World investment prospects to 2011 : foreign direct investment and the challenge of political risk

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Foreign direct investment is not coming to Indonesia. Really?

The Report stresses that with the right policy initiatives, incentives and regulatory framework, TNCs can and must contribute significantly to both mitigation and adaptation. It also proposes a global partnership to galvanize low-carbon investment and advocates concrete initiatives such as a new technical assistance centre to support policy formulation and implementation in developing countries. The series has been contributing to investment policy-making at the national and international levels.

I commend it to all involved in our common quest to build a better world for all. This sparks some cautious optimism for FDI prospects in the short run and for a full recovery further on.


However, these FDI prospects are fraught with risks and uncertainties, including the fragility of the global economic recovery. Invested one quarter of global FDI outflows. The evolving nature and role of FDI varies among regions. Africa is witnessing the rise of new sources of FDI. Industrial upgrading through FDI in Asia is spreading to more industries and more countries. Latin American transnational corporations TNCs are going global. Foreign banks play a stabilizing role in SouthEast Europe, but their large scale presence also raises potential concerns.

World Investment Prospects to 2011: Foreign Direct Investment and the Challenge of Political Risk

High levels of unemployment in developed countries triggered concerns about the impact of outward investment on employment at home. For landlocked developing countries LLDCs to succeed in attracting FDI they need to shift their strategy to focus on distance to markets rather than distance to ports.

It is characterized by simultaneous moves to further investment liberalization and promotion on the one hand, and to increase investment regulation in pursuit of public policy objectives on the other. Economic stimulus packages and state aid have impacted on foreign investment, with no significant investment protectionism observed so far. The international invesment agreement IIA universe is expanding rapidly, with over 5, treaties at present on average four treaties signed per week in The IIA system is rapidly evolving as well, with countries actively reviewing and updating their IIA regimes, driven by the underlying need to ensure coherence and interaction with other policy domains e.

Global initiatives, such as investment in agriculture, global financial systems reform, and climate change are increasingly having a direct impact on investment policies. Internalization advantages reflect the preference of MNEs to internalize engage in FDI where the benefits of performing internal operations are greater than employing a market solution e. Along the same lines, Brewer argues that factors such as market size and growth, labor availability and costs, inflation, external debt, and the balance of payments situation have always been considered the main indicators of the degree of attractiveness of a location for investment projects and international trade.

All of these factors reflect a country's macroeconomic conditions. Table 1 summarizes the main FDI location determinants frequently referred to in the literature and their expected relationship with FDI. Table 1. FDI location determinants. According to Bengoa and Sanchez-Robles , the sunk cost of FDI leads multinational firms to invest in countries with larger market size in order to exploit economies of scale. In this way, countries with large markets reflect higher potential demand Marr, and should attract more FDI inflows than smaller countries.

Regarding market growth, a market with a higher growth rate is expected to receive higher FDI flows Mohamed and Sidiropoulos, Multinational firms tend to invest in countries with higher growth performance insofar as they indicate a larger market potential for their products Marr, Level of trade openness. According to Beven and Estrin , FDI is encouraged if the host country has a liberal trade regime because multinational firms have a higher propensity to export.

As Beven and Estrin , p. Therefore, FDI and the level of human capital should be positively related. Another factor which is usually considered influential in terms of an MNE's decision to engage in FDI is production costs, particularly labor costs. MNEs seek locations where labor costs are lower to increase their competitiveness at the international and local levels Bevan and Estrin, According to Vijayakumar et al.

Poor infrastructure leads to higher transport costs and hampers the movement of goods, thereby affecting firms' location decisions Mlambo, It is expected, therefore, that quality of infrastructure and FDI are positively related. Financial and fiscal incentives. With regard to tax incentives, liberalization of taxes tax reductions, subsidies and exemptions in a host country is widely believed to create incentives for MNEs, since this translates into lower initial costs. According to Cleeve , a country with a stable economy characterized by price stability, full employment and an adjusted balance of payments will tend to attract more FDI flows.

Macroeconomic uncertainty or instability leads to a higher perception of risk, negatively affecting both domestic and foreign investment Mlambo, Corruption, political instability, and institutional quality. According to Biglaiser and Staats , political corruption tends to increase the cost of establishing a new plant and creates uncertainty about future payments required by the government. Thus, the existence of corruption will tend to reduce FDI inflows. Regarding political stability, according to Pastor and Hilt the type of political system and considerations of economic and political risk may also influence FDI.

