Foreign Direct Investment 1

A CRITICAL EVALUATION OF FOREIGN DIRECT INVESTMENT IN SPAIN

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Table of Contents
Foreign Direct Investment and the Spanish Economy.................................................................... 3

Cross-Country FDI.......................................................................................................................... 3

Reverse FDI in Asian Developing Countries.................................................................................. 4

FDI in Spain .................................................................................................................................... 5

Overview of Global FDI ..............................................................................................................6

Spain and the Expansion of FDI ..................................................................................................6

Determinants and Sector Orientation of FDI ...............................................................................7

FDI- Source and Destination .......................................................................................................8

Profitability ..................................................................................................................................8

Effects on the Economy of Spain.................................................................................................9

Determinants of FDI in Spain ......................................................................................................... 9

Data and Variables ..................................................................................................................... 10

Theory and Empirical Evidence................................................................................................. 10

Theoretical Approaches ........................................................................................................ 10

Empirical Evidence for Spain ............................................................................................... 15

Regional Distribution ................................................................................................................. 16

A General Perspective........................................................................................................... 16

The Spanish Case .................................................................................................................. 18

References ..................................................................................................................................... 19
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A CRITICAL EVALUATION OF FOREIGN DIRECT INVESTMENT IN SPAIN

Foreign Direct Investment and the Spanish Economy

The past thirty years of the Spanish economy have been prodigal with intensive growth and

production, particularly due to the escalating inflows of Foreign Direct Investment (FDI). In

1986, Spain went into accord with the European Community (EC) which resulted in noteworthy

improvement in FDI. This was also reflected in the promising forecasts of the future of Spain’s

economy. However, limited empirical evidence is available despite the significant contribution

of FDI to the economy of Spain (Bajo-Rubio and Sosvilla-Rivero 1994).

Capital movements have been increased internationally over the past couple of decades with the

liberalization of business activities. According to OECD (2011), the flows of FDI have grown

tremendously despite the global financial crisis of 2008. Economic growth is considered to be

driven by FDI. According to UNCTAD (2014), around 54% of global FDI flows are received by

the developing countries. 39% and 7% of the FDI flows are received by the developed countries

and the countries in transition, respectively. As suggested by Roca (2010), Spain has been

attracting inward FDI since the mid-80s, with unequal distribution among the regions.

Consequently, regional inequalities have astoundingly increased in Spain.

Cross-Country FDI

FDI across countries is determined by various factors who empirical analyses retain a multitude

of econometric specifications. Gravity equation has been mainly used in various studies

examining the cross-country flows of FDI. The gravity equation considers the geographic

distance between the two countries, alongside the sizes of their economies, and some relevant

proxies. Theoretical models have been developed by the researchers, that are based on the FDI

decisions of the multinational corporations (MNC’s) (Carr, Markusen & Maskus 2001;
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Bergstrand & Egger 2007). These models suggest that the patterns of FDI are also determined by

various other factors.

According to these studies, the gravity model must be modified to explain the patterns of FDI

accurately. The variables used in the gravity model explain that firms engage in FDI to outsource

their operations to other markets so that more consumers can be attracted. Additional controls are

indispensable so that firms are able to find low-cost labor at inexpensive locations to boost

production. These studies imply that MNC’s make complicated decisions regarding FDI that the

two variables, endowments of skilled labor and GDP, must be used to account for their impact on

the patterns of FDI. On the contrary, the researchers have modelled FDI as a result of MNCs’

decisions to engage in cross-country mergers and acquisitions.

Reverse FDI in Asian Developing Countries

A substantial growth in FDI has been observed since the 80s, particularly from the developing

countries found in South Asia, Southeast, and the East. The outflows of FDI are linked with

massive levels of foreign reserves, household savings, export orientation, Gross Domestic

Product (GDP) and the inflows of FDI in source countries. The development level of each factor

determines its significance and strength. FDI was once assumed to have been flowing to

countries with a dearth of capital and industrialization, from more industrialized countries, rich

in capital. In the contemporary era, FDI has been flowing in the reverse direction. In simple

words, FDI has been flowing into the developed and developing countries, from other

developing countries. The major flow of FDI is found amongst developed countries (UNCTAD

2012).

