"THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN CHINA AND INDIA"
Foreign direct investment (FDI) is pivotal to the internationalization process of firms. Within the past 20 years FDI has exceeded the growth of world output and global trade. Although most of FDI flows are attracted into developed countries, the share of FDI has been shifted significantly to the developing world. FDI typically accounts for over 60% of private capital flow to developing countries (World Bank, 2006).
China and India, as the two largest developing economies, have experienced rapid increases in FDI flows since 1980 (World Investment report, 2007). China emerges as one of the world most attractive destination for FDI with the annual average inflows rising from $3.9bn in 1985-92 to $37.8 bn in 1993-2000 and $59 bn in 2001-06 (World investment report, 2007). Since the implementation of "open door" policy in 1991, India has received more FDI into the country. FDI inflow in 2006 was $17.5 bn compared to only $2-3 bn during the 1990s (World investment report, 2007). However, its total FDI is still lagging behind China. The causes of differences in FDI flows between these two countries suggest an interesting area for further research. This literature review aims to examine the determinants of FDI inflows in China and India.
The review is structured as follows: section 1 discusses the determinants of FDI inflows. Section 2 concludes.
What are the determinants of FDI?
According to Blonigen (2005), FDI inflows are determined by both endogenous and exogenous factors. Particularly, internal factors include GDP, country risk and political risk while external factors range from exchange rates, taxes to trade protection and trade flows. Nonnemberg and Mendonca (2004) studied the determinants of FDI by using panel data analysis for 38 developing countries. They found that market size, the level of education; trade openness, inflation, country risk and per capita energy consumption were significant determinants for FDI flows. Although there are various determinants identified across the literature, the most important factors can be summarized as: market size, political risk, exchange rate, inflation, openness, human capital and infrastructure (Sinha, 2007).
Market size:
Market size, as measured by GDP (Gross domestic product) or GNI (Gross national income) per head, is perhaps one of the most important factors in explaining FDI (Chakrabarti, 2001). When a transnational corporation (TNC) aims to produce for the local market, the attractiveness of a particular location may be indicated by the size of a specific market. Once a country's GDP reaches a certain threshold, it offers better opportunities for TNCs to access the market, develop economies of scale and explore profitability.
A survey of literature on FDI determinants, including that of Dunning (1973), Kobrin (1976), Levis (1979), Resmini (2000) and Ramirez (2006), had all found evidence about the correlation between FDI and the host countries' market sizes. A study by Ang (2007) on the factors affecting inward FDI in Malaysia also emphasized, along with other determinants, the significance of market size. The analysis suggested that a larger domestic market resulted in more FDI inflows, owing to the benefits of economies of scale. Particularly, the finding showed that a 1% grow in GDP would lead to about 0.95% increase in FDI.
A survey by Agarwal (1980) summarized the basic factors determining FDI in a country. Most empirical studies reviewed in this survey supported the positive relationship between market size and FDI. However, this linkage is challenged by Lucas (1993) in a study of 7 Asian countries including Indonesia, Philippines, Singapore, Malaysia, South Korea, Thailand and Taiwan. Lucas considered two measures of market size: one focuses on the export market and the other relates to the domestic market. The results showed a weak positive relationship between the size of "domestic consumption spending" and the rate of inbound FDI and high degree FDI responsiveness to earnings in the main export markets. This probably indicates the outward orientation of foreign firms in these areas.
For individual countries, the market effects have been analyzed in several studies. For instance, Wei (2005) found that the market size had a significant effect on the volume of FDI in both China and India. Chen (1996), Henley et al. (1999) and Zhang (2001) concluded that market size and preferential policies, along with others, were primary factors for China. Dees (1998), Hong and Chen (2001) and Liu et al. (2001) confirmed the significance of this relationship. However, their studies are only at the national level, relating to one country (China), covering a relatively short period of time and suffering from limited degrees of freedom. Therefore, this may lead to unreliable results in their findings.
