Foreign Direct Investment and Environmental Regulation: A New Theoretical Framework

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Foreign Direct Investment and Environmental Regulation:

A New Theoretical Framework

MSc. International Business and Management

Faculty of Economics and Business

The University of Groningen

Student number: S2068567

Student: Jiajing Ou

Supervisors: Rajiv K. Kozhikode

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Abstract:

Environmental regulation is theoretically expected to exert an influence on inbound foreign direct investment (FDI). Surprisingly, less empirical studies attempting to proof this argument have met with only limited success. This thesis presents a new theoretical framework to settle down the research puzzle that arose in previous researches. I suggest that the relationship between environmental regulation and inbound FDI is varying under different conditions. The new framework interprets these various relationships by incorporating two factors: economic development stages and spatial effects. By discussing the characteristics of host-countries at different development stages, the effects from neighborhood regulation levels and the interaction between these two factors, propositions are drawn out, and limitation and implication of this new framework are discussed.

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Introduction

Environmental issue has been raised up in recent years, individual, organizations and governments are all called up to participate into the actions that dealing with the world‟s environment problem. Consequently, there is an uptrend of the stringency of environmental regulations both nationally and internationally. These changes reflect the public‟s increasing concern about environmental problems. Governments and companies take more care about this issue since environmental regulation has an essential influence on a nation‟s or a company‟s development.

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A number of researchers have attempted to settle down the puzzle of relationship between environmental regulation and FDI. Empirical results from detailed surveys of research studies conclude that, compared with other common perception (e.g. labor costs, market size), environmental regulations have little impact on investment decision (Brunnerrmeier & Levinson, 2004). The explanation is that compliance costs1 are too small to have a significant effect on industry location decisions. Some studies, which apply diversified approaches to test the pollution haven hypothesis, assert that empirical evidence of this phenomenon does not exist (Esty & Geradin, 1998). However, there are still some studies found evidence on the influence of regulation stringency. By using the panel data approach, Akbostanei, Tunc and Turut-Asik (2007) in their study found that pollution haven hypothesis exists in Turkey. Keller and Levinson (2002) also find robust evidence that environmental regulation stringency(proxy by pollution abatement cost) have had moderate deterrent effects on foreign investment.

All in all, these studies used various approaches, period, measurement and data, making the results difficult to be compared and analysed. They can hardly address this question explicitly and the explaination for the blurring correlation between environmental regulaiton and FDI is insufficient. My research paper is going to settle down this problem and find out how FDI inflows are associated with environmental regulations.

The relative importance of FDI determinants changes over time. UNCTAD (1996: 97) argued that, as a consequence of globalization, "one of the most important traditional FDI determinants, the size of national markets, has decreased in importance. At the same time, cost differences between locations, the quality of infrastructure, the ease of doing business and the availability of skills have become more important." Following UNCTAD's line of reasoning, I suggest that the effect of environmental regulation changes over time as well. For instance, less developed county may have lower

1_{Compliance cost: the time and money that firms have to spend in response to regulations (e.g., Clean Air Act}

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environmental regulation as a way to attract FDI. Meanwhile, from an investor‟s view, such policy advantage is more attractive than its market size. When this country becomes more developed, its market potential may turn into the most attractive determinant to FDI and the effect of environmental regulation is diminished. What‟s more, world‟s industry structure changes as well, UNCTAD (1998: 113) notes that the boom of FDI in developing countries is largely due to a stronger engagement of multinational enterprises (MNEs) in the services sectors of developing countries. The services sectors are less affected by environmental regulation than the manufactory sectors which have played an important role in earlier periods.

However, previous literature failed to discover the dynamic nature of determinants that shaping the distribution of FDI. Therefore, I am going to build up a theoretical framework, showing the dynamic impact of environmental regulation over a long time. And the contribution of this study will be significant because policymakers could no longer rely on the previous empirical literature stressing the overriding role of some clearly defined factors shaping the distribution of FDI, if the statement that relative significance of determinants of FDI changes over time is proved to be true. Important policy implications will be made if we can understand the dynamic nature of determinants of FDI.

Research question:

How does environmental regulation affect FDI inflows?

