Foreign Direct Investment and Economic Growth in ASEAN-4
A. Hadiman
Student Number: 1711296
Supervisor:
dr. J.P. Elhorst
University of Groningen
Faculty of Economics and Business
Abstract
This thesis discusses the inflow foreign direct investment (FDI) to developing countries, which has widely been addressed in economics. There are two objectives: the first is to investigate the determinants of FDI in the ASEAN-4, i.e. Indonesia, Malaysia, the Philippines and Thailand, over the period of 1984 – 2003. The determinants examined consist of economic and political variables. The second objective is to examine the impact of FDI on economic growth. Investigation on the determinants of FDI suggests that the economic variables by means of human capital and openness affect FDI inflows while political variables have insignificant effect. Nevertheless, different result was found when the possibility of endogeneity was taking into account, in which the level of human capital and FDI inflows in the earlier period significantly affected inward foreign investment. With regard to the second objective, the results suggest that FDI and domestic investment show significant impact on economic growth. Likewise the first objective, we also consider the potential of endogeneity. The results show that the previous period of economic growth continues to the next period growth. The studies carried out in this thesis conclude that FDI is affected by economic variable – mainly human capital – and political variables seem do not show insignificant effect on FDI. Furthermore, the findings in this thesis support the argument that FDI contributes to economic growth even though the effect of FDI on economic growth is small compared to domestic investment.
Keywords: Foreign Direct Investment; Economic Growth; ASEAN.
Table of Contents
Abstract 2
List of Tables 4
List of Figures 4
Chapter 1 Introduction 5
Chapter 2 Literature Review and Theoretical Analysis 9 2.1. The Determinants of Foreign Direct Investment 9
2.1.1. Motives of Foreign Direct Investment 10 2.2.2. Theory of Foreign Direct Investment 12 2.2. Foreign Direct Investment and Economic Growth 21
Chapter 3 Methodology 29
3.1. Data Specification 29
3.2. Methodology and Model Specification 34
Chapter 4 Empirical Results 38
4.1. Foreign Direct Investment Determinants 38
4.2. Growth Equation 41
Chapter 5 Conclusions and Recommendations 45
References 47
List of Figures
Figure 1 Net inflow of Foreign Direct Investment 7
Figure 2 GDP growth (annual %) 7
List of Tables
Table 1 Expected sign of independent variables in FDI equation 35 Table 2 Expected sign of independent variables in growth equation 36
Table 3 Correlation matrix 36
Table 4 Panel unit root tests in Level data for individual variables 37 (ASEAN-4, 1984–2003)
Table 5 Panel unit root tests in First difference for individual variables 37 (ASEAN-4, 1984–2003)
Table 6 FDI determinants 39
Table 7 Growth equation 42
1. Introduction
Foreign direct investment has widely been recognised of its contribution to economic developments. Since the 1980s developing countries have eagerly attempted to attract foreign investors. Many studies have extensively investigated the determinants of foreign direct investment (see for example: Wheeler and Mody, 1992; Chakrabarti, 2001; Moosa and Cardak, 2006). Most of the studies explain FDI inflow from a different starting point. One part explains flow of FDI based on economic factors and neglect political factors (see Root and Ahmed, 1979; Culem, 1988; Markusen and Zhang, 1998), while another part discusses the political-related factors and neglect economic factors (see Wei, 2000; Brouthers et al., 2008). Other studies have attempted to combine economic and political determinants of FDI (see Schneider and Frey, 1985; and Edwards, 1990; Noorbakhsh et al., 2001). In the present study we explore the influence of economic factors and political factors on FDI inflow.
Another issue on FDI-related subject is the effect of FDI on economic growth. This issue has been extensively studied in many literatures. (see for example: Chen et al., 1995; Balasubramanyam et al., 1996; Borensztein et al. 1998; Zhang, 2001). Diverse studies have explored the association between FDI and economic growth from different views, for example: Yao et al. (2007) investigate the effect of FDI on economic growth from the perspectives of newly industrialized countries. Other studies examine the FDI-led growth issue under developing countries framework. Example of these studies are Chakraborty et al. (2008) which assess the impact of FDI on India’s economic growth based on a sector level analysis.
With regard to the developing countries, during two past decades, these countries experienced an increasing flow of FDI. In addition, there was a growing importance of FDI on host countries’ economies. Many developing countries obtained new technology, increased trade and employment and achieved higher economic growth.
According to UNCTAD1 (2008), the developing countries in 2006 receive inward FDI equal to US$ 379,052 million, while the developed countries receive US$ 874,082 million and the economies in transition obtain US$ 52,716 million. In the developing countries, Asian economies have the largest share of FDI inflow, which equal to US$ 259,433 million. Among the
1 For details see http://stats.unctad.org/Handbook/TableViewer/tableView.aspx?ReportId=1923
Asian economies, the South East Asian economies are account as FDI-recipient economies. Southeast Asia’s middle-income countries such as Indonesia, Malaysia, the Philippines and Thailand (hereafter described as ASEAN-4) are accounted as FDI recipient countries.
In the case of ASEAN-4, FDI is thought to stimulate economic growth via several channels such as implementation of new technology and transfer of new knowledge, enhancing export which increases host country international trades activities. The ASEAN-4 recognizes the importance of FDI in the process of economic growth. In the 1980s, these countries carried out structural reforms in their economies, creating policies towards openness and liberalization aimed at improving the investment climate. These improvements caused a substantial amount of FDI flows, for example inward foreign investment from newly industrialized economies (NIEs) such as Japan and South Korea.
In the recent years, ASEAN-4 maintained relatively stable economic growth rates. Figure 1 shows GDP growth rates over the period 1980-2005. In the mid of the 1990’s the ASEAN-4 experienced an economic crisis which caused a decline in the GDP growth rate. In the Asian financial crisis 1997-1998, Indonesia and Thailand suffered most from the crisis.
Regarding to FDI, over the period of 1997 – 2003, FDI inflows were fluctuated due to economic crisis in Asia and also economic slowdown in other parts of the world mainly in USA, Europe and Japan. Figure 2 presents trends in net inflows of FDI in ASEAN-4. Generally, ASEAN-4 experienced a downward trend on FDI. However, this trend was bounced back in 2004.
A recover in FDI inflows show that the effect of the economic crisis on FDI inflows slowly disappeared. According to Asian Development Outlook (2005), merger and acquisitions (M&As) accounted as one that boost inward FDI and eliminates the adverse effect of crisis on FDI inflows. Several evidences from ASEAN-4 show that privatization of state owned assets and foreign acquisitions of private companies have increased FDI inflows. In 2005, the ASEAN-4 has relatively high inflow of FDI. Asian Development Outlook (2005) reported that the increased in net inflows reflect an improvement of investors’ confidence in the economy.
