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Host Country Effects of Foreign Direct Investment

ANDREAS JOHNSON Host Country Effects of Foreign Direct Investment ANDREAS JOHNSON Host Country Effects of Foreign Direct Investment The Case of Developing and Transition Economies JIBS Dissertation Series No. 031 JIBS Dissertation Series No. 031 ANDREAS JOHNSON Host Country Effects of Foreign Direct Investment The Case of Developing and Transition Economies This thesis consists of four individual essays and an introductory chapter. While independent from each other, these essays share some common properties. They are all empirical and focus on the interaction between in? ws of foreign direct investment (FDI) and host country characteristics. The primary focus of the thesis lies in how in? ows of FDI affect developing and transition economies. Macro-level data are used in all essays. The ? rst essay analyses the FDI in? ows that the transition economies of Eastern Europe have attracted and tries to ? nd determinants of these in? ows. The following two essays compare the effect of FDI between developing and developed economies. The second essay studies the relationship between corruption in the host country and the volume of FDI in? ows. The third essay explores the effect of FDI in? ws on host country economic growth. The fourth and ? nal essay analyses the relationship between FDI and trade, focusing on the link between FDI ? ows and host country exports in eight East Asian economies. ISSN 1403-0470 ISBN 91-89164-64-4 ANDREAS JOHNSON Host Country Effects of Foreign Direct Investment The Case of Developing and Transition Economies Jonkoping International Business School P. O. Box 1026 SE-551 11 Jonkoping Tel. : +46 36 10 10 00 E-mail: info@jibs. hj. se www. jibs. se Host country effects of foreign direct investment: The case of developing and transition economies JIBS Dissertation Series No. 31 © 2005 Andreas Johnson and Jonkoping International Business School ISSN 1403-0470 ISBN 91-89164-64-4 Printed by ARK Tryckaren AB, 2005 ii Acknowledgement As I have learned during the past years, writing a dissertation in economics is not only a stimulating but a very challenging undertaking and I have occasionally asked myself whether I would actually be able to complete this project. Now, when the goal finally has been reached, I would like to take this opportunity to express my gratitude to all the people who to some extent made this possible.

First and foremost, I would like to thank my supervisors, Professors Borje Johansson and Charlie Karlsson, who offered me the position of doctoral student at JIBS. Their comments and recommendations have been invaluable and a necessity in order for me to successfully finalise this dissertation. Another important contribution to reach this goal has been the Friday seminars at the economics department, introduced and chaired by Professor Bo Sodersten and later chaired by Professor Ake E. Andersson, which have been instrumental in identifying the pitfalls and problems in my dissertation papers.

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Taking advantage of the insightful comments of the seminar participants, I have been able to significantly improve the quality of the chapters that I presented there. I am very grateful to Professor Hans Loof who acted as discussant during the final seminar and provided invaluable comments and suggestions for further improvement of the dissertation. I have also benefited significantly from co-operation and discussions with Tobias Dahlstrom, the co-author of the second paper. Scott Hacker has been helpful in providing suggestions for improvements of the empirical work.

I would also like to express my appreciation for all comments and suggestions from my other colleagues at the economics department during the years. Gratitude is also owed to Bjorn Kjellander for his professional and timely help in correcting the language of this dissertation, and to Kerstin Ferroukhi for her support with all practical matters. I would also like to thank my friends back home at the Malardalen region for patiently waiting when I return from my ten-year-long ‘exile’ in Jonkoping as an undergraduate and doctoral student. Hopefully, there will now be more opportunities to get together.

My parents have always supported and encouraged me. During all these years, the opportunity of spending a few days in their company has made it possible for me to regularly get a break from the pressures and expectations of being a doctoral student and remind me that there are other things in life besides research and teaching. iii Finally, and most importantly, a thanks goes to my wife Lilia who have always been supportive and often had to share some of the frustrations and stress caused by my recurrent Ph. D ‘blues’… Jonkoping, December 2005 Andreas Johnson iv Abstract

This thesis consists of four individual essays and an introductory chapter. While independent from each other, these essays share some common properties. They are all empirical and focus on the interaction between inflows of foreign direct investment (FDI) and host country characteristics. The primary focus of the thesis lies in how inflows of FDI affect developing and transition economies. Macro-level data are used in all essays. The first essay analyses the FDI inflows that the transition economies of Eastern Europe have attracted and tries to find determinants of these inflows.

The following two essays compare the effect of FDI between developing and developed economies. The second essay studies the relationship between corruption in the host country and the volume of FDI inflows. The third essay explores the effect of FDI inflows on host country economic growth. The fourth and final essay analyses the relationship between FDI and trade, focusing on the link between FDI flows and host country exports in eight East Asian economies. v Table of Content Chapter 1. Introduction and Summary of the Thesis (by Andreas Johnson) 1. Introduction 2.

FDI data 2. 1 Compilation of FDI data and availability 2. 2 The quality of FDI data 3. FDI trends 3. 1 The development of FDI between 1850 and 1945 3. 2 FDI during the post-war period 4. Theories of FDI: a chronological overview 4. 1 Early theories of FDI 4. 2 Firm-specific advantages and the OLI paradigm 4. 3 FDI and the new trade theory 4. 4 Knowledge-capital and complex FDI forms 5. Host country effects of FDI inflows 5. 1 Technology spillovers from FDI 5. 2 Employment effects 5. 3 FDI inflows and host country institutions 6. Outline of the thesis 6. FDI inflows into the transition economies of Eastern Europe: magnitude and determinants 6. 2 Bureaucratic corruption, MNEs and FDI 6. 3 The effects of FDI inflows on host country economic growth economies 6. 4 FDI and exports: the case of the high performing East Asian References Chapter 2. FDI Inflows to the Transition Economies in Eastern Europe: Magnitude and Determinants* (by Andreas Johnson) 1. Introduction 2. The magnitude of FDI in the transition economies 2. 1 The heritage of an administrative economic system 2. 2 FDI during transition vii 1 1 4 4 5 7 7 8 17 17 18 21 23 25 26 27 28 29 29 30 31 32 34 9 40 42 42 43 2. 3 Geographical sources of FDI flows to the transition economies 3. Host country determinants of FDI in the transition economies 3. 1 The OLI paradigm and location advantages in Eastern Europe 3. 2 Earlier studies of FDI inflows to the transition economies 3. 3 Traditional determinants of FDI 3. 4 Transition-specific determinants 4. Empirical analysis 4. 1 Data 4. 2 Model and regression analysis 5. Conclusions and discussion References Appendix Chapter 3. Bureaucratic Corruption, MNEs and FDI (by Tobias Dahlstrom and Andreas Johnson) 1. Introduction 2.

