Foreign Direct Investment. A Review of the Determinants and Economic Effects

Bachelor Thesis, 2019

72 Pages, Grade: 1,3


Table of Contents

List of Figures

List of Tables

List of Abbreviations

1. Introduction

2. Theoretical Background
2.1 Foreign Direct Investment
2.1.1 Definition
2.1.2 Conceptual Foundation
2.2 The Eclectic Paradigm
2.3 Economic Effects

3. Method: Theoretical and Analytical Procedure

4. Results
4.1 Drivers of Foreign Direct Investment
4.1.1 Political Drivers
4.1.2 Economic Drivers
4.1.3 Social and Cultural Drivers
4.1.4 Geographical Drivers
4.2 Economic Effects of Foreign Direct Investment
4.2.1 Direct Effects
4.2.2 Indirect Effects
4.3 Dependencies Between Drivers and Effects

5. Conclusion and Research Directions
5.1 Theoretical Implications
5.2 Managerial Implications
5.3 Limitations and Future Research




Both the drivers and effects of foreign direct investment (FDI) are complex and multifaceted. This thesis provides a conceptual overview of a selection of the most frequently considered drivers and economic effects of FDI in literature. The overview aims to support host countries in providing targeted incentives to attract FDI by raising the awareness of controllable drivers. Drivers for selecting a specific host country are presented hierarchically according to their controllability by the host country. The governance infrastructure as a driver, for instance, is easier to control by the target country than market characteristics, cultural distance, or resource endowments. This thesis discusses the drivers according to their decreasing controllability, starting with political factors, followed by economic, social, and cultural, as well as geographical factors. The reasons why these factors may attract FDI are outlined in the respective subsections. Moreover, this overview presents the economic effects of FDI on the host country. These effects include increased competition or spillover effects from foreign to local companies. The composition of direct and indirect effects leads to the conclusion that all these effects impact economic growth, which represents both a driver and an effect of FDI simultaneously. Thus, this thesis refers to the dependencies between drivers and effects with their interrelated factor economic growth. Further, it is argued that the effects of FDI are significantly interdependent among each other. Therefore, the realization of specific effects, such as economic growth, strongly depends on conditions and specific characteristics, such as the particular threshold level of human capital in the host country.

List of Figures

Figure 1: Inward Foreign Direct Investment Flows per One Million USD, 2005-2018

Figure 2: Drivers of Foreign Direct Investment

Figure 3: U.S. Foreign Direct Investment Inflows and the Real Exchange Rate

Figure 4: Overview of the Classification of Direct and Indirect Economic Effects

Figure 5: Factors influencing the Relationship Between Foreign Direct Investment and Economic Growth

Figure 6: Dependencies Between Drivers and Effects

List of Tables

Table 1: Homogeneity of Results in the Literature

Table 2: Controllability of Drivers by the Host Country

List of Abbreviations

FDI = Foreign direct investment

GDP = Gross domestic product

GPP = Gross provincial product

MNC = Multinational corporation

No. = Number

OECD = Organization for Economic Co-operation and Development

OLI = Ownership-, location-, internalization advantages of the eclectic paradigm

SDGs = Sustainable development goals

U.S. = United States of America

1. Introduction

Nowadays, an omnipresent topic is the idea of sustainability. The significance is so tremendous that the United Nations has set 17 goals to be achieved by 2030 that are supposed to ensure sustainable development of the world, the so-called sustainable development goals (SDGs). To achieve these goals, countries are trying to acquire additional capital and, therefore, often seek to attract FDI in their country. One reason for this is that FDI is a source of external financing and can have an influence on the economy of the target country (Chowdhury & Mavrotas, 2006, p. 3; OECD, 2019b, p. 3). Thus, FDI can affect the sustainable development of host countries and thereby may even have a direct effect on the SDGs. Increasing productivity and employment, for instance, contributes to SDG No. 8, which deals with decent work and economic growth (OECD, 2019b, pp. 3, 15, 17; United Nations, 2015).

The importance of FDI for countries is evident. However, FDI has declined continuously over the past years and touched its lowest level in 2018 since the global financial crisis. This development can be seen in Figure 1, which presents FDI flows received by countries between 2005 and 2018. Reasons for the decline are complex interactions between different factors: policy changes such as tax reforms, general volatile political conditions, unstable and unpredictable economic environments, or even the assumption that globalization is already stagnating. (Ballard, 2019; OECD, 2019a, p. 1ff.) The decline implies that fewer FDI resources face a large number of host countries, thus increasing the competition between the countries to attract FDI. This increase has led to the fact that countries implement incentives to enhance their chances. Incentives range from income tax holidays to infrastructure investments and import duty exemptions (Aitken & Harrison, 1999, p. 605). For example, the company Canon Inc., which had planned to open a production facility, involving the creation of 300 new jobs in East Asia in 2001, decided to locate in Vietnam because of the offered incentive package, which included a 10-year tax holiday for the company (Bjorvatn & Eckel, 2006, p. 2). Therefore, today it is even more critical for countries to be aware of the drivers of FDI and to understand how to influence them to attract FDI. An individual country’s characteristics, such as its political framework or human capital, influence the extent to which the country benefits from the economic effects of FDI, and the degree to which it contributes to achieving the SDGs. (OECD, 2019b, p. 13)

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Inward Foreign Direct Investment Flows per One Million USD, 2005-2018

Source: (OECD, 2018)

An enormous amount of literature deals with the drivers and economic effects of FDI, from theoretical models that attempt to explain the intention of FDI decisions to empirical studies in both developing and developed countries (Swenson, 1994, p. 261; Wang & Swain, 1995, p. 374). Besides, the literature deals with the economic effects of FDI in host countries, referring, for example, to FDI as a mean of achieving effects such as technology spillover, which can profit local firms. Furthermore, FDI can affect economic growth if certain threshold levels are present within a given country. (Balasubramanyam, Salisu, & Sapsford, 1999, p. 34ff.)