Political risk
An unstable political environment could be a deterrent to investment, for instance; TNCs prefers a stable government since their investment is more secured. According to Butler and Joaquin (1998), "political risk" is the risk that a sovereign host government will suddenly alter "the rules of the game" under which businesses are operated. Changes in policies and political institutions could make investment unfavourable. Therefore, this would affect location decision and investment behaviour of TNCs. Some indicators of political risks identified by Sinha (2007) are: currency inconvertibility, negative attitude of the government towards TNCs, non-allowance of fund transfer, corruption, war, coup and threat of a takeover of TNC assets.
Many empirical studies have pointed out the relationship between political stability and FDI inflows. In particular, Jun and Singh (1996), using data of 31 developing countries, found the significance of political risk: the correlation suggested that countries with high political instability attract less FDI. Likewise, Hines (1995) examined the link between various political variables and the US outward FDI. The study showed that American firms were less attracted to invest in countries when corruption was significant. Wei (2000) concluded that if China and India could reduce red tape and corruption to a level comparable to Singapore, FDI inflows would be 218% and 348% higher respectively for these countries. In contrast, Egger and Winner (2005) found a positive association between corruption and FDI in 73 countries over the period of 1995-99. They suggested that with excessive regulation and administrative controls on hand, corruption may serve as a catalyst for the encouragement of FDI.
Recent studies have considered the linkage between FDI and fundamental democratic rights. Applying different econometric techniques and data, Jesen (2003) and Busse (2004) found that TNCs prefer democracies over dictatorships. Li and Resnick (2003) argued that democratic rights improve property rights protection, which in turn increases FDI. However, apart from this indirect effect, democracy may reduce FDI. Yet this analysis narrowly focused on very specific indicators, omitting a broader range of political risk variables. Thus, their findings may not always apply globally. Similarly, other studies could not find democracy, political instability or political and economic risk as important FDI determinants (Lansbury et al., 1996; UNCTAD, 1998; Assiedu, 2002). This lack of significance in those findings could be due to the fact that the outcome of a certain political or economic event's risk appraisal is dependent on the country's FDI portfolio (Busse and Hefeker, 2006). Each country affects this directly by differentiating in guarantees against political risk. Additionally, it is arguable that while political risk is an important consideration, the location decision is also based on many other factors.
Exchange rate:The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk The outcome of a certain political or economic event's risk appraisal is dependant on their FDI portfolio. Each country affects this directly by differentiating in guarantees against political risk
Exchange rate is defined as the price of domestic currency in terms of a foreign currency (bized, 2010). This impacts both the total volume of FDI and the allocation of investment across a range of countries. Depreciation in the value of a currency would have two implications for FDI inflows. Firstly, it reduces the country's wages and production costs compared to those of its foreign counterparts. The real currency devaluation makes the country more attractive towards productive capacity investments. Therefore, the diminished currency value would improve the rate of returns to foreign investors. Secondly, the depreciated currency in the destination market increases the relative wealth of source country agents and lowers capital costs. This allows investors to make significantly larger investments abroad. Data on Japanese acquisitions found evidence supporting the hypothesis that real dollar devaluation increased the likelihood of Japanese acquisitions in US industries with firm specific assets (Goldberg, 1993). Goldberg and Klein (1997) examined the connection between exchange rate and outward FDI from Japan and the US to Southeast Asia and Latin America. Their empirical results suggested that the appreciation of the Yen did stimulate direct investment from Japan to these regions. This was also boosted by the decrease of the East Asian real exchange rate and a sharp appreciation of the Yen.
In addition to the effects of exchange rate levels, the volatility of exchange rate is also significant. Arguments for volatility effects are broadly divided into "production flexibility" and "risk aversion". The first approach argues that increased volatility is associated with increased FDI and more potential excess for capacity. Goldberg and Kolstad (1995) looked at the link between FDI and short-term exchange rate variability. They supported this hypothesis of the contribution of exchange rate instability to the internationalization of production. On the other hand, the "risk aversion" argument suggests that if the exchange rate is highly volatile, the expected returns of investments are reduced and hence FDI. Cushman (1985) studied the impacts of real exchange rate risk and anticipations on FDI. The results indicated that increases in the current real foreign exchange value reduced the US FDI significantly and the expectations of appreciated real foreign exchange reduced this further. Crowley and Lee (2003) also found a negative relationship between exchange rate instability and FDI. The two approaches mentioned provide different predictions of exchange rate volatility implications for FDI. Which one is better at explaining the influence of exchange rate movements on FDI requires further evidence.