Bureaucratic corruption and MNEs 2. 1 Institutions and corruption 2. 2 How to measure corruption: the Corruption Perceptions Index 2. 3 Perceived corruption 3. Modelling MNEs, bureaucrats and bureaucratic corruption 3. 1 Bureaucrats and MNEs 3. 2 The costs of corruption 3. 3 Model implications 4. Effects of host country corruption on FDI inflows 4. 1 The regression equation 4. 2 Data 4. 3 Analysis 5. Conclusions References Appendix Chapter 4. The Effects of FDI Inflows on Host Country Economic Growth (by Andreas Johnson) 1. Introduction viii 46 47 48 50 51 55 62 62 65 74 76 80 9 89 91 91 93 94 96 96 98 103 107 107 108 109 114 116 118 123 123 2. FDI inflows and economic growth 2. 1. Firm-specific advantages, knowledge capital and externalities 2. 2 Physical capital and labour 2. 3 Greenfield and brownfield FDI 3. Modelling FDI and host country economic growth 3. 1 FDI as a source of inflow of physical capital 3. 2 FDI as a source of technology spillovers 3. 3 Model implications 4. Data and empirical analysis 4. 1 Some descriptive data 4. 2 Empirical approach, data and regression variables 4. 3 Cross-section analysis 4. 4 Panel data analysis 5. Conclusions References Appendix Chapter 5.

FDI and Exports: the Case of the High Performing East Asian Economies (by Andreas Johnson) 1. Introduction 2. The relationship between FDI and trade 2. 1 Theoretical studies of FDI and trade 2. 2 Empirical research of FDI and trade 3. FDI and trade in East Asia 4. Empirical analysis 4. 1 Data and stationarity tests 4. 2 Estimation and results 5. Conclusions References Appendix 128 129 130 131 132 132 133 137 139 139 142 144 149 152 153 156 161 161 163 163 168 169 173 173 178 183 185 188 ix x Chapter 1. Introduction and Summary of the Thesis Chapter 1. Introduction and Summary of the Thesis

Andreas Johnson 1. Introduction During the last 20 to 25 years, there has been a tremendous growth in global foreign direct investment (FDI). In 1980 the total stock of FDI equaled only 6. 6 per cent of world GDP, while in 2003 the share had increased to close to 23 per cent, UNCTAD (2004). This dramatic development has taken place simultaneously with a substantial growth in international trade. The growth in international flows of goods and capital implies that geographically distant parts of the global economy are becoming increasingly interconnected as economic activity is extended across boundaries.

FDI is an important factor in this process of globalisation in that it intensifies the interaction between states, regions and firms. Growing international flows of portfolio and direct investment, international trade, and information along with migration are all parts of the process. The large increase in the volume of FDI during the past two decades provides a strong incentive for research on this phenomenon. FDI is closely linked to multinational enterprises (MNEs). It is the MNEs that generate FDI flows.

An MNE is defined as a firm that controls or owns production assets located in more than one country. Generally, MNEs can be described as consisting of a parent and one or more affiliates owned and controlled by the parent. An MNE has established production activities 1 (affiliates) in one or more host countries through FDI. Whether a particular firm should be classified as an MNE is not always obvious but depends ultimately on the concepts of ownership and control. For statistical purposes ownership is used as a criterion for FDI since ownership is possible to quantify.

Direct investment is assumed to have occurred when an investor has acquired 1 Henceforth, ‘host country’ refers to a country that receives an inflow of FDI while ‘source country’ refers to a country that generates an outflow of FDI. 1 Jonkoping International Business School 10 percent or more of the voting power of a firm located in a foreign economy , IMF (2004a). FDI is different from portfolio investments since FDI is performed in order to incorporate the asset in the investing MNEs existing business activities as a part of firm strategy to maximise profits.

FDI implies that the investing MNE achieves a significant degree of control over the asset. The asset itself in the form of a production, research or distribution facility is incorporated into the MNE intrafirm network of geographically separated affiliates. There are two main modes of foreign direct investment: greenfield and brownfield FDI. In the case of greenfield FDI, the MNE constructs new facilities in the host country. Brownfield FDI implies that the MNE or an affiliate of the MNE merges with or acquires an already existing firm in the host country resulting in a new MNE affiliate.

Whether investment takes the form of greenfield or brownfield FDI has important implications for the effects of FDI on the host country. UNCTAD (2004) suggests that brownfield FDI in the form of mergers and acquisition dominates. MNEs are integrated international production systems existing as a result of FDI. A single MNE can be involved in a large number of activities including investment, production of goods and services, distribution of goods, selling of goods to external customers, or within the MNE network, research and innovation.

A driving force behind MNE operations is the possession of firm specific advantages allowing the MNE to operate profitably in foreign countries, Hymer (1960). It can be argued that MNE activities are fundamental 3 for the globalisation process. MNEs are important participants in the process of globalisation as they interact with other promoters of globalisation including customers, suppliers, competing firms, international organisations and governments. This interaction gives rise to flows of goods, services, information and technology as well as human and physical capital.

These flows generated by MNE activity serve to strengthen the links between the different parts of the global economy. Protests against the globalisation process in general and MNEs and their activities in particular have been common in recent time, especially among young people. These protests have been fuelled by personalities such as Naomi Klein, (Klein, 2000). However, policy makers and governments have a much more positive view of MNEs and FDI. It is obvious that government attitudes toward FDI inflows have changed a lot since the end of the 1980s, resulting in substantial policy changes.

UNCTAD (2004) presents data for changes in national regulations on FDI for the period 1991 to 2003. A simple calculation shows that close to 94 per cent of these changes liberalised the FDI regime. Many economies, particularly developing and transition economies, have designed incentive schemes in the form of tax holidays or exemptions from environmental standards to try to stimulate inflows of FDI. The transition 2 2 Lipsey (2003) provides a detailed description of how the definition of FDI has changed over time. 3 Bhagwati (2004) aptly defines the MNEs as ‘the B-52s of capitalism and of globalisation’. Chapter 1. Introduction and Summary of the Thesis economies of Eastern Europe are competing vigorously for the attention of multinationals. But how beneficial are incentive schemes for FDI inflows? Mody and Wheeler (1992) argue that so-called location tournaments in the form of costly incentive programs provide little benefit. To avoid implementing expensive and potentially harmful incentive schemes, it is important for policy makers in developing and transition economies to achieve more knowledge about the effects of FDI inflows and what host country factors determine the volume of inflows.

Such knowledge should help decision makers adopting economic policies not only serving to attract FDI but maximising the benefits and diminishing the potential disadvantages of the FDI inflows the host economy receives. This dissertation aims to provide knowledge about the nature of FDI that can help policy makers in host countries to take appropriate decisions. The discussion indicates that there is a large number of interesting research questions regarding FDI. For example, what host country factors can explain the large volumes of FDI some host countries have been able to attract?