Prior research on FDI has focused mostly on either factors or effects, but less on a juxtaposition of the two. Their relationship is characterized by an intersection as a country's economic growth simultaneously represents both a driver and an economic effect of FDI. In this respect, FDI may not only have an impact on the economic growth of the host country but also vice-versa, which is described as bidirectional causality. (Beugelsdijk, Smeets, & Zwinkels, 2008, p. 459; Chowdhury & Mavrotas, 2006, p. 9; Nair‐Reichert & Weinhold, 2001, p. 168)

The lack of a simultaneous overview of drivers and effects, or their interdependencies, results in a research gap. Emerging from this research gap, the following research questions can be developed:

(1) What are the determinants and economic effects of FDI, and to what extent can they be controlled by the host country to attract FDI?
(2) What do dependencies between FDI drivers and effects look like, and how can economic growth be seen as an interconnecting element between drivers and effects?

Therefore, this thesis aims to make four contributions to the existing literature. First, it presents a concept-centric overview of drivers and effects, including a comparison of contradictory results. Second, it refers to factors that affect the relationship between drivers, FDI, and economic effects. These factors, in turn, influence the extent to which countries experience economic effects or contribute to the achievement of the SDGs through FDI. Third, the thesis presents hierarchically the varying controllability of the different drivers, which allows a clear illustration of their influenceability. This, in turn, can support host countries to create incentives to attract FDI. Finally, the thesis considers the relationship between the drivers and economic effects of FDI and their interfacing factor, economic growth.

The thesis is organized as follows: Section 2 presents the theoretical foundation by introducing the concept of FDI and the eclectic paradigm, as well as defining the term economic effects. This section is followed by a presentation of the results, which attempts to answer the research questions. The results are divided into drivers and economic effects of FDI, as well as the dependencies between them. Finally, the thesis concludes with theoretical as well as managerial implications and limitations, leading to suggestions for future research arrays.

2. Theoretical Background

This section introduces the concept of FDI and the eclectic paradigm, as well as the definition of economic effects used in this thesis.

2.1 Foreign Direct Investment

2.1.1 Definition

The literature contains numerous definitions of FDI. Most studies build their definition on those provided by the United Nations Conference on Trade and Development (United Nations, 1999, p. 465) or the Organization for Economic Co-operation and Development (OECD, 2008, p. 17). The following definition merges identified key aspects of a selection of definitions presented in Appendix 1: FDI is an international investment strategy reflecting the objective of an investor resident in one economy (the direct investor, also known as a multinational corporation (MNC)) acquiring a permanent interest in an enterprise resident in another economy (the investment firm), known as the host country. The lasting interest implies the existence of a long-term relationship between the investor and the investment firm, as well as a significant influence by the investor on the management of the firm, which involves effective management decision power and ownership control of foreign assets. This aspect distinguishes FDI from portfolio investments in which the investor generally does not expect to influence the management of the MNC. A direct investment relationship exists when the direct investor has acquired 10% or more of the ordinary shares or voting rights of the entity abroad.” (OECD, 2008, p. 17; United Nations, 1999, p. 465)

There are also foreign operation modes other than FDI. The three basic types are export modes, contractual modes, and investment equity entry modes. FDI is a hierarchical model of international market entry and, therefore, an investment equity entry mode (Morschett, Schramm-Klein, & Zentes, 2015, pp. 324, 418). Appendix 2 shows an illustration of the primary foreign operation modes. The main distinguishing feature between FDI and other forms is the element of control over management decisions as well as the necessary resource commitment related to the assets that an MNC must provide for foreign operations (Morschett et al., 2015, p. 327).

2.1.2 Conceptual Foundation

The thesis views the concept of FDI from a macroeconomic perspective. This view considers an FDI to be a special form of capital flow across national borders that extends from the home to the host country measured in the balance of payments statistics. (Lipsey, 2001, p.1). The shift from a partial equilibrium firm-level framework to a general equilibrium perspective can examine the extent to which exogenous macroeconomic factors influence a firm’s FDI decisions. Thus, the macroeconomist is interested in identifying which activities are best carried out by companies in specific countries. (Dunning & Lundan, 2008, p. 109)

Besides the view of the host country, FDI can be categorized either from the perspective of the host country or of the investor. From the investor’s point of view, one can distinguish between horizontal (market-seeking), vertical (efficiency-seeking), and conglomerate FDI. The distinction between these types, often synonymously referred to as forms, or categories, is taken into account as some scholars claim that different types of FDI affect growth in different ways. (Beugelsdijk et al., 2008, p. 452; Moosa, 2002, p. 4f.) The intention to avoid trade costs by placing production closer to consumers, leads to horizontal FDI, arising as a substitute for exports. The term refers to the production of the same goods abroad as in the home country. For horizontal FDI to occur, product differentiation needs to be the decisive element of the market structure. (Beugelsdijk et al., 2008, p. 454; Buckley & Casson, 1981, p. 84; Caves, 1971, p. 3f.) Vertical FDI, on the other hand, is used to capture differences in factor costs of, e.g., raw materials between the home and host country. It involves adding a stage in the production process that occurs earlier or later than the main processing activity of the enterprise. (Caves, 1971, p. 3; Hudson, Xia, & Yeboah, 2005, p. 387f.; Marchant & Kumar, 2005, p. 380) The third type of FDI, which comprises both horizontal and vertical FDI, is called a conglomerate FDI (Moosa, 2002, p. 5).

