Factors affecting inward foreign direct investment

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By Kyaw Win Tin

Foreign direct investment (FDI) is an investment made by a company or individual in one country in business interests in another country, in the form of either establishing business operations or acquiring business assets in the other country such as ownership or controlling interest in a foreign company.
Developing countries emerging economies and countries in transition due to advantages related to FDI have liberalized their FDI regime and followed best policies to attract investment. It has been recognized that the maximizing benefits of FDI for the host country can be significant including technologies spillovers, human capital formation support, enhancement of competitive business environment, contribution to international trade integration and improvement of enterprise development. FDI can also support not only economic benefits including improvement of environment and social condition but also alleviating poverty of the nation.
There are two concepts of foreign direct investment (FDI) and two matching ways of measuring it. One is that FDI is a particular form of the flow of capital across international boundaries. It gives rise to a particular form of international assets for the home countries, specifically, the value of holdings in entities, typically corporations, controlled by a home-country resident or in which a home-country resident holds a certain share of the voting rights. The other concept of direct investment is that it is a set of economic activities or operations carried out in a host country by firms controlled or partly controlled by firms in some other (home) country. These activities are, for example, production, employment, sales, the purchase and use of intermediate goods and fixed capital, and the carrying out of research.
The former of these two concepts is the one reflected in balance of payments accounts. The measures of it, flows and stocks of direct investment, are the only virtually ubiquitous quantitative indicators of FDI. However, if the effects of FDI stem from the activity of the foreign-owned firms in their host countries, the balance-of-payments measures have many defects for any examination of these impacts.
The FDI is also beneficial to the overall economy invests in a foreign enterprise using resources including business capital, technology and managerial skills. One of the benefits of long-term FDI is that the host country achieves a higher financial status compared to the home country. The use of advanced technology means that the host country has easy access to higher technology assets, thus improving its operating efficiency and productivity. FDI can lead of creation of jobs in higher skill category for the host country, which can be translated into better employment opportunities and competitive skills in a globalized job market. Other benefits of FDI for the host country is larger global market for its products. For the benefits to the home country is the creation of jobs and inward flow of capital. Human resources in the home country have access to better technology and labour skills, thus improving their employability factor. The overall quality of the goods produced in the home country improves as the local produces have to now compete with the foreign investors. Increased mutual inflow of FDI can reduce the current account deficit of the home country or event result in a current account surplus.
The main factors that affect foreign direct investments are wages rate, labour skills, tax rates, transport and infrastructure, size of economy (potential for growth), political stability (Property rights), commodities, access to free trade areas and exchange rate.
Wage rates: A major incentive for a multinational to invest abroad is to outsource labour intensive production to countries with lower wages. Due to the fact that wage rate has a significant effect on attracting FDI; it is possible that a country would lower it wages as a way of enticing new foreign direct investment away from other developing countries.
Labour skills: the effect of FDI on relative skilled labour demand is likely to vary across countries especially depending on relative skill abundance of the recipient economy as compared to the investor. Therefore multinationals will invest in host countries with a combination of low wages but high labour productivity and skills.
Tax rates: Tax competition for FDI is a reality in today’s global environment. Investors routinely compare tax burdens in different locations, as do policy makers with comparisons typically made across countries that are similar in terms of location and market size. Therefore large multinationals used to seek to invest in countries with lower corporation tax rates.
Transport and infrastructure: A key factor in the desirability of investment are the transport costs and levels of infrastructure. A country may have low labour costs, but if there is then high transport costs to get the goods on to the world market this is a drawback. Transport infrastructure, foreign direct investment and economic growth are co-integrated, indicating the presence of long-run equilibrium relationship between them. Size of economy (Potential for growth): Foreign direct investment is often targeted to selling goods directly to the country involved in attracting the investment. And the size of population and scope for economic growth will be important for attracting investment. Specifically FDI can appear to go up in country where customers put higher emphasis on product cost rather than product performance and features and overall firms’ marketing practices and buyers’ behavior in a country are very likely to draw the attention of multinational enterprises considering investment in that country.
Political stability/property rights: Foreign direct investment has an element of risk. Countries with an uncertain political situation will be a major disincentive. Also economic crisis can discourage investment. And FDI related to political stability is the level of corruption and trust in institutions especially judiciary and the extent of law and order.
Commodities: capital inflows and volatile commodity price movements pose significant policy challenges for developing countries. One reason for foreign investment is the existence of commodities. Large capital inflows and rising commodity prices have strongly affected macroeconomic quantities as well as prices. Commodity prices freight costs and other indicators are often pointed to as potential gauges of underlying economic activity.
Clustering effects: Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is that they can benefit from external economics of scale-growth of service industries and transport links. Also, there will be greater confidence to invest in areas with a good track record. The government may apply its policy support to attract FDI for high tech clustering and the FDI dominated cluster may start the three interrelated elements: (1) a pragmatic goal of government support: (2) complementarities with the international leading firms in the market, technology and equipment linkages: (3) Sustainable capacity of technological learning to drive local developments.
Access to free trade areas: One of empirical results indicates that there is a positive relationship between participation in multilateral agreements and FDI inflow into the Asia-Pacific region. AFTA (ASEAN Free Trade Area) is unique in that large increases in FDI and trade in the region have led to the agreement instead of the other way around. AFTA is projected to significantly boost GDP growth in the region. To the extent the AFTA increases GDP growth, FDI flows into the region will be enhanced as well.
Exchange rate: One of the most factors affecting FDI is the exchange rate. Exchange rate movements and exchange rate uncertainty appear to be important factors investors take into consideration in their decision to invest abroad. Much of the literature on exchange rate movements and FDI concentrates on two issues: level of the exchange rate and the volatility of the exchange rate. The level of exchange rate may influence FDI because depreciation of the host country currency against the home currency increases the relative wealth of foreigners thereby increasing the attractiveness of the host country for FDI as firms are able to acquire assets in the host country relatively cheaply. Thus a depreciation of the host currency should increase FDI into the host country and conversely an appreciation of the host currency should decrease FDI.
The theoretical arguments linking volatility to FDI have and risk aversion argument. According to production flexibility arguments, exchange rate volatility increases foreign investment because firm can adjust the use of one of their variable factors following the realization of nominal or real shock for developed countries. According to the risk aversion theory, FDI decreases as exchange rate volatility increases in developing countries. This is because higher volatility in the exchange rate lower the certainty equivalent expected exchange rate. Certainty equivalent levels are used in the expected profit functions of firms that make investment decision today in order to realize profits in future periods. A foreign direct investment in a country with a high degree of exchange rate volatility will have a riskier stream of profit. Therefore, most of literature suggest that a weak exchange rate in the host country can attract more FDI because it will be cheaper for the multinational to purchase assets. However exchange rate volatility could discourage investment because investors are concerned with future expected profits.

Reference
1. International journal of applied Econometric and Quantitative studies V6-2 (2009)
2. Factors affecting FDI Tejvan Pettinger 2017
3. The impact of free trade agreements on FDI in the Asia-Pacific Region

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