taylor - the impact of host country government policy on us multinational investment decisions

8/11/2019 Taylor - The Impact of Host Country Government Policy on US Multinational Investment Decisions

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The Impact of Host Country

Government Policy on US

Multinational Investment Decisions

Christopher T. Taylor

1. INTRODUCTION

OREIGN direct investment (FDI) is playing an increasing role in the worldeconomy. One-half of all trade and one-fifth of world GDP are attributable

to multinational corporations (Rugman, 1988). The sales of firms affiliated withUS-based multinationals are over twice the size of US exports. Exports from US-based firms to affiliates abroad accounted for approximately one-third of total USexports. In addition, despite the large share of US exports accounted for by

multinational corporations, sales of goods in foreign countries by majority-ownedforeign affiliates of US firms are over five times the size of US exports bymultinationals (US Department of Commerce, 1995). In addition, the importanceof investment of multinationals to a countrys growth or productivity is beingscrutinised. Some researchers have found that FDI is more important to acountrys growth than domestic investment since investment by multinationalsincludes improved technology (Borensztein, de-Gregorio and Lee, 1995; andBlomstrom, Lipsey and Zejan, 1992). Others, however, have found that there areno productivity differences between foreign and domestic firms

1(Globerman et

al., 1994).

Blackwell Publishers Ltd 2000, 108 Cowley Road, Oxford OX4 1JF, UKand 350 Main Street, Malden, MA 02148, USA. 635

CHRISTOPHER T. TAYLOR is an economist at the Federal Trade Commission. Views andopinions expressed in this paper are solely those of the author and should not be interpreted asreflecting the views of the Federal Trade Commission, any of its individual Commissioners, orother members of the staff. Comments on this work from Arona Butcher, Michael Ferrantino,William Donnelly, an anonymous referee, and the participants of the US International TradeCommission workshops on the Dynamic Effects of Trade Liberalisation are gratefully acknow-ledged.1 The differences in these results may be attributable to the countries being examined. Lesser

developed countries may see productivity benefits that more developed countries do not. However,the productivity impact of foreign investment is still an open question.


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even with the rapid growth in Asia outside of Japan, this region still accounts foronly seven per cent of the assets of US affiliates.

The following section of the paper reviews the previous research on the effectsof government policy on FDI and the previous measures of openness used inthese investigations. Section 3 describes the hypothesis tested concerning therelationship between changes in US multinational investment and hostgovernment policy and the data used. Section 4 presents and discusses theestimates. The final section presents concluding comments on the relationship of government policy and FDI.

2. THE EFFECT OF GOVERNMENT POLICY ON FOREIGN INVESTMENT

While there are many determinants of FDI other than government policy, thisreview focuses on those determinants related to government policy. A number of articles have examined the effects of trade policy on FDI. Some of the articles inthis literature are described below to give a range of results. A lesser amount of research has been done on the impact of FDI policy on foreign investment.

Markusen (1995) summarises the results of recent research on the relationshipbetween trade barriers and FDI by stating that trade barriers cause a substitutiontoward FDI, but they also depress both trade and investment. Thus high barriersto trade will tend to cause a substitution away from exports to a country towards

FDI (affiliate sales), but simultaneously depress both trade and investment.Early research suggested that the higher the tariff level in a country and

industry, the higher the investment. In order to overcome tariffs, firms couldinvest in manufacturing within the country in question, i.e. tariff-jumpinginvestment. This result implies that exports from the multinationals homecountry and affiliate sales generated by FDI are substitutes, given the existence of trade barriers. Horst (1972) examined a cross-section of industries in Canada; theresults showed a negative relationship between other countries exports andtariffs. The higher the tariff the more likely a US firm was to supply the Canadian

market from Canadian affiliates. Orr (1975) found that these results were notrobust to slight variations in the data set. When less aggregated industrygroupings were used the negative relationship between tariffs and exportsdisappeared. Other studies have shown a negative relationship between tariffs andFDI (Nicholas, 1986; and Hollander, 1984). There are also a number of studiesthat found no relationship between tariffs and exports as a substitute forinvestment (Buckley and Dunning, 1976; and Ferrantino, 1993).