However, researchers have now become attracted to the idea of reverse FDI due to its increasing

popularity and significance. Reverse FDI is an ancient concept that originated in Japan, during
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the 60s and 70s. Japan’s economy was the first amongst the Asian economies to have

experienced steady economic growth and industrialization. Taiwan, Hong Kong, Singapore, and

South Korea were the first Asian dragons to have welcomed investment from Japan. Japanese

investment then flowed to the Asian countries in Southeast, North America and the European

Union (EU). Towards the end of the 20th century, the Asian tigers retraced the footsteps of

Japan’s foreign expansion (Bano & Tabbada 2015).

FDI in Spain

Spain has not only been receiving FDI, but has also become its source, particularly since the

2000s. Increased FDI in Spain has helped the economy to expand into other markets. The

mounting flows of FDI can well be explained by globalization. Developed countries, particularly

the EU have maintained their lead in FDI, now followed by an ever-increased participation of the

developing countries. The Spanish economy ranks third amongst the European economies in

case of outward FDI as a proportion of GDP. Spain ranks second in case of inward FDI. The

MNCs in Spain usually drive outward FDI and the services sector of the economy consumes

most of the inward FDI. Spain receives investments mainly from the US and Europe.

The outward FDI driven by Spain flows towards Latin America and Europe. Outward FDI from

and inward FDI in Spain has turned out to be profitable with regards to employment, growth in

the GDP and exports. In addition, firms in Spain have become more efficient. Spain has been

investing abroad, especially in research and development (R&D) and human resources.

Policies must consider attracting FDI into the Spanish economy, and also encourage the

diversification of Spanish FDI. The inflow of FDI in Spain has led to the development of MNCs.

These are owned by the non-residents. It is through the outward FDI that Spanish companies

develop their branches abroad. On the contrary, investments are made by the subsidiaries of
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foreign MNCs from within the Spanish territory. Myro’s (2015) analysis considers the variable,

foreign direct investment position (FDIP). It measures the FDI stock. The FDIP data is collected

through two sources; the foreign investments register and the balance of payments. Trends seem

alike upon the comparison of both the sources. However, higher values have always been

identified with the balance of payments.

Overview of Global FDI

For the next three decades starting from the 80s, the world economy has greatly developed

through the swift growth of FDI. However, the recent recession has adversely impacted the

growth of FDI. However, the progress of FDI has been on track since the figures recorded in

2012 were still higher than those of 2007. The trend observed in the decade of 2000s is

noteworthy because the FDI stock increase by more than threefold. However, the growth rate

started to boost even before the commencement of the decade, particularly towards the end of the

90s.

FDI flows have been mainly received and issued by the European Union, implying that the

developed countries are the key players in FDI. However, since 2007, developing countries have

also been actively partaking in the FDI flows. In 2012, the developing countries acquired 1/3rd of

the global aggregate direct investment. This exceeds the figure recorded in 2005 by ten

percentage points. According to Guillén and García-Canal (2011), the emerging market MNCs

have traits distinct from the traditional MNCs. Consequently, this has posed many difficulties in

the analysis of the MNCs. In the perspective of Helpman (2011), mounting globalization and its

impact on the world economy play a key role in explaining the FDI expansion.

Spain and the Expansion of FDI

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According to Myro (2015), Spain has contributed a lot to the expansion of FDI. It first received

inward foreign investment, and later, since the 2000s, became a source of FDI. It was in 1990

when the foreign investments started to escalate. They accounted for about 3.2% of the global

aggregate. This percentage started to decline with the expansion of international flows before its

recovery in 2007. Foreign investments by the Spanish firms rose to 3% of the global investments

in the same year. It happened in 2000s that Spain turned into a foreign investor, from being

merely a recipient of foreign investments.

Between 2004 and 2006, Spain turned into a buyer of businesses, having a share of 385 in

European cross-border acquisitions. Spain aspires to retrace the footsteps of France and the

United Kingdom, being both the sources and destinations of FDI. Germany issues FDI more than

it receives. This is particularly due to the fact that its share of inward FDI in relation to GDP is

poor. It is because of the present crisis that Spain currently ranks low in world FDI. However, the

volumes of inward and outward FDIs have significantly grown, in comparison to other European

countries. This can be explained through the decline of the shares of outward and inward FDIs of

the developed countries, relative to the ascent of those of the developing countries (Myro 2015).

