009 Freedom in the World Report [online]. [accessed 17 th June 2009].Available From World Wide Web:

Heritage Foundation 2009 Index of Economic Freedom [online]. [accessed 14 th June 2009].Available From World Wide Web:

IMF World Economic Outlook Database [online]. [accessed 7th June 2009]. Available FromWorld Wide Web:

Transparency International 2009 Corruption Perception Index [online]. [accessed 10th June2009]. Available From World Wide Web:

UNCTADInward Potential FDI Index 2004-2006 [online]. [accessed 29 th May 2009]. AvailableFrom World Wide Web:

UNDP World Development Indicators 2007/08 [online]. [accessed 5th June 2009]. AvailableFrom World Wide Web:

World Bank Governance Indicators 2009 [online]. [accessed 12th August 2009]. Available

From World Wide Web:


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Appendix I.

Combined List of Countries Used in Sample Population of Model One and Two:

Albania Iran South AfricaAlgeria Ireland South Korea

Angola Israel SpainArgentina Italy Sri LankaArmenia Jamaica SudanAustralia Japan SurinameAustria Kazakhstan SwedenAzerbaijan Kenya SwitzerlandBahamas Kuwait SyriaBahrain Kyrgyzstan TaiwanBelarus Latvia TajikistanBelgium Lebanon TanzaniaBenin Libya ThailandBolivia Lithuania TogoBotswana Luxembourg Trinidad and Tobago

Brazil Macedonia TunisiaBrunei Madagascar TurkeyBulgaria Malawi United Arab EmiratesBurkina Faso Malaysia UgandaCameroon Mali UkraineCanada Malta United KingdomChile Mexico United StatesChina Moldova UruguayColombia Mongolia UzbekistanCongo, Dem Rep Morocco VenezuelaCosta Rica Mozambique VietnamCote dIvoire Myanmar YemenCroatia Namibia Zambia

Cyprus Nepal ZimbabweCzech Republic NetherlandsDenmark New ZealandDominican Republic NicaraguaEcuador NigerEgypt NigeriaEl Salvador NorwayEstonia OmanEthiopia PakistanFinland PanamaFrance Papua New GuineaGabon ParaguayGambia, The Peru

Georgia PhilippinesGermany Poland


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Ghana PortugalGreece QatarGuatemala Republic of CongoGuinea RomaniaGuyana Russian FederationHaiti Rwanda

Honduras Saudi ArabiaHong Kong SenegalHungary Sierra LeoneIceland SingaporeIndia SlovakiaIndonesia Slovenia

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