-15 -10 -5 0 5 10 15 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Figure 1. GDP growth (annual %)
Indonesia Malaysia Philippines Thailand
Source: World Development Indicator, various issues.
-6000 -4000 -2000 0 2000 4000 6000 8000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 M il li on U S $
Figure 2. Net inflow of FDI
Indonesia Malaysia Philippines Thailand
Source: World Development Indicator, various issues.
The study aims to contribute to the existing studies in two ways. Firstly, the present study investigates the determinants of FDI in the four middle-income countries in Southeast Asia. Which determinants can explain the rapid growth of FDI inflow in the ASEAN-4? The Southeast Asia middle-income countries have implemented an export oriented, investment-led development strategy, which in turn shaped an international base for manufacturing and services. Relatively large markets and a large pool of labour may also have attracted FDI. Furthermore, the relatively stable political situation may have contributed to attract FDI.
Secondly, the purpose of this study is to examine the impact of FDI on economic growth. On the one hand, many studies argue that FDI has played a key role in host countries’ economies. Modernization hypothesis (see Rostow, 1960) suggests that capitalistic development helps industrialization and transformation processes of a third world country into modern society. With regard to FDI, the modernization hypothesis postulates that FDI from an advance-capitalistic country brings modern technology, providing external capital, and thus promotes host country’s economic growth. FDI can affect economic growth through several channels such as export promoting activities, technology transfer, (see Balasubramanyam et al., 1996; Borenzstein
et al., 1998; Baldwin et al., 2005). On the other hand, many would argue that FDI has negative relationship with host countries’ economies. The dependency hypothesis suggests that foreign investment from core countries (advance-capitalistic) is deterring host countries’ long-term economic growth. International capitalism creates a global division of labour, which causes a negative impact on developing (host country) country’s economic, decreasing economic growth and increasing income disparity. Hence, to increase economic growth developing countries have to independent of foreign investment and goods (see Stoneman, 1975).
This study is an investigation of the determinants of FDI in developing countries and the impact of FDI on host countries economic growth. The study focuses on four middle-income countries in Southeast Asia, namely Indonesia, Malaysia, Philippines and Thailand (referred as ASEAN-4). The time frame of the research spans from 1984-2003. The thesis is organized as follows: chapter 2 explains the theoretical framework of the determinants of FDI and the impact of FDI on host economies. Chapter 3 describes the methodology and data set used in this study. Chapter 4 presents the empirical results of the determinants of foreign direct investment and FDI impact on economic growth. Chapter 5 offers some concluding remarks.
2. Literature Review and Theoretical Analysis
Previous studies on FDI provide explanations of the determinants of foreign direct investment and the role of FDI on economic growth. The Ownership-Locational-Internalization (OLI) paradigm initiated by Dunning (1980) is the eminent principle, explaining FDI. The OLI paradigm generally consists of economic explanations. Follow ups on the issue of the determinant factors of FDI also include political considerations, for example, government stability and the corruption level as factors that influence foreign direct investments. Negishi (2007) concludes that political risk is important factor determine inward FDI. Wei (2000) finds that increase on corruption level in the host country reduces inward FDI. Brouthers et al. (2008) examine the impact of corruption on FDI and find that corruption discourages resource-seeking FDI. These factors have effect on multinational companies’ (MNCs) profits and therefore affect inward FDI.
Until recently, there was a belief that FDI has a positive effect on economic growth (see Borensztein et al., 1998; Alfaro et al., 2006 and Haskel et al., 2007). FDI might affect growth-driving variables such as investment, level of technology, human capital, and exports and thereby FDI promotes economic growth in ASEAN-4. Through export promoting-FDI, ASEAN-4 countries are able to gain higher economic growth (Thomsen, 1999).
This chapter provides literature review of the theoretical framework. The first section provides literatures on the determinants of FDI and the second section describe literatures on the relationship between FDI and economic growth.
2.1. The determinants of foreign direct investment
FDI is defined as “investment that involves a long-term relationship reflecting a lasting interest of a resident entity in an economy other than that of the investor. The direct investor’s purpose is to exert a significant degree of influence on the management of the enterprise resident in the other economy” (IMF, Balance of Payment Manual, 1993). Furthermore, there are several distinctions between FDI and foreign indirect (i.e. portfolio) investment. FDI is an investment made in a foreign country (outside the territory of the parent company). The objective of FDI is to take over an existing firm or setting up a new firm (i.e. control and own foreign production
facilities). FDI involves transfer of a package of assets or intermediate products. Foreign indirect (or portfolio) investment comprises of financial credits or the purchase of stocks in order to gain return with no intention to gain control over management (see Kjeldsen-Kragh, 2002 and Dunning, 1993).
FDI can be classified into vertical FDI and horizontal FDI. The former related with FDI inflows to less developed countries and the latter related with FDI inflows to developed countries (Markusen et al., 1996). In case of vertical FDI, MNCs relocate a particular phase of their production process in order to exploit differences in factor prices between the home and the host country. A common example of this type of FDI is that MNCs relocate their labour abundant activities in a particular region that provides a lower wage rate. In addition, MNCs are also motivated by the availability of natural resources, infrastructures and specific skills. Vertical investments can be in the form of backward investments or forward investments. Backward investments refer to investments in which a firm produces raw materials that processed in further stages within that firm. These investments intended to secure supplies, for example: business relationship between MNCs and their suppliers (Javorcik, 2004). Backward investments made by industrial countries in developing countries. Forward investments take place in form of subsidiaries sales. These investments are made by industrial countries in other industrial countries. Forward investments are intended to serve potential demand in foreign countries. From the view of product life cycle theory, forward investments occur in the growth phase in which advanced-industrial countries export their products to meet other industrial countries’ demand.
In case of horizontal FDI, MNCs seek to gain benefits from new markets. MNCs set up new plants in foreign countries to produce the same final goods or services. Therefore, MNCs aim to penetrate host countries’ market. The theory of product life cycle explains that MNCs will focus on attempts to find new markets when there is a high level of price competition, which induces MNCs to start a large-scale production.
2.1.1. Motives of FDI
Generally, motives of FDI are divided into several categories: market seeking, resource seeking, efficiency seeking, and strategic asset or capability seeking (Dunning, 1993). Nevertheless, in
recent days FDI are not only induced by single motive but also by multiple motives. These motives also change due to host countries’ environment or due to changes in MNCs’ condition.
