UNCTAD VIRTUAL INSTITUTE

TRAINING PACKAGE ON ECONOMIC AND LEGAL ASPECTS OF

INTERNATIONAL INVESTMENT AGREEMENTS (IIAs)

Module 1
Concepts, trends and economic aspects of foreign direct investment
Theme 3
DETERMINANTS OF FDI
Part I. Host country determinants of FDI
Part II. Firm level determinants of FDI

Kampala, 10-14 November 2008

Zbigniew Zimny
UNCTAD consultant


Part I
HOST COUNTRY DETERMINANTS OF
FDI
Why some countries receive more FDI than
others? Why a host countrys FDI inflows may
drastically fluctuate over time?
What determines how much FDI does a host
country receive?

Case 1. Brazils FDI inflows from 1970 to 2007
Questions: Why Brazils inflows were lower during 1983-1994 than in 1983? Why
they started recovering only after 1995? Why did they peak during 1997-2000 and
then fell again?
FDI inflows into Brazil, 1970-1993, $ bln and share of DCs' inflows in %
0
5
10
15
20
25
30
1
9
7
2
1
9
7
3
1
9
7
4
1
9
7
5
1
9
7
6
1
9
7
7
1
9
7
8
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
%
0
1
2
3
4
5
$

b
l
n
Share of DC inflows, % FDI inflows, $ bln
FDI inflows into Brazil, 1990-2007, $ bln and share of DCs' inflows in %
0
2
4
6
8
10
12
14
16
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
%
0
5
10
15
20
25
30
35
40
$

b
l
n
Share of DC inflows, % FDI inflows, $ bln
Case 2. India vs. China (with Brazil as a
reference) since 1980
QUESTION: Since China has emerged as a host country, it has always received much
larger FDI inflows than India. Why?
FDI inflows to China, India and Brazil (for reference), 1980-1989, $ million
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Brazil China India
FDI inflows into China, India and Brazil (for reference), 1990-2007
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
$90,000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Brazil China India
Case 3. Investors perspective: what TNCs
consider important when choosing a location?
1. FDI locational factors in developing countries, 2007, top
importance (1=not at all important; 5=extremely important)
3.4 3.6 3.8 4.0 4.2 4.4 4.6
Quality of universities and research institutes
Quality of international sea links
Hiring and firing regulations
Quality of life
Corporate income taxes
Access to export markets
Attitude towards foreign investors
Investment incentives
Quality of international air connections
Quality of banking and other financial
Supply of high-skilled labour
Costs of high-skilled labour
Quality of telecommunications
Macroeconomic stability
Political stability
2. FDI locational factors in developing countries, 2007, less
important (1=not at all important; 5=extremely important)
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0
Quality of rail network
Costs of low-skilled labour
Supply of low-skilled labour
Personal taxation
Costs of real estate
Availability of natural resources
Bilateral investment treaties
Ability to recruit internationally
International schools
Presence of other companies in the same
Proximity to sophisticated customers
Double taxation treaties
Quality of road network
Quality of housing
Energy costs
General costs of doing business
Quality of local suppliers of goods and services
Sorting out host country FDI determinants
To answer these questions and explain differing records of
countries in attracting FDI we need to understand key
factors determining FDI inflows into countries
As a rule, countries that offer what TNCs seek stand a
greater chance to attract more FDI
TNCs seek many things (called locational advantages) in
host countries. Key among them are economic attractions
including:
natural resources (giving TNCs access to, and control of, natural
resources)
large and dynamic domestic markets and access to international markets
(permitting TNCs to grow faster than in national markets, spread the risks and
better service the markets)
lower costs of resources such as labour and other inputs, e.g.,
infrastructure services (permitting TNCs to reduce costs of production and
operations)
availability of firms possessing assets needed by TNCs (e.g., R&D,
brands, customers base, marketing or other capabilities)