Are there special host country conditions in developing and transition economies determining the size of FDI inflows? How is FDI related to the institutions in the host economy? For example, how is FDI affected by corruption in the host country? Can FDI inflows bring benefits such as an increase in the rate of economic growth? Are there any policies or incentive schemes which host country governments can implement to maximise the volume of FDI the country receives as well as the benefits of the inflow? What is the relationship between trade flows and flows of FDI? The studies in this thesis try to answer this type of questions.

This thesis analyses the following major research questions as regards FDI: 1. Host country determinants of FDI inflows 2. The relationship between host country corruption and FDI inflows 3. The effects of FDI inflows on host country economic growth 4. The relationship between FDI and exports The dissertation investigates these four research questions empirically on the macro-level using aggregated data for FDI. The choice of research topics has been made in order to allow for the possibility of finding results that can provide advice to developing and transition economies about policies maximising the benefits of FDI inflows.

This introductory chapter has the following outline: Section 2 describes the compilation and quality of FDI data. Section 3 provides an overview of global and regional trends in FDI flows with a focus on the post-war period. The 3 Jonkoping International Business School following section reviews the theories of FDI and the MNE. Section 5 provides an overview of host country effects from FDI. Finally, Section 6 provides an overview and summary of the four studies included in the thesis. 2. FDI data This section provides an overview of FDI data. Section 2. describes the compilation and availability of FDI data and Section 2. 2 discusses the quality of the data. 2. 1 Compilation of FDI data and availability How is FDI data compiled? Generally, there are two main alternatives for compiling FDI data: to use balance of payments statistics or to perform firm surveys. The balance of payments data measures FDI as the financial stake of a parent in a foreign affiliate. The advantage of balance of payments data is that they can be collected relatively easy for virtually all existing countries. Unlike balance of payments data, firm surveys focus on the actual operations of MNEs.

As argued by Lipsey (2003), surveys provide a broad description of MNE activities and usually report data for balance sheets, employment, exports and R&D expenditures, among other things. The advantage of survey data is that it provides information about the characteristics of MNE parents and affiliates. Unfortunately, firm survey data is only available for a limited number of countries including the United States and Germany. FDI data is reported as a stock or a flow value. As described in IMF (2004a), flows of FDI consist of equity capital, reinvested earnings and what is usually referred to as ‘other capital’.

Equity capital represents the direct investor’s share purchases in enterprises in foreign countries. Reinvested earning are profits which are retained and reinvested by affiliates. The ‘other capital’ category includes various forms of lending and borrowing between the parent and affiliates. Data for FDI flows are normally presented on a net basis, meaning that disinvestment has been taken into account. Stocks of FDI are similarly composed of equity capital, reinvested earnings and other capital. Inflows of FDI and the inward stock of FDI is a result of investment performed in the host country by foreign MNEs.

Correspondingly, outflows of FDI and the outward stock of FDI represents investment in foreign countries performed by MNEs based in the source country. The value of FDI stocks is calculated using the book value in order to take into account the prices prevailing when the investment was made. This thesis primarily analyses FDI in developing and transition economies. What about the availability of FDI data for these two country groups? For the developing economies, FDI data is generally not available before 1980. 4 Chapter 1. Introduction and Summary of the Thesis

Furthermore, FDI data is limited to country aggregates. Industry composition of FDI is not available. Data for bilateral flows of FDI are very scarce. For the case of the Eastern European transition economies, data availability problems are similar. An additional complication for this country group is that FDI data is unavailable before the start of the transition process, i. e. around 1990. For the first years of the 1990s, FDI data is only available for a limited number of the transition economies. FDI data exist from around 1970 for most developed economies.

For the OECD economies, data for bilateral FDI flows are available as well as the industry composition of FDI. What are the main sources of FDI data available to researchers? FDI data is collected and reported by several international organisations. IMF compiles and reports FDI data for the majority of the countries in the world. The data is based on balance of payments statistics and according to IMF (2004a) compiled from international transactions reporting systems and data from exchange control or investment control authorities. UNCTAD prepares the annual publication of the World Investment Report.

The report presents data for both flows and stocks of FDI as well as additional data such as the share of FDI in GDP. The report presents data for most countries. UNCTAD primarily tries to collect data directly from national official sources such as the central banks and statistical offices of individual economies. If this is not possible, data is complemented or obtained from the IMF or the OECD. OECD reports FDI data for its member countries. The data is primarily based on balance of payments statistics as reported from the central banks and is presented in the International Direct Investment Statistics Yearbook.

Data for bilateral flows of FDI is reported and there is some data for the distribution of FDI among industrial sectors in the OECD economies. The World Bank includes FDI data among the so-called World Development Indicators. The data is primarily based on balance of payments data from the IMF and cover most countries. There are also a number of regional organisations such as ASEAN and EBRD reporting data for particular geographical regions. The European Bank for Reconstruction and Development (EBRD) presents FDI data for the European transition economies in the annual publication Transition Report; see for example EBRD (2004).

The FDI data is compiled on the basis of data from the IMF, data from central banks and EBRD’s own estimates and surveys. 2. 2 The quality of FDI data Is it possible to somehow evaluate the quality of FDI data? To begin with, do stocks and flows of FDI accurately represent the magnitude of FDI activity? As described in the previous section, the balance of payments FDI data only measures the financial stake of a parent in a foreign affiliate. However, the FDI data is nonetheless used as a proxy for MNE activity in empirical studies.

Lipsey 5 Jonkoping International Business School (2003) reports that aggregate stocks of FDI tend to be fairly closely correlated with MNE employment and sales in the host country. Consequently, at least at an aggregate level, balance of payments FDI data can be used as a proxy for the magnitude of MNE activities in the host country. Still, balance of payments FDI data can never be more than an imperfect proxy for actual MNE operations. How accurate is the balance of payments FDI data presented by the international organisations?

In fact, it is very easy to prove the existence of inconsistencies in the reported data. By definition, the global inward and outward stocks of FDI should be of equal size. Table 1 compares inward and outward stocks of total FDI using data from UNCTAD (2004). Table 1 Inward and outward global stocks of FDI, millions of USD Inward FDI stock Outward FDI stock Ratio inward / outward FDI stock 1980 692 714 559 629 1. 24 1985 972 205 738 809 1. 32 1990 1 950 303 1 758 216 1. 11 1995 2 992 068 2 897 574 1. 03 2000 6 089 884 5 983 342 1. 02 2003 8 245 074 8 196 863 1. 1 Source: UNCTAD (2004) Annex Table B. 6 Table 1 reveals that the size of the inward and outward global stocks of FDI differs for all of the six years. The ratio between inward and outward FDI shows that the difference was particularly large during the 1980s. Since then, the discrepancy has decreased, and for the most recent years inward and outward 4 stocks are approximately of the same size. This suggests that the measurement problems were substantial during the 1980s but that the situation has improved significantly over time.