Inflation:
The stability of macroeconomic policy, especially price stability is fundamental for investment and growth (Rogoff and Reinhart, 2003). In its absence, the risks of conducting business increases intensely and external and internal trades are hindered significantly.
A high and unpredictable rise in price level indicates the instability of the macroeconomic policy of the host country. This consequently creates a form of uncertainty that hampers potential investment (Razafimahefa and Hamori, 2005). More specifically, higher inflation will drive up prices and curb investment due to increases in interest rates. Therefore, TNCs' decision of investing in the host country can be adversely affected by the price volatility which raises the costs of doing business.
Estrin et al. (1997), Lipsey and Chrystal (2006) found that high inflation reduced the interest of TNCs in the host country as it depreciated the currency. Glaister and Atanasova (1998) looked at the impact of inflation on employment in Bulgaria. Their analysis showed that although inflation did not have a direct impact on FDI, it did influence factors such as wages, unemployment and economic growth. These factors formed important criteria for firms when making investment abroad, therefore affecting FDI. Furthermore, Garibaldi et al. (2001) and Trevino et al. (2002) suggested that high inflation would "crowd out" investment since it reduced the confidence of foreign firms to invest in the country.
Based on Coskun (2001), FDI flows into Turkey are said to gain more traction if low interest rate and inflation, along with other factors such as EU membership and high economic growth are sustained. Wint and Williams (2002) emphasized the necessity of maintaining a stable economy with low inflation for FDI inflows, especially in countries where FDI is promoted as a source of capital flows. Similarly, in a study on the determinants of FDI in emerging markets, Fisher and Sahay (2000) indicated that an inflation stabilization policy adopted by the governments of these countries was necessary for more FDI inflows and the success of the "economic reform".
To contest the above, Akinkugbe (2000) found that inflation rate was not significant in explaining FDI in developing countries. However, Udoh and Egwaikhide (2008) challenged this result by applying the data in the case of Nigeria. Their finding was consistent with others that high inflation contracted FDI inflows. One possible explanation for the lack of significance in Akinkugbe (2000) model is that the inflation rate was used instead of inflation rate uncertainty as employed by Udoh and Egwaikhide (2008); this may lead to inaccurate inference on the link between FDI and inflation. Hence, another finding would probably be obtained if the inflation rate uncertainty was adopted.
Trade Openness:
Trade reforms have been historically given much attention with regards to the role of economic freedom in attracting FDI. The degree of openness to trade is generally measured by the proportion of exports and imports to GDP. This ratio is usually clarified as "quantification of trade restrictions".
The effects of trade openness on FDI were examined by Kokko and Blomstrom (1997). The study showed that fewer restrictions on investment and more trade liberalization had different impacts on FDI, depending upon the motives of firms involved. Particularly, horizontal FDI is "market seeking" and TNCs, instead of exporting from the home country, may prefer direct investment in the host country to avoid trade barriers. Conversely, vertical FDI is "efficiency seeking" where TNCs may invest in a relatively open economy as trade openness enables multinationals to operate more effectively across borders.
Lee (2005) found that trade restrictions such as quotas and tariffs affect multinationals' behaviour in host countries. Import tariffs, in particular, would force TNCs to conduct manufacturing in the host country. Belderbos (1997) analyzed the correlation between FDI and trade barriers in the case of Japanese firms in the electronics sector. The findings showed that protectionist measures taken by the US and the European Union induced Japanese "tariff jumping" FDI. This is where trade protection tends to boost FDI as firms try to lower their costs through shifting production rather than exporting from home. Findings from Lunn (1980) support the positive role of tariff to FDI. Culem (1988) and Bolonigen and Feenstra (1997), however; found a negative relationship between FDI and trade control. Their explanation is that trade limitation may be taken as a sign of policy imperfections such as "exchange rate control", resulting in a contraction of FDI inflows. This is arguably in favour of vertical FDI.