Part of the analysis of the FDI concept is an analysis of its flows, which record capital provided by investors to the foreign enterprise as well as capital received by the investor from the foreign enterprise during a certain period (OECD, 2018; United Nations, 1999, p. 465f.). The flows can be categorized as inward and outward FDI, depending on whether the view of the host economy (inward) or of the home economy (outward) is taken. In principle, FDI flows are measured in the country's currency and as a percentage of the gross domestic product (GDP). (OECD, 2018)

2.2 The Eclectic Paradigm

Due to the complexity and multifaceted nature of the concept, it is necessary to be familiar with the theoretical foundation to comprehensively understand the drivers and effects elaborated later in this thesis. The most prominent theory is the eclectic paradigm of John H. Dunning.

The eclectic paradigm intends to offer a holistic framework that could reconcile the various approaches and hypotheses that deal with the existence of FDI but are not able to fully explain the concept on their own. (Dunning, 1980, p. 9; 2015, p. 1)

An MNC will emerge if all conditions for FDI are given. The conditions represent the demand for a particular product where a company owns an advantage, the existence of internalization gains, and location factors that favor expansion abroad. These three conditions, known as the OLI conditions, provide the attractiveness of FDI for a corporation that wants to maximize the value of the company. (De Mooij & Ederveen, 2003, p. 675; Moosa, 2002, p. 37)

The first condition, known as the ownership advantage, refers to the advantage of a company compared to others. It may consist of institutional or intangible assets, such as specific technological knowledge. (Dunning & Lundan, 2008, p. 101)

The location-specific advantages define the attractivity for an MNC to produce abroad to gain a comparative locational advantage. Otherwise, the company would opt for export rather than investment. The condition exists because of various advantages such as abundant natural resources or favorable institutional conditions in the host country. These advantages relate to the choice of the host country. Three categories describe the specific advantages of each country: economic benefits, political benefits, and social benefits. (Amal, 2016, p. 19; Dunning, 1980, p. 10ff.; 2015, pp. 4,12; Moosa, 2002, p. 37)

The third condition relates to the advantages of internalization, referring to the fact that it should be more attractive to a company to carry out activities within the company rather than selling or leasing them. (De Mooij & Ederveen, 2003, p. 675; Dunning, 2015, p. 12)

Overall, reflecting the political, economic, and social characteristics of the host country, the OLI parameters of the eclectic paradigm depend on the context (e.g., the industry) and vary from firm to firm. (Denisia, 2010, p. 57)

2.3 Economic Effects

Since the results section presents the economic effects of FDI, its definition in this thesis is briefly outlined.

In general, an effect refers to an impact on something caused by a particular reason or event. Therefore, an economic effect is an influence on individual actors or the economy as a whole that is analyzable using economic theories and models. One appropriate measurement of economic effects on the performance of a company might be a comparison of the level of GDP per capita or exports per capita over a given period. (Blomström & Wolff, 1994, p. 40; DUDEN, 2019)

3. Method: Theoretical and Analytical Procedure

The literature review was carried out in 3 steps: an acquisition of information, a quality assessment, and exclusion of papers due to restricted access, irrelevance, or insufficient ranking, as well as an analysis of the relevant content.

The acquisition of articles was conducted using the databases EBSCOhost, OPAC, and Google Scholar. In addition, the literature research started with the extracting articles mentioned in the papers of Chowdhury and Mavrotas (2006), and Blonigen (2005).

The collected literature was filtered according to the quality of the article, measured by the ranking of the journal. The two used ratings were the VHB and the h-index of the Scimago Journal Rank. The intend was to select only articles with a rating of B or better or a corresponding h-index. However, some literature relevant to this thesis was found that was either not ranked or ranked worse, such as the NBER working papers. Due to their specialization on the topic and their plausibility as confirmed by other papers, they were included in the thesis. However, articles ranked worse than B were studied attentively and supported with additional, higher-ranked literature. Appendix 3 presents a list of all papers used in this thesis but ranked worse than Q2.

Articles concerning drivers and economic effects were scrutinized for their topicality in order to present a review reflecting the current conditions. Nevertheless, older papers are also cited, to quote primary authors, instead of secondary sources.

The relevant content was analyzed by creating a literature table. To obtain added value, 110 articles were systematically scanned according to key results as can be seen in the literature table in Appendix 9. Subsequently, concept matrices were established to provide the concept-centric review recommended by Webster and Watson (2002, p. xvif.). The OLI paradigm was incorporated as guiding theory, used to structure the first part of the results according to the locational aspects: economic, political, and social drivers. The equally relevant but missing cultural and geographical drivers were added. The former was supplemented to the category social, while the latter was listed as a separate category.

4. Results

The just mentioned drivers are outlined in the next subsection, followed by the presentation of the economic effects of FDI as well as the subsection discussing the dependencies between drivers and economic effects. The entire section intends to answer the defined research questions.