Natural resource
-seeking
Efficiency-seeking
Market-seeking
Strategic-asset
seeking
TNCs
What TNCs seek in host countries determines the
types of FDI
Mining
Tourism
Oil and gas extraction,
Access to a large domestic
(Brazil, China, India) or
regional market (EU, NAFTA,
ASEAN) horizontal FDI
Divide and specialize production
in line with the comparative advantages
of different locations vertical FDI
export-oriented FDI
primarily through M&As
Each type of FDI has a different set of
economic requirements
Motive of FDI Key determinants
Natural resource-
seeking FDI
Abundance and cost of natural resources
Physical infrastructure (ports, roads, railways, etc.)
Price movements
Market-seeking FDI

Market size and purchasing power (per capita income)
Market growth
Access to regional and global markets
Tradability of product/service
Structure of markets
Efficiency-seeking,
export-oriented FDI
Quality and cost of human resources
Physical infrastructure (ports, roads, telecom, etc.)
Trade costs
Quality of suppliers, clusters, etc.
Regional integration agreements
Strategic asset-
seeking FDI
Presence of firm-specific assets
Ease of cross-border M&As
Efficiency and transparency of financial markets

Three groups of host country FDI determinants
Economic attractions are very important but they are
only one group of host country determinants
The two other groups are:
Policy determinants divided into two sub-groups:
1. FDI policy proper including policy
measures affecting only or mainly foreign
investors
2. Policies affecting all investors. Some of
them may be more and some less important
for foreign investors
Business facilitation, including investment
promotion
Policy as FDI determinant: core FDI policies
Rules and regulations governing the entry and establishment of foreign
investors in a host country
-- e.g., prohibition of entry, restrictions on ownership (joint venture
requirement) or liberalization of entry
Treatment of foreign investors concerning entry, establishment and
operations
-- non-discrimination in the treatment of foreign and domestic firms
(national treatment) and among foreign firms (most-favoured nation
treatment)
-- preferential treatment of foreign or domestic firms (e.g., incentives only
to FDI)
-- distinguish treatment before and after entry
Protection of foreign investors
-- expropriation and nationalization; fund transfers; and dispute settlement
are key issues in protection
-- protection against regulatory takings is a new issue
General policies affecting FDI
Policies affecting
economic,
political and
social stability
Trade policy
Privatization policy
Tax policy
Monetary
fiscal
exchange rate policies
import-substitution vs.
export-orientation
membership of regional
integration schemes
can be a powerful
determinant of FDI
inflows
tax heavens
tax incentives
corporate and
personal taxes
Key general policies that affect FDI
NOTE: THERE ARE MANY OTHER POLICIES AFFECTING FDI IN ONE WAY OR THE OTHER,
RANGING FROM EDUCATIONAL POLICIES THROUGH LABOUR MARKET POLICIES TO
ENVIRONMENTAL AND SECTORAL (E.G., MINING) POLICIES
What is Investment Promotion?
Investment promotion is undertaken by Investment Promotion
Agencies (IPAs). WAIPA has a membership of 231 agencies
from 156 countries.
INVESTMENT PROMOTION FUNCTIONS:
Image-building (advertising, exhibitions, missions, seminars on investment
opportunities marketing a host country)
Investor generation and targeting (industry specific activities: direct
mail campaigns, missions, seminars, targeting individual investors, e.g., Intel to
invest in Costa Rica)
Investment facilitation (all types of help to new and existing investors:
counselling services, applications and permits, post-investment services)
Policy advocacy with a view to improving the investment
climate (policy task forces, lobbying activities, drafting laws and policy
recommendations, reporting investors perceptions)

Why Investment Promotion may matter?
When choosing investment locations, TNCs
o face market failures in information due to high
transactions costs of collecting information about
investment locations.
o Their information base is far from perfect and their
decision making process is often subjective and biased
o Most TNCs consider only a small range of potential
investment locations and many countries (with real
investment opportunities) are not even on their map
Through investment promotion Governments can
o bridge or diminish the information gap by providing better
information and improving the countrys image
o help foreign investors reduce the costs of entering,
establishing and operating in the country
o better understand and meet the needs of investors and
improve the investment climate through policy advocacy

