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I. Introduction
Foreign direct investment is one of the key tools at the disposal of developing
countries to stimulate economic growth. The benefits FDI inflows bring to
developing countries are well documented. Most importantly they bring
opportunities for increased earnings through the creation of new employment
opportunities and potentially higher wages. Further to this, FDI widens
employment choices through improved working practices, as generally it is
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 3
believed that foreign firms pay higher wages than domestic ones. FDI is also
a potentially valuable source of fiscal revenue for host countries, which in turn
can support economic and social development programmes. However at the
same time, foreign investors are often though to be deterred by high taxes,
therefore the benefits from such revenue can be marginal.
Numerous studies1 have also shown that given a certain level of
development, FDI inflows instigate technology spillovers, create a competitive
business environment, contribute to human capital formation and assist with
international trade integration. All these factors in turn contribute to higher
levels of economic growth, thus having a positive effect on poverty alleviation.
Attracting FDI is also appealing for developing countries because it is
perceived to provide long-term benefits as it is bolted down unlike short-term
debt, which is driven by speculative considerations such as changes in
exchange rate and the moral hazard-associated expectation, that
governments will be willing to bail out the banking system at the first sign of
trouble.2 In other words, there is a belief that FDI is less susceptible to boom
and bust cycles than financial liberalisation.
FDI is very unevenly spread across the world. Outflows come mainly from
developed countries. During the 1980s the UK, USA, France, Germany and
Japan were responsible from 70 percent of FDI outflows. During this period
1
Foreign Direct Investment: Maximising Benefits, Minimising Costs Overview. OECD2FERNANDEZ-ARIAS, E & HAUSMANN, R. Is Foreign Direct Investment a Safer Form ofFinancing? Emerging Markets Review. 2001: 2 (1), pp.34-49
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 5
concise answers. The research question therefore is: What endogenous
factors best explain FDI inflows into developing countries?
II. Literature Review
i. Introduction
The literature review section focuses on the theories concerning the
determinants of FDI inflows and explores previous studies that have focussed
on the areas of interest covered in this thesis. FDI discourse has been
researched and studied in various disciplines although mainly political
science, economics, development studies and business studies. The first
section provides a broad overview of the main competing theories regarding
FDI and multinational corporation (MNC) investment decisions. It then goes
on to explore the literature that debates the supposed benefits of FDI and the
regulatory policies used to attract it by governments. The final section of the
literature review examines the main studies regarding the effect of regulatory
policies, democracy, conflict, corruption, education and infrastructure upon
FDI inflows into developing countries.
ii. Theoretical Understandings of Foreign Direct Investment
Unlike the study of international trade, there has been very little to try and
quantify and compare national policies towards FDI. Given the prominence of
FDI in the global economy, it can be argued that is of equal importance to
international trade. The rationale for liberalising FDI is very similar to that of
trade; the assumption being that deregulated FDI results in more efficient
allocation of resources in line with the Ricardos theory of international free
trade. There are two main competing and somewhat complementary theories
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as to why MNCs trans-nationalise their production capabilities formulated by
Hymer and Dunning. These theories are amongst the best established in
international business studies literature and are important when addressing
the central research question of this thesis.
Hymer pioneered the study of why firms engage in transnational production.4
His theory was based on industrial organisation theory, particularly concerning
barriers to market entry with countries. He started from the assumption that
domestic firms would posses an inherent advantage over foreign firms, such
as a better understanding of a particular market, and considering such
advantages, foreign firms would need to posses some sort of firm-specific
asset in order to compete. These could be for example: market share, brand
name, technological capabilities amongst others which would allow them to
out compete rivals in their own domestic markets. This theory clearly explains
why firms may begin to trans-nationalise their operations, however it is limited
in that it has no way of illustrating the attractiveness of one country over
another as an investment opportunity. It is an explanation of this very
important issue that John Dunning has provided his groundbreaking study
which is at the heart of the research question in this study, considering its
emphasis on the locational aspects of FDI.
4 HYMER, S.H. The International Operations of National Firms: A Study of Foreign DirectInvestment. Cambridge: MIT Press. 1976.p23
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Dunnings eclectic model5 states that there at least three forms of advantage
that influence the decision of MNCs to expand their investments abroad
outside their home country. These are: Ownership, Location and
Internationalisation. This thesis is concerned specifically with the Location
aspect. By this it is meant the location specific advantages that certain
countries posses in order to attract FDI inflows. Such advantages can depend
on an individual countrys specific comparative advantage variables, which will
be examined further in the thesis. Generally these are considered to be
markets, resources, production costs, socio-political conditions and cultural
and linguistic attributes. In this sense it is a useful paradigm as it emphasises
the crucial role that geographic location or specific government policies that
are used to attract FDI for MNCs, when they decide to make their investment
decisions.
Dunning has further stated that there are three main types of FDI. These are:
Resource seeking (seeking natural, physical or human resources) market
seeking (looking to find additional markets for a product or service outside a
MNCs domestic boundary) and finally efficiency-seeking (looking to expand
into locations that are capable of producing more efficient or capable of
specialization).6 FDI inflows into developing countries are usually concerned
with the second and third of the three mentioned.