Brainard (1997) examines substitution between exports and foreign affiliatesales in a jointly determined framework with explicit incorporation of tariff andnon-tariff barriers. As an elasticity the relationship between tariffs and affiliatesales is shown as between 0.38 to 0.45. For example, for a one per cent increase

THE IMPACT OF HOST COUNTRY POLICY ON INVESTMENT 637

Blackwell Publishers Ltd 2000


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in the tariff there is an increase of approximately one-third to one-half per cent inaffiliate sales.

Government policy on FDI can be more complex than trade policy. Often FDIpolicy is in reality a group of policies rather than a policy. Some governmentsplace restrictions on FDI such as technology transfer requirements, local-contentrequirements or sectoral prohibitions. Governments also give incentives forforeign investments such as lower operating taxes or tariff breaks on importedinputs. A countrys FDI policy also includes the legal protection afforded toforeign investors against such threats as expropriation. With an increased interestin bilateral and multilateral investment negotiations, the effect of FDI liberal-isation on FDI flows is important. The investment agreement in the UruguayRound on trade-related investment measures (e.g., minimum export and localcontent requirements) and domestic regulations that may impede FDI (e.g.,licensing requirements) was a move toward liberalising the investmentenvironment. This negotiating process is only beginning, and other more wide-ranging investment agreements are under discussion.

The complexities of FDI regimes and their varying effects make empiricalestimation challenging. In order to measure the effect of FDI policy, a measure of the restrictiveness or openness of a countrys FDI policy must be constructed.The empirical work to this point has relied on a tally of the number of restrictionson or incentives for FDI that exist in a country. Therefore, most evidence on theeffect of FDI policy on FDI is still anecdotal or covered in case studies. The case

study research emphasises the effect of inducements more than restrictions.Reuber (1973) shows that a variety of inducements are offered to investors

including tariff protection; import quota protection; tariff reductions on importedequipment, imported components and tariff reductions on imported rawmaterials; tax holidays; accelerated depreciation of plant and equipment for taxpurposes; and government-built infrastructure. In the case studies the author doesnot find a significant effect of these inducements on increasing FDI. The surveyof companies suggests that firms believe governments that give inducements toattract investment will raise firm costs in other ways to recover lost revenue. This

paper also summarises previous empirical studies on the impact of FDIrestrictions and incentives, which show mixed results. Guisinger and Associates(1985) wrote case studies of 74 major investments in 30 countries. They foundthat over 50 per cent of these investments benefited from some type of inducement. Also the number of inducements was actually greater forinvestments to serve the local market than it was for exports.

There has been some empirical work on cumulative FDI openness measureseffects on FDI. Brainard (1997) finds a sizeable negative effect of FDI barriersand affiliate sales. FDI barriers are measured by using a survey measure from theWorld Competitiveness Report . For a one per cent increase in FDI barriers thereis a 3.2 per cent decrease in affiliate sales, while exports increase by 1.6 per cent.

638 CHRISTOPHER T. TAYLOR



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Ferrantino (1993) finds restrictive policies on FDI lessen the amount of investment in a country as well. His measure of FDI openness is derived from theUS Commerce Department FDI surveys. Wheeler and Mody (1992) examine USmultinational investment in manufacturing and electronics. One of the variablesin their analysis is an openness measure that combines both trade and investmentpolicy variables. They find the more open countries have less investment.However, the effect that they find for openness on investment is small. Inaddition, sensitivity testing showed these results to be somewhat unstable.

Throughout the literature on the relationship between trade and FDI policy andFDI and a somewhat separate literature on openness and productivity or growth,many different measures of openness are used. Edwards (1998) reviews a numberof trade openness measures that have been used in previous research. In addition,his regressions show that best performing trade openness measures are themultidimensional measures drawn from the World Development Report and theHeritage Foundation. One of the worst performing measures of openness in hisempirical work was the tariff rate.