Host country determinants
Host Country Determinants of FDI
Policies on functioning and structure of markets
(especially competition and M&A policies)
Privatization policy
Good infrastructure and support services e.g.
banking, legal accountancy services
Note: this type of FDI takes place through cross-
border M&As for a variety of strategic reasons
Availability of firm-specific assets: technological,
innovatory, marketing, brand names, etc.
Buying market power or new markets, spreading
risks, lowering transaction costs
Availability & cost of skilled labor
A. Market-
seeking
Market size and per capita income
Market growth
Access to regional and global market
Country specific consumer preferences
Structure of markets
Availability of raw materials and natural resources
(e.g., for tourism)
Cost of raw materials
Physical infrastructure (ports, roads, railways,
power, telecom)
Low-cost unskilled labour or skilled labour
Cost of resources and labour adjusted for
productivity
Other input costs, e.g. transport and communication
costs to and from and within host economy
Regional integration agreements (inter-country
division of labour)
B. Resource
-seeking
C. Efficiency-
seeking
D. Strategic
asset-
seeking
I. Policy framework for FDI
Economic, political and social stability
Rules regarding entry and operations
Standards of treatment of foreign affiliates
II. Economic determinants
Hassle costs or red tape (corruption,
administrative efficiency, etc)
Social amenities (quality of life, bilingual
schools etc.)
Social capital; attitude to work
International trade and FDI
agreements


Trade policy (tariffs and NTBs) and coherence
of FDI and trade policies
Tax policy
TO NAME A FEW..
Investment promotion
Investment incentives
III. Business facilitation
Type of FDI by motives of
TNCs
Principal economic determinants in host
countries
Notes on host country FDI determinants
FDI determinants differ according to the type (motive) of
FDI (e.g. efficiency-seeking or market-seeking), the mode of
entry (greenfield vs. M&As) and the sector of investment
(services or manufacturing)
A number of determinants are important to all investors:
e.g., political and economic stability, the rules of entry,
establishment and treatment of FDI and protection of FDI
Typically there are many host country factors involved in
deciding where an FDI project is located
It is often difficult or impossible to pinpoint to the most
decisive factor
The interrelationships among the three sets of determinants
must be borne in mind
Economic determinants are key determinants: countries that
do not have them will not attract a given type of investment
Notes continued
Strong economic determinants (e.g., large and
dynamic market, oil, or privileged access to large
markets) can bring much FDI in less than perfect
business environment
The importance of two other sets of determinants
should be considered under the assumption other
things being equal
Economic attractions being equal or similar,
countries whose policies are most conducive to TNC
activities, stand a better chance of attracting FDI
Other things being equal, incentives or FDI
promotion can win an investment project

Back to the Brazil, China and
India: how determinants can
make a difference?
Brazil in the 1970s and 1980s: loss of stability
Debt crisis hit Brazil in 1983
Severe macroeconomic and
political instability followed:
large budget deficit,
hyperinflation (3,000% in
1990!) and low growth (GDP
per capita fell)
The Real Plan in 1994
restored stability
In 1995 FDI inflows
exceeded pre-crisis level and
started growing again