5 DUNNING, J. The Eclectic Paradigm of International Production: A Restatement and Some
Possible Extensions. Journal of International Business Studies.1988: 19 (1), pp.1-316 DUNNING, J. Toward An Eclectic Theory of International Production: Some EmpiricalTests. Journal of International Business Studies. 1980: 11, pp.9-11
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Central to this study is the relationship between governments and
international businesses. Peter Dicken provides a broad summary of the
relationships between MNCs and states in his textbook Global Shift.7 He
argues that this relationship is one that contains both rivalry and collusion. In
this sense the goals of both actors are fundamentally divergent in their aims
and goals. The goal of an MNC is to maximise profits and shareholder value
while minimising the cost base. For a state, the ultimate aim of FDI is to
maximise the growth of their GDP and create as many employment
opportunities for the population within its boundaries. In regards to developing
countries, the greater the number of countries vying for investment, the
weaker their particular bargaining positions will be as MNCs are capable of
playing one state off against another in order to attain the highest return on
their investment.8
Advocates of FDI maintain that its benefits for developing countries include
injecting new capital within a host economy, which can provide additional
investment in both physical and human capital. However many academics
argue that the rapid growth of MNCs is marginalising the role of the state in
the global economy. Susan Strange argues9 this is part of a structural change
in the international system of world politics, which has in part been
responsible for a tide of economic liberalisation around the world. According
to Strange this is largely due to the rapidly rising power of MNCs in the
preceding few decades to the point where they are now major actors in North-
7DICKEN, P, Global Shift: Mapping The Changing Contours of The World Economy. London:SAGE Publications. 2007. p.2368ibid.p.2389STRANGE, S. States, Firms and Diplomacy. International Affairs. 1992: 68 (1), pp.1-15
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South relations. This now means that developing countries have become
economic competitors amongst each other to attract MNCs looking to further
internationalise their production capabilities. Accordingly this has resulted in a
seismic shift where states compete amongst each other for world market
shares in their constant pursuit to sustain economic growth. Her research
based on a series of interviews in Turkey, Brazil and Malaysia with MNC
directors, public officials and politicians. This study is particularly well known
as it represented one of the first attempts to merge business studies and
international political economy discourse together in examining the rise of
MNCs as powerful non-state actors in the international system.
iii. Economic and Regulatory Policies for attracting Foreign DirectInvestment
Amongst the very first empirical studies in the area of FDI was conducted by
Root and Ahmed. They examined10 several policy variables that were
considered to be conducive to FDI inflows. In their study they tested 44
economic, social and political and policy variables against the FDI inflows of
41 developing countries. They found that tax laws and relative level of
economic freedom were not significant variables, while increases in corporate
tax levels, had a negative association with FDI inflows. This study had
important policy implications for developing countries during its publication in
the 1970s as it advocated a neoclassical economic policy as an incentive to
attract foreign investment.
10 ROOT,R & AHMED, A. The Influence of Policy Instruments on Manufacturing DirectForeign Investment in Developing Countries. Journal of International Business Studies. 1978:9, pp.81-93
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More recently, Golub11 has gone about categorising various government
policies towards FDI using a multivariate cross-sectional regression.
Considering that many of these policies and restrictions are often specific to a
particular industry, a high level of disaggregation was used. 73 developed and
developing countries were used in the regression. The results indicated that
developing countries on average are more restrictive than developed
countries concerning their investment regulations. Specifically, the European
Union states and Latin America has amongst the lowest entry restrictions
while the Middle East and South Asia tended to have higher restrictions.
Using time-series data, there is evidence that these restrictions have been
relaxed. The one exception in these results was that the USA was amongst
the least restricted economies in the 1980s but by the mid 1990s was firmly in
the middle of the pack, thus indicating that there has been almost no changes
in liberalising investment restrictions since then.
Busse and Groizard also examined the effects of government regulations on
FDI inflows.12 Their findings suggest that highly regulated economies are less
likely to be able to utilise the benefit of an MNC presence within their borders
as regulations hinder the potential for profits to be made, thus leading to lower
economic growth within a country. This study corresponds well the to
investment theories of Hymer. However a strong counter argument to this
assertion is that the removal of FDI related restrictions does not create
additional attractive factors for MNCs. Instead it merely allows them to take
11 GOLUB, S. Openness to Foreign Direct Investment in Services: An International
Comparative Analysis. The World Economy. 2009: 32 (8), pp.1245-126812 BUSSE, M & GROIZARD, L. Foreign Direct Investment and Growth. The World Economy.2008: 31 (7), pp.861-886
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advantage of the existing capabilities more freely, thus it has been argued that
liberalisation of investment restrictions needs to be complimented by strong
endogenous capabilities within countries.13
One of the most often cited work on the topic of the relationship between
economic growth and FDI is Borensztein et al14, which emphasised the
positive impact of FDI inflows on economic growth in a cross-country study of
69 developing countries over the 1970-89 period. They found that this growthwas totally dependent on the relative level of human capital within a country.
For countries with very low levels of human capital, FDI could even have a
negative impact on economic growth. This fits with one of the main
hypotheses of this study that; that greater levels of education and a skilled
workforce subsequently results in increasingly FDI inflows.