Liberal trade policies mirrored by the openness of an economy are an important factor driving export-oriented FDI. Openness makes the transfer of goods and capital in and out the host country easier in the absence of any restriction, and thus stimulates production and reduces costs (Singh and Jun, 1995). World Bank and United Nations Conference on Trade and Development (UNTCAD) have been requiring emerging economies to open up their markets so that "free trade" can help boost growth in developing countries. Balasubramanyam et al. (1996), using cross-country data for 46 developing economies concluded that trade openness is essential for gaining the potential growth benefit from FDI. They argued that countries more open to trade attracted higher amount of FDI and better utilized the investment than closed economies. This important role of trade liberalization was confirmed by Hufbauer et al. (1994) in the examination of the US and Japanese firms' investment decision.
Generally, results from the literature seem to be divided into positive and negative impacts of trade openness on FDI. It is, therefore; ambiguous to state how trade liberalization influences FDI without considering the structure and motives for investment.
Human capital:
Since the 1980s, there have been considerable changes in the sectoral composition and location determinants of FDI. As a result of great advances in technology, FDI inflows have shifted towards more capital, knowledge and skill-insensitive manufacturing. Comparative location advantage is not limited to "tangible location" factors but also consists of "intangible assets" such as infrastructure, institutional framework and human capital which become increasingly important to competitiveness. The quality of human capital in a country is crucial for technology transfer, managerial techniques and spill-over effects of FDI.
The important role of human capital in determining FDI has been embodied in literature. For instance, Lucas (1990) assumed that low level of human capital deterred FDI in less-developed countries. Dunning (1988) believed that labour's skill and education could affect both FDI and the activities taken by TNCs in a country. Also Zhang and Markusen (1999) identified skilled human capital as a prerequisite and a significant determinant of FDI inflows. Sinha (2007) maintained that efficiency-seeking FDI or vertical FDI took place only when there was enough efficient labour in specific host countries. Sinha states that the recent "Business process outsourcing" boom in India occurs thanks to the qualified workforce well-skilled in English-speaking and technologically educated in "IT enabled services".
Hanson (1996) considered the availability of skilled labour in host countries as a possible factor explaining the geographic allocation of FDI. Nevertheless, he revealed that political stability and property rights security may have dwarfed human capital as explanations of inbound FDI. It is worth pointing out, however; that the accumulated FDI stock considered was for 1967- when human capital may have been less crucial for FDI in developing countries. Furthermore, Hanson did not look at the impact of other determinants of FDI as a whole, but instead used human capital as the only regressor- whilst controlling for discrepancies in the colonial status of the "recipient countries". The two aspects of this analysis may, therefore, have led to inadequate conclusion towards the role of human capital. Likewise, Schneider and Frey (1985), in a cross-section study for 54 developing countries, observed that the human capital, although significant in some cases, was insignificant in their model.
Narula (1996) examined the determinants of FDI in 22 developing countries during the periods of 1975, 1979, 1984 and 1988. He showed that while the technology capacity was significant but concluded with an unexpected negative relationship, the correlation to human skills was insignificant. Narula implied that the level of a country's economic structure better explained the extent of FDI activities in developing countries. These results were different from those received for 18 industrialized countries, where skills of human and technological competency were highly significant. Narula argued that FDI into industrialized economies was planned to seek complementary "created assets" and also that the existence of human capital played an increasingly essential part when countries progressed along their development path.
Despite what seems to be as consensus on the hypothesis that human capital is of importance in explaining FDI, the findings are often inconclusive and some of them appear to be implausible (Schneider and Frey, 1985 and Narula, 1996). Thus, further research for more consistent evidence is necessary.
Infrastructure:
Infrastructure is a vital factor for growth and globalization. It is known to be a parallel process to development as its dynamic incentive and association to the economy are diversified and intricate. It also influences manufacturing and consumption directly, and creates spill-over and developmental effects.