However, a closer look at the FDI data provided by UNCTAD (2004) reveals additional anomalies. There are cases where the estimate of the inward FDI stock for an economy is negative. The most problematic examples include Iraq, Libya, Sierra Leone and Suriname. The explanation is that for some countries the FDI stock is measured by cumulating FDI flows over a limited period of time. If disinvestment takes place during the period (foreign affiliates in the country are being closed down), the inward FDI stock at the end of the period is erroneously reported as negative.

On the positive side, the number of suspicious observations is mostly limited to the four mentioned countries, and since these are among the world’s poorest economies, most other data is missing altogether or of questionable value anyway, excluding these countries from analysis. 4 A similar analysis of the international trade data reported in IMF (2004b) shows that the discrepancies between total exports and total imports are of a similar magnitude as the discrepancies in the FDI data. 6 Chapter 1. Introduction and Summary of the Thesis

What measures are taken by the organisations which report FDI data to ensure that data of the highest possible quality is presented? For the case of IMF, reporting countries are expected to follow the guidelines of the Balance of Payments Manual5, (IMF, 1993). While IMF provides clearly defined guidelines, this is not a guarantee that the reporting countries follow or are even able to follow these guidelines when providing the requested statistics. For example, some countries do not include reinvested earnings in their reported FDI data despite the fact that the IMF advocates this should be done.

IMF and OECD (2003) present an extensive review of how reporting countries follow, and in some cases do not follow, the guidelines revealing that there are indeed problems of non-compliance. However, IMF and OECD (2003) also reports several examples of how FDI collection from reporting countries data has improved between 1997 and 2001 suggesting the problems are decreasing over time. 3. FDI trends The aim of Section 3 is to provide an overview of the development of FDI flows, thereby illuminating the increasing importance of FDI for the global economy.

Focus lies on the period from 1980. The section also provides a discussion of the collection and quality of FDI data. 3. 1 The development of FDI between 1850 and 1945 The first appearance of activity that could be regarded as FDI started to appear in the mid or late nineteenth century. Wilkins (1988) argues that ‘1870-1914 was the initial era of the modern multinational enterprise’. Flows of financial capital in the form of British portfolio investments still dominated but in 1914 international production and MNEs were firmly established as parts of the global economy.

Some of the MNEs which were active at this time include Cadbury, Nestle and Unilever. The United Kingdom was by far the most important source country of FDI, being responsible for around 45 per cent of the global stock of FDI in 1914 while USA, France and Germany also were important direct investors, Dunning (1983). Sweden had also emerged as an international investor by the turn of the century, giving rise to companies such as L. M. Ericsson and SKF, Lundstrom (1986). Accordingly, almost all of the flows of FDI originated in industrialised economies.

Whereas the industrialising economies generated large flows of FDI among themselves during the second half of the nineteenth century, as time passed an increasing share of FDI flowed to the non-industrialised economies. The most important motive for FDI 5 The same guidelines are used by the OECD. 7 Jonkoping International Business School during this period was resource seeking through MNE exploitment of natural resources or agricultural production, Dunning (1983). Resource-seeking and the existing colonial structure tended to direct FDI flows toward economies outside of Europe and North America.

However, as argued by Wilkins (1988), the United States was in 1914 the single most important host country for FDI due to its large market, high tariffs and abundance of natural resources. The First World War severed many of the interconnections in the global economy and destroyed large amounts of real capital including a substantial share of the European stock of FDI. However, during the inter-war period there was an increase in the global stock of FDI as well as an increase in the number of MNE subsidiaries.

Still, the pre-war value of the global stock of FDI was not surpassed until the 1930s, Dunning (1983). 3. 2 FDI during the post-war period The Second World War caused another serious destruction of real capital but the end of the war resulted in a climate suitable for international business activities. The mid-1940s saw the creation of several important institutions such as the IMF, the World Bank, GATT and the Bretton Woods system resulting in a favourable economic environment where stable currencies helped to encourage international trade and production.

The new military technologies which had been developed during the Second World War could now be used in society as a whole and gave rise to new business opportunities. The United States emerged as the dominant Western power after the war, both politically and economically, and replaced the United Kingdom as the most important source country of FDI. In 1960, the United States accounted for around 60 per cent of the developed economies outward stock of FDI, (Dunning, 1979). A process had also started where developing economies became less important as host countries for FDI.

Whereas in 1938 close to two thirds of FDI flowed to the developing economies, in 1960 two thirds of global FDI flowed to the developed economies, Dunning et al. (1986). The volume of FDI flows as well as trade flows increased strongly after the end of the Second World War. During the high-growth period of the 1960s, flows of FDI grew twice as quickly as global GNP and 40 per cent faster than world exports, Dicken (2003). The primary sector became less important as a destination for international investment and the decreasing importance of the developing economies as host countries for FDI continued.

Instead, FDI increasingly tended to flow between the developed economies. Dunning (1979) points to the increasing diversity among the source countries of FDI during the 1970s. The share of the United States and the United Kingdom in the total outward stock decreased while countries such as West Germany and Japan became more important as source countries of FDI. The first small outward flows of FDI from the developing economies also started to appear during the early 1970s. 8 Chapter 1. Introduction and Summary of the Thesis There were also changes in the distribution of FDI inflows among host industries.

As the significance of the primary sector declined, the manufacturing industry emerged as the dominant host industry for FDI inflows. The growing importance of production of services also affected the destination of FDI and in the middle of the 1970s the share of FDI going to the service sector started to increase relative to manufacturing. This development has continued during the 1980s and 1990s (Dicken, 2003). During the 1970s and the first half of the 1980s, trade and FDI grew on par, but growth in FDI took off in the second half of the 1980s, growing at an average annual rate of 28 per cent.

These increases in flows of FDI and trade came hand in hand with a period of intensified globalisation and a growing importance of MNEs, Dicken (2003). Table 2 describes the development of FDI stocks since 1980. The total inward stock of FDI grew by 1 090 per cent between 1980 and 2003. During the period 1980 to 1990, the increase was 182 per cent while between 1990 and 2000 there was an even larger increase of 212 per cent. The stock of FDI has increased faster in the developed economies than in the developing economies. Table 2 Inward stocks of FDI, millions of USD

Region World total Developed countries Developing countries Least developed economies Central and Eastern Europe 1980 692 714 390 740 301 794 4 119 1990 1 950 303 1 399 509 547 965 8 949 1995 2 992 068 2 035 799 916 697 16 518 2000 6 089 884 4 011 686 1 939 926 37 503 2003a 8 245 074 5 701 633 2 280 171 56 821 Change 1980-2003 +1 090% +1 359% +655% +1 279% .. 2 828 39 573 138 271 263 270 – Source: UNCTAD (2004), Annex Table B. 3 Notes: “.. ” indicates that data are not available a: Estimate 9 Jonkoping International Business School How can the increase in global FDI be explained?