Balasubramanyam15et alhave argued that the type of trade regime (import-
substituting or export promoting) within a state is crucial to understanding the
impact of FDI inflows. The rationale here is that import-substituting strategies
incur various distortions within the economy such as factor prices. They found
that export-promoting countries better utlilised the effects of FDI on economic
growth rates between 1970 and 1985 while the effects of import substituting
were insignificant. Therefore the export orientation of a country is one of the
13LALL, S & NARULA, R. Foreign Direct Investment and its Role in Economic Development:Do We Need A New Agenda? The European Journal of Development Research. 2004: 16 (3),pp.447-46414 BORENSZTEIN, E., DE GREGORIO, J & LEE, J. How Does Foreign Direct Investment
Affect Economic Growth? Journal of International Economics, 1998: 45 (1), pp.115-13515 BALASUBRAMANYAM, V, SALISU. M & SAPSFORD, D. Foreign Direct Investment andGrowth EP and IS Countries. Economic Journal. 1996: 106 (434), 92-105
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main exogenous variables that explain a particular countrys attractiveness to
foreign investors.
However not all academics are convinced of the benefits of FDI inflows to
developing countries. Andrew Summer has argued16 that the debate
concerning whether FDI has a positive or negative impact on economic
growth and poverty reduction is misguided and the focus should be on the
terms that FDI is accepted in developing countries. As he correctly argues, for
FDI to have a positive impact, there must be a net positive transfer of capital
into the recipient country, allowing local firms to crowd in through joint
ventures and local spillovers.17 Greenfield investments for example are far
more likely to have a positive impact on the economy as they create new
employment sectors, bring in new forms of capital and are more likely to result
in spillovers. The character of a host economy is also important too as
economically developed countries are more likely to benefit from FDI. The
effectiveness of FDI is thus attached to the FDI policy regime of a particular
country. This viewpoint can be seen in opposition to neoclassical assumption
that the state should not interfere with potential external private investment
opportunities.
More recently he has suggested18 that many countries in the developing world
have reached a tipping point, as the conventional wisdom during the 1990s
16 SUMNER, A. Is foreign direct investment good for the poor? A review and stocktake.Development in Practice, 2005: 15 (3&4), pp.269-28517
ibid.pp.269-28518 SUMNER, A. Foreign Direct Investment in Developing Countries: Have we reached apolicy tipping point? Third World Quarterly, 2008: 29 (2), pp.239-253
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that FDI is an essential precondition for economic growth is no longer
unconditionally accepted by developing countries. Evidence of this can be
seen through the tightening of investment regulations in many countries and
the renationalisation of key industries in states such as Venezuela and Bolivia
and the increasing political swing to the left in many other Latin American
countries as they look to endogenous ways to develop their economies.
Mayer has also pointed out that implementing policies to attract FDI is notwithout cost,19 especially for poor countries with limited public funds and
resources. Tax breaks, subsidies and improvements in infrastructure are
example of this. Money on such projects that could be well spent on improving
education, health care and other public provisions. However this ties into the
work Sumner has done, which emphasises that developing countries need to
ensure they attract the right kind of FDI which can enhance economic growth.
Therefore high value greenfield investments are to be encouraged. It could be
argued that this presents a dilemma for developing countries, as without FDI it
is often hard to instigate significant economic and social development yet the
very policies that governments use to attract MNCs to invest are often at the
expense of welfare provisions, thus leading to increased income inequality.
Therefore it is important to be sure of a clear causal link between FDI and
subsequent economic growth. Hansen and Rand conducted research20 on
this topic and found a strong causal link between FDI inflows and economic
19MAYER, T. Policy Coherence for Development: A Background Paper on Foreign Direct
Investment. OECD Development Centre, 2006: 253, pp.1-6020 HANSEN, H & RAND, J, Causal Links Between FDI and Growth in Developing Countries.The World Economy, 2006: 29 (1), pp.21-41
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growth. Furthermore they found that the effects of FDI on economic growth
were the same irrespective of the region in the globe or level of economic
development.
Shah and Slemrod found21 that international investors were attracted to lower
corporate tax rates in Mexico, therefore recommending that Mexico aim for
taxes that were lower than the rate in the US as a way to provide incentives
for investment within the country. However such a viewpoint negates other
important variables as how to attract FDI with its narrow focus on structural
adjustment policies. However such recommendations were typical of the early
1990s when the World Bank and International Monetary Fund were attaching
structural adjustment conditions to their aid and loans, which involved far
reaching macroeconomic reforms in line with the neoliberal economic
consensus of the time.