4.1 Drivers of Foreign Direct Investment

As FDI offers the potential for a positive outcome for the host country, countries compete to attract FDI. A selection is based on different factors that characterize the country at hand. The following section elaborates on the drivers that appear to be the most important in the literature, divided into four categories: political, economic, social and cultural, as well as geographical drivers. Within these categories, related factors are grouped, as shown in Figure 2 and presented in the concept matrix in Appendix 4. The presentation of the drivers is structured in hierarchical order according to their controllability by the host country. The most controllable drivers are listed first.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: Drivers of Foreign Direct Investment

Source: Own Illustration

4.1.1 Political Drivers

The reference to political drivers as the first category is based on their controllability by the host country since regulations such as tax and trade policies can be better controlled by the host to attract FDI than other factors.

Governance Infrastructure

The institutional framework of the host country can significantly influence the success of an FDI. As a result, the institutional environment, here referred to as governance infrastructure, is a decisive factor. The term covers public institutions and policies, meaning the framework for legal, economic, and social relations established by the government. Institutions form the foundation for efficient markets as they declare formal and informal rules for the market economy and thus enable lower transaction and information costs, protect property rights, and reduce uncertainty. (Bevan, Estrin, & Meyer, 2004, p. 45; Globerman & Shapiro, 2003, pp. 5, 24f.; North, 1990, p. 3)

Therefore, a country’s political system is an essential consideration for investors. It can be shown that democratic institutions, along with federal political systems, can promote FDI. As Jensen (2006, p. 85) examines, an increase of 50% in FDI flows could occur as a result of a change from an authoritarian to a democratic regime. This increase results from the fact that democratic systems are known to protect property rights. In contrast, a system characterized by corruption would reduce FDI, as the costs of doing business increase. (Blonigen, 2005, p. 14)

Another important consideration involves the political stability of the host country. Investors avoid unpredictable, unstable political environments due to the increasing costs of uncertainty (Globerman & Shapiro, 2003, p. 24). Furthermore, FDI seems to positively correlate with increased government expenditure, which can increase overall demand and stimulate economic growth. Therefore, government spending (although enhancing the risk of an increase in government debt) appears to have a positive impact on the economic performance of host countries. (Amal, 2016, p. 39)

In summary, democratic institutions, political stability, and government spending are drivers of FDI and should be taken into account by the host, as they can influence these factors to increase their attractiveness to investors (Bailey, 2018, p. 146).

Trade Policy

The second political driver is the trade policy of the host country, which explicitly affects FDI and can promote or inhibit trade. Host countries seeking to attract FDI thus, need to develop a trade policy that is favorable for investors. Trade openness is one of the main determinants and is described by trade flows between two countries, as well as by the exchange rate. The reason for including the exchange rate as an economic determinant later on in this thesis is the influence of economic conditions with their corresponding reduced controllability. Trade rules, in contrast, are determined by policies established by the host government. (Amal, 2016, p. 39)

Nearly all host governments present some barriers to FDI. These include foreign ownership restrictions and licensing procedures linked to performance requirements. At the same time, many governments provide explicit and implicit incentives for MNCs to establish subsidiaries in their host countries. (Globerman & Shapiro, 1999, p. 513f.) In cases where tariff protection constrains trade, FDI and trade are likely substitutes (implying a negative relationship between strict trade policies and FDI) as investors tend to avoid domestic tariffs and set up subsidiaries in the host country. However, if trade is relatively unrestricted, FDI and trade are more likely to complement, implying a positive relationship between less strict trade policies and FDI. (Globerman & Shapiro, 1999, p. 519f.)

For example, Globerman and Shapiro (1999, pp. 513, 526) examined the extent to which policy changes in Canada affected FDI. Their findings suggest that government policies can have considerable effects, but in fact, often do not. In the case of Canada, the free trade agreements led to a significant increase in FDI, whereas the foreign investment review act did not have a significant impact on FDI.

Overall, examining the effects of specific policies is difficult because of the isolation from other factors as they are part of the overall environment influencing FDI decisions (United Nations, 1993, p. 99). Therefore, it might be reasonable to accept that the relationship between FDI and trade policies can be both negative and positive. Nevertheless, trade policies can be managed by the host to attract FDI.

Tax Policy

As FDI can be influenced by a country’s tax policy, this consideration is highlighted below. On the one hand, tax policies can be influenced by host governments to attract FDI. On the other hand, they also depend on agreements with the investor’s country, hampering the controllability of tax policy somewhat. Consequently, this is the last political driver considered in this thesis.

The complexity of each country’s tax systems and the interaction of systems of the home and host countries’ system complicate the investigation of the relationship between tax policies and FDI. For this reason, this subsection refers to the main determinants for understanding the impact of tax policies on FDI. This simplified presentation of the complex relationship between the host’s tax system and FDI is not a holistic view, as that would require more specifications than permitted by the limited scope of the thesis.

One consideration of investors, concerning tax policies is the real after-tax return available for alternative investments that influences investors’ location decisions. Furthermore, investors avoid high tariff or trade barriers, such as exports, leading to an increase in FDI. (Hartman, 1984, p. 476; Swenson, 1994, p. 245f.)

Second, a favorable tax policy agreement for the investor involves paying as little taxes as possible to the host country, the home country, or both. The payment of taxes to both countries is referred to as double taxation, arising when both home and host countries ignore the multinational nature of a company. However, since double taxation hampers international economic activity, most countries avoid it through bilateral tax treaties. In their estimation of incoming and outgoing FDI to the United States (U.S.), Blonigen and Davies (2004, p. 21) found that the implementation of a bilateral tax agreement was a significant determinant of FDI. FDI activity can be increased between 2% to 8% for each additional year in which such an agreement is in force. The reason is that treaties serve as an obligation between countries to protect and promote FDI. Therefore, such treaties can lead to higher returns of income to the home country and a reduction in investor uncertainty, resulting in increased FDI (Blonigen & Davies, 2004, pp. 2,6).