Determinants and Sector Orientation of FDI

Presently, Spain has around 9,000 subsidiaries of foreign MNCs, of which 4,000 are owned

directly. The empirical studies suggest that subsidiaries are being set up in Spain because of the

rapid expansion of the market. These subsidiaries are mainly found in the services sector,

particularly in the operations requiring low capital and in businesses mainly relying on imports.

These include metal, chemicals, motor vehicles, pharmaceuticals and ICT manufacturing. Spain

could draw in more FDI by integrating into the European Union. As a result, MNCs found Spain

attractive as it had open policies with its partners in the European Union.
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Two other incentives include steady growth and macroeconomic stability. This infers that inward

FDI could be attracted through economic recovery, competitive markets, and innovation. Large

and profitable Spanish companies take on the process of investing abroad, by strongly

establishing themselves in the target markets. The companies that invest abroad tend to be more

productive than those that do not invest abroad, roughly by 18%. It is through the expansion of

these companies abroad that they are able to reap the benefits of economies of scale and

maximize their profitability, especially in the countries that are both culturally and

geographically close. These include Latin America and the northern neighbors of Spain.

FDI- Source and Destination

Europe is rather significant for Spain’s inward FDI than outward. US invests intensely in Spain.

Italy has gained significance since 2011, with its companies holding the largest volume of the

investments’ stock. Argentina, Portugal, Israel, Brazil, UAE and Mexico have been penetrating

extensively. Europe has been specialized with outward FDI. Latin America is a major recipient

of FDI because of its linguistic and cultural association with Spain. However, Spain pulled out

its investments from Latin America to diversify them, immediately after the European Union

integration. Spain is still on the way to penetrate into Asia (Myro 2015).

Profitability

The returns on Spanish investments abroad and those on the investments in Spain by the foreign

MNCs are parallel to those of Germany. In other words, the returns rank below those of the UK

but higher than those of Italy and France. Although the returns declined amid the crisis, the

foreign investments of Spain remained acceptable. When the returns on investment are strong,

the strength the strategies of domestic and foreign MNCs, and the investment activity continues

to rise. Between 2003 and 2007, the returns on Spanish investments abroad reached to up to
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17%. The global financial crisis of 2008 changed the situation and the figures were cut down by

half (Myro 2015).

Effects on the Economy of Spain

According to the earlier researches, the economy of Spain improved with the establishment of

the subsidiaries of foreign MNCs within the country. Not only an upward trend in the GDP has

been observed, but exports and employment have also increased. Myro (2015), during 2006-

2013, assessed the effects of inward FDI in the Spanish economy. A general equilibrium model

was used for this purpose that estimated how the employment rate increased by 5.25%, with a

decline in the unemployment rate by 3.15%. Real salaries increased by 1.89%, increasing the

welfare of the Spaniards by 2.79%.

Spanish firms that invested abroad also casted positive impacts. A positive impact on

employment and labor skills was observed, alongside increased technological developments and

exports. Companies not having their subsidiaries in Spain had six times as many people working

in R&D that companies not having their subsidiaries anywhere else in the world. The research

also estimated that firms tend to spend around 5,000 euros for every employee’s training on an

annual basis after investing abroad. According to Huertas and Salas (2014), this intensity of the

human capital is more like dependent upon higher quality business management.

Determinants of FDI in Spain

Globalization in the economy of Spain has been greatly shaped by FDI. FDI has proven

significant to the balance of payments of a country, alongside its productive capacity. In fact,

investments received by a country cast a substantial impact onto the structure of business

corporations, innovation, potential technical advancements and the distribution of employment.

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Data and Variables

FDI in Spain has determinants that pursue two different approaches. The first approach revolves

around the aggregate investment for the entire country. The second approach is based on

studying the regional distribution of FDI on multiple investment levels. The techniques of the

panel data derive favorable econometric outcomes that can be taken advantage of, through the

latter approach. These advantages are maximized by analyzing the determinants of FDI in Spain

through the analysis of the breakdown of 28 sectors found in the economy of Spain. The study

covers a period between 1993 and 2002. Investments are analyzed regionally through the use of

gross effective investment, forming the dependent variable. As per the Spanish Ministry of

Economy (SME), the greatest indicator of FDI is the Gross Effective Foreign Investment

(Rodriguez & Pallaz 2008).

