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Source of risk and gain in FDI INTRODUCTION Foreign Direct Investment (FDI) is one of the most important forms of international capital flows. FDI has been growing steadily in its importance, relative to other forms of international investment, for the last 30 years and has accounted for about three quarters of total International Capital Flows from 1998 to 2003. Particularly for developing countries, FDI has been the most important source of foreign investment and an important source of techno
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  Source of risk and gain in FDI INTRODUCTION Foreign Direct Investment (FDI) is one of the most important forms of internationalcapital flows. FDI has been growing steadily in its importance, relative to other forms of international investment, for the last 30 years and has accounted for about three quartersof total International Capital Flows from 1998 to 2003. Particularly for developingcountries, FDI has been the most important source of foreign investment and animportant source of technological spillovers.Despite the fact that over the past three decades, the rate of growth in the number of studies devoted to FDI has probably surpassed that of the FDI itself, the number of issuesin the area that require economic analysis does not seem to be decreasing. How is FDIaffected by the growth of newly created assets in emerging markets? How is the adventof electronic commerce likely to change the patterns of competitive advantage of firmsand locational advantage of countries? What is the impact of FDI on economic growthand development in host countries? How does FDI affect the volatility of the worldeconomy? Should governments and international institutions control FDI flows and, if so,how can they influence them? These are just a few of the currently unanswered or  partially answered questions. 1 This thesis investigates some aspects of these key issuessurrounding the economics of FDI. More particularly, it attempts to resolve issues whichrelate to FDI attraction policies of the host country governments.The themes of research presented in the following chapters, though focused on differentFDI data sets and using different models and techniques, are consistent in the sense thatall of them are related to the same public policy issue: the issue of a host countrygovernment’s strategy in competition for FDI. This general warming of attitudes towardsFDI has taken place in the context of the promotion of outward-looking economicstrategies as envisaged by the ‘Washington Consensus’ institutions, namely theInternational Monetary Fund and the World Bank. Hence, developing countries have been undertaking policy shifts from inward looking, import substitution industrializationmodels towards more outward-looking, export-oriented economic policies (Narula 1996,Ozawa 1992). The increased role of MNEs in certain sectors is in part a result of aggressive liberalization of FDI regimes and privatization programmes. Indeed, thegreatest change has been the reduction in state ownership and the subsequent privatization of assets.The less developed a country is, the greater the need for such MNE externalities, as ameans to alleviate resource and skill constraints normally associated withunderdevelopment. Developing countries actively seek FDI to strengthen industrialcompetitiveness and enhance their growth prospects1. As a result, developing countryattitudes towards FDI have changed, with dramatic improvements in the FDI policyregimes2.Governments in developing countries have not only reduced barriers to FDI buthave also been offering special incentives to attract foreign firms and foster relationships between MNEs and local firms3. The debate on the merits and de-merits of FDI started in 1 Ashworth, W. (1967). The International Economy since 1850 , Longmans, London. Feldstein, M. (1999).  International Capital Flows , The University of Chicago Press, Chicago. Copyright © 2010 Moses Umar  1  Source of risk and gain in FDI the 1960s (Reuber et al 1973, Lall and Streeten 1977) and is still far from over. This topichas assumed greater importance in the context of the anti-globalisation movement whichopposes further liberalisation of international trade and investment. FDI and itsdevelopmental effects is therefore a topic which attracts considerable attention andinterest from academia and policy makers. Furthermore, Foreign Direct Investment usually brings to mind a significant contributionof FDI to domestic investment. However, there has been a lot of skepticism concerningthe contribution of inward FDI to domestic investment. As noted by Froot (1993), FDI(the purchase by a domestic resident of a controlling stake in a foreign company) actuallyrequires neither capital flows nor investment in capacity. 2 A comprehensive study byBosworth and Collins (1999) provides evidence concerning the effect of capital inflows ondomestic investment for 58 developing countries during 1978-95. The authors distinguishamong three types of inflows: FDI, portfolio investment, and other financial flows(primarily bank loans). Theories of FDI can essentially be divided into two categories:micro (industrial organization) theories and macro (cost of capital) theories. The earlyliterature that explains FDI in microeconomic terms focuses on market imperfections, andthe desire of multinational enterprises to expand their monopolistic power. Subsequentliterature centered more on firm-specific advantages owing to product superiority or costadvantages, stemming from economies of scale, multi-plants economies and advancedtechnology, or superior marketing and distribution (see Helpman(1984)). Studiesexamining the macroeconomic effects of exchange rate on FDI centered on the positiveeffects of an exchange rate depreciation of the host country on FDI inflows, because itlowers the cost of production and investment in the host countries, raising the profitabilityof foreign direct investment.Furthermore, based on possession of “intangible capital” in the source country, the FDIinvestor can apply more efficient management standards in the host country compared todomestic. The unique advantage to FDI, that has only recently been explored, is its potential for superior micro-management, based on the specialization in niches of industry in the operation in the source country. Important issues are:(1) Which are the salient characteristics of the free-FDI-flows equilibrium, when FDIinvestors take control over domestic firms?