Countries adopt either a credit system or an exemption system. The U.S., for example, uses a credit system through which tax liabilities in the host country are offset against taxes in the company’s home country. However, many countries have opted for an exemption system that exempts MNCs from taxation in the home country. Overall there are reasons for both systems, whereby both, only generate the same tax burdens if the host country’s tax rate is equal to or higher than that in the home country. (Hartman, 1985, p. 108)

Regardless of the tax system used, the literature discusses appropriate measurements of tax rates to capture their effect on FDI. A distinction is usually made between average and effective tax rates. Average tax rates express taxes paid in a country as a percentage of income earned in that country (Swenson, 1994, p. 254). Effective tax rates address the wedge between pre-tax and post-tax returns in an investment where companies can earn economic rent (De Mooij & Ederveen, 2003, p. 677). Average tax rates may result in better proxy tax effects than effective tax rates because changes in depreciation allowances, investment tax credit levels, and corporate income tax rates determine the effective tax rate. Besides, the effective tax rate is sensitive to assumptions about interest rates. (Swenson, 1994, p. 258f.)

In summary, the literature presents different findings for the relationship between the tax rates of a country and FDI. In a study on the U.S.’ taxes, Swenson (1994, p. 261) confirms that the U.S.’ tax increases raised FDI. In contrast, Hartman (1984, p. 485) presents an increase in FDI as a result of a tax reduction.

The different results can be attributed to different estimation methods, ad hoc specifications, data, and the difference in countries’ tax systems, complicating the comparison. A short list of some select authors presenting different results concerning this relationship can be found in Appendix 5. However, a response of FDI to tax policies can be confirmed and is, therefore, to some extent controllable by the host government in the form of bilateral agreements. (De Mooij & Ederveen, 2003, p. 674; Hartman, 1984, p. 486)

4.1.2 Economic Drivers

The following subsection focuses on the economic drivers most frequently discussed in the literature. Possible strong controllability is more limited than for the political drivers. The reason for this is that economic drivers are heavily dependent on an enormous number of different macroeconomic factors.

Market Characteristics

Foreign investors pay particular attention to the economic determinants of a potential target country. Accordingly, the host’s economic performance is considered in terms of its market characteristics and economic growth. (Amal, 2016, p. 39) As the market size is one of the most covered market characteristics, it is emphasized first.

The market size of the host country presents a statistically significant factor for FDI to the country at hand. Tests show a beta assigned to the market size equal to or even greater than 1, indicating an over-proportional increase of FDI relative to market size. Therefore, large markets host disproportionately high levels of FDI. (Yeaple, 2003, pp. 727, 730) From the investors’ perspective, this disproportionate correlation results from the fact that a market size above a certain level enables the use of economies of scale, specialization of production factors, and fixed plant costs, promoting the achievement of cost minimization. (Yeaple, 2003, p. 732)

Different measures for the relationship between FDI and the market size exist. The most frequently applied indicator is the GDP of a country. In addition, the sales of MNCs and the gross provincial product (GPP) can be analyzed. (Coughlin & Segev, 2000, p. 19f.; Moosa, 2002, p. 27) Using the GDP as a measure of market size, Wang and Swain (1995, pp. 368, 374) tested the economic and political factors that influenced FDI in Hungary and China between 1978 and 1992. The results show that in both countries, FDI correlated positively with the market size.

Another market characteristic is the presence of related companies, such as suppliers and distributors, in the host’s market. Proximity to suppliers enables the effectiveness of such arrangements as coordination mechanisms become easier. In addition, the close settlement of companies, forming a supply chain, can lead to information sharing and thus network effects. (Blonigen, Ellis, & Fausten, 2005, p. 1) Indeed, in their sample of Japanese investments in the manufacturing sector, Blonigen et al., (2005, p. 16) demonstrate evidence of information externalities due to network connections. In particular, they conclude that the exchange of information may enable better navigation through the tax and regulatory environment of another country, as well as the lower costs of information acquisition. As a result, FDI in this location becomes more likely. (Blonigen et al., 2005, pp. 4,18)

Overall, the market size and the presence of companies within a supply chain are positive drivers for FDI. However, there are further market characteristics, such as the competitive industry, that affect FDI but are not covered here for reasons of scope (Bailey, 2018, p. 139). Considering the controllability, the characteristics of a market can be influenced in the form of the right regulatory framework and incentives to attract FDI.

Exchange Rate

Exchange rates fluctuate significantly since the Bretton Woods’ system of fixed exchange rates no longer exists. Fluctuation is associated with increased uncertainty about firm decisions to enter a specific foreign market. Indeed, studies have shown that the expected future exchange rate not only influences entry decisions but that uncertainty about the future behavior of exchange rates also prevents firms’ entry. The influence of future exchange rates on the cash flows of a company justifies these concerns. (Campa, 1993, p. 614; Cushman, 1985, p. 304f.)

Although a general statement about the effects of exchange rates on FDI activity is due to many moderating effects on the relationship not quite simple, the majority of the literature agrees on a correlation between FDI into the U.S. and the value of the dollar, as illustrated in Figure 3. More precisely, FDI tends to fall with a strong dollar and rise with a weak dollar (Froot & Stein, 1991, p. 1209f.; Klein & Rosengren, 1994, p. 1). The reason is shown by Froot and Stein (1991, p. 1192f.) with their regression of FDI against the exchange rate, as a depreciated dollar offers a possibility for foreign companies to acquire domestic assets more cheaply. The authors confirmed additional FDI inflows of about $5 billion as a result of a 10% dollar-depreciation, including a standard error of less than $2 billion.