Theory and Empirical Evidence

Theoretical Approaches

The dependent variable, RFDI, was thoroughly analyzed by the researchers, Singh and Jun

(1999) to study some variables associated with the FDI of the developing countries. RFDI was

tested under certain conditions to study how the market size of the developing countries,

alongside the costs of labor, private restructuring, exchange rate, and debt equity swaps were

impacted. The researchers also analyzed the developing countries’ home country and

interregional characteristics. This thorough and meticulous study later revealed that FDI is

mainly determined by the level of political risk. In addition, the researchers also disclosed that

the investment flows are negatively affected by the sociopolitical instability. Where the FDI is

mounting, the flows are usually determined by the level of exports.

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Another research by Lizondo (1990) was based on studying how diversified the risk is, alongside

the size of the market, rates of return, and technical developments. To test the determinants of

FDI, the researcher also took oligopolistic competition, strength of the currency, liquidity

position, market failure, tax policies, instability in the political system and government

regulation into account. According to the findings of the study, the phenomenon of FDI is rather

vast and there is no one definition to attach a clear meaning to the concept of FDI. However, the

factors pertaining to microeconomics and macroeconomics are associated with FDI, as proven by

various hypothesis.

In the perspective of Nonnenberg and Mendonca (2004), the determinants of FDI are related to

the firms and to source country factors, as well as to the location factors. The two researchers

based their research in about 33 countries in the developing world between 1975 and 2000, and

selected nine variables to study the determinants of FDI in the developing countries. The

variables analyzed by the researchers are as follows:

1. ESCOL: This variable analyzes how educated the workforce is;

2. G5PIB: This variable analyzes the average rate of how much the GNP has grown over the

past 5 years;

3. PIB: This variable analyzes the level of GDP;

4. ABERT: This variable analyzes how open and liberal the trade is;

5. RISCO: This variable determines the risk rating;

6. INFLAÇÃO: This variable determines the inflation rate;

7. DOWJONES: This is the Dow Jones Index;

8. ENERCON: This variable analyzes the energy consumption per capita;

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9. PIBOECD: This variable analyzes the aggregate GNPs of the exporters of the largest

OECD capital to the developing countries.

Log Foreign Direct Investment (LFDI) was the dependent variable used by the researchers in

their study. Asiedu (2002) studied the 71 developing countries in Africa and the findings

revealed that Africa could not benefit in any way despite its commendable and endless efforts at

attracting investment. In other words, the continent of Africa could not reap the benefits of

elevating flows of investment to the developing countries. In studying the determinants of FDI,

Lim (2001) analyzed Portugal, Spain, Mexico, Argentina and Brazil, collecting data between

1981-1998. The findings reported that market size and economic growth are the most efficient

determinants to attract FDI. 31 developing countries were studied by Hallward-Driemeier (2003)

between 1980 and 2000. The findings of the study revealed that FDI flows are mainly

determined by the per capita GDP of the host country, sizes of the host and the source countries,

macro-economical stability of the host country, and trade openness.

Campos’s and Kinoshita’s (2003) study of 25 transitional economies, Baltic and East European

countries during 1990-1998 revealed some of the primary determinants of FDI. These

determinants revolve around agglomeration, institutions and openness to trade.

During 1984-2003, up to 83 countries in the developing world were studied by Busse and

Heffeker (2007). The findings of their study revealed that foreign investment flows into these

developing countries when the internal conflict is minimum, and there are no ethnic differences.

Besides, the stability of the authoritative system and the government, alongside ensuring the

steady state of law and order ensure that these 83 developing countries become an attractive

location for FDI.

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The findings of a study headed by Buch and Kickulenz (2010) shed light onto the some of the

determinants of FDI. Developing countries tend to receive increased remittances especially when

the age-dependency ratio and the literacy rates are high. In addition, increased participation of

women in the working sector also increases the remittances received by the developing countries.

However, the remittances received by developing countries remain unaffected by certain factors.

The level of remittances received by developing countries remain unaffected despite

development in the economy or higher returns on financial assets.