Market seeking FDI intended to obtain and to take advantage over new markets or to maintain and to protect existing markets. Market oriented FDI is relates to host countries’ market size and market growth. In addition to market size, there are several other reasons that cause MNCs to undergo market-seeking FDI (Dunning, 1993). The first reason MNCs carry out market oriented FDI is because their suppliers or customers relocate their production facilities overseas. To maintain business continuity MNCs also invest overseas. Second, there are necessities to adjust MNCs’ product with local preferences and to indigenous resources and capabilities. Adjustment with local preferences will enhance MNC’s competitiveness compare to local companies. The third reason for market seeking FDI is cost consideration. Setting up a new firm (i.e. production facilities) overseas will give advantage because MNCs can lower production and transaction costs. MNCs will relocate their production facilities to get closer to important markets, or to cope with host countries’ regulations, import controls or trade strategies. The fourth reason is related to market competition. It is crucial for MNCs to operate in markets which are served by its competitors. This reason is relates to MNCs strategy either defensive or aggressive strategy. FDI is considered as MNCs’ strategy to compete in the market in order to protect their market shares (defensive strategy), to acquire new market and to acquire competitors’ market share (aggressive strategy).
The background for resource seeking FDI is the opportunity to obtain particular resources (i.e. physical and natural) at a lower cost than in the home country. Resource oriented FDI will increase MNCs’ competitiveness and profits. Dunning (1993) classifies this type of FDI into three categories. The first category refers to FDI with objective to obtain specific physical resources or other kind of resources. MNCs that fall into this category are primary producers and manufacturers. Their motives are minimizing costs and securing source of supply. The second category concerns with the requirement to obtain technical, management and organizational skills. The third category focuses on MNCs with the aim to find supplies of cheap, unskilled or semi-skilled labour. MNCs are setting up production facilities in a country (i.e. such as less developed countries or developing countries) which provides an abundant pool of labour. This type of FDI occurs in labour-intensive industries in which labour costs account for a large fraction of production costs.
The efficiency seeking FDI is motivated by economies of scale and scope and by risk diversification. This kind of FDI combines advantages that result from market seeking FDI and resource seeking FDI. MNCs that undertake this type of FDI will gain benefit from differentials between country-specific characteristics (i.e. endowments, economic systems, trade policy, institutional, etc). MNCs will concentrate production in certain places to serve several markets. Efficiency oriented FDI can be divided into two types. The first type is related to division of labour between MNCs’ production in developed countries and developing countries. In the developed countries, MNCs are concentrated on capital-technical-informational intensive activities. While in the developing countries, MNCs are emphasized on labour and natural resources intensive activities. MNCs are prompted to take benefits of the availability of resources and to obtain gains from differentials on costs of production, mainly from cost of inputs. The second type is intended to achieve economies of scale and scope and to take benefit stemming from different consumer preferences and supply capabilities. This efficiency seeking FDI occurs in countries with identical characteristics (in terms of economic structures and income level).
The strategic asset seeking FDI is intended to secure and to enhance long-term firms’ competitiveness. The benefits of this type of FDI are stemming from the market imperfection in which MNCs are involved in. The strategic asset seeking can be in the form of any motive mentioned above, combine with assets of the firm.
2.1.2. Theory of Foreign Direct Investment
The above paragraphs have explained the differences between portfolio investment and FDI. Furthermore, the previous section has also described motives of FDI. Nevertheless, the question of “why firms engage in foreign direct investment?” or “why firms establish foreign production facilities?” remains unsolved. This section reviews theory on FDI that have been synthesized by many scholars.
Stephen Hymer
Hymer (1960) applies an industrial organization approach to the theory of foreign production. Hymer argues that MNCs are willing to own or to control foreign facilities if they have a particular firm specific advantages (i.e. innovation, financial, or marketing, which is specific to
their ownership) that grant them with competitive advantage over their local competitors. In other words, these particular advantages are limited to the particular foreign firm only (thus they have an ownership advantages).
From the previous paragraph, it is clear that a firm will exploit its specific advantages. These advantages entail market failure since the firm knows its potential ownership advantages better than the market. The exclusive use of ownership advantages provide firm with some sort of monopolistic power and stimulate firm to start foreign production unit
Furthermore, Hymer also explores the idea of territorial expansion of firms in order to enhance their monopolistic strength. Hymer focuses on the governance of economic activities by MNCs as an instrument to increase their monopoly power instead of as an instrument to reduce costs, to improve product’s quality or to induce innovation.
Hymer’s only concerns on particular subjects of ownership advantages, mainly how to control and to exploit the advantages. Nonetheless, Hymer does not provide a general explanation of MNCs’ international involvement.
The product life cycle theory
The theory of the product life cycle combines the concept of the technological gap with factor endowments’ differentials and the prospect to undertake foreign direct investment (Kjeldsen-Kragh, 2002). The theory itself emerged in the 1960s to explain market-oriented production by firms with specific ownership. The theory of product life cycle is based on three ideas. Firstly, a particular product undergoes a life cycle, which starts with the introductory phase, the growth phase and finally the stagnation phase. Secondly, the production location will move to another location when the product passes through various stages of life. Thirdly, the theory is based on the mobility of production factors across national boundaries. This mobility may take place in the form of foreign direct investment. The theory of product life cycle views foreign direct investment as a means of technology (knowledge) transfer from one country to another.
The product life cycle is a micro economic principle used by Raymond Vernon (1966) to examine foreign activities of US MNCs. Vernon’s notion starts from the idea that the countries’ involvement in trade will depend on the countries’ capability to improve natural/physical and human resources (endowments) or to invent new endowments. This idea implies that countries’ technological skill plays an important role in conjunction with improvement and innovation of
new resources. In addition, there is country-specific effect that might impact the efficacy of firms to organize these endowments.
Vernon shows that US firms’ ownership advantages – innovation and production process – are influenced by the structure and pattern of US endowments and markets. Nonetheless, the ownership advantages of innovating firms might decline due to the existence of foreign competitors that produce goods based on their conditions. Vernon’s explanation on US firms’ product life cycle runs as follows: at the beginning, the product is produced for the local market (US) in the location close to the market and innovatory place. As the product goes to the growth phase, US firms – with their ownership advantages – are exporting the product to other countries, which have the same condition on demand and supply. Implicitly, this means that US will export its product to other industrialize countries. As the product achieves a certain level of maturity, firms’ ownership advantages change from advantages to produce a unique-specific product to advantages of marketing skills or cost savings on production. In addition, there are changes in the market that may lead to more competitors and thus to higher levels of price competition. Firms also take more weight on minimizing costs. Since labour costs become a crucial factor in production costs it raises the importance to acquire cheap labour. Because of high degree of price competition there is need of large-scale production and to accommodate this production a big market is required. Several considerations such as costs minimization and market expansion to other countries affect firms to relocate their production to foreign countries that provide cheap labour and big market. In the end, if host countries’ condition support production activities, the subsidiary could play role as exporter.
Following from Kragh-Kjeldsen (2002), the product life cycle theory can be describes as follow: a new product is invented and developed in country A. Initially the product is dedicated to domestic market. However, in the next period there is demand for the product in country B. Thus, country A starts to export to country B. At a later period, there is demand from country C, and to meet this demand country C starts to import the good from country A. In each country the product passes through the three different growth stages, the introductory stage, the growth stage, and finally the stagnation stage where consumption declines a new product replaces the old one.