The authors state that international investors are not attracted by authoritarian regimes. A democratic regime is viewed as providing greater benefits to investors because property rights are better protected than under an authoritarian regime, and are more likely to inspire investor confidence Pastor and Hilt, Similarly, Jensen states that democratic institutions present advantages of credibility with respect to supplementary property rights, which, in turn, tend to reduce political risks for potential investors.

In contrast, Oneal argues that authoritarian regimes have advantages over liberal regimes insofar as they install a stable investment climate for investors. Authoritarian regimes generally do not face electoral constraints and have the ability to repress any opposition, and in that sense they may offer advantages over democracies. Their study highlights a macroeconomic approach and an institutional approach examining political instability, institutional quality, and tax incentives, among others to explain MNE investment in Latin America.

Finally, regarding resource endowments, according to Dunning and Lundan , MNEs can increase their competitiveness by investing in locations that provide high-quality natural resources at a lower cost than the home country. As a result, we can expect a positive relationship between resource endowments and FDI. Several empirical studies have analyzed location advantages in order to test the importance of the FDI location determinants identified previously.

According to Mohamed and Sidiropoulos , a country with a larger market size and higher growth rates would be expected to receive higher FDI flows. Tuman and Emmert , Bengoa and Sanchez-Robles , Santana and Vieira and Ramirez , focusing their research on Latin American countries, confirmed the expected relationship: They found a statistically significant positive relationship between the size and growth of the market and FDI market size is usually measured by gross domestic product GDP , GDP per capita and the number of inhabitants, while growth is represented by the growth rate of real GDP.

Theoretically, a positive relationship between trade openness and FDI is expected. The results of this indicator are not, however, free of ambiguity since among the set of countries characterized by a high degree of trade openness, as measured by the weight of foreign trade exports and imports in GDP, we find countries with poor results in terms of FDI ECLAC, Santana and Vieira , Benito et al. However, Tuman and Emmert do not obtain the same result in their study, since this factor does not have a significant impact on Japanese FDI directed towards Latin America.

Foreign direct investment and human capital level should be positively related. Bengoa and Sanchez-Robles and Santana and Vieira point out that the human capital level shows a positive correlation with FDI in Latin America, especially when evidence of skilled labor is high. Measured using the secondary and primary school enrollment ratio, the effect obtained by Bengoa and Sanchez-Robles is positive. Additionally, Santana and Vieira use the enrollment rate in secondary education as a proxy for the human capital level and this variable appears with the expected signal positive and significant in determining FDI flows in Latin America.

According to Dunning and Lundan , countries with lower labor costs and thus lower production costs are expected to attract more FDI. This effect was confirmed by Vijayakumar et al. However, other authors e. None of the studies focusing on Latin America e. Vieira, ; Amal et al.

Foreign Direct Investment -- Business Environment -- BCOM/BBA/BCA/HONOURS -- Anurag Conceptuals

These authors attempt to explain Japanese FDI in Latin America in the period and include a variable for the annual exchange rate of the yen against other currencies in the 12 countries analyzed to examine the effects of production costs. However, the results obtained are not statistically significant. Although quality of infrastructure and FDI should be positively related, the conclusions are not unanimous. Vijayakumar et al. Bengoa and Sanchez-Robles use the physical units of railways variable as a proxy for public investment.

This may reflect the level of infrastructure, obtaining a positive correlation between this variable and FDI, but it is not significant. As stated by Root and Ahmed , a positive relationship between financial and fiscal incentives and FDI is expected. Of the studies analyzed, Cleeve uses financial and tax incentives as a determinant of FDI, seeking to ascertain to what extent they contribute to attracting FDI to Sub-Saharan Africa. To measure this variable the author uses three proxies: temporary tax exemptions, repatriation of profits, and tax concessions for specific sectors.

However, the results are not conclusive, since Cleeve does not find a statistically significant relationship between the three variables and FDI for the sample of countries under study. Focusing on Latin America, Tuman and Emmert analyze the effects of government adjustment policies which include reduced corporate tax rates and privatization of state enterprises and conclude that economic adjustment policies have an important impact on FDI. According to Mlambo , macroeconomic stability promotes investment.

Several indicators are used to assess a country's economic stability, but the inflation rate and exchange rate are the most common Benito et al. Economic freedom is also used to evaluate economic stability. Studies focusing on economic freedom in Latin American countries provide evidence of a positive effect in terms of attraction of FDI inflows.

Using indicators from the Heritage Foundation and the Fraser Institute both organizations evaluate characteristics such as the openness of the economy, government intervention, distortions in the economy and levels of corruption , Bengoa and Sanchez-Robles and Ramirez show that the level of economic freedom has a positive and significant effect on attracting FDI inflows. Amal et al. A depreciation of the currency of the host country encourages multinationals to acquire assets in the country, leading to an increased flow of FDI to the host country.