Malaysia seemed to be an attractive location for Fazidah (2013) to conduct a study in, in order to

identify the FDI determinants. The findings of the study initiated by the researcher revealed that

FDI inflows and outflows in Malaysia were determined by the size of the market and the

infrastructure of the country. The exchange rate, however, did not cast any statistical impact on

the inflows or the outflows of FDI in Malaysia. MINT and BRICS were studied by Akpan, Isihak

and Asongu (2014) during 2001-2011. According to the findings, the availability of

infrastructure, size of the market, and openness to trade were the key determinants of FDI flows

into MINT and BRICS. Basu and Srinivasan (2002) initiated a research in Uganda, Mauritius,

Lesotho, Botswana, Swaziland, Namibia and Mozambique between 1980 and 2002. As per their

findings, stability in the political and economic system, and sound macroeconomic policies were

the main determinants of FDI. Kinoshita (1998) suggested that domestic market, infrastructure

and political environment were significant variables of FDI in Asia in 1993.

UK, Sweden, Portugal, Switzerland, Norway, Sweden, Ireland, Finland, Austria, Greece,

Belgium, Germany, Italy, France, Spain and Netherlands were studied during 1983-2002 by

Foad (2005). The findings revealed that correlation exists between FDI and exchange rate.

Olapido (2010) initiated a study in Nigeria to determine the FDI determinants. According to the
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findings, the primary determinants of FDI in Nigeria are the size of the country’s market, human

resources, level of exports, stability of the country into the macroeconomic system, and facilities

associated with the infrastructure. Between 2003 and 2006, a study was conducted in Africa by

Braga de Macedo, Pereira and Lopes (2009). It was found that stability of the macroeconomic

system and size of the economy were the positive indicators of FDI flows. However, the

complementarities alluding to FDI-aid, law and accountability, forming the three institutional

variables were insignificant.

According to Broadman and Recanatini (2001), the development of infrastructure, size of the

market and other factors regarding the environmental policies were the major determinants of

foreign investment flows across Russia. Of all the capital flows into the countries found in Latin

America, FDI has the greatest share especially when the countries are risky and geographically

distant. The flows of FDI into countries found in Latin America tend to be rich in resources and

weak. These countries also tend to be underdeveloped, as studied by Hausmann and Fernandez-

Aria (2000). The economy tends to grow when FDI flows are high and frequent (Carkovic &

Levine 2005).

Total Factor Productivity has substantially increased in the coastal region of China, according to

Graham and Wada (2001). According to Singh (2005), FDI flows have proven to be favorable

for the Indian economy. Not only the growth rate of tele-density has been the greatest, but the

number of people using the Internet has reached its acme. Tariffs have been reduced and there is

no dearth of bandwidths for software exports. In the perspective of Har, Teo and Yee (2008),

there is a strong association of Malaysian FDI inflows with the growth of the economy.
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Empirical Evidence for Spain

In the analysis of the period 1961-1988, Bajo-Rubio (1991) found the the unit labor costs and the

size of the market are linked to FDI. In addition, the location of FDI in the manufacturing sector

is greatly determined by the skills of the workforce. The researcher analyzed the period through

co-integration, and found a long-term association of FDI inflows with distinct variables. These

variables comprise of the inflation rate, the real GDP, foreign capital stock and the trade barriers.

Egea and López-Pueyo (1991a) suggest that substantial dynamics in exports, internal demand

and production are found in areas the receive most of the FDI, during the period 1986-1989.

Martín and Velázquez (1996) studied the factors that determined the FDI flows between OECD

countries, with special attention to the inward FDIs received by Spain.

The researchers concluded that foreign capital can be attracted through the availability of quality

transport facilities and infrastructure, a dynamic market, liberal FDI regulations, and skilled

workforce. FDI flows into Spain with regards to the market size, costs and qualifications of

workforce. The regional perspective has also gained significant attention. Egea and López-Pueyo

(1991b) carried out a cluster analysis between 1985 and 1989. The researchers identified that

human capital, per capital, productive structure and per employee income are the major

determinants of the location of FDI. However, the rate of unemployment, subsidies and

infrastructure endowment are of no significant use. The researchers have also used distinct

techniques of estimation to reveal that the size of the market, qualifications of the workforce, aid

and other incentives cast a positive influence on the FDI flows’ regional location. However, FDI

is not driven by infrastructure, as highlighted in the study.