The role of country A as an exporter also declines gradually since the location of production changes. In the beginning, the production process moves to country B and later on to country C. Regarding to the location of production, the theory of product life cycle notes that
demand conditions, production and competition are different in each phase of the product’s cycle. Because of differences in endowments, each country will or will not produce the product dependent on the product’s life cycle stage.
Internalization theory
Dunning (1993) describes internalization theory as an attempt to examine the background why transnational transactions of intermediate products are arranged by hierarchies instead of market forces (external market). The basic idea of the internalization theory is that multinational hierarchies are explanation for another mechanism to organized value-added activities abroad. Internal market (intra-firm) is the alternative for external market and internalization theory focuses to identify in which situation the internal market gives more benefit than the external market. MNCs will use internal market if the external market does not exist or the costs for the internal market are lower than the external market. FDI is an instrument employed by MNCs to coordinate and to use ownership advantage (knowledge-specific advantage) intra-firm in order to retain control over ownership advantage and to maximize its return (Parry, 1985).
In the development of internalization theory there are two branches of arguments: one suggests that internalization theory is a general theory of FDI (Rugman, 1980) and another one criticizes internalization theory (Parry, 1985). Internalization as a general theory means that the internal market which used by MNCs is able to explain all FDI cases. Parry’s (1985) critique is based on several arguments. First, internalization theory does not explain why the internal market is preferred over the external market in case of specific market failures such as a tariff. It is clear that tariffs and other trade barriers cause market imperfections and that these barriers eventually increase external market costs relative to intra-firm costs. With regard to market failure, internalization theory does not describe which activities are internalized by MNCs.
The second argument links to other forms of MNCs’ international involvements – licensing and joint ventures. Generally, these international activities require contractual agreement between both parties (for example: contract between the licensee and the licenser). The critique aims to the argument that there is a market imperfection that leads to failure on setting up the price level of the specific-knowledge sold by the MNCs. Put differently the external market is not able to accommodate firms’ option to sell specific-knowledge. However, the price does exist in technology transfer although it might cope with some difficulties on price
setting in the market for technology transfers. Contractual agreements might allow technology transfers as well as internal markets. In addition, there is a drawback in terms of monitoring and controlling the ownership knowledge within internal hierarchies. There is a possibility of disclosure on MNCs’ ownership advantages and the problem worsens if MNCs have many subsidiaries across the world. Thus, contractual agreements (licensing or joint ventures) might offer better monitoring and controlling activities.
The third argument is relates to joint ventures – another form of MNCs’ international involvement. In this case, the internalization theory does not explain which parts of production are organized through intra-firm and what type of transactions are organized through contractual agreement (i.e. joint ventures).
The fourth argument focuses on organization and control structures within the MNCs’ hierarchies. International hierarchies may raise some issue related to subsidiary-independent behaviour, which under particular conditions subsidiary may be independent to certain activities. Parent company and subsidiary also might have different objectives. Regarding to monitor and control tasks, there is possibility that parent company might have inconsistency in monitoring and controlling subsidiary (i.e. the parent company only conduct monitor and control on general areas). The internalization theory does not consider the limitation of monitoring and controlling.
Rugman (1985) responds to these arguments and retains that internalization is a general theory of FDI. There are several points suggested by Rugman to tackle Parry’s critiques. In accordance with Parry’s view that internalization is not a general theory because FDI does not fit properly in some condition, Rugman argues that internalization is still a general theory because FDI is one of three options that firms have to engage in international activities.
Other arguments from Rugman explain that the option between FDI and licensing is based on different situations. There are situations in which licensing is preferable to FDI. To assess whether licensing is superior to FDI under certain conditions, there is a need to make an evaluation of host countries’ conditions like political risks, information cost, and environmental factors. The fact which shows that licensing preferred than FDI does not necessarily mean that internalization is inconsistent as a general theory. FDI is preferred than other modes of foreign activities when the benefit of internalization is larger than the cost of internalization.
In conjunction with organizational, control, and strategy of MNCs, Rugman provides evidence (see Rugman, 1985) that the higher the number of activities being internalized by
MNCs, the higher the efficacy that results from internalization. In addition, controlling and monitoring tasks may become stronger when there are various and frequent information run through internalization process. The parent company will impose strict control over its subsidiaries. Rugman also argue that the strategic management stemming from internalization process provide effective control contrast with limited control claimed by Parry.
Eclectic paradigm
The eclectic paradigm tries to provide an explanation for MNCs’ activities abroad. From the view of eclectic paradigm, FDI link to the advantages that possessed by MNC. These advantages, called OLI – ownership, locational, internalization – are related to each other. Dunning (1980, 1993) is one of the proponents of this concept. Eclectic paradigm has appeared in many studies on the subject of MNCs activities, primarily in FDI. Kjeldsen-Kragh (2002) has made a brief description of eclectic theory.
The eclectic paradigm begins with the recognition of trade theory that provides explanation of spatial distribution of particular output. Furthermore, the existence of market failures offers explanation with regard to the ownership of that particular output and how to distribute other types of output using firm-specific resources (Dunning, 1993). These market failures can take place in two forms. First, structural market failure, differentiates firms in terms of their ability to obtain and to maintain control over property rights or to arrange and organize cross border value-added activities. Second, market failure on intermediate product market in which the transaction cost in intermediate product market is higher than the internal market (in form of hierarchy).
It appears that MNCs’ activities combine several aspects, for instance cross-national border production (or value added) activities and common arrangement of cross-border activities. In addition, motives of FDI as described in the previous sections may be related to OLI advantages.
The first principle of eclectic paradigm – firm-specific advantages – is in line with previous work performed by Hymer (1960). This principle argued that MNCs are willing to own or control foreign facilities if they have particular advantages (i.e. innovation, financial, or marketing) which are exclusively owned by MNCs (thus called ownership advantages) and these advantages are large enough to cover their disadvantages when competing with local firms. The
first principle explains the reason ‘why firms decide to invest in foreign countries?’ Generally, innovations emerge from wealth-industrial countries. These innovations are firms’ specific advantages (knowledge) and yield income via several ways2. The specific advantages are MNCs’ competitive advantages, which allow them to compete with foreign firms abroad. Market imperfection allows firms to be able to exploit their ownership advantages. Dunning (1993) distinguishes market failure into structural market failure and transactional market failure3.
Firm-specific advantages explain why MNCs have strong competitive positions compared to local-owned firms. However, this theory does not provide any explanation what MNCs should do with their specific knowledge, whether they should choose to export goods that result from the specific knowledge or whether they should establish overseas production facilities. The second principle – theory of location – provides reasons for MNCs to take the decision whether exporting or setting up a production unit abroad. In addition to the decision of whether exporting or setting up overseas production facilities, the second principle entails the question of ‘where is the suitable location to exploit ownership advantages?’