In addition to the choice of openness measure there are a number of endogeneity issues with using openness measures (Edwards, 1998; and Rodrik,1995). For example, more open countries may grow faster. Countries that haveattracted FDI in the past may be more open. In an attempt to mitigate theseendogeneity issues, the regressions in this paper were run for various time periodsusing the same openness measure. By looking at both past and future flows with

the same openness measure the regressors become predetermined.

3. HYPOTHESES AND DATA DESCRIPTION

In this analysis of the effect of trade and FDI policy on investment, twohypotheses are tested. First, do countries with greater openness to FDI, measuredby the restrictions placed on FDI, receive larger or smaller amounts of investmentby US multinationals? Second, does a relationship exist between investment flows

and openness to trade? Since the previous research on these relationships comes tovery mixed conclusions, there can be no maintained hypotheses. The rest of thevariables in the analysis are other determinants of FDI suggested by the literature.

In terms of country-specific determinants of FDI, there are a few categories of variables typically used. One category attempts to measure the attractiveness of the market. In other words, variables such as GDP (for the size of the market),GDP per capita (for the wealth of the market) and growth in GDP (for the growthin the market) could all be positively related to investment. Another category of variables measures the attractiveness of the market for production. Variables suchas labour cost can be used as a determinant of FDI. Other variables which gaugethe overall attractiveness of the market include inflation and exchange rate

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variation which have been used to measure macroeconomic policies and risk.Each of the above variables is used in empirical research on FDI, depending ondata availability and the specific research question. Industry-specific variablessuch as the level of corporate profits in the industry are used as well.

The dependent variables in this analysis are the change in the dollar value of the assets of US affiliates in a cross-section of countries and industries. Theanalysis is performed for two time periods and for a cross-section of industries.

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There are 37 countries for which all the variables were available. These 37countries represent a broad cross-section of developed and developing countries.Most of the countries in the OECD, Latin America and Asia are included in thissample.

The general specification is a reduced-form investment equation. Due to thenumber of observations available in examining US FDI flows in cross-section,only a limited number of determinants of FDI flows are analysed. 4 FDI is shownas a function of trade and FDI openness, the size of the economy, gross domesticproduct (GDP), the stability of the economy, inflation, cost of production, wagesand the profit rate for a previous year. Below is the specification used in thisanalysis along with a summary of the expected relationships.

FDI = F(Trade Openness, FDI Openness, GDP, Inflation, Wages, Profits)

Four sets of regressions are estimated using the above specification: (1) A

regression for the change in the assets of US affiliates for 39 countries between1983 and 1997. (2) A regression for the change in the assets of US affiliates for the39 countries between 1983 and 1993. (3) A regression for the 28 countries andthree industries using industry dummy variables to separate industry effects for thechange in assets of US affiliates between 1983 and 1993. (4) For each industry, theabove specification is estimated separately allowing for a correlation across theerrors of the three regressions, a system of seemingly unrelated regressions.

The variables in this analysis are shown with means and standard deviations inTable 2. The dependent variables are the first three in the table: Change in total

assets of US affiliates between 1983 and 1997 and between 1983 and 1993 andchange in total assets of US affiliates between 1983 and 1993 by industry. Thirty-nine countries have data for the change of assets of US affiliates between 1983and 1993 and between 1983 and 1997. A subset of 22 of these 39 countries hadcomplete asset data for 1993 in the three broad industry categories: services,

3Using a panel of yearly observations was investigated but rejected. Most of the variation in the

openness measures is by country not by time. See Wheeler and Mody (1992) for a discussion of thisissue.4 Other variables such as GDP per capita, GDP growth and exchange rate variation were used in

the specifications but were not significant. These variables were dropped to preserve degrees of freedom and did not significantly affect the results.




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The measure of trade openness in this analysis comes from the World Competitiveness Report for 1993. One of the survey questions in this reportconcerns the degree to which government policy discourages imports. The resultsof this survey question rank countries between 1 and 10 with respect to tradeopenness.

The data for the other determinants of FDI come from a variety of sources.GDP and the inflation measure, the GDP deflator, for 1993 comes from the WorldBank Development Indicators database. The measure of wages comes from theUS Department of Commerce (1994). Wages paid to workers of US affiliates aredivided by the number of workers at US affiliates for a given country in 1993. Allof the data are in logarithmic form except profits due to existence of negativevalues.