It is likely that the increase is a result of several different factors. UNCTAD (2004) shows that there has been a substantial liberalisation of FDI regimes since the beginning of the 1990s. The past decades have also seen a substantial decrease in transport and communication costs. It is possible that these changes have improved the conditions for MNE activities and thereby also increased the volume of FDI. Table 3 shows how the total inward stock of FDI is distributed among different types of host economies. The developed economies account for the majority of the total stock.

In 2003, more than 69 per cent of the world inward stock of FDI was located in the developed economies. The share of the total stock in the developing economies decreased substantially during the 1980s. In 2003 the share of the developing economies was around 28 per cent. Table 3 Percentage share of the total inward FDI stock 1980 1990 Developed economies 56. 4 71. 8 Developing economies 43. 6 28. 2 Least developed economies 0. 6 0. 5 Central and Eastern Europe .. 0. 1 Source: Based on UNCTAD (2004), Annex Table B. 3 1995 68. 0 30. 6 0. 6 1. 3 2000 65. 9 31. 0. 6 2. 2 2003 69. 2 27. 7 0. 7 3. 2 The least developed economies include approximately 50 economies which the United Nations has classified as the poorest nations, such as Bangladesh and Ethiopia. This country group has attracted an extremely small share of the total stock of FDI, and the countries in this group are in great need of foreign capital inflows to restructure their economies. The flows of FDI have increased in absolute value, but Table 3 shows that the least developed economies have been unsuccessful in increasing their share of the total stock.

Most of these economies experience high rates of corruption likely to reduce inflows of FDI. Extremely low income-levels also eliminate market-seeking where the aim is to serve demand in the local market as a motive for FDI in these economies. The second study of this dissertation analyses the effect of host country corruption on FDI inflows in both developed and developing economies. The transition process in Eastern Europe started during the late 1980s and early 1990s and turned the region into a new destination for FDI.

In 1990, the total inward stock of FDI in Central and Eastern Europe was well below 1 per cent of the global stock. Transition opened the region for activities of foreign firms and the inflows of FDI during the 1990s were substantial. Table 3 reveals that the region attracts a small but increasing share of the world total stock of FDI and is in a process of catching up. The first study of the thesis analyses and describes the magnitude of FDI flows into Central and Eastern Europe during transition in more detail. 10 Chapter 1. Introduction and Summary of the Thesis

It should also be instructive to study the size of FDI stocks in individual economies. Table 4 presents the inward and outward stocks of FDI for the ten most important host and source countries of FDI. 6 Table 4 The ten most important host and source countries of FDI, millions of USD and percentage share Host country Stock of inward FDI 2003 Per cent of world total inward stock in 2003 and GDP in 2001 18. 8 (32. 2) 10. 6 (3. 7) 8. 2 (4. 6) 6. 6 (6. 0) 5. 3 (4. 3) 4. 1 (1. 2) 3. 3 (2. 2) 2. 8 (1. 9) 2. 3 (0. 3) 2. 1 (1. 2) 64. 1 (57. ) Stock of outward FDI 2003 Per cent of world total outward stock in 2003 and GDP in 2001 25. 2 (32. 2) 13. 8 (4. 6) 7. 8 (4. 3) 7. 6 (6. 0) 4. 7 (1. 2) 4. 6 (3. 7) 4. 2 (0. 8) 4. 1 (13. 5) 3. 8 (2. 2) 2. 9 (3. 5) 78. 7 (72. 0) USA a China UK Germany France Netherlands Canada Spain Ireland Australia Sum 1 553 955 876 519 672 015 544 604 433 521 336 149 275 779 230 332 193 442 174 240 5 290 556 USA UK France Germany Netherlands Chinaa Switzerland Japan Canada Italy Sum 2 069 013 1 128 584 643 398 622 499 384 404 373 104 344 104 335 500 307 855 238 877 6 447 338 Source: Based on UNCTAD (2004), Annex Table B. 3 and B. and United Nations (2004) Notes: a: including Hong Kong Data for Belgium and Luxembourg are missing, but it is likely that these economies should be included among the top ten host countries of FDI. 6 The inward stock of FDI is the value of the foreign-owned assets in the host country while the outward stock of FDI is the value of assets abroad owned by firms in the source country. 11 Jonkoping International Business School According to Table 4, the United States is the most important host country as well as source country of FDI. China has emerged as the second most important host country but also has a substantial outflow of FDI.

Based on additional data from UNCTAD (2004), China accounts for around 38 per cent of the total inward stock of FDI in the developing economies and 43 per cent of the outward stock. An obvious explanation for the large inflows to China is the large domestic market but also the low labour costs. United Kingdom, Germany and France are among the most important economies for both inflows and outflows of FDI. Table 4 shows that economies attracting large inflows of FDI also tend to have large outflows, since the seven most important host countries for FDI are included in the ten most important source countries of FDI.

This exemplifies the fact that many economies have both substantial inflows and outflows of FDI simultaneously. Furthermore, intra-industry FDI between pairs of countries is common, as claimed by Baldwin and Ottaviano (2001). Table 4 clearly shows how FDI tends to flow primarily between the developed economies. Section 4. 3 argues that this can be explained by the dominance of horisontal FDI, where the production process is duplicated and located close to the local market. Horisontal FDI tends to arise between economies which are similar in size and endowments. What about FDI in the developing economies?

Table 5 presents the inward stock and inflow of FDI in 2003 for the five most important host countries among the developing economies. Table 5 FDI in developing economies, millions of USD Economy Inward FDI stock 2003 China 501 471 (22. 0) Hong Kong 375 048 (16. 4) Mexico 165 904 (7. 3) Singapore 147 299 (6. 5) Brazil 128 425 (5. 6) Sum 1 318 147 (57. 8) Source: Based on UNCTAD (2004) FDI inflow 2003 53 505 (31. 1) 13 561 (7. 9) 10 783 (6. 3) 11 409 (6. 6) 10 144 (5. 9) 99 402 (57. 8) The share of the total stock and inflow is given in parenthesis in order to describe the concentration of FDI in the developing economies.

Table 5 reveals that the majority of FDI in the developing economies is concentrated to a limited number of host countries. Close to 60 per cent of the FDI stock was located in five economies. China and Hong Kong have attracted around 38 per cent of the total FDI stock. The inflows of FDI in 2003 generally followed the distribution of the stock. These observations indicate the size of FDI flows to developing countries reflect their progressive integration in the world economy. In essence, FDI is cross-border capital allocation in a world where the friction of capital movements is decreasing.