Locational advantages of different host countries affecting MNCs’ decision to relocate their subsidiaries. Host countries’ competitiveness in attracting foreign investment relates to several aspects, for example: host countries’ resources (natural and/or human), host countries’ policy (i.e. relates to incentives in trade and investment and artificial barriers), cultural and language, political and institutional differences and the availability of infrastructures.
The second principle can be described as follows: there is a different production condition between the home country and the host countries. There are two barriers, the cost of exporting and the cost of setting up a unit facility abroad. These barriers can be natural barriers (i.e. lack of local culture, institutional problems, and technical conditions) or artificial barriers (i.e. political). Export activity will cope with natural barriers such as transportation costs, sales costs, and production costs. In addition, it also encounters artificial barriers in the form of tariffs, and restrictions.
The decision to export from home country to host country depends on the level of economic advantage (with respect to specific advantages) and the host country’s production
2 Firstly, firms might use specific knowledge to create unique products and export the product. Secondly, firms may
sell this specific knowledge to the foreign firms. Thirdly, the other possibility of generating income is setting up new production facilities overseas.
3 These market failures are briefly mentioned in the previous paragraph.
advantages plus export barriers. The larger the economic advantages from the possession of specific knowledge compared to host country’s production advantages plus export barriers, the greater the chance to export. On the other hand, the decision to undertake FDI closely relates to the cost savings from the establishment of production facilities in the host country and from unnecessary export costs. These cost savings must be compared with other costs (FDI-related costs). The larger the cost savings relative to the FDI-related costs, the higher home country propensity to engage in FDI.
As mentioned earlier, the locational advantages also relate to non-economic factors. Factors like institutional problems, government stability, and bureaucratic procedure are among other factors that influence inward FDI to a particular location. Root and Ahmed (1979) find that political stability influences inward FDI. According to Negishi (2007), political factors become increasingly important as determinants of FDI. A stable government creates sound policy, reliable regulatory framework and reduces uncertainty, which leads to better investment climate.
Corruption is one of non-economic factor that has received wide interest as a determinant of FDI. Habib et al. (2002) suggest that corruption deters FDI inflows. Corruption is morally wrong, creates difficulties in organizing activities and also creates additional cost in their activities. Habib et al. (2002) also suggest that the difference in corruption level between home and host countries has a negative effect on FDI. Brouthers et al. (2008) describe that the effect of corruption on FDI is depends on the type of FDI. In market-seeking FDI, corruption effect is less prominent since market attractiveness4 compensates the additional cost raises from corruption. In resource-seeking FDI, corruption has a detrimental effect. Resource-seeking FDI is attracted to a particular market because this market provides access to inputs or to secure the availability of inputs and to lower costs (for example labour costs). Market attractiveness can not be compensated by additional costs raise from corruption.
The third principle of the theory of internalization explains the MNCs’ decision whether to sell its knowledge to foreign competitor or to internalize their ownership advantage in foreign subsidiaries. Put differently, MNCs will decide whether to use external markets (selling to foreign competitors) or the internal market to gain benefit from its ownership advantage
4 Market attractiveness in market-seeking FDI can takes place in form of large and wealth economies. In the wealthy
economies, one can finds rich consumers with high income and weak price-sensitivity. MNCs are able to pass high prices caused by corruption to these wealthy consumers.
(knowledge). Implicitly, the third principle explains the mode of MNCs’ involvement in international activities.
MNCs will consider internalizing their ownership advantage based on several reasons. The first reason is related to the objectives of the MNCs whether to increase or maintain their market share. Second, there is market imperfection (i.e. transactional market failure) for knowledge particularly in terms of pricing the knowledge. The value of knowledge is probably much higher when used by the firm itself rather than when the firm decides to sale the knowledge on the external market. This problem also relates to imperfect information. It is difficult to express specific-knowledge on trade agreement. Imperfect information is one reason why it is difficult to value the specific-knowledge. The purchaser is reluctant to pay the full price for knowledge since there is insecurity about knowledge in the future. The purchaser does not have complete information about the knowledge and from the seller’s view, it is unprofitable to give complete information because it might cause the purchaser to withdraw the trade – specific knowledge – agreement. The third reason is related to MNCs’ ability to control specific knowledge, because selling specific-knowledge entails loosing influence and control over that knowledge. FDI allows a parent company to sale the knowledge internally to the subsidiary and simultaneously allow the parent company to maintain control over its ownership advantages.
Macro-economic theory of FDI
Macro economic theory focuses on the most suitable activities of firms in foreign countries (Dunning, 1993). The above paragraphs explained the background of a particular firm to invest in foreign countries based on absolute costs and benefits. The macro-economic theory of FDI considers FDI based on comparative costs and benefits. The analysis of FDI based on macro economic perspective was pioneered by Kojima (1973). Ozawa (2007) provides the background of development in macro theory of FDI.
The analysis originally relates to the Heckscher-Ohlin theorem5, which was extended by Rybczynksi (1955) to a change in factor endowments and its effect on domestic output. Next, Mundell (1957) employed the previous theorems to investigate capital movements between
5 Heckscher-Ohlin theorem often describes as factor proportion theory and it consists of three parts. The first part is
factor endowment determines the pattern of international trade. The second part is international trade equalize factor returns, unless there is a product specialization, which leads to partial equalization of differences. The third part states that abundant production factor gain benefit from international trade while scarce factor will lose (see Kjeldsen-Kragh for details).
countries. Mundell’s idea begins with capital movement from capital-abundant countries (for simplicity, rich countries) to a particular place, which provides a high marginal rate of return on capital (namely – capital-scarce countries – for simplicity: less developed countries/LDCs)6. The capital inflow to capital-scarce countries will have impact on shifting their production capacity, especially in capital-intensive industries (i.e. LDCs’ comparatively disadvantage industries). In contrast with capital-intensive industries, the capital-scarce industries (i.e. LDCs’ comparatively advantage industries) will experience contraction. The opposite consequences occur in the capital-abundant countries. As a result, capital movements remove comparative advantage (which becomes the basis of trade) between countries. In terms of FDI, this phenomenon refers to FDI as a substitution of trade.
In contrast with Mundell’s idea, Kojima (1973) views FDI as a complement of trade. Kojima explains his idea using the background of Japan’s overseas investments (FDI) and compares it with US overseas investments. The differences are as follow: Japan’s FDI is directed to utilize resources (natural or labour) in resource-abundant countries and the output of Japan’s FDI is exported to Japan or other countries. By contrast US foreign investments are aimed to produce capital-intensive products (i.e. requires advance technology) and the output is directed to local market. Kojima describe Japan’s FDI as a complement of trade and US FDI as a substitution of trade.