The wealth of the host economy, as measured by GDP per capita, is expectedto be positively related to investment. The countrys macroeconomic stability, asmeasured by the inflation rate, is expected to be positively related to FDI.Surveys and case studies have shown that firms like stability since it easesplanning and decision making. The wage rate paid by US affiliates in the countryis expected to be negatively related to FDI. Investing in a country with highwages is not attractive all else being equal. Profit is expected to be positivelyrelated to the change in FDI over the period. Higher profit rates in previousperiods will attract more investment. For the change in assets from 19831993the profit rate in 1988 was used. For the change in assets for the 19831997

period the profit rate for 1993 was used.7

4. EMPIRICAL RESULTS

Tables 3 and 4 present the results of the series of regressions on thedeterminants of investment by US multinationals. Table 3 shows the results of regressions of the change in total assets of US affiliates abroad for the sample of 39 countries, for two time periods, and for 28 countries separated into the threeindustry groupings. Table 4 displays the results for the system of regressions, onefor each industry, for the 28 countries. The adjusted R-squared across theregressions ranges between 72.9 and 95.4 showing a reasonably good fit forcross-sectional analysis.

The relationship between FDI openness and investment is similar in theregressions on Table 3 and is significant at the 99 per cent confidence level.These coefficients suggest a one per cent increase in FDI openness leads to a 34per cent larger flow of investment or increase in the assets of US affiliates in the

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Sensitivity testing of the results showed that there was a lag in profit rates affecting investmentflows, and the effect of profits on investment flows was of a limited duration.




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TABLE 3Change in Foreign Direct Investment Assets:

Coefficients and t -Statistics 2

FDI FDI Trade GDP Inflation Wages Profit 4 Petroleum Manufactu Measure 1 Openness 1 Openness 1 1993 1 1993 1 1993 1

Total 4.05** 1.06* 1.07** 0.08 0.42** 11.34** ( 3 ) (3 )19831997 (4.96) (1.97) (8.11) ( 0.86) ( 1.92) ( 4.41)

Total 3.31** 1.29* 1.29** 0.04 0.72** 7.90** ( 3 ) (3 )19831993 (3.48) (1.87) (10.23) (0.70) ( 2.79) (3.03)

By Industry 3.11** 1.06* 0.91** 0.22** 0.16 2.12 2.25** 0.2619831993 (3.81) (1.90) (6.19) ( 2.53) (0.54) (0.84) ( 7.59) ( 0.92)

Notes:1 Variables in natural logs.2

t -Statistics reported are heteroscedastic-consistent using the White procedure.3

Not applicable.4

Profit is 1988 for regressions with data for 198393 and 1993 for 198397.** Significant at the 5 per cent confidence level.* Significant at the 10 per cent confidence level.

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country. For example, if Turkey or South Africa were to increase their opennessscore from approximately 5 to the level of the United Kingdom at approximately7, the regression would predict a corresponding increase in the investment flowsof over 100 per cent.

8This change is a sizeable increase in investment, but it is

obtained by comparing two of the more closed regimes to one of the more openregimes in the survey. It is a movement from approximately the mean FDIopenness to one standard deviation above.

The trade openness measure is positive and significantly related to FDI flows.In other words, trade openness and US FDI increase or decrease together. Thecoefficients on trade openness range between 1.06 and 1.29, showing the moreopen a countrys trading regime, the more investment it attracts. Three othermeasures of trade openness were examined: the average most favoured nation(MFN) tariff rate, the range of MFN tariff rates, and the non-tariff barriercoverage ratio. None of these measures when used in the regressions showed asignificant relationship to FDI. That the most useful openness measures tend to bemultidimensional corresponds to the results in Edwards (1998). Since thegovernment policies tend to be multidimensional, the measures of the policiesneed to be as well.