The strong concentration of FDI implies that many of the less fortunate developing economies, including many of the 12 Chapter 1. Introduction and Summary of the Thesis African economies, only have been able to attract an extremely small volume of FDI. The small size and low income level in these economies is likely to neutralise market-seeking as a motive for FDI, reducing the inflows. The first study of the dissertation includes a discussion of host country determinants of FDI inflows. Table 4 presents the ten most important source countries of FDI. Are these source countries also home countries to the majority of the largest MNEs?

Table 6 tries to answer this question by depicting the distribution of the 100 largest non-financial MNEs (ranked by foreign assets) according to home country. Table 6 The world’s 100 largest non-financial MNEs by home country in 1990 and 2002 Number of Country Number of MNEs in 1990 MNEs in 2002 USA 27 USA 27 France 14 France 14 Japan 12 Germany 13 UK 12 UK 12 Germany 9 Japan 7 Switzerland 6 Netherlands 5 Sweden 5 Switzerland 5 Netherlands 4 Canada 4 Italy 4 Italy 3 Canada 3 Spain 3 Australia 2 Australia 2 Belgium 2 Finland 2 Other 2 Other 7 102a 104a Source: Based on UNCTAD (2004) Annex Table A.

I. 3 Notes: a: Some of the MNEs are registered as having two home countries resulting in a total number of entries exceeding 100. Country From Table 6 it is obvious that the top ten source countries of FDI also are home countries for the majority of the most important MNEs. For the year 2002, the United States, France, Germany and the United Kingdom were home countries to as many as 66 of the largest 100 MNEs. The EU was the home region for 55 of the largest MNEs. China had a substantial outflow of FDI but had only one MNE among the 100 largest in 2002.

Generally, there are only small differences when comparing the distribution of MNEs between 1990 and 2002. The five most important home countries in 1990 are still in top for the year 2002. However, for some countries, such as Sweden, there are substantial differences. In 1990 there were five Swedish firms among the 100 13 Jonkoping International Business School largest (Volvo, Electrolux, SCA, SKF and Stora). In 2002, only Volvo remained on the 100-list. An alternative measure of the importance of FDI for an economy is the stock of FDI as a share of GDP.

Table 7 presents data for selected individual economies as well as country groups. Table 7 Inward and outward stocks of FDI as share of GDP in 2003 Individual economies / Inward stock of FDI as country groups share of GDP in 2003 Individual economies Netherlands 65. 6 Sweden 47. 5 United Kingdom 37. 4 Germany 22. 6 USA 14. 1 Russia 12. 1 Japan 2. 1 Regions South East Asia 34. 6 Western Europe 33. 0 South America 30. 4 Africa 25. 3 Central and Eastern 23. 7 Europe Country groups Developing economies 31. 4 Least developed 24. 5 economies Developed economies 20. 7 Source: UNCTAD (2004), Annex Table B. Outward stock of FDI as share of GDP in 2003 75. 0 62. 7 62. 7 25. 8 18. 8 11. 9 7. 8 15. 9 41. 2 10. 5 6. 6 6. 0 12. 2 2. 7 26. 4 Table 7 clearly shows the large variations in the share of FDI stocks compared to GDP for individual economies. The extremely low inward share for Japan can be explained by its tendency to insulate itself from the activities of foreign firms. USA also has a low inward share. The large size of this economy tends to diminish the influence of foreign firms. The low share for Russia can be explained by the slow transition process and remaining obstacles for foreign investors.

For smaller and more open economies such as Sweden or the Netherlands, both inward and outward stocks of FDI constitute a much larger share of GDP. Turning to the country groups, the inward share for the developing economies is surprisingly high. An explanation can be that since these economies often are quite small as measured by GDP, MNEs tend to be dominant in these economies. The large share for South East Asia is partly explained by large inflows to China. 14 Chapter 1. Introduction and Summary of the Thesis

The share for the developed economies is most likely decreased by the small shares of Japan and the USA. The figure for the economies of Central and Eastern Europe is in line with the developed economies. The low outward share for the developing economies and Eastern Europe can be explained by the fact that these economies so far only have managed to give rise to a very limited number of MNEs. Since there are variations in FDI as a share of GDP which are not always obvious how to explain, it might be instructive to complement the description with an alternative measure of the importance of FDI for a host country.

Table 8, therefore, presents inward stocks of FDI per capita for the year 2002. Table 8 Inward and outward stocks of FDI per capita, USD Individual economies / Inward stock of FDI per Outward stock of FDI regions capita 2002 per capita 2002 Individual economies Netherlands 19 603 21 575 Sweden 13 218 16 177 United Kingdom 9 594 15 557 Germany 6 446 7 515 USA 5 220 6 381 Japan 615 2 393 Russia 357 331 Regions EU-15a 7 228 8 947 1 974 107 Central Eastern Europeb South Americac 737 280 371 152 South East Asiad CISe 302 179 188 44 Africaf Source: Based on UNCTAD (2004), Annex Table B. and B. 4 and population data from the World Bank (2004) Notes: a: Excluding Belgium and Luxembourg. b: Includes Czech republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia. c: Excluding Suriname. d: Includes Afghanistan, Bangladesh, Bhutan, China, India, Indonesia, North Korea, South Korea, Lao, Malaysia, Maldives, Mongolia, Myanmar, Nepal, Pakistan, Philippines, Singapore, Sri Lanka, Thailand and Vietnam. e: Includes Armenia, Azerbaijan, Belarus, Georgia, Kazaksthan, Kyrgyz Republic, Moldova, Russia, Tajikistan, Ukraine and Uzbekistan. : Based on data for 51 countries. The data for individual economies in Table 8 suggest that small, developed economies such as the Netherlands or Sweden have large inward and outward 15 Jonkoping International Business School stocks of FDI. Japan again stands out with a very low per capita stock of inward FDI but a much larger outward stock. Studying the data for regions it is obvious that an economy’s level of income has a large effect on the amount of FDI inflows it receives.