To support the idea of FDI as a complement of trade, Kojima suggests that FDI affects host countries’ industries in which the output of less-capital industries will expand and the output of capital-intensive will contract. Consequently, FDI will increase the basis of trade. This view contrasts to Mundell’s view (factor movement) that FDI will eliminate the basis of trade. The difference between these views goes back to the definition of FDI. Mundell views FDI as financial transfers, while Kojima views FDI as a transfer of capital, managerial and technological skill.
2.2. Foreign direct investment and economic growth
The issue of the impact of FDI on economic growth has been widely discussed and explored. Essentially, FDI promote economic growth via enhancing technological change in host countries
6 Capital movement from capital-abundant countries to capital-scarce countries induced because the latter imposed
and promoting the adoption of advanced knowledge (i.e. managerial, and/or financial). The recipient countries acquire the advanced knowledge via several channels. Lensink et al., (2006) state that these channels may occur as imitation, competition, training and linkages.
Previous studies have found many channels that explain the impact of FDI on economic growth. Borensztein et al. (1998) and Xu (2000) provide an explanation that FDI affects economic growth through technology diffusion. The studies share the same conclusion that in order to have a positive effect of economic growth, host countries require certain level of absorptive capability. Other studies show that FDI may affect economic growth via productivity
spillovers. Empirical works based on productivity has produced various results. Haskel et al. (2007) conclude that FDI increases domestic firms’ productivity. Javorcik (2004)
finds a positive relationship between FDI and productivity through backward linkages. In contrast with two previous studies mentioned before, study by Aitken et al. (1999) find
negative link between FDI and productivity of domestic owned firm. Another channel describes FDI may affects economic growth through financial sector. Alfaro et al. (2006) explore the role of financial market to support FDI enhancing economic growth. The study provides evidence that an increase in FDI generates higher economic growth.
In many studies, the impact of FDI on economic growth has been analysed within the neoclassical framework (see Balasubramanyam et al.,1996; Obwona, 2001), which employs several assumptions such as constant return to scale, diminishing return on each factor, and positive and smooth substitution between production factors. Recently, there have been several improvements like assuming technology develops endogenously and adding cross-country variation variables (i.e. human capital condition) that leads to enhancement of conditional convergence. The first phase of the development of neoclassical model results is based on the belief that long-run economic growth is determined by exogenous factors (variables outside of the model) namely, saving, population growth rate and technological progress. The second phase of the development of neoclassical model put forward by economist such as Romer (1986), Lucas (1988), Rebelo (1991). The developments thereby contribute to construct endogenous growth models.
Endogenous growth models suggest that long-run growth rate is determined by variables within the model, and highlight the importance of human capital, the development of science and technology and also externalities in economic development. There are several developments in
the endogenous growth model, for example, the growth rate may continue, since there are no diminishing returns as economies continue to grow. One example of an endogenous growth model is the AK model with the basic belief of elimination of diminishing return to capital. Several contributions on the growth framework also include R&D theories and imperfect competition. Further developments of the endogenous growth model also consider the inclusion of technology diffusion. The latter developments on technology diffusion explain imitation as one mode for less developed economies to catch up with advanced economies (Barro and Sala-i-Martin, 1995).
In perspective of neoclassical growth model, the effect of FDI on economic growth is limited due to the nature of diminishing returns on capital. Thus FDI can not affect long run economic growth. In view of endogenous growth model, FDI may affect economic growth via
externalities and spillovers, which cause increasing returns in production. According to Romer (1990) economic growth may result from innovation induced by investment. Knowledge
spillover from FDI stimulates innovation, which lead to promote economic growth.
FDI may affect economic growth positively. Inward FDI may generate innovations – whether in production process or in managerial and organizational – and this idea
is in line with Schumpeter’s argument saying that technical progress and innovations lead to booms in economy (Chaudhuri, 1989). According to De Mello (1997), FDI affects economic growth by accumulating capital in host countries. FDI embodied with advanced technology, influences host countries’ production capabilities. Furthermore, FDI affects economic growth through knowledge transfers that can take place in forms of labour training, new method of organizing and management practices. Thus, FDI increases knowledge in the recipient countries. In general, externalities and spillover effect play an important role in promoting economic growth. Moreover, these effects occur as a result of innovations created by FDI.
De Mello (1997) find several conclusions, firstly, the relationship between FDI and economic growth depends on the country-specific factors along with host countries’ endowment that attract FDI. Moreover, spillovers on productivity and externalities play a role in the promotion of economic growth. Secondly, considering that FDI may lead to economic growth via technical transfer, the effect may be considerable larger in less developed country while the impact of FDI via technical transfer on advanced countries’ growth may be smaller. Thirdly, the conclusions concern the level of substitutability and complementarity of technology. The
findings show that substitutability between host countries’ (old) technology and FDI’s (new) technology appears to be higher in advanced countries. The complementarity between old and new technology implies that host countries’ technology is less productive. The type of technology transferred by FDI from advanced countries depends on the host countries condition. Fourthly, concern the causality of FDI and economic growth. The link between FDI determinants and FDI inflows is stronger compared to the link between FDI and growth, thereby the causality operates from growth to FDI inflow. Finally, domestic investment environment is crucial. Therefore, there is a need to improve domestic investment climate.
The contribution of Barro and Sala-i-martin (1995) on economic growth theory gives
opportunities to explore the process through which FDI boosts economic growth. Borensztein et al. (1998), using endogenous growth model attempt to explore the impact of FDI
on economic growth. The basic equation as follow:
g = c0 + c1FDI + c2FDI*H + c3H + c4Y0 + c5A, (1)
where FDI is foreign direct investment; H is the stock of human capital; Y0 is the initial GDP per
capita; and A is a set of variables, which impact economic growth. The study proposes that economic growth as result of technological progress and FDI plays a role in transferring new knowledge, which eventually leads to technological progress. Furthermore, in order to benefit from advanced technology, the recipient countries require a certain level of human capital. Hence there is an interaction effect between human capital and FDI.
Utilizing data of 69 countries over period of 1970-1989, Borensztein’s et al. (1998) results show that FDI promotes economic growth via technology diffusion. The results also suggest that host countries need to achieve a certain level of absorptive capability. FDI will have more contribution on economic growth if FDI is supported by human capital.
Yao et al. (2007) investigate the impact of FDI on economic growth in frame of newly industrializing economies (NIEs). The study proposes that FDI contributes to economic growth through its role on moving host countries’ production efficiency and shifting host countries’ production frontier. NIEs are considered as late comers of industrialization. In order to catch up with industrialized economies, NIEs must meet certain requirements. First, human capital, which is closely related to education, is the most basic condition to innovate or to imitate new
technology. Second, liberalization or openness allows a particular country to obtain new knowledge. Third, it is difficult for a country, which is considered to be a late comer of industrialization to create advanced technology available in developed countries. NIEs (late comers) which have capability to innovate and to adopt new technologies are able to obtain all advanced technologies in a shorter time through FDI.