Due to uncertain exchange rate fluctuations, returns in local currency will vary. A risk-averse entity will not enter if its expected present value of future earnings equals the cost of entry. As the option pricing theory (which theoretically values an option) examines, firms will still enter if the expected return equals the cost of entry plus compensation for the degree of uncertainty due to the volatility of the exchange rate. (Campa, 1993, p. 616)

The pooled estimation of Cushman (1985, p. 305f.) measures the relationship between exchange rates and FDI. By using annual bilateral FDI flows from the U.S. to Germany and other countries, he shows that the appreciation of the real foreign currency accompanied a significant decline of U.S. FDI. Cushman was able to prove that a 1% change in the exchange rate could affect the flow of FDI from the U.S. to Germany for a given year, by over 28%, depending on the estimating variable used.

To summarize, the exchange rate has a systematic impact on FDI and is, therefore, a driver for the selection of a particular host country (Froot & Stein, 1991, p. 1215). Since, in simplified terms, exchange rate fluctuations are caused by the supply and demand behavior of market participants and the intervention of the respective central bank, they do not represent a determinant that can easily be influenced by the host government. However, the possibility of exerting influence is by no means excluded.

Abbildung in dieser Leseprobe nicht enthalten

Figure 3: U.S. Foreign Direct Investment Inflows and the Real Exchange Rate

Source: Froot & Stein, 1991, p. 1193

Stability and Uncertainty

Another driver of FDI, which is interwoven with the exchange rate, is the stability and uncertainty of the host country. This is of relevance to investors as the profit of their investment relies on the host county’s economic situation. Unlike the exchange rate, this subtopic refers to the host economy only, which is one of the reasons why a consideration separated from the exchange rate is deemed appropriate. Additionally, instability can lead to uncertainty about future developments and thus can lead to an appreciation or depreciation of the host currency. As a result, a measure for uncertainty is the inflation rate. However, this appreciation or depreciation leads to a stronger or weaker host currency compared to the home country’s currency and thus to a change in the exchange rate. This demonstrates the interconnectedness of stability, uncertainty, and exchange rates.

Increased macroeconomic instability, measured by the inflation rate and reflected in the exchange rate, points to an adverse business climate and thus leads to uncertainty. These conditions result in less attractiveness for FDI in that location. (Asiedu & Lien, 2011, pp. 104, 106) Own thoughts provide the reason that investors do not want to invest in economies that are suffering an economic decline as this would result in lower profits.

Thomas and Grosse (2001, pp. 64, 72), outline a negative correlation between instability and FDI volume in Mexico. They show that an appreciation of the home country’s currency relative to the host country’s leads to an increase in FDI. Due to the strong interconnectedness of factors that can lead to stability and uncertainty, it is difficult for the host country to influence this collectivity of factors specifically.

Labor Costs and Real Income

Further essential considerations of investors in their location decision are the cost of local labor and the level of domestic purchasing power, meaning the level of real income in the host country. The impact of other controllable factors, such as the aforementioned basis of an appropriate regulatory framework and the right incentives, can affect a change in labor costs and real income in favor of attracting FDI. Studies conclude that labor costs are a negative determinant of FDI, implying that countries with cheaper labor costs generally attract more FDI than countries with higher levels of labor costs (Coughlin & Segev, 2000, p. 21). This relationship corresponds to the location hypothesis stating that the international immobility of some factors of production, such as labor and natural resources is the reason for FDI to occur. These factor differences include different wage levels. Thus, high-wage countries are interested in relocating labor-intensive production to countries such as India. However, high wage levels can also be a signal of quality and, therefore, might have a positive impact on FDI. Nevertheless, as this influence depends on the industry of the company, evidence of the relationship is mixed. (Moosa, 2002, p. 33f.) Wang and Swain (1995, p. 375f.), for example, discovered that in Hungary, relatively cheap labor correlates weakly with FDI flows. Consequently, FDI will increase for those sectors that intensely use factors where the host country has a comparative advantage, as for example, in cheap labor (Yeaple, 2003, p. 726).

The second determinant of interest, the real income level, describes the volume of the domestic purchasing power in a host country. Investors—especially with horizontal FDI—are attracted to countries with higher real incomes (Addison & Heshmati, 2003, p. 21). The reason is that a higher purchasing power leads to an increase in the actual level of purchases made and thus contributes to the economy.

Economic Growth

Previously, the characteristics of a particular market as a positive impact on FDI were presented. The following subsection now shifts the focus from individual industry market characteristics to the economy as a whole, including its growth and productivity, which is more difficult to influence by the host country.

Economic growth is a key factor in the choice of a target country. Therefore, the percentage change in GDP (as a measure of economic growth) and FDI in host countries seem to represent a correlating relationship. Thus, one can expect that host countries with stronger growing economies will attract relatively more FDI. (Coughlin & Segev, 2000, p. 21; Globerman & Shapiro, 1999, p. 519) Own considerations reflect the following aspects: companies conducting FDI intend to receive returns equal to the cost of entry plus compensation. If the economy is growing, there is probably a healthy interplay between supply and demand, leading to the possibility of profit generation. In simplified terms, economic growth suggests that companies run less of a risk of investing without making profits. Therefore, they will be more likely to invest.