(2) What constitute the gains from FDI flows to the host economy in this context, giventhat the foreign investors appropriate the private rewards resulting from their superior management skills; and(3) Whether or not the free-FDI-flows regime is efficient.In Razin and Sadka (2002), we developed a stylized model of FDI in the presence of imperfect information with respect to the firm’s productivity. In an integrated capitalmarket, with full information, 3 all forms of capital flows (FDI, loans, and Portfolio equityand debt) are indistinguishable. In the presence of incomplete information, these flows aresignificantly different from one another. The disadvantage of portfolio investments relativeto FDI is rooted in the following problem. If the competition between potential FDI 2 Barry P. Bosworth and Susan M. Collins, 1999, Capital Flows to Developing Economies: Implications for Saving and Investment, Brookings Papers on Economic Activity:1, Brookings Institution, pp. 143-69. 3   Joel Hecht, Assaf Razin, and Nitsan Shinar, 2002, “Capital Inflows and Domestic Investment: New EconometricLook,” mimeo, Bank of Israel. Copyright © 2010 Moses Umar  2  Source of risk and gain in FDI investors is perfect, all the benefits from the superior FDI management skills accrue to thehost economy, leaving the FDI investors with a return on their investment just equalingthe world rate of interest. The gains to the host economy from FDI inflows can therefore be classified into two categories. First, there are the conventional gains that stem fromopening the economy to the new flow of capital, thereby allowing a more efficientintertemporal allocation of consumption (via consumption smoothing). Second, there arethe intrinsic gains associated with the superior micromanagement by FDI investors. Theentire gain of the FDI investors is captured by the domestic economy because of assumed perfect competition among these investors over the domestic firms.Kindleberger (1969) suggested that in order to think about FDI we must ask not whycapital might flow into a country, but rather why some particular asset would be worthmore under foreign than under domestic control. I discussed here a theory of FDI, whichcaptures a unique feature: hands-on management standards to react in real time to achanging economic environment in the firms that FDI investors gain control. Equippedwith superior managerial skills, foreign direct investors outbid portfolio investors for thetop productivity firms in a particular industry in which they have specialized in the sourcecountry. 4 Consequently, FDI investors would make investment, both larger, and higher quality, than the domestic investors. The theory can explain both two-way FDI flowsamong developed countries, and one-way FDI flows from developed to developingcountries. Gains to the host country from FDI stem from the informational value of FDI.The predictions of the theory are consistent with the evidence: larger FDI coefficient in thedomestic investment and output growth regressions relative to the equity flow coefficientreflects a more significant role for FDI in the domestic investment process. I would like toend with a cautionary word based on the Irish case. It may be argued that the heavy subsi-dization of FDI in Ireland in the past two decades resulted in impressive GDP growth, butwith less pronounced effect on the well being of Irish residents, as proxied by the IrishGNP growth rates. Gains to the country that serve as host to FDI flows are not necessarilycaptured by the increase in domestic investment, and productivity, to which FDI flowsgive rise. 4   Prakash Loungani, Assaf Razin, ”How Beneficial Is Foreign Direct Investment For Developing Countries?” Financeand Development, June 2001,Volume 38, Number 2 Copyright © 2010 Moses Umar  3  Source of risk and gain in FDI CHAPTER 1 FDI’S AND THE IMPORTANCES ON ECONOMICDEVELOPMENT This chapter sets the scene for what follows by defining FDI, analysing the historical background and recent trends in FDI, outlining the research issues, and providing anoverview of the thesis and its contributions.The growing importance of FDI represents one of the defining features of globalisation and the reshaping the international business environment and there are anumber of studies that have examined the changing structure of international productionand documented the meteoric growth in FDI activities (see Narula 2003a for a review). 5 This section highlights some of the salient trends and country/ regional characteristics interms of inward FDI. Over the past two decades, world FDI inflows have more thantripled, increasing from around US$ 55 billion in the late 1980s and reach US$651 billionin 2002. In 2002 more than 70 per cent of total world FDI inflows have been directed todeveloped countries, with the remainder being shared by developing regions. It isnoteworthy that an increasingly large proportion of aggregate FDI flows takes the form of cross-border mergers and acquisitions (M&As) which includes the acquisitions of publicenterprises through various national privatisation programmes.   In 1999, M&As accounted for around 80 per cent of total FDI inflows,corresponding to substantial high shares across developing regions (UNCTAD 2000).The take-over of former parastatal companies represented an increasingly important FDIdriver in developing economies as these countries continue to liberalise their economies(Liberatori and Pigato 2000). Inward FDI stock in developing countries has increasedfrom US$ 307.5 billion in 1980, reaching US$ 2,340 billion in 2002. This corresponds toaround 33 per cent of total world inward FDI stock. The magnitude of inward FDI stock going to developed economies, accounting to 65 per cent of world total in 2000 comparedto 56 per cent in 1980. For the developing economies, the same share decreased from 44 per cent in 1980 to around 35 per cent in 2002. It is noteworthy that within thedeveloping country groupings, there are marked differences among the developingregions. It is noteworthy to highlight the relative ‘weight’ of China in terms of inwardFDI attraction in recent years. For example, in 2002, China’s share in total inward FDIstock stood at 6 percent, compared to 0.1 per cent in 1980 . 1.1 THE CONCEPT OF FDI FDI as a category of international investment that reflects the objective of aresident in one economy (the direct investor) obtaining a lasting interest in an enterpriseresident in another economy (the direct investment enterprise). The lasting interest 5   http://www.merit.unimaas.nl Copyright © 2010 Moses Umar  4
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