The OECD has provided specific guidelines22 as to the policies host
governments should pursue to attract FDI. They can be summed summarised
into three key points: First and foremost is a general improvement in
macroeconomic and institutional framework, secondly creating a regulatory
framework conducive to the needs of international investors and finally
ensuring infrastructure, technology and human capital whereby international
21 SHAH, A & SLEMROD, J. Do Taxes Matter for Foreign Direct Investment? The WorldBank Economic Review. 1991: 5 (3), pp.473-491
22 CHRISTIANSEN, H & OGUTCU, M. Foreign Direct Investment For Development:Maximising Benefits, Minimising Costs. Global Forum On International Investment. 5/6December 2002, Shanghai, p.9
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firms can recognise their benefits. An OECD working paper23 concerning FDI
in sub-Saharan Africa concluded that the region had lagged behind other
regions in the world. Although the 1990s brought increasing levels of
investment as a result of political and economic reforms, this one-size-fits-all
approach was now inappropriate for many of the countries in the region due to
their individual circumstances. Several policy recommendations were
prescribed in this report. The first regarding macroeconomic conditions within
a country states that countries such as Uganda and Mauritius have had astable environment, yet this alone is not sufficient. An adequate physical and
social infrastructure is also an important factor in determining the investment
appeal of a country. One of the strongest arguments for the lack growth in
inward FDI to sub-Saharan Africa is that investment has been concentrated in
primary industries with little added value for economic growth.24
Nunnenkamp argues25 that for FDI to be affective in alleviating poverty in
developing countries. Firstly governments need to ensure their country is
attractive to foreign investors and secondly the environment of the country
must be conducive to the potential spillover effects that FDI can bring.
Therefore the challenges for developing countries are similar in that their
policy goals include developing a policy and regulation framework that is
capable of attracting foreign investment. However as he correctly asserts,
these factors are no guarantee of encouraging investment conducive to
23 ODENTHAL, L. FDI in sub-Saharan Africa. OECD Development Centre, 2001: 173, pp.1-5524
ibid.pp.1-5525 NUNNENKAMP, P. To What Extent Can Foreign Direct Investment Help AchieveInternational Development Goals? The World Economy, 2004: 27 (5), pp.657-677
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respect for human rights. The neoclassical economic approach stresses the
benefits that FDI can bring to a state. According to this logic, developing
countries that liberalise their economies, along with the benefits of increasing
levels of economic growth, will benefit from the added knock on effect of an
increasingly stable political environment, which has respect for human rights.
In stark contrast to this view, advocates of dependency theory regard FDI as a
threat to the economic and social wellbeing within a state. The rationale
behind this is that one of the ways that developed states are able to ensuretheir dominance over weaker developing states is through economic
penetration which is based on a fundamentally unequal exchange of goods
and services.29 This approach therefore would view FDI, as a tool for wealthy
states to ensure their enduring influence over the economic policies in
developing states.
Countries with democratic institutions are associated with higher levels of FDI
inflows. For example, it has been argued30 that democratic governments,
even after other domestic variables are controlled for, account for as much 70
percent more FDI as a percentage of GDP than authoritarian governments.
According to his logic, one of the key advantages for MNCs operating in
countries with democratic institutions is the credibility the host governments
offer to businesses. Thus, once investments have been made, there are
considerable political risks for firm such as nationalisation and expropriation.
29 CAPORASO, J, Introduction to the special issue of International Organization ondependence and dependency in the global system, International Organization, 1978: 32 (1),
pp.1-1230 JENSEN, N. Democratic Governance and Multinational Corporations: Political Regimesand Inflows of Foreign Direct Investment. International Organization, 2003: 57 (3), pp.587-616
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However these potential risks involved are accordingly minimised in
democratic countries. Jensens study involved a set of four tests. The first
involved an OLS regression for 79 countries over the period 1990-97. The
dependent variable in this study was net inward FDI as a percentage of GDP,
which was taken from the World Bank Development Indicators in 1999.
Another controlled variable used is Government consumption. This is used
because the degree of consumption can be used as a way of possibly
correlating the type of government regime within a certain country.
Budget deficits is another variable that is controlled for, the assumption here
being that governments with large deficits maybe more attracted to FDI as a
way of balancing the books. In his regression government expenditure had a
negative relationship with FDI. More importantly his findings indicate that a
move from an authoritarian regime to a democratic one increases FDI flows
by 60 percent.31 His analysis shows that countries move from one standard
deviation below the mean to the mean level of democracy. A move to full
democracy would increase FDI as a percentage of GDP by 1.2 percent. He
asserts the most significant advantage of democratic government is that it
increases the legitimacy of political leaders from the perspective of
international financial markets. The assumption is that democratic systems
produce leaders who are less likely to implement policies unfavourable to
MNCs.32 His OLS regression indicates a statistically significant positive
relationship between levels of democracy and country risk ratings. This study
has important policy implications for developing countries and supports one of
31 ibid.pp.587-61632 ibid.pp.587-616
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the hypotheses of this study; that democratic countries receive higher levels
of FDI inflows than authoritarian governments.
Li and Resnick also conducted research33 into the effects of democratic
governments on the amount of FDI inflows into countries around the world.
Their conclusion was that the effect of democratic institutions on FDI inflows
into developing countries, were conflicting and often quite complex. They
argue that improving protection for property rights in developing countries wasmore likely to inspire confidence in international investors, however this in
itself is directly related to country regime type since democracies generally
provide superior property rights protection. They used a times series OLS
regression using Freedom House data as the independent variable. Their
output found that a one unit increase in democracy results in a decrease of
88-94 million dollars in FDI inflows to a country. In contrast a one-unit
increase in property rights protection leads to an increase of 52 million dollars
in FDI inflows.