Since economic growth refers to the entire economy, including all determinants, many moderating factors exert an influence, such as the institutional framework or federal guidelines (Hotho & Pedersen, 2012, p. 240). For instance, Coughlin and Segev (2000, p. 19) have investigated determinants that are significant determinants of FDI in China. The scholars show that economic growth expressed by GPP and average productivity is a positive determinant of FDI. Other empirical findings suggest that not only GDP growth rates cause FDI but also vice-versa. Chowdhury and Mavrotas (2006, p. 10) found, e.g., strong evidence of bidirectional causality between the GDP and FDI in Thailand and Malaysia. Section 4.3 presents a review of the juxtaposition of driver and effects.

Overall, host countries can influence economic conditions to attract FDI. However, since there are many influencing factors on a country’s economic growth, all of them must be taken into account, resulting in a moderate level of controllability.

4.1.3 Social and Cultural Drivers

In addition to the political and economic determinants that favor FDI, it is equally important to consider the social and cultural drivers. However, social and cultural factors are less controllable because although the host country may be able to influence education and skill levels, a reduction of the cultural distance felt by the investor between his home and the host country is less likely.

Education and Skill Level

As above-mentioned, investors base their decisions on fundamentals reflecting the economic performance of the target country. The skill level of the host country, involving the education of the labor force as well as specific knowledge, such as technical, market, or scientific expertise, represents one of these fundamentals. A measure that is considered a benchmark is the illiteracy rate. (Blomström, Kokko, & Mucchielli, 2003, p. 4; Coughlin & Segev, 2000, pp. 14, 21) For example, Coughlin and Segev (2000, p. 22) found in their study that the illiteracy rate is a negative determinant of FDI in Chinese provinces; the higher the level of illiteracy, the lower the level of FDI. Programs enhancing the skill levels of workers, including training and educational encouragement, can therefore, help improve the illiteracy rate and perhaps the general level of education, resulting in the attraction of FDI.

Additionally, some studies have reported that the relationship between labor qualification and the level of FDI depends on national skilled worker abundance and industrial skilled worker intensity. This thesis does not refer to these aspects in greater detail but suggests the study “The role of skill endowments in the structure of U.S. outward foreign direct investment” by Yeaple (2003, p. 727) for the interested reader.

Trust, Country Reputation, and Cultural Distance

The section about economic drivers has shown that investors tend to invest in countries that offer as little uncertainty as possible. As predicting the future is not possible, investors need to trust in overall positive development. Since FDI involves long-term trades, they may be subject to contractual imperfections and therefore are heavily based on trust, which is shaped by different aspects (Guiso, Sapienza, & Zingales, 2009, p. 24). One important consideration involves the reputation of a country, described as the shared perception based on personal experience and information (Kang & Yang, 2010, p. 53). A shortlist of definitions of country reputations can be found in Appendix 6. Although a reputation is no guarantee for positive future developments, it is powerful as it can be assumed that a positive reputation of a country will lead to a proportional increase in FDI in that country. For example, it has been shown that a host country’s participation in human rights regimes forms a "reputation umbrella" (interpretable as a good reputation), which in turn leads to a positive impact on FDI. (Garriga, 2016, p. 168) This is because investors tend to trust that information provided by the reputation will be confirmed (Loo & Davies, 2006, p. 198).

As noted above, trust in the overall positive development of the host country is an essential factor influencing the choice of investors. The evidence suggests that trust has a significant impact on FDI. Guiso et al. (2009, p. 24f.) confirm that the level of FDI will increase by 25% due to one standard deviation increase of trust. However, the impact of trust weakens as available information from experience increases. Furthermore, cultural distance influences trust, as elaborated below. In addition, trust is more likely to exist when effective formal institutions and similar legal systems as in the home country exist. (Dunning & Lundan, 2008, p. 306)

Cultural distance does not only influence the formation of trust but also the level of FDI as it can increase the costs of foreign operations. It refers to cultural differences between home and host countries concerning interactions between companies and institutions (Ghemawat, 2001, p. 3; Loree & Guisinger, 1995, p. 289). Although different findings have provided mixed results about the relationship between cultural distance and trust, the following section addresses the negative relationship as it is the most presented perspective. The varying results of studies using similar cultural distance constructs are, however, due to time-period or other contextual differences that affect the results. (Bailey, 2018, pp. 140, 142; Thomas & Grosse, 2001, p. 66f.)

The relationship between cultural distance and the level of FDI is negative as barriers, created through distance, need to be overcome and therefore lead to information acquisition costs. These expenses include the cost of further research regarding the different habits and preferences of consumers. (Thomas & Grosse, 2001, p. 66) Barriers can arise from differences in social norms, language, and religious beliefs, as these psychic distances can result in different behaviors and local customs as well as bureaucracy which may complicate FDI. (Grosse & Trevino, 1996, p. 150; Shenkar, 2001, p. 521f.) The created distance may significantly affect FDI. For instance, Ghemawat (2001, p. 3) presents that under otherwise identical conditions, trade between countries with the same language will be three times greater than with different languages.

To conclude, investors determine a target country based on trust, resulting from the fact that the host country has a good reputation or is not perceived as culturally distant. Therefore, host countries can try to achieve a positive reputation through an appropriate regulatory environment and practices. Nevertheless, investors will still form their own opinions.

4.1.4 Geographical Drivers

While the OLI paradigm does not list geographical aspects, they are equally crucial concerning FDI, which is why they are separately outlined in the following. Since geographical factors relate to location-specific advantages, such as the endowment of resources in a country and the geographical distance between the home and host countries, control by the host is hardly possible.