FDI inflows into Brazil, 1970-1995, $ mln, and 5-years trendline
0.0
500.0
1 000.0
1 500.0
2 000.0
2 500.0
3 000.0
3 500.0
4 000.0
4 500.0
5 000.0
1
9
7
0
1
9
7
1
1
9
7
2
1
9
7
3
1
9
7
4
1
9
7
5
1
9
7
6
1
9
7
7
1
9
7
8
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
Brazils peak in 1997-2000: privatization
Brazils privatization
programme was among the
biggest in the world, valued
at $105 bln from 1991 to
2002
Largest sales, $65 bln, took
place in 1997-1998,
With big privatizations of
utilities completed,
unprecedented FDI inflows
proved to be unsustainable
until 2007 due to large FDI
in metal mining
FDI inflows into Brazil, 1995-2007, $ billion and 5-years average trendline
0.0
5 000.0
10 000.0
15 000.0
20 000.0
25 000.0
30 000.0
35 000.0
40 000.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
China vs. India
Market size and growth
The size of population is not much different but China has much
higher income per capita, more than two times larger market
and has grown much faster than India
China vs. India, population, GDP and GDP per capita, 2005
0
500
1000
1500
2000
2500
Population,
mln
GDP, $bln GDP per
capita, $
China
India
China vs. India, annual rate of GDP growth, 1980-2005, %
0
2
4
6
8
10
12
1980-1989 1990-2000 2001-2005
China
India
Type of investment
CHINA
Both market-seeking
and export-oriented
FDI mainly into
manufacturing
The share of FDI in
exports: 1989 9% >
2002 50% (91% in
technologically quite
advanced products)
INDIA
Mainly market-
seeking with the
exception of IT
services (call
centres, back-office
services, R&D)
The share of FDI in
exports: 3% in the
1990s > 10 % now

Strategies and policies
CHINA
Opened to FDI in 1979
and liberalized
progressively
In spite of restrictions and
requirements it favoured
FDI over domestic firms
Privileges to foreign firms
led to FDI round-tripping
estimated at 25% of FDI
INDIA
Permitted FDI long before
China did but started
liberalizing seriously since
1991
India pursued for a long
time import-substitution
strategy relying on
domestic resources and
firms
Trying to encourage FDI
only in high-tech

Less red tape in China?
China has higher literacy and education rates
and better physical infrastructure in coastal areas
Procedures are easier, decisions taken more
rapidly, business laws more flexible, labour
climate better and entry and exit of firms easier
India has (a narrow) advantage in skilled IT
manpower and language skills
Overseas Chinese in Asia invest much more in
China than overseas Indians do in India


CHINA COMES UP MUCH HIGHER THAN INDIA AS AN FDI
DESTINATION IN INVESTORS SURVEYS
Part II
FIRM LEVEL DETERMINANTS OF FDI
What explains FDI? Why firms invest abroad?
What are their underlying motivations and strategies?
SO FAR WE HAVE DISCUSSED WHAT FIRMS ARE SEEKING
WHEN INVESTING ABROAD IGNORING THE QUESTION WHY
THEY INVEST INSTEAD OF EXPORTING OR SELLING THE
TECHNOLOGY

FOR NON-TRADABLE SERVICES THE ANSWER IS SIMPLE: FDI
IS THE ONLY WAY TO SELL SERVICES ABROAD. BUT IT IS
NOT SO FOR MANUFACTURING GOODS WHERE THERE ARE
OTHER OPTIONS TO SERVICE FOREIGN MARKETS

Early macro-level theories not helpful in explaining
the internationalization of economic activity through
TNCs/FDI
In the world assumed by trade theory TNCs could
not exist > immobile production factors (including
capital) and no scale economies
FDI as a capital flowing from countries with
capital surplus to countries with deficit. Wrong
most FDI in the world is among capital-rich areas
FDI and trade as substitutes (Mundell, 1957) >
FDI as a capital flow replaces home country
exports. Later empirical evidence has proved it
wrong. FDI and trade are largely complementary
Micro-level approach: Hymers contribution
Inspiration from industrial organization theory
Starting point: in serving a particular market,
domestic firms have an intrinsic advantage over
foreign firms. They have better local connections
and a better understanding of the local business
environment, the nature of the market, business
customs and legislation and the like
Consequently foreign firms wishing to produce in
that market have to possess some kind of a firm-
specific advantage to offset the advantage held
by the domestic firms
Sources of firm-specific advantages
Firm size and economies of scale
Market power
Marketing skills (e.g., brand names or advertising
strength)
Technological expertise (either product, process
or both)
Managerial expertise
Access to cheaper sources of finance
Once established, the control of productive
assets abroad multinationality itself
becomes a source of competitive advantage