Richards, Gelleny and Sacko have looked at the relationship between FDI
and government respect for human rights using a logit model of analysis.34
They used cross sectional time series data across the period of 1981-1995.
The results indicated that FDI and portfolio investments both have a positive
33RESNICK, R, & LI, Q. Reversal of Fortunes: Democratic Institutions and Foreign DirectInvestment Inflows to Developing Countries. International Organization , 2003: 57 (3), pp.175-211
34 RICHARDS, D, GELLENY, R & SACKO, D. Money with a Mean Streak? ForeignEconomic Penetration and Government Respect for Human Rights in Developing Countries.International Studies Quarterly, 2001: 45, pp.219-239
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impact on increasing government respect for human rights. Therefore these
results support the neoclassical economic theory that increased financial and
economic liberalisation results in greater democratisation and respect for
human rights. These findings therefore contradict the pessimistic assertions of
dependency theory regarding the consequences of FDI inflows in the
developing world.
v. Political Stability and Its Effect on Foreign Direct Investment
I hypothesise that political stability and the absence of violent conflict within a
state increases the potential for FDI inflows, as international investors are
attracted to states with minimal risk. Therefore countries with stable rule of
law will increasingly benefit from external investments, as MNCs will have
greater levels of confidence in receiving a return on their investment. This
area of study is also intrinsically linked to the studies on democratic
governance and FDI. Democracies are associated with lower levels of internal
and external conflict as states in the democratic peace theory.35 This
hypothesises that democracies do not go to war with other democracies, as
the citizens and electorate are unwilling to bear the potential costs of such
conflicts.
Gartzke, Li and Boehmer conducted research into the relationship between
international investment, economic interdependence and international conflict.
Their dependent variable was the onset of militarised interstate disputes.
Their findings suggested that interdependent states avoided increasing
35OWEN, J. How Liberalism Produces Democratic Peace. International Security, 1994: 19(2), pp.87-125
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threats to military hostilities. As part of their study, monetary independence
was measured through whether a state has pegged its currency to that of
another state and whether it was part of a joint monetary zone. The
measuring of capital investment impact was measured through economic
restrictions in place within a state. Their overall findings link in further with the
larger democratic peace theory.
Busse and Hefeker also researched
36
this area, instead examining the effectsof perceived political risk and institutions upon FDI inflows using a cross-
sectional regression analysis using time series data from 1984 2003. Like
other academics, they also found a statistically significant relationship
between democratic institutions and increasing FDI inflows. They concluded
that MNCs are highly sensitive to changes in political stability within a country
and therefore, their results contradict those found by Li and Resnick.
Additionally they assert that MNCs are concerned by external and internal
conflicts in the host countries they have invested in to ensure minimal risk.
Easterly and Levine37 looked the reasons for sub-Saharan Africas failures in
sustaining economic growth, arguing its ethnic diversity has impeded
economic development and researched this using a cross-sectional OLS
regression analysis. They concluded that continent has such as dismal record
in economic growth and attracting investment due to low educational
36BUSSE, M & HEFEKER. Political Risk, Institutions and Foreign Direct Investment.
European Journal of Political Economy, 2005: 23 (2), pp.397-41537EASTERLY, W & LEVINE, R. Africas Growth Tragedy: Policies and Ethnic Divisions. TheQuarterly Journal of Economics, 1997: November. pp.1204-1250
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Wei also came to a similar conclusion as that of Habib and Zurwacki as he
found that the incidence of corruption within a country has a similar effect to
that of raising corporate taxes41, which in turn deters potential foreign
investors. He used a linear OLS regression with net FDI inflows as the
dependent variable and tax rate and corruption as independent variables.
However, one notable finding was that MNCs tended to invest in countries
that possessed a similar level of corruption as that of the home country of aparticular MNC.42
vii. Infrastructure and Its Effect on Foreign Direct Investment
Burnside and Dollar have found43 that low level of communication related
infrastructure and trade repels foreign investors thus making local firms less
likely to become exporters. They compared various large cities in developing
countries such as Brazil, China, Honduras, India and Nicaragua. The
variables they used included time taken to clear customs, time to get a fixed
telephone line and power losses. For example their results imply that
Karachis share of foreign invested firms in certain sectors would jump from 1
percent to about 20 percent if it could raise its infrastructure standards to that
of Shanghai in the above-mentioned variables.
41WEI, S. How Taxing Is Corruption on International Investors? The Review of Economicsand Statistics. 82 (1). pp.1-1142
ibid.pp.1-1143DOLLAR, D, BURNSIDE, C. If you Build it, Will They Come? Foreign Aids Effect onForeign Direct Investment. MPSA National Conference, 2007: 14/04, pp.1-20
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have. Countries that rely on solely on low skilled labour or natural resources
are unlikely to entice high value FDI into a country thus leading to slower
economic growth.
ix. Conclusion
To conclude, the literature concerning FDI is extremely broad and attracts
study from researchers across various academic disciplines in the social
sciences. There is no clear consensus across all the disciplines regarding the
benefits of FDI to the economic growth in developing countries. Business
studies and economics scholars generally tend emphasise the positive
aspects of FDI for growth thus associating with the neoclassical-school of
thought. Therefore maintaining the benefits of creating and economic and
regulatory framework conducive to needs of international investors. However
other such as Sumner are more cautious as to the immediate benefits.46
The main body of literature suggests that endogenous factors such as
democratic governance, corruption, infrastructure, political stability and
education are important variables in explaining the attractiveness of particular
countries for international investors. Having considered the literature on FDI,
the following hypotheses have been formulated for analysis in this study:
Hypothesis I:Lack of corruption within a country positively affects itslevels of FDI inflows.