Resource Endowments

FDI occurs, as already mentioned, due to immobile factors of production, including the individual characteristics of a country such as its resources (Moosa, 2002, p. 33).

Foreign investors invest in countries that provide access to the resources required for production. Therefore, countries that offer the investor access to needed production materials, such as energy or other natural resources are chosen. (Sheth, 2011, p. 170) This access describes a locational advantage as soon as the company can reduce costs or generate some other advantage through it. The company might save costs as the production of needed factors is cheap in the target country or due to the saved costs of no longer needed shipments of materials from the place of production to the place of use. As a result, the company can also avoid delays in production and delivery. (Moosa, 2002, p. 36)

Therefore, it is reasonable that companies include the availability and costs of resource endowments in their selection of a target country, even though these factors can hardly be influenced by the host country.

Geographical Distance

In addition to the aforementioned cultural distance, the geographical proximity or distance may also, either facilitate or complicate the implementation and operation of FDI. In terms of geography, the same principle as with cultural distance is generally true: the greater the distance between countries, the more difficult it becomes to do business. However, the term geographical distance does cover not only the physical distance between two countries but also aspects such as the average distance within countries to borders, access to oceans and waterways, as well as the physical size and its topography, which are noncontrollable drivers. (Ghemawat, 2001, p. 7)

The study of Gao (2005, p. 164) suggests that due to cultural and geographical proximity, a large proportion of FDI in China comes from Asian home countries. Furthermore, several authors have provided evidence that coastal locations have a significant positive effect on FDI. Broadman and Sun (1997, p. 339f.) note that coastal areas receive over 90% of the total amount of FDI in China. This study uses coastal location as a variable representing several determinants that were not included in the estimation but differed between coastal and non-coastal areas, such as access to waterways. However, differences in FDI between coastal and non-coastal areas may also be due to other important aspects, such as differences in development, infrastructure network, or experience with FDI in general. (Coughlin & Segev, 2000, p. 15)

Overall, greater geographical distance between the home and host country harms FDI. It is thereby important to assess geographical influences in the light of other factors (such as the stage of development) that may influence the relationship significantly.

4.2 Economic Effects of Foreign Direct Investment

After examining the drivers of FDI, the following subsections highlight the economic effects generated in the host country. Since an extensive body of literature deals with the question of how FDI affects the host, there exists a wide range of empirical results, some of which show little evidence of convergence. Hence, this thesis focuses on the economic effects most frequently considered in the literature.

The analysis of the impact of FDI on the host’s economy distinguishes between direct and indirect effects. Classifying the effects by this subdivision is done by considering direct economic effects as influencing the growth and economic prosperity of the host country (e.g., competition) regardless of whether external effects arise or not. In contrast, indirect effects are the external effects or spillovers caused by the presence of MNCs in the economy. Also, indirect effects refer to those effects not representing direct economic effects themselves but can lead to economic effects in a second step. The literature presents different perspectives regarding which effects are direct or indirect. Therefore, the following classification, presented in Figure 4, is based on the most frequent reasoning of scholars and own plausibility considerations. In many cases, the distinction between the effects is blurred due to their interrelatedness. A concept matrix listing these effects can be found in Appendix 7.

Abbildung in dieser Leseprobe nicht enthalten

Figure 4: Overview of the Classification of Direct and Indirect Economic Effects

Source: Own Illustration

4.2.1 Direct Effects

Competition and Productivity of Local Firms

Increased competition in the host country’s economy affects FDI. The fact that MNCs provide suppliers for the respective industry with firm-specific assets or technologies to ensure a higher quality of their inputs provides an answer to the question of how this increased competition can occur. This expertise, leading to increased productivity, is transferred to different suppliers to prevent the exertion of price pressure. By transferring technology to several suppliers, competition increases and prices for input materials decline. To the detriment of the MNC, they cannot hinder suppliers from selling inputs to competitors attracted by the induced price declines, thus leading to increased competition in the industry. (Moran, Graham, & Blomström, 2005, p. 81)

The increased competition results in further effects. To mention just one example, it promotes greater efficiency in the domestic industry, and therefore leads to improved productivity of local firms in order to survive in the market (Globerman, 1979, p. 43). In their meta-analysis, Havranek and Irsova (2011, p. 16) estimate, taking into account publication and misspecification bias, that an increase in foreign presence by 10 percentage points is accompanied by an increase in the productivity of domestic firms in subcontracting industries of around 9%. The reason for the assumed increase in productivity is that MNCs are not able to capture all quasi-rents due to imperfect market conditions (Caves, 1974, p. 176).


Excerpt out of 72 pages


Foreign Direct Investment. A Review of the Determinants and Economic Effects
LMU Munich  (Institut für marktorientierte Unternehmensführung)
Catalog Number
ISBN (eBook)
ISBN (Book)
FDI, Driver and Effects, Foreign direct Investment, Economic Effects, Eclectic Paradigm, Political Drivers, Economic Drivers, Social and Cultural Drivers, Geographical Drivers, Direct Effects, Indirect Effects, Dependencies between Drivers and Effects
Quote paper
Antonia Haberger (Author), 2019, Foreign Direct Investment. A Review of the Determinants and Economic Effects, Munich, GRIN Verlag,


  • No comments yet.
Look inside the ebook
Title: Foreign Direct Investment. A Review of the Determinants and Economic Effects

Upload papers

Your term paper / thesis:

- Publication as eBook and book
- High royalties for the sales
- Completely free - with ISBN
- It only takes five minutes
- Every paper finds readers

Publish now - it's free