According to Pelegrín and Bolancé (2008), FDI can be manufactured through increased R&D

and agglomeration economies. However, each industry values the determinants of FDI location
Foreign Direct Investment 16

differently. In the perspective of Rodríguez and Pallas (2008), FDI is attracted by the demand

factors, the export potential of each sector in the economy, cost of labor workforce, and the

differential between the productivity of labor, during the period between 1993 and 2002. A

methodological approach was adopted by Villaverde and Maza (2012) who analyzed how the

FDI was distributed across the regions in Spain. An explanatory factor analysis was performed

by the researchers that led labelled the four factors as competitiveness, market size, labor

conditions and the economic potential.

FDI is attracted mainly by the labor conditions, economic potential and competitiveness, as

revealed by the econometric analysis. FDI is both attracted at the sectorial level, as well as the

aggregate level. In addition, when the analysis was extended to consider the spatial effects, there

were some negative topographical spillovers linked with the two factors; competitiveness and

economic potential. There are mixed results of the empirical evidence. However, there are some

factors that are common amongst all the empirical studies. Inward FDI flows into Spain through

various resource-seeking and market-seeking FDI factors. In other words, these factors include

the market size, labor conditions, human capital and physical infrastructure endowment.

Regional Distribution

A General Perspective

FDI has grown tremendously over the last decades, hence, the determinants of FDI have become

a very interesting topic for the academicians and experts to research upon. A lot of empirical

studies have examined this topic at a national level. The primary focus of these studies is riveted

at the classical determinants of FDI. These include taxes, trade effects, exchange rates,

institutions, political risks, etc. According to Mullen and Williams (2005), this issues has been

addressed very little at a regional level. Therefore, the variables mentioned above are irrelevant
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because of their similarity across the regions of a country. The “eclectic paradigm,” as suggested

by Dunning (2001) summarizes the entire debate. “Location advantages,” “Internationalization

advantages,” and “Ownership-specific advantages” make this pattern a combination of

comparative advantage and the agglomeration approach.

The agglomeration approach is based on agglomeration economies. Financial and intellectual

spillovers mainly drive these economies. The horizontal FDI is determined primarily by the

agglomeration economies. However, the comparative advantage approach of the neoclassic

suggest that vertical FDI is determined by the availability of the input and differences in the costs

of the input (transport, labour, energy, etc.). There are many empirical studies that analyze how

the agglomeration approach and the comparative advantage approach summarize the regional

characteristics.

Many researchers have now turned their focus to China since the country has become one of the

frequent recipients of FDI. FDI determinants have also been analyzed traditionally by a group of

researchers. The researchers conclude that the largest chunk of FDI is received by those

provinces that engage a lot more in international trade in relation to other provinces, have more

R&D manpower and low wage rates, are rapidly advancing in agglomeration and contribute to

higher growth rates in GDP. In contrast, the researchers have also shown that realized FDI is

driven by only some of these variables. The location of FDI was studied by Hong, Sun and Li

(2008) in the provinces of China. Considering the significance of spatial interdependence, the

researchers concluded that FDI in host province is significantly affected by the FDI is the

neighboring provinces.

Boermans, Roelfsema and Zhanh (2011) achieved their conclusions through the amalgamation of

the factor-based approach and the panel approach. FDI has been spatially distributed in the US,
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which has become the subject of interest. Many papers that focus the flow of FDI into the

manufacturing sector confirm that traditional determinants, comprising of labor market

characteristics, per capita income, etc. cast an impact on the FDI distribution amongst the states.

These determinants also highlight how the manufacturing density can be favorable. According to

Bobonis and Shatz (2007), the state distribution of FDI is affected significantly by the presence

of agglomeration economies.

The Spanish Case

The situation in Spain is more are less the same as the other countries. Egea and Lo´pez (1991c)

has presented a thorough analysis of the regional distribution of FDI. FDI location is primarily

determined by the human capital, market size and public incentives. On the contrary,

infrastructures become insignificant when the coefficient of the labor costs is positive.
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