46
SUMNER, A. Foreign Direct Investment in Developing Countries: Have we reached apolicy tipping point? Third World Quarterly, 2008: 29 (2), pp.239-253
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allows for comparison of countries regardless of population size. This data is
converted from three-year periods to offset annual fluctuations within the
dataset. This data is compatible with the central research question, which is
What are the endogenous determinants of FDI inflows into developing
countries? The dataset omits various small countries associated with tax
haven status as they have the potential to skew the data. Several emerging
market countries were also omitted due to the large fluctuations in data
associated with them. It is an average value, which is normalised to yield ascore between 0 to 1.
FDI includes the three following components: equity capital, reinvested
earnings and intra company loans. The coefficient does not provide actual
aggregate data on FDI, but instead provides a solid indication of countries
attractiveness to foreign investors. Therefore providing a good estimate of
how much FDI a country receives proportional to its population size. This
measure, more importantly, provides a solid indication of the attractiveness of
a particular country to foreign investors. Using annual net FDI inflow data has
problems with reliability due to considerably large annual fluctuations in the
data set therefore potential inward FDI is a more appropriate dependent
variable.
ii. Independent Control Variables
GDP per Capita: The first independent variable used is Gross Domestic
Product per capita using the purchasing power parity method (GDP per capita
PPP). Using the PPP data allows for the data to be adjusted for the individual
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costs of living within each country measured although this is based upon an
estimate. The data was taken from the International Monetary Fund 2006
statistics.48 The variable is used to control for the other independent variables
as this study is not attempting to try and prove a correlation between GDP per
capita and FDI inflows as the link between the two is obvious. The variable is
measured in United States dollars.
Economic Freedom: The data for levels of economic freedom was taken
from the 2009 Index of Economic Freedom published by the Heritage
Foundation.49 This ranking is created from a composite of 10 independent
data sources. These are: Business freedom, trade freedom, fiscal freedom,
government size, monetary freedom, investment freedom, financial freedom,
property rights, freedom from corruption and labour freedom. Each of these
components, are equally weighted in determining the country scores. The
2009 data was compiled from the second half of 2007 through to the first
quarter of 2008. Much of this data was taken from surveys whose
respondents included business with investments in countries included in the
index and regional experts.
Corruption: As it would be a nigh on impossible task to actually measure
global corruption in all countries as there is a lack of empirical data. Therefore
it is operationalised through Transparency Internationals Corruption
Perception Index, which is regularly used in academic studies to quantify
48IMF World Economic Outlook Database [online]. [accessed 7th June 2009]. Available From
World Wide Web: 49 Heritage Foundation 2009 Index of Economic Freedom [online]. [accessed 14 th June2009]. Available From World Wide Web:
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perception of corruption.50 This is a ranking of perceived corruption amongst
public officials and politicians within 180 countries. The data is gathered
through surveying those who are directly affected by corruption using cross-
sectional methods. This method of measurement has obvious weaknesses,
as it does not measure actual corruption per se but the perception of
corruption within a given country. This is still significant given that the thesis
hypothesises that increasing levels of corruption will be associated with
diminishing levels of FDI inflows. Therefore it is expected that countries thatare perceived to be corrupt are likely to be associated with diminishing FDI
flows.
Education: This is operationalised through the UN Education Index,51 which
further makes up part of the Human Development Index. The index is
compiled through creating a coefficient score for each country. This score
includes a two thirds weighting for adult literacy rate combined with the gross
enrolment ratio for primary, secondary and tertiary education. The latest data
was released in December 2008 and this particular data source is used in the
regression. Higher levels education, are expected to yield increasing levels of
FDI inflows within a country. The rationale behind this is that MNCs are
attracted to invest in areas with a skilled and adaptable workforce as this can
potentially provide higher rates of return in production and efficiency.
50 Transparency International 2009 Corruption Perception Index [online]. [accessed 10 th June2009]. Available From World Wide Web:
51UNDP World Development Indicators 2007/08 [online]. [accessed 5th June 2009]. AvailableFrom World Wide Web:
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Considering this thesis explores government capability to attract FDI. The
dependent variable is a coefficient score for potential FDI inflows, this is
analysed and researched using a cross-sectional OLS regression with the
eight endogenous independent variables. The first empirical test uses a
sample size of 139 countries including developed, emerging market and
developing economies and runs an OLS regression against the seven
independent variables. This sample size includes most countries in the world
of significant size and omits various states associated with tax haven status
due to their potential to skew the results.