However, an appreciation of the host country's currency may prompt an increase in the purchasing power of citizens, which may also have a positive impact on FDI aimed at supplying the foreign market market-seeking FDI. In regard to inflation, Bengoa and Sanchez-Robles , Amal et al. Harms and Ursprung test the popular hypothesis that multinational firms prefer to invest in countries where civil and political rights are not respected; their results do not support the hypothesis. On the contrary, they conclude that multinational firms seem to be attracted to countries in which individual freedoms are upheld.

According to Biglaiser and Brown , the preference for political stability remains an important factor for investment in Latin American countries. The investment risk related to the protection of property rights has a significant effect on attracting FDI to Latin America, together with the existence of a liberal government in the host country Benito et al. The results indicate that the institutional environment dominates the macroeconomic environment as a determinant of FDI in Latin America.

Since MNEs who engage in FDI must deal with the institutional environment of the host country, they undertake FDI in countries where the institutional distance between the home and host country is minimal. Amal and Seabra , exploring the role of institutional variables as determinants of FDI in Latin America, obtain statistically significant coefficients with the expected sign.

Several empirical studies Deichmann et al. None of the studies analyzing Latin America e. In sum, several empirical studies have been performed to identify the main determinants of attraction of FDI to a particular location. However, although these studies have focused on emerging markets e. Those that focus on Latin America identify several determinants of the flow of FDI to this region, including market size and growth, level of trade openness, human capital education level , tax liberalization, and economic and political stability of the host country although the latter factor reveals a certain ambiguity about the expected effect.

As reported by Porzecanski and Gallagher , there is unanimity among empirical studies on FDI in Latin America that the key determinants of FDI in the region are the large size and growth of the market, and a low level of inflation and debt that is, macroeconomic stability. In this paper, our aim is to improve our knowledge about FDI in Latin America using cluster analysis, a technique rarely used in studies on this topic.

Cluster analysis allows for grouping countries according to their similarities in terms of a set of variables directly related to FDI location determinants. The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor on the management of the enterprise.

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Foreign direct investment is regarded as the type of capital flow that causes the fewest adverse effects in the host country ECLAC, In the case of Latin America, FDI has been an important source of external financing for growth, reducing problems associated with the lack of domestic savings Santana and Vieira, When considered individually, however, the countries in Latin America perform very differently Figure 1. Figure 1.

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We use the average for a five-year period, , to account for variations over the period analyzed since FDI flows can fluctuate significantly from year to year. A comparison of the share of FDI net inflows to GDP significantly changes the ranking of countries, but there is still a very uneven distribution: Panama is at the top of the list, followed by Nicaragua, Chile, and Honduras, while Ecuador appears at the bottom of the ranking Figure 2.

Figure 2. Source: Authors' calculations, based on World Bank data. It is clear that FDI is not distributed uniformly in the region, as just one country absorbs more than one-third of all FDI flows. Regarding the variables related to the determinants of attracting FDI identified in Section 2, similar to OECD we include a set of economic, social, and institutional variables that are indicative of a country's structural characteristics.

Given the international dimension of our sample 19 countries in Latin America we identify the variables associated with each factor, which may prove important in explaining the growth and direction of FDI flows in this region. The variables and their proxies that serve as the basis of this analysis are shown in Table 2 , which also provides descriptive statistics of the data. Table 2. Variables related to determinants of attracting FDI. Panama has the highest value at In regard to the remaining variables, starting with GDP per capita the proxy used for market size, similar to Bengoa and Sanchez-Robles, ; Santana and Vieira, ; and Ramirez, , we find an average of USD 6, Chile has the highest value USD 14, To measure market growth, we use the annual growth rate of real GDP as a proxy, following Tuman and Emmert The average value for the region is 5.

As for economic stability, we use the inflation rate as a proxy for this factor. High inflation rates are a classic symptom of a runaway economy in a country, both fiscally and monetarily, so the inflation rate is used to measure the level of economic instability e. Venezuela has the highest value To measure the level of trade openness we use the weight of foreign trade sum of exports and imports in GDP, following Janicki and Wunnava and Benito et al.

The highest value corresponds to Panama To measure the quality of infrastructure we use two proxies: the number of telephone lines per inhabitants and the Logistics Performance Index. Given that this study focus mostly on developing countries, we understand, as did Mohamed and Sidiropoulos , that the first proxy may better reflect the degree of development in this region.

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World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk
World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk
World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk
World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk
World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk
World investment prospects to 2011 : foreign direct investment and the challenge of political risk World investment prospects to 2011 : foreign direct investment and the challenge of political risk

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