The FDI stock per capita for African economies is below three per cent of the stocks attracted by the EU-15 countries. The small outward flows from the Eastern European and African economies reinforce the earlier argument that transition and developing economies only have fostered a limited number of MNEs. The investment development path theory described in Section 4. 2 provides an explanation for the small outflow of FDI from most developing economies based on the country’s development level. As described in Section 3. , during the end of the nineteenth century a large share of FDI flows was directed to the primary sector in the developing economies. Data for FDI stocks by industrial sector are scarce, but Table 9 describes the recent industry composition of the inward stock of FDI for nine OECD countries. Table 9 Inward FDI stock as percentage of total FDI stock by industrial sector Country France Germany Italy Mexico Netherl. Norway Sweden UK USA Primary sector 1990 1995 2001 6. 4 4. 3 0. 2 0. 1 0. 5 0. 2 3. 5 3. 1 2. 9 2. 6 2. 4 .. 0. 2 3. 1. 3 49. 0 39. 4 29. 1 .. .. .. 23. 1 21. 9 11. 6 13. 5 3. 2 2. 2 Secondary sector 1990 1995 2001 37. 5 35. 7 19. 7 36. 4 23. 4 11. 5 38. 2 38. 5 39. 8 63. 7 46. 9 .. 55. 5 40. 8 33. 2 10. 6 10. 9 20. 3 42. 4 65. 6 .. 36. 1 31. 5 25. 1 39. 0 45. 1 35. 7 Tertiary sector 1990 1995 2001 56. 1 60. 1 80. 2 63. 4 76. 1 88. 4 58. 3 58. 5 57. 2 34. 3 50. 8 .. 44. 3 55. 3 65. 5 40. 4 49. 8 50. 6 57. 6 34. 4 .. 40. 8 46. 6 63. 3 47. 5 51. 7 62. 1 Source: Based on data from OECD (2005) Notes: “.. ” indicates that data are not available

Table 9 shows how the importance of the primary sector as a destination for FDI has decreased between 1990 and 2001, indicating natural resource seeking is becoming relatively less important. Only Norway and the United Kingdom had substantial shares of their total inward FDI stocks in the primary sector in 2001. The importance of the primary sector for these economies can be explained by their large oil production. In 2003, Norway accounted for 4. 1 per cent of the world total production of crude oil and the United Kingdom produced 3. 0 per cent, EIA (2005).

Table 9 indicates that the secondary sector also has lost much of its importance. Instead, the service sector has increased the share of total FDI inflows during the period, possibly as a result of the growing importance of this sector for the global economy. A growing service sector can explain the importance of horisontal FDI discussed in Section 4. 3. In 2001, the tertiary sector had attracted more than 50 per cent of the total inward stock of FDI. 16 Chapter 1. Introduction and Summary of the Thesis What are the most important characteristics of FDI which have been described in Section 3?

First and foremost, there has been a large increase in global FDI flows but the increase has been uneven. Since 1980 an increasing share of the total stock of FDI is located in developed economies. Most of the developing economies have received very small inflows of FDI. The economies in Eastern Europe (excluding most of the former Soviet republics) have attracted substantial FDI inflows since the process of transition started but are still far behind the developed economies. Instead, most FDI at present flows between developed economies with similar structure.

Furthermore, FDI not only tends to flow between similar economies but between the same industries. The tertiary sector has become increasingly important for FDI inflows. 4. Theories of FDI: a chronological overview There exists no general theory that can explain the existence of MNEs and FDI. When considering the large number of motives an individual firm can have to perform FDI, the fact that there is no general theory of FDI is not surprising. In the same way that there is no general theory explaining all trade flows, neither is there a general theory able to explain all flows of FDI.

As a result of this, the FDI-literature is diverse and spans over several different disciplines including international economics, economic geography, international business as well as management. There exist several studies providing overviews of FDI theories, see for example, Agarwal (1980), Cantwell (1991), Meyer (1998) and Markusen (2002). Whereas this thesis primarily focuses on developing and transition economies, most of the theories described in this section can be applied to all types of economies. 4. 1 Early theories of FDI The theories of FDI have emerged during the post-war period.

The process of globalisation took a new start after the Second World War. The increasing importance of MNEs and FDI during the 1950s and 1960s created an incentive for researchers to find theories able to explain the behaviour of MNEs and the existence of international production. The early theories could only explain a limited share of the total FDI flows. The theories were also inadequate in that they failed to realise that FDI is not only a capital flow but constitutes a package including other components such as management and technology transfer.

Consequently, some of the attempts to develop a theory of FDI failed to incorporate the fundamental difference between portfolio and direct investment. An example is the so-called capital markets approach (Aliber, 1970). The idea was to use already existing theories for flows of portfolio 17 Jonkoping International Business School investment to explain flows of FDI. FDI was treated as portfolio investment and consequently FDI should flow to locations where the financial return on investment was highest. However, the theory of FDI is really a theory of the MNE.

During the 1960s, researchers started to focus more explicitly on MNEs and their activities. Vernon (1966) applied the idea of the product life cycle to international trade in order to explain the existence of international production as well as trade. According to Vernon, as a product moves through the product-life cycle, the characteristics of the product change. These changes imply that the optimal location for production of the product also changes over time. The basic idea is that the high level of income and demand in the U. S. results in an environment conducive for innovation.

The product-life cycle begins when innovations are transformed into actual products. Increasing competition eventually forces production to move from the U. S. to lower income economies in order to reduce production costs. As the standardisation of the product and its production process intensifies and the product moves into the mature stage of its life cycle, production in high and average income economies comes to an end as a result of ever fiercer competition. The demand for the product is instead satisfied through exports from low income, developing economies to the rest of the world.

Vernon (1966) was a contribution since it could explain some of the outflows of FDI from the U. S. during the 1950s and 1960s. It was also the first theory treating trade and direct investment as two dynamic alternatives to serve demand in a foreign market. Unfortunately, the theory fails to explain most of the flows of direct investment observed today. The large flows of FDI between developed economies described in Section 3 cannot be explained by Vernon’s theory. The focus on innovations also makes the theory difficult to apply to outflows of FDI from industries which are not innovative. 4. 2 Firm-specific advantages and the OLI paradigm

The theory of firm-specific advantages developed by Stephen Hymer emerged approximately at the same time as Vernon’s theory. Hymer’s dissertation from 1960 (Hymer, 1960) contributed the foundation necessary for the so-called eclectic paradigm that has had a large impact on FDI theories. The theory of firm-specific advantages was the first theory treating international production explicitly, and the first focusing on the MNE itself. To Hymer, firms operating in a foreign country are at a disadvantage compared to the domestic firms. The disadvantage is a result of operating in a foreign environment.

The domestic firms are assumed to have lower costs of operation since they are more familiar with local conditions such as legislation, business culture, language and so on. A foreign firm must therefore have an offsetting, firm-specific advantage allowing it to compete with domestic firms. Firm-specific advantages include superior technology, brand name, managerial 18 Chapter 1. Introduction and Summary of the Thesis skills and scale economies. Firm-specific advantages have to be excludable for a substantial time period in order to provide the possessing firm with a long-term advantage.

A weakness of the concept of firm-specific advantages is that it had little to say regarding the actual decision about FDI. This void was filled by John Dunning, who developed the idea of firm-specific advantages further, resulting in the so-called OLI paradigm of FDI, also known as the eclectic theory of FDI. The paradigm was presented in Dunning (1977). The contribution of the OLI paradigm is that it provides a framework for a discussion of the motives for FDI. It also allows for a discussion of the choice of an MNE between licensing, exports and FDI in order to serve a foreign market.