The second test removes all countries with a Potential FDI inflows coefficient
score of 0.2360 or higher, leaving a sample size of 81 developing and
emerging market economies. The purpose of this is that developing countries
are often fundamentally different in their economic, political and social
structure from industrialised countries therefore the determinants of FDI
inflows to these countries could vary from that of developed countries. This
should provide a set of results that are more specific to developing countries.
One of the main reasons for this is that developing countries often attract
different MNC investment usually associated as efficiency seeking or
resource seeking. To mitigate to problems of reverse causality or
autocorrelation, all the variables used are lagged or use weighted averages
from the 2000s to ensure appropriate time order with the dependent variable.
One of the weaknesses of a pooled model is that countries that are very
different in their structural makeup are pooled together and by virtue of
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 33
exhibiting similar rankings in the dependent variable coefficient. Cross-country
variations in data thus present a dilemma, as regional differences may well be
significant and require a qualitative case study related method of research for
concise results specific to the context of individual states. One of the
weaknesses of using an OLS regression is that it may yield an inconsistent
estimate of the causal effects being examined in this thesis. However since
the purpose of this study is to examine which endogenous contemporary
factors prevalent within a country contribute to greater levels of FDI inflowstherefore an OLS regression and provide clear and concise results, as the
data used in the dependent and independent variables is empirical. More
specifically, an OLS regression provides an estimate of the effect of y on
unexplained changes inx.
This approach is the most widely used the literature concerning determinants
of FDI inflows and government policies that attract it. This methodological
approach is therefore appropriate. Due to limitations in data availability, a time
series regression was also not possible. Internal validity is accounted for, as
the statistical inferences are valid for the countries in the study. There is
appropriate time order sequencing between the dependent and independent
variables. The sample size in both models is sufficiently large including most
countries of sufficient size to eliminate the threat of selection bias. The study
possesses construct validity, as all the variables are appropriately
operationalised.
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IV. Results/Findings
In this study, two OLS regressions were run. Table 1 shows the cross
sectional output from model one, which included 139 countries in the sample
population. Table 2 shows the output from model two, which included a
sample size of 82 developing and emerging market economies.
i. Model One
Unstandardized Coefficients
Standardized
Coefficients
Model B Std. Error Beta t Sig.
(Constant) .104 .048 2.176 .0
GDP 08 PPP 3.769E-6 .000 .520 7.308 .0
Corruption .016 .005 .308 3.083 .0
Economic Freedom Index -.002 .001 -.148 -1.881 .0
Freedom House Ranking .000 .000 .076 1.353 .1
Political Stability 8.644E-5 .000 .071 1.317 .1
Oil Exports 1.713E-8 .000 .163 4.173 .0
Education .084 .018 .204 4.595 .0
1
Regulatory Quality .000 .000 .101 1.168 .2
a. Dependent Variable: Inward Potential FDI.04.06
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 35
ii. Model Two
Unstandardized Coefficients
Standardized
Coefficients
Model Two, Table 2. B Std. Error Beta t Sig.
(Constant) .101 .041 2.477 .0
GDP 08 PPP 6.549E-6 .000 .599 6.171 .0
Corruption -.009 .005 -.185 -1.608 .1
Economic Freedom Index 7.858E-5 .001 .013 .105 .9
Freedom House Ranking -5.374E-5 .000 -.018 -.192 .8
Political Stability 8.772E-5 .000 .158 1.976 .0
Oil Exports 1.514E-8 .000 .181 2.300 .0
Education .046 .013 .319 3.475 .0
1
Regulatory Quality -3.689E-7 .000 .000 -.005 .9
a. Dependent Variable: Inward Potential FDI.04.06
GDP per Capital PPP: As expected the relationship between GDP per capita
and FDI inflows is highly significant and important in its substantive impact in
both models holding all other variables constant. It would of course be a gross
over simplification to suggest a countrys FDI inflows are a function of its GDP
per capita. The relationship between the two variables is highly complex as it
is the case that FDI inflows contribute to a countrys wealth so it very hard to
say whether one is a linear function of the other.
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Corruption: Lack of corruption is correlated with positive increase in FDI
inflows thus corresponding to most of the conclusions of the literature in the
field in the Model One output. For a one unit increase in lack of corruption
perception there is a 0.16 increase in FDI Potential inflows controlling for all
other variables. This is significant to the 0.005 level. In Model Two the
statistical significance no longer holds as it is only to the 0.112 level. Also
there is interestingly a slightly negative relationship between lack of corruption
and increasing FDI inflows. This corresponds well the study by Egger and
Winner56 mentioned in the literature review, who conducted a similar study
using the same data from Transparency International. Therefore the output
seems to suggest international investors in developing countries are attracted
to countries where there is potential to bribe politicians and public officials.
The results therefore seem to suggest that on the whole, the perceived
presence of corruption within a society is deterrent to international investors,
however when considering developing countries, the potential to bribe officials
could act as an incentive to invest on terms favourable to an MNC. However,
this is not to suggest corruption in developing countries is something to be
encouraged.