Late comers can reduce the technological gap – between their technology (old technology) and advanced technology (industrialized countries) – through FDI. Using superior technology from industrialized countries, late comers can increase their efficiency in production. Furthermore, increasing production efficiency may have a positive impact on late comers’ production frontier. Put differently, the actual output of late comers will increase above their old production frontier.
Yao et al. (2007) develop a growth equation to test their propositions. China is used to test their proposition empirically because China experiences fast economic growth that emerges from liberalization in form of adopting FDI and export-promoting strategy. The growth equation based on augmented Cobb-Douglas production function takes the form:
Yit = β0 + β1kit + β2nit + β3hit + β4FDIit + β5EXPit + β6exct + β7transit + β8t
+ β9(t *FDI)it + β10east + β11central + vit. (2)
All variables are in natural logarithm, where i denote province (i = 1,2,…,29); t denotes years (t = 1979,…,2003); k is capital; n is labour; h is human capital; FDI is foreign direct investment (FDI = ln (FDI / (FDI + DI))); EXP is export share to GDP (EXP = ln(EXP/GDP)); EXC is
exchange rate (exc = ln(real exchange rate)); trans is a measure of transportation (trans = ln(highway mileage per 1000 km2 of land area)); east is a dummy variable, 1 for eastern
region and 0 otherwise; central is a dummy variable, 1 for central region and 0 otherwise.
The results show that all explanatory variables have the right sign and significantly affect the dependent variable – economic growth. The results confirm the first proposition: FDI contributes to production, and the second proposition: FDI contributes to technological progress which eventually leads to more economic growth.
Balasubramanyam et al. (1996) provide an explanation concerning the impact of FDI on
import substitution) and economic growth within the framework of an endogenous growth model. Building upon Bhagwati’s (1978) work, which hypothesized that the volume and the
effectiveness of FDI depend on the trade strategy taken by the recipient countries,
Balasubramanyam et al. (1996) emphasize the effectiveness of FDI. Subsequently, they describe that export promoting strategy (EP) is suitable for inward FDI, while import substitution strategy (IS) is not suitable for inward FDI.
Export promoting strategy (EP) provides conditions that attract inward FDI. It is argued that EP has neutral policy orientation; therefore it allows market forces and allocation of resources based on the comparative advantage induces specialization and economies of scale. In addition, EP also promotes competition, both internationally and domestically which leads to more R&D activities and human capital investment. On the other hand, IS – self reliance policy – has a deterioration effect. Bhagwati (1994) explains that the IS strategy allows the occurrence of rent seeking activities and other unproductive activities. IS strategy distorts investment climate, deters inward FDI and eliminates the impact of FDI.
Endogenous growth theory emphasizes human capital accumulation, R&D activities, and externalities or spillovers. These features contribute to growth and FDI fosters the recipient countries to acquire these features. With regard to trade strategy, FDI will have effect on growth if the recipient countries apply EP strategy. The presence of foreign investors – with their superior knowledge – will enhance competition, which in turn encourages local firms to be more active in their R & D activities. FDI plays a role in accumulating human capital via providing labour training as well as generating spillovers of knowledge and technology via connection between foreign investors and their local business partners.
Balasubramanyam et al. (1996) use an extended production function in which FDI and
export are incorporated as inputs of production. The inclusion of FDI is based on the argument that FDI is the source of new technology and human capital and, as a result, it is expected that FDI will capture spillover and externality effects. The export-led growth argument is a ground for inclusion of export as one of input variables (see Ram, 1985; Greenaway et al.,1994). The model used in estimation is:
y = α + βl + γ( I/Y) + ψ(FDI/Y) + Φx,
where y is GDP; l is labourinput; (I/Y) is the share of domestic investment in GDP; (FDI/Y) is the share of foreign investment in GDP; and x is exports. The coefficient of (FDI/Y) is expected to be positive. Moreover, the coefficient of FDI to GDP also expected to be higher in the countries that apply the EP strategy than in countries that apply the IS strategy.
The results show that countries with EP strategy experience higher economic growth as a result of inward FDI. Thus the results support the hypothesis that FDI will generate greater effect on economic growth if the recipient countries employ EP strategy.
As explained above, inward FDI promotes economic growth. However, based on the dependency hypothesis (see Stoneman, 1975; Hein, 1992) the presence of foreign capital may exert negative effect on host countries’ growth. The dependence hypothesis suggests that foreign investment may have a short-run effect on economic growth. However, in the long run, dependency on foreign investment may have detrimental effects on economic growth. According to Jackman (1982), there is a “periphery – core” relation which implies the exploitation of periphery (LDCs) by core countries (industrialized/developed countries). It is argued that foreign investors transfer their profits back to home countries (core countries), or that penetration and large involvement of foreign investors may inhibit growth.
According to Boswell and Kentor (2003), there are several forms of dependency. Firstly, foreign penetration that refers to domination of MNCs in host countries. Foreign penetration creates negative effects on host countries’ economy, for example: particular countries, through their MNCs’ dominant position, may have advantage over the recipient countries (see Galtung, 1971). Another example is lack of backward or forward linkages generate negative externalities such as inequality and impede growth (see Dixon and Boswell, 1996). Secondly, foreign investment concentration that refers to the situation in which the recipient countries (host countries) have a high dependency on foreign capital originating from particular countries. MNCs might exert their influence on economy, politics, and social life in the recipient countries. The situation becomes worse when the recipient country depends on a single foreign investor. The investing country will use power to protect its investments and its citizens in the recipient countries, influencing the host country government to implement a policy that benefits the foreign investor. In some cases, the host country’s resources are not fully utilized. High intervention of foreign investor in the local government tends to create negative effects such as corruption, or government instability. Thirdly, trade dependence, refers to the unequal condition
of international trade structure in LDCs. Trade dependence might take place in form of trade composition, export commodity concentration, and export partner concentration.
3. Methodology
The study investigates the underlying factors of FDI inflows and the impact of FDI on economic growth. The sample in the present study is ASEAN 4, i.e., Indonesia, Malaysia, Philippines, and Thailand. The research period is 1984 - 2003. The choice of the sample countries and of years is basically determined by data availability. There are several sources of data for this study, mainly obtained from World Development Indicator (WDI)7. Data for labour costs were obtained from United Nations Industrial Development Organization (UNIDO). Data for human capital variable is taken from United Nation Statistic Division. The data of political variables were obtained from International Country Risk Guide (ICRG)8.
3.1. Data specification
The first objective of this study is to examine the determinants of inward FDI. Therefore, the dependent variable for the estimation is net inflow of FDI. To ensure comparability of data, particularly data on FDI inflows, the data of inward FDI were obtained from one single source, namely balance of payment of each country which provided by WDI.