The focus on the internal ownership-
specific characteristics of TNCs has
become an accepted part of the
theoretical literature and has laid ground
for the theory of international production
Better understanding of FDI/TNCs
FDI is a mechanism by which TNCs maintain
control over productive activities abroad
It means international production rather than
international exchange or merely a capital
flow
FDI is primarily about the transfer of non-
financial assets (such as knowledge or
technology) across different countries by
TNCs while still retaining the property or
control of such assets
OLI paradigm (Dunning) a framework
integrating various explanations of
international production
O ownership-specific (or competitive)
advantages, discussed earlier, permitting to
overcome the firms disadvantages vis--vis local
firms
L locational advantages of host countries, or
host country determinants of FDI, discussed
earlier, such as natural resources, large and
dynamic markets, lower costs of labour and/or
superior infrastructure
I internalization advantages
I-advantages are benefits of exploiting O&L
advantages through FDI rather than arms length
transactions
Markets for assets or production inputs (technology,
knowledge or management) may be imperfect and
involve significant transactions costs or time lags
The major incentive for internalization of markets is
uncertainty over the availability, price or quality of
supplies or of the price of firms product
A firm may prefer to retain exclusive right to, or at least
control of, assets, called core assets (especially a new
technology or a brand name), which confer upon it a
significant competitive advantage resulting in higher
profits or monopoly rents
Internalization is especially likely to occur in the case of
knowledge

FDI takes place when three sets of OLI
advantages exist simultaneously
If only the first condition is met (O
condition), firms will rely on exports,
licensing or a sale of patents to service a
foreign market
If the third condition (I) is added to the
first (O), FDI becomes the preferred
mode of servicing the foreign market (or
undertaking efficiency-seeking
investment), but only in the presence of
location-specific advantages
Notes on OLI paradigm
The paradigm is sometimes criticized as a
list of factors explaining a TNC rather than
the explanation itself
Theoretical relations between the different
factors too often remain un-theorized
It is however widely used as a conceptual
structure within which specific cases of FDI
can be examined
How the three conditions for FDI are
satisfied varies according to the type of FDI
TNC as a sequential process (Vernon, Swedish
school). TNCs move to FDI gradually
Changing strategies and structures of TNCs
From stand-alone to integrated strategies
(or from horizontal to vertical FDI)
From simple integration to complex
integration
From multi-domestic to regional and global
structures
CHANGING STRATEGIES AND TYPES OF
INTERNATIONAL PRODUCTION LEAD TO SHIFTS
IN LOCATIONAL DETERMINANTS OF FDI
Towards integrated production
Stand-alone, multi-domestic
Simple integration -- outsourcing
Complex, vertical integration
FINANCE
PRODUCTI0N
R&D
ACCOUNTING
PROCUREMENT
FINANCE
PRODUCTI0N
R&D
ACCOUNTING
PROCUREMENT
FINANCE
PRODUCTI0N
R&D
COUNTRY B COUNTRY A COUNTRY B COUNTRY A
From shallow to deep integration between parents and affiliates
INTER- AND INTRA-FIRM EXCHANGE
OF GOODS, SERVICES, PERSONNEL
BASED ON DIVISION OF LABOUR
AND AS PART OF INTEGRATED
PRODUCTION, WITH COMMON
GOVERNANCE OF TNCs OVER
MOST FUNCTIONS
Shallow Integration
ACCOUNTING
PROCUREMENT
INTER-FIRM ARMS LENGTH TRADE IN GOODS
AND SERVICES BASED ON DIVISION OF LABOUR
BETWEEN INDEPENDENT PRODUCERS
FINANCE
PRODUCTI0N
R&D
ACCOUNTING
PROCUREMENT
TRAINING
ETC.
Deep Integration
TRAINING
ETC.
TRAINING
ETC.
TRAINING
ETC.
REAL LIFE EXAMPLES OF
INTERNATIONAL INTEGRATED
PRODUCTION
Ford network in Europe in the 1960s:
economies of scale and specialization
Toyota: from exports to multi-domestic affiliates to
regional networks
Toyotas domestic and international
production, 2004
Toyota: global supply network of finished
products (vehicles)
Toyota: regional supply network of finished
products, components and services