Regulatory Quality and Economic Freedom: Two of the most striking from
the Model One output is the lack of a statistically significant relationship
between regulatory quality, economic freedom and FDI. Model One actually
56EGGER, P & WINNER, H. Evidence on corruption as an incentive for foreign directinvestment. European Journal of Political Economy, 2005 21, pp.932-952
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increases human capital through knowledge and technology spillovers in host
countries. The findings in both Model One and Two provide strong indications
that international investors are highly attracted to locations, which provide an
educated and skilled workforce this reinforcing the findings of previous
studies. The rationale behind this being that MNCs will invest overseas to
utilize a skilled labour force at lower cost than available in their home country,
thus conducting efficiency seeking FDI.
Political Stability: Another surprising result from the regression is the
absence of statistical significance concerning the relationship between
political stability and FDI inflows. This is particularly interesting given the
broad array of literature that stresses the importance of stable political system
and the culture of political risk analysis that many MNCs engage in. Model
One indicates that the relationship is only significant to the 0.191 level
meaning the null hypothesis cannot be rejected. However for Model Two the
results are remarkably different with a sig column score of 1.976 giving even
less confidence in this relationship regarding developing and emerging market
economies
Democracy: Model One finds no relationship between democratic
government, political freedoms and FDI inflows. This is another surprising
result. The findings in Model Two present a similar output from the regression,
although the statistical significance is far weaker. The findings of this study
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 41
The results from this study have several policy implications for developing
countries. Firstly, creating a regulatory framework conducive to attracting
investment from foreign firms and implementing liberalizing reforms within a
country does not appear to be entirely sufficient to attract FDI. This alone
does not create the value added determinants that attract foreign firms to
invest in a particular location. As has been mentioned in the past, the benefits
of FDI to countries which are still at a low level of development is marginal
due to threshold externalities, meaning they have yet to reach a certain levelof educational, technological and infrastructure related level of development
and therefore do not reap the full benefits of FDI.61
The results from the regression clearly indicate the crucial role of education in
attracting investment. It is also often the case that FDI provides knowledge
spillovers into host countries as well, once it has been attracted through on-
the-job training therefore creating a further positive effect from sound
government educational policies. Corruption is also endemic problem, which
appears to impede FDI inflows to a country. Although the two models used,
resulted in different directional relationships, it is clear that corruption either
impedes FDI inflows or nullifies the potential positive impact the may have on
socio-economic conditions within a country.
Surprisingly the findings suggest no significant relationship between political
stability/lack of violence and FDI inflows considering the amount of literature,
which has concluded there is a relationship between the two. However, since
61Foreign Direct Investment: Maximising Benefits, Minimising Costs Overview. OECD
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ENDOGENOUSDETERMINANTSOFFDIFLOWSINTODEVELOPINGCOUNTRIES 43
however build upon previous literature to give a broad overview of the key
endogenous determinants of FDI inflows into developing countries and the
key characteristics that are shared by them to successfully attract value
added foreign direct investment.
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VI. Bibliography
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ii. Websites
CIA World Factbook 2009 [online]. [accessed 27 th June 2009]. Available From World WideWeb:
Freedom House, 2009 Freedom in the World Report [online]. [accessed 17 th June 2009].Available From World Wide Web:
Heritage Foundation 2009 Index of Economic Freedom [online]. [accessed 14 th June 2009].Available From World Wide Web:
IMF World Economic Outlook Database [online]. [accessed 7th June 2009]. Available FromWorld Wide Web:
Transparency International 2009 Corruption Perception Index [online]. [accessed 10th June2009]. Available From World Wide Web:
UNCTADInward Potential FDI Index 2004-2006 [online]. [accessed 29 th May 2009]. AvailableFrom World Wide Web:
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From World Wide Web:
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Appendix I.
Combined List of Countries Used in Sample Population of Model One and Two:
Albania Iran South AfricaAlgeria Ireland South Korea
Angola Israel SpainArgentina Italy Sri LankaArmenia Jamaica SudanAustralia Japan SurinameAustria Kazakhstan SwedenAzerbaijan Kenya SwitzerlandBahamas Kuwait SyriaBahrain Kyrgyzstan TaiwanBelarus Latvia TajikistanBelgium Lebanon TanzaniaBenin Libya ThailandBolivia Lithuania TogoBotswana Luxembourg Trinidad and Tobago
Brazil Macedonia TunisiaBrunei Madagascar TurkeyBulgaria Malawi United Arab EmiratesBurkina Faso Malaysia UgandaCameroon Mali UkraineCanada Malta United KingdomChile Mexico United StatesChina Moldova UruguayColombia Mongolia UzbekistanCongo, Dem Rep Morocco VenezuelaCosta Rica Mozambique VietnamCote dIvoire Myanmar YemenCroatia Namibia Zambia
Cyprus Nepal ZimbabweCzech Republic NetherlandsDenmark New ZealandDominican Republic NicaraguaEcuador NigerEgypt NigeriaEl Salvador NorwayEstonia OmanEthiopia PakistanFinland PanamaFrance Papua New GuineaGabon ParaguayGambia, The Peru
Georgia PhilippinesGermany Poland
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Ghana PortugalGreece QatarGuatemala Republic of CongoGuinea RomaniaGuyana Russian FederationHaiti Rwanda
Honduras Saudi ArabiaHong Kong SenegalHungary Sierra LeoneIceland SingaporeIndia SlovakiaIndonesia Slovenia