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The opening of markets in developing countries in recent years has brought with it
burgeoning foreign direct investment (FDI) flows. governments in developing countries
acknowledge that they need outside capital to achieve their development objectives, partly
because industrial nations have stabilized foreign aid and development loans. Second,
export-oriented FDI brings relief from rampant foreign exchange shortages. Third,
recognizing that reversal of portfolio investment is less costly, a fact that exacerbated
recent financial crises in a number of developing countries, governments now prefers FDI
(UNCTAD, 1999). Fourth, host-country governments recognize that MNEs have access to
resources other than capital, that can assist with their development (such as technology,
management and access to foreign markets). Recognizing the long-term costs of failure to
integrate their economies into the global environment, developing countries have opened
up their markets in order to attract more FDI.

The role that FDI plays in the modern Brazilian economy is different than that which it
played in previous eras. Prior to WWII, FDI was concentrated in public utilities, including
transportation, in the primary goods export economy, and in banking, with a small
percentage in the manufacturing sector. Similar to Argentina, post-WWII FDI flows shifted
to manufacturing as part of an import substitution industrialization strategy. In the 1990s,
the role that FDI
played changed considerably. Brazil adopted institutional and macroeconomic reforms,
partially designed to stimulate FDI. Elements of these reforms included establishment of
the real plan, privatization of stateowned enterprises, and implementation of the Mercosur
free trade area.

For developing countries to compete for FDI inflows, they must implement macroeconomic
policies designed to reduce inflation, stabilize the exchange rate and increase the GDP of
the host country. With market-oriented economies in Latin America effectively in operation
for little more than a decade, instability of prices, employment and output would be
expected. A high rate of inflation is a sign of internal economic instability and of a host
governmentǯs inability to maintain expedient monetary policy. From the MNEǯs viewpoint,
high inflation createsuncertainty regarding the net present value of a costly, long-term
investment. For these reasons, companies may avoid making investments in countries with
high inflation. By ceteris paribus, a constant real exchange rate is preferred by MNEs in
order to reduce the exchange rate risk inherent with investment in a foreign country.
The demand-side of FDI theory argues that investment will go primarily to markets large
enough to support the scale economies needed for production. Although Tuman and
Emmert (1999) used GDP as a surrogate for market size and found it to be insignificant in
explaining FDI among Latin American countries, more recently Trevino et al. (2002) found
that GDP was a significant and positive indicator of FDI flows in Latin America. Further,
UNCTAD (1994) concluded that market size was the primary determinant of FDI.
Within Institutional theory lies political risk, which may be defined as the risk that a host
country government will unexpectedly change the institutional environment within which
businesses operate (Butler & Joaquin, 1998). From a financial perspective, political risk
may alter operating cash flows via discriminatory policies and regulations.
MNEs may deal with political risk by avoiding the risk altogether, by buying insurance, or
by negotiating with the governing body prior to investment. In order for developing
countries to attract FDI, they mustattempt to enforce a capital allocation system withstrict
and transparent rules and regulations. At thesame time, they should not exert excessive
controlover capital account transactions, such as viaexchange-rate controls and/or
repatriation or foreignownership restrictions. If governments maintain strict control over
capital transactions, such as via 236 L.J. Trevinƿo, F.G. Mixon Jr. / Journal of World Business
39 (2004) 233Ȃ243 foreign exchange controls and restrictions on FDI, then MNEs may be
reluctant to invest due to fears about restrictions on new capital formation, divestment and
repatriation.

The relationship between capital markets liberalization in Latin America and the expansion
strategies of international banks into the region is one example of FDI decisions made by
MNEs in response to institutional reform. Interest rates were allowed to be determined by
market forces, instead of by fiat, and financial resources were allocated on the basis of
supply and demand. During the first phase of reforms, banks were invited to operate in
markets in which they did not have prior access. These included areas such as leasing and
factoring, brokerageunderwriting and pension fund management. With economies of scale
and scope becoming an increasingly important factor to foreign banks, the ability to
operate in these areas was seen as increasingly important to their plans to globalize
operations. The second phase of reforms created a regulatory environment similar to that
of international banksǯ home country environments, in the process creating a more certain
investment climate and opening the door for foreign banks to operate in the local market.
Capital markets liberalization, thus, helped to create an environment with appropriate
institutions and removed the entry barriers for foreign banks, enabling them to expand into
Latin America and to gain an increasingly large market share in the region (ECLAC, 2003).
One example of a multinational bank that has made significant inroads into Latin America
in the postreform era is Citigroup, one of the worldǯs largest financial institutions.

Institutional reform was initiated in the early 1990s in much of Latin America in response
to shortcomings in many sectors, including a lack of public funds for investment and gaps
in technology. During this timeframe, governments introduced reforms designed to attract
foreign private capital. Although reforms took place in many sectors, nowhere is this policy
more evident than in the telecommunications sector. In the early years of reform, many
Latin American countries privatized their public telecommunications companies and
allowed unprecedented foreign participation, attracting large investments and substantial
improvements in the telecommunications infrastructure.

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