The World development report (1994) classified infrastructure into physical and social-institutional infrastructure. The former comprises services such as transport, roads, water system, electricity and communication, whilst the latter consists of health facilities, education and other forms. The report also emphasized the significance of infrastructure as an integral factor for: expense reduction, better utilisation of potential resources and factors of production, enhancing the distribution networks and coordinating the market forces. It is, therefore, an important location determinant of FDI.
Studies on the relationship between infrastructure and FDI seem to show a highly positive correlation. The empirical evidence demonstrates that countries possessing adequate levels of infrastructure facilities tend to attract more FDI. Considering FDI determinants in the case of the American TNCs in electronics and manufacturing, Wheel and Mody (1992) found that the quality of infrastructure is an important predictor of FDI in less developed countries. They also suggested that taxes and other short-term incentives only had limited impact on FDI since transfer pricing and foreign tax deduction provided different ways to lower the total taxes paid. Richaud et al. (1999) confirmed the positive role of infrastructure on FDI. Based on endogenous growth theory, they built up a model to assess the influence of infrastructure on trade, growth, indigenous investment and FDI. Their results supported the positive linkage between FDI and infrastructure.
Belderbos et al (2001) verified the importance of the size of regional component industry and infrastructure base for Japanese multinational corporations' vertical linkages of FDI. Mohan (2004) analysed FDI in the Association of Southeast Asian Nations (ASEAN) and found that transportation services including all modes of transport such as see, air, land, internal gateways and related support service are a determinant of FDI in this region. Likewise, the availability of a port and its proximity have been found to impact the flows of FDI as it lessens inland transportation and reduce costs (Sinha, 2007). Developing port-based strategic infrastructure also helps to stimulate export-oriented FDI. Ang (2007) stressed the necessity of providing good infrastructure facilities as he argued that it was an efficient tool for encouraging FDI inflows.
Infrastructure can be considered the most effective instruments of economic and social development. It is considered as a driving force of FDI location choice and overall most of the studies have shown a high degree of association between infrastructure and FDI.
Conclusion:
This paper has reviewed the important literature on the determinants of FDI in China and India as well as related countries. In particular, the main factors have been identified as market size, political risk, exchange rate, inflation, trade openness, human capital and infrastructure. These key elements by and large determine the forms and geographical locations of FDI.
Market size reflects the attractiveness of a specific market, which provides opportunities for TNCs to develop economies of scale and realize potential profits. Most of empirical studies seem to agree that the size of a host country market has a positive impact on FDI. Similarly, infrastructure is considered as a driving force for growth and investment. Its significant effect on FDI inflows has been confirmed in numerous studies.
There is a general consensus on the role of human capital as a positive indicator of FDI due to significant changes in the sectoral composition and location determinants of FDI. Many studies have sought to show the correlation between human capital and FDI, but no large positive impact has really been observed. Most of the findings are inconclusive and some are unreliable.
The directions of exchange rate and trade openness effects on FDI are uncertain as there are divided views among the literature. For the former factor, it is suggested that the real currency devaluation would make a country more attractive to FDI, although; exchange rate instability comprises both negative and positive impacts. Similarly, how trade openness affects FDI depends on the type of FDI and motives of firms for investment. Specifically, horizontal FDI is encouraged by trade restriction while vertical FDI would be stimulated by trade liberalization.
Political risk and inflation generally tend to have negative linkages to FDI. There are a few studies resulting in positive or no correlations between those factors and FDI. However, majority of those studies do not always apply or exhibit some problems in the adopted models.
In spite of divergent studies on FDI determinants, there are gaps in the literature regarding FDI for individual countries. Many studies focus on groups of countries with India and China included, but there is limited literature concerning the two countries separately, especially from India. There are a few analyses such as that by Anantarm (2004) investigating determinants of FDI in India at a micro- state level and his result cannot be applied to a macro-scale analysis. Wei (2004) attempts to explore FDI in India and China, however; his research focuses predominantly on China. There are inadequate numbers of studies considering FDI in India by Kurma (1990) and Venktachalam (2000) compared to various studies on East Asia, China and ASEAN countries. This provides a starting point for further research exploring the determinants of FDI India to eventually compare and justify the differences in total FDI between China and India.
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