The other determinants of FDI shown in Table 3, GDP, inflation, wages andprofit, show results similar to those found in the literature. GDP has a positiveand significant coefficient of approximately one throughout the regressions. Thisestimate suggests a one per cent increase in GDP accompanies a one per cent

increase in investment flows. The wages and inflation measures are bothnegatively related to FDI as hypothesised. However, these relationships are notalways significant. The profit measure, return on sales in 1988, is positively andsignificantly related to FDI in the two overall regressions. The greater the profitrate of US affiliates in the country in a previous year, the larger the increase ininvestment.

The third regression on Table 3 suggests there are significant differencesacross the industries with respect to US multinational investment flows acrossindustries. The petroleum industry is significantly different from services and

manufacturing. In addition the restriction that all three industries have the samecoefficients for the independent variables was rejected. These differences led tothe specification of separate industry effects regressions shown in Table 4.Independence of the error terms across the industries was rejected so a system of seemingly unrelated regressions was estimated.

FDI openness continues to show a positive and significant relationship toinvestment flows in Table 4. However, FDI openness is more important inservices than in petroleum or manufacturing. This may be due to the large

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This is calculated by multiplying the percentage change of FDI openness from 5 to 7 by thecoefficient on the FDI openness variable in the regression.




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TABLE 4Change in Foreign Direct Investment Assets by Industry 19831993:

Coefficients of Seemingly Unrelated Regression and t -Statistics 2

FDI by FDI Trade GDP Inflation Wages Prof Industry Openness 1 Openness 1 1993 1 1993 1 1993 1

Manufacturing 1 2.31** 1.18** 0.90** 0.13 0.24 (2.54) (2.03) (5.50) ( 1.41) ( 0.83)

Petroleum 1 2.91** 0.08 0.69 0.22* 0.10 (2.20) (0.93) (2.84) ( 1.64) (0.83) (

Services 1 4.75** 0.77 1.21** 0.19* 0.69** 1(4.82) (0.96) (7.29) ( 1.66) ( 2.22)

Notes:1 Variables in natural logs.2

t -Statistics reported are calculated using the quadratic form of the analytic first derivative.3

Adj. R2

is for estimation of the separate equations.** Significant at the 5 per cent confidence level* Significant at the 10 per cent confidence level.

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increase in services investment over the time period or the type of services beingprovided. Only in the manufacturing regression is trade openness significantlyrelated to FDI flows. This is not unexpected since this is the industry where thepresence of imported inputs may be most important. GDP is significant in theservices and manufacturing equations with a coefficient of approximately one.This is consistent with results in Table 3. This is not surprising since investmentin petroleum would be driven by the natural resource, not necessarily an interestin serving the host countries market. Wages have a negative and significantrelationship for services FDI. The higher the wage rate, the less investment inservices industries. Profit shows a positive and significant relationship to the flowof FDI into services.

5. CONCLUSIONS

In this article prior research on the relationship between government policy ontrade and investment and FDI was reviewed and new estimates on therelationship between government policy and US FDI were presented. The resultsof this empirical investigation suggest that countries with more open policies interms of trade and investment attract larger amounts of US FDI, all else equal.While Brainard (1997) finds a slightly smaller elasticity of affiliate sales to FDI

openness, the results of FDI openness in this paper are of a similar magnitude.Interestingly, the policy variables for trade and investment openness typically

had some of the larger impacts on US investment flows. FDI openness in terms of an elasticity has the largest effect of the determinants examined and, from apolicy perspective, may be easier to change than the other determinants.However, FDI policy is really a set of policies, as stated earlier. Any number of government policies, from labour to intellectual property protection, can act todiscourage investment.

The results across industries have important policy implications as well. The

results suggest that to attract manufacturing FDI, openness in both trade andinvestment is important. Investment openness is important in attracting petroleumand services investment while trade openness seems to be less important.

Since government policies on trade and investment tend to be multi-dimensional, measurement of those policies needs to be multidimensional aswell. The above regressions revealed that the survey measure of a countrys tradeopenness was significant while more standard measures like tariff rates and non-tariff barrier coverage ratios were not. Collection of a time series of multidimensional trade and FDI openness measures would greatly facilitateresearch on the effects of government policy on investment and other relatedissues.




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taylor - the impact of host country government policy on us multinational investment decisions

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