The explanatory variables are comprised of economic variables and political variables. Economic variables employed in this study are market size, labour costs, human capital, and the degree of openness. These variables are related to advantages that exhibited by the Ownership-Locational-Internalization (OLI) paradigm proposed by Dunning (1993). Political variables employed in this study are government stability and corruption. It is expected that an increase in the value of these variables – indicating more stable government and less corruption – will increase FDI inflows.
Market size can be categorized as a traditional determinant of FDI and it is appear to have positive relation with inward FDI. Chakrabarti (2001) use GDP per capita as a proxy for market size, while Moosa and Cardak (2006) in their research of the determinants of foreign direct investment define market size as real GDP. A larger market size provides opportunities for would-be foreign investors to exploit their economies of scale and to gain benefits from high
7 WDI database is provided by Groningen University in form of electronic database. Access to WDI database is
available via university workstation.
8 Available at: http://www.prsgroup.com
sales activities. The economies of scale might result from MNCs’ ownership advantages, which potentially give larger benefits through internalization activities in foreign subsidiaries. In order to profit from their ownership advantages (i.e. advanced technical production processes that allow MNCs to achieve economies of scale) MNCs need a large market size. From the perspective of product cycle theory, FDI may occur in the growth phase and/or the stagnation phase. In the growth phase, costs become important factor in price setting due to high demand for a particular product and also due to strict price competition. Increase in demand leads to increase in production and since there is an increase in price competition as a result MNCs need to obtain advantage from large-scale production or specialization. In addition, capital and managerial skills (i.e. organizational skills) are playing a significant role9. Hence, foreign investors will move their production facilities to other industrial countries that have similar condition on supply capabilities. This implies that the host countries (i.e. industrial countries but not necessarily countries with superior technology) must have enough capital and skills to accommodate and adopt foreign investment. Moreover this particular country must have a prospect to supply a bigger market. The stagnation phase is characterized by the following condition: the decline in product demand, the fixed and certain production process and product type10, and price competition becomes more severe. To maintain competitive, there is a need of reducing costs especially labour costs. To lower labour costs, MNCs move their production facilities to countries which have an abundant stock of labour and low wage rates. These countries usually fall into less developed countries (LDCs). In addition, price competition leads to large scale production, which eventually raises the need of a large market size. However, since LDCs are not always having large markets and therefore limited sales, large scale production is also dedicated to export.
The previous paragraph described MNCs need to reduce costs, for example labour costs. As explained earlier, in the stagnation phase, cheap labour is crucial. Developing countries (DCs) or less developed countries (LDCs) having big populations generally provide cheap labour. Hence, MNCs that operate in labour-intensive industries will invest and establish their production facility in DCs or LDCs. Labour costs and FDI are expected to have a negative
9 Increased in production needs more investments in capital stock. Therefore capital becomes a crucial input of
production. In the growth phase, where there is an increase in the level of production, organizational skill also becomes crucial.
10 Put differently, there is no longer uncertainty with regard to the product’s characteristics and the production
process.
relation. Regarding the measurement of labour cost, previous studies show different possibilities. Culem (1988) employs unit labour costs as a measurement of labour cost. This measurement takes account that a low wage rate is attractive to the extent that it is not accompanied by a low productivity. Wheeler and Mody (1992) measure labour costs by the average of hourly wage rate in manufacturing. Noorbakhsh et al. (2001) employs two indicators of the cost of labour. The first alternative is the relative wage cost measurement. The second indicator is a proxy that represents the cost of labour in each country, which measured by two proxies: the efficiency wage and the product wage. The present study use average earnings per workers in the manufacturing sector as a proxy for labour costs.
Nowadays there is increasing role of human capital as an underlying factor of inward FDI linked to the type of FDI. In resource-seeking FDI, human capital is less important while in efficiency-seeking FDI - which cope with capital-technology intensive activities – the role of human capital becomes more important. In general, MNCs’ decision to invest abroad based on the availability of certain level of human capital in the recipient countries, which is usually assessed through educational levels. A higher value of human capital leads to a higher inflow of FDI. There are different approaches to measure human capital. Noorbakhsh et al. (2001) employs three different approaches to measure human capital. Firstly, Noorbakhsh uses school enrolment ratio, which indicates flow of investment in human capital. Secondly, he uses the accumulated years of secondary education in the working age population. Thirdly, to obtain the representation of higher technical and managerial ability, Noorbakhsh uses the accumulated years of tertiary education in the working age population. The last two approaches can be rationalized as a reflection of a stock of human capital. Miyamoto (2003) defines human capital as the adult literacy rate. He argues that the literacy rate has some benefits, for example literacy rate is available in most countries and it is relatively easy to compare literacy rate between countries and regions. UNESCO (2002) describe that adult literacy in developing countries has improved over the past two decades. That is, the literate working age population increased from 70 % (of the total working population) in 1980 to 80 % in 2000. In the present study, human capital is measured by the adult illiteracy rate.
Openness is related to trade policy. According to Harrison (1995) openness is linked to neutrality, which states that the incentive to import substitution activities (saving a unit of foreign exchange) is equal to the incentive of export activities (obtaining a unit of foreign
exchange). High levels of export promoting activities or high levels of import substitution (inward oriented) do not fit with the neutrality concept. In the existing literatures, there are several measurements of openness. Haufbaeur et al. (1994) and also Noorbakhsh et al. (2001) measure openness by the ratio of total trade to GDP, while Moosa and Cardak. (2006) state that exports as a percentage of GDP could be a proxy for openness. A straightforward measurement of openness is export plus import as a share of GDP. Results from this measurement are expected to produce a positive relationship between openness and FDI.
There are many proxies for political instability. Barro and Sala-i-Martin (1995) use average numbers of revolutions per year and the number of political assassinations per million inhabitants as a proxy of political instability. Political variables employed in this study are government stability and level of corruption. The data of these variables are in index form. Political instability affects profitability of investments through rising uncertainty in the future and tends to lower the incentive of investments. Consequently political instability will lower inflow of FDI.
Host countries’ government stability also plays an important role as one of underlying factor on FDI inflows. The term of government stability relates to the consistency of officials to run government. Government instability may result from many sources, for example severe economic recession may lead to government instability in Indonesia. After the economic recession in 1997, there were mass of protests which demand Indonesia’s president to resign. Political unrest as a result of controversial policies generally tends to create government instability. Political scandals also lead to government instability. These kinds of government instability affect host countries’ economic conditions. Government instability will deter host countries’ investment climate.
Corruption distorts economies. Regarding to investments, it is argued that corruption increases costs of investments. Corruption can be in the form of bribery or special payments. A lucid example of corruption is special payments to government officials to obtain “special treatment” for business continuity. In special cases, there is a particular party that tries to get advantages from corruption. For example, foreign investors might bribe officials or local governments to obtain special treatments that allow foreign investors to have monopolistic power over their competitors. These special cases are contrast with the general thought of corruption, which is corruption creates disadvantages to economies. Investors will demand a lower