This choice is determined by ownership advantages, location advantages and internalisation advantages, thus the acronym OLI. Ownership advantages are based on the concept of firm-specific advantages. To cancel out the disadvantage of operating in a foreign country, a firm must possess an ownership advantage. The ownership advantage comes in the form of an asset reducing the firm’s production cost and allows it to compete with domestic firms in the foreign economy despite the information disadvantage. Ownership advantages come in the form of assets such as patents, management or technology.

In order to provide an ownership advantage, the possessing firm has to be able to exclude competing firms from using the asset. To create conditions for FDI, ownership advantages also have to be transferable to a foreign country and possible to use simultaneously in more than one location, to create conditions for FDI. Location advantages determine how attractive a location is for production. A strong location advantage reduces a firm’s production costs in that location. Location advantages can never be transferred to another location but can be used by more than one firm simultaneously.

For example, a supply of cheap labour can provide a location advantage for several labour-intensive firms. If the home country provides the strongest location advantage to the firm, FDI does not take place. Instead, production is located in the home country, and the output is exported in order to meet demand in the foreign economy. The existence or non-existence of an internalisation advantage determines how the MNE chooses to use its ownership advantage. Existence of an internalisation advantage implies that the firm’s most efficient alternative of using an ownership advantage is through exports or FDI.

If an internalisation advantage is missing, it is more profitable for the firm to exploit its ownership advantage through selling the right of its use to another firm through licensing. Existence or non-existence of an internalisation advantage determines an MNEs choice between own production and licensing of the production to an external firm. While possession of an ownership advantage is a prerequisite for a firm to be able to serve demand in a foreign market, it is the existence of location and 19 Jonkoping International Business School internalisation advantages that determines how the foreign market is served.

Table 10 clarifies the alternatives. Table 10 OLI advantages and MNE channels for serving a foreign market Channel for serving foreign market Ownership advantage Internalisation advantage Location advantage in foreign country Yes No No FDI Exports Licensing Source: Dunning (1981) Yes Yes Yes Yes Yes No FDI only occurs when the MNE possesses both an ownership and an internalisation advantage and the foreign country has a location advantage. For the case where the MNE lacks an internalisation advantage, production is licensed to local firms in the foreign market.

If the MNE’s home country has the strongest location advantage, the MNE uses exports to serve the foreign market. The OLI paradigm can, therefore, also be used as a framework for a discussion about the relationship between FDI and trade. The closing study of the thesis analyses this relationship in more detail. Dunning (1981, 1986) use the framework of the OLI paradigm as a base for the investment development path (IDP) theory. The idea of the IDP-theory is that there is a U-shaped relationship between the level of an economy’s development and the net outward flows of FDI. In the first low income stage, FDI inflows are mall and outflows are zero or close to zero. Domestic firms have not yet acquired ownership advantages and therefore have no prospects for investing abroad whereas location advantages are too weak to attract inward FDI inflows. Economies where significant improvement of the location advantages take place (for example, an improvement of the educational level), enter the second stage. Inflows of FDI increase substantially while outward FDI remains very small, resulting in an increasingly negative net outward FDI position. During the third stage, net outward flows are still negative but increasing.

There are two possible causes for this. The first possibility is that outward investment is constant and inward investment is falling. Alternatively, the outflows of FDI are rising faster than the inflows due to eroded ownership advantages of the foreign investors or as a result of domestic firms developing ownership advantages, generating outflows of FDI. During the fourth stage, the outward flows of FDI surpasses the inflows of FDI, implying domestic firms have developed strong ownership advantages. Empirical applications of the IDP-theory include Barry et al. (2003), who analyse inward and outward FDI flows for Ireland.

They find that the growing inflows and subsequent outflows of FDI are consistent with the IDP-theory. The theory can be applied to the presentation of FDI data in Section 3. 2. Most 20 Chapter 1. Introduction and Summary of the Thesis developing economies are still in the first low income stage, explaining the extremely small inward stocks of FDI per capita for Africa and Asia presented in Table 8. On the other hand, Table 4 shows China has attracted large inflows of FDI but also has a substantial outward stock of FDI, suggesting China is currently in the third stage. . 3 FDI and the new trade theory The new trade theory developed in response to the failure of classical trade theories of incorporating concepts observed in actual flows of international trade such as intra-industry trade. The contribution of the new trade theory was that it allowed the construction of general equilibrium trade models which could include increasing returns to scale, imperfect competition and product differentiation, see Helpman and Krugman (1985). The new trade theory, therefore, provided models more in line with actual observations of the economy.

A weakness of the early contributions to the new trade theory was that they failed to incorporate MNEs and FDI. The dominant assumption in the new trade theory of single-plant national firms limited the usefulness of these models for explaining FDI. In fact, international production was often ruled out. Markusen (1995) provides a critical view of the inability of these early models to explain the existence of MNEs. However, during the 1980s and 1990s, James Markusen and other researchers have modified the new trade models to allow for inclusion of MNEs and FDI.

An important contribution of new trade theory models incorporating MNEs is that they can be used to analyse a firm’s decision between FDI and exports. Why does a firm decide to serve a foreign market through foreign production rather than exports? The decision revolves around the so-called proximity-concentration trade-off, where MNEs compare trade costs to the costs of producing at several locations. The advantage of producing in a single location to achieve scale economies is compared to the reduction in trade cost achieved when production takes place at several locations close to the local market.

The proximity-concentration tradeoff has resulted in the idea of two primary forms of FDI, horisontal and vertical. The distinction between these forms has been fundamental for modeling MNEs and FDI, Markusen (2002). Horisontal FDI means that an MNE replicates the same activities in several different geographical locations, whereas vertical FDI implies that an MNE locates production stages according to factor costs. MNEs existing as a result of horisontal and vertical FDI are classified as horisontal and vertical MNEs, respectively.

Vertical and horisontal FDI have different motives. Horisontal FDI occurs when the motive of the MNE is primarily market-seeking and the firm wants to satisfy foreign market demand by local production. In this case there exists a foreign market with a demand that the MNE wants to serve by producing close 21 Jonkoping International Business School to the market. A reason for this might be that it is necessary to adapt the product to the preferences of local customers. Higher trade costs in the form of tariffs tend to increase the incentive for horisontal FDI.

An MNE performing vertical FDI has primarily an efficiency-seeking motive, that is, the MNE exploits differences in factor costs between geographical locations. The MNE decomposes the production process geographically into separate stages according to factor intensity. For example, the labour-intensive stage of production should be located where labour costs are low. Similarly, a capital-intensive stage should be located where the cos


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