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Foreign Direct Investment and Economic Growth

The relationship between foreign direct investment (FDI) and growth has been a hot debate amongst academics, politicians and business leaders for a long time. FDI is generally considered to be essential for economic growth. FDI-based development strategies are then commonly used among countries, especially developing countries that have been sparing no efforts to induce FDI (Narula & Dunning, 2000). The economic rationale for offering special incentives to attract FDI arises from the belief that foreign direct investment can produce externalities, which include productivity gains, technology transfers, the introduction of new processes, managerial skills, and know-how in the domestic market, employee training, international production networks, and access to markets (Cave, 1996). This view has been theoretically bolstered by recent developments in growth theory, which strengthened the importance of improving technology, efficiency, and productivity so as to stimulating economic growth (Lim, 2001). Although not the only ways available, spillovers from FDI are conceived as one of the most efficient and practical ways through which industrial development and upgrading can be achieved (Narula & Dunning, 2000). Romer (1993) argued that there is an important “idea gaps” between rich and poor countries, and foreign investment can fill this gap by transferring technological knowledge and business know-how from advance countries to poorer countries. FDI may boost the productivity of all firms in the host-country, thus, have substantial spillover effects for the entire economy. Empirical literature and statistical reports (OECD, 2002) also suggested that FDI does bring some benefits for host-countries, such as access to improved management techniques, technology transfers and integrated to global market.

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know-how, management skill, etc.). In a typical model of technology diffusion, the rate of economic growth of a less developed country depends on the extent of adoption and implementation of new technologies that are already in use in advanced countries (Borensztein, Gregorio, & Lee, 1998). Findlay (1978) suggested that foreign direct investment increases the host-country‟s rate of technical progress through a „contagion‟ effect from the more advanced technology, management practices, etc. that are used by foreign firms (investors). Wang (1990) further incorporated this idea into a model, which was more in line with the neoclassical growth framework. This new model assumed that one of the functions of FDI is reflected by the increase in „knowledge‟ applied to production.

Technological spillover can occur through a variety of channels that involve the transmission of ideas (e.g., innovation, know-how, etc.) and new technologies (e.g., production process, physical distribution, etc.). One of the most significant aspects of spillover efficient benefits is those associated with and through human capital development (Narula & Marin, 2003). On the one hand, spillovers can take place directly by increasing the generation of employment in the host county, because the more multinational companies set up subsidiaries in host-country, the more job opportunities they offer. Therefore, inward FDI have potential positive spillovers for its host-country to increase the employment level quantitatively. One the other hand, MNEs can improve the quality of the domestic workforce by providing various training programs, as well as transferring their superior technological knowledge to the domestic employees through the process of learning-by-doing.

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MNEs.

Besides taking place through labor turnovers, the spillover effects of foreign direct investment can occur through the imports of high-technology knowledge and exploitations of new technology by MNEs. MNEs are considered as the most technologically advanced ﬁrms, accounting for a substantial part of the world‟s research and development (R&D) investment. Conventionally, the main function of overseas R&D activities (or technological investment) is conceived to be adaptation and demand-oriented, that is, to adapt the technologies generated within the home-country and integrated with local input conditions, regulations, or to investigate the tastes of the host-countries and supports the local production and sales activities. In other words, there are, presumably, aiming to seek a scope for further innovation through the exploitation of home-countries‟ technological knowledge bases and transmission of advance technological knowledge to improve affiliates‟ production and sales (Kuemmerle, 1997). However, more and more MNEs‟ overseas R&D investments are aimed at exploiting local technological pool and enhancing their general technological capabilities. Iwasa & Odagiri (2004) studied the contribution of R&D at home and abroad, using a sample of 137 Japanese multinationals. They emphasized that overseas R&D investments play an important role in sourcing the best and newest scientiﬁc and technological knowledge at the global level. Their findings supported the suggestion that MNEs‟ R&D investments not only as a mean of transferring advance technological knowledge, but also exploiting host-country potential technological seeds and stimulating technological knowledge development.

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inward FDI on economic development, the empirical studies resulted in different conclusions as well.

Generally speaking, studies on this issue confirmed the view that FDI can foster economic growth of the host-country, provided that the host-country is able to take advantage of the spillovers of the inflows of FDI through existence of minimum social capacity (Borensztein, Gregorio, & Lee, 1998). Dees (1998) found that FDI has been essential in explaining the booming economic growth in China. Bengoa and Sanchez-Robles (2003), by using panel data analysis for a sample of 18 Latin American countries for 1970–1999, found that economic freedom in the host-country is a positive determinant of FDI inflows, moreover, foreign direct investment is positively correlated with economic growth in the host-countries. Borensztein, Gregorio, and Lee (1998) suggested that the differences in the technological absorptive ability may explain the variation in growth effects of FDI across countries. Their study showed that FDI is an important vehicle for the transfer of technology, contributing relatively more to growth than domestic investment. By using cross-country data empirical analysis, Alfaro, Chanda, Kalemli-Ozcan and Sayek (2004) showed that FDI alone plays an ambiguous role in contributing to economic growth. However, countries with well-developed financial market development gain significantly from inwards FDI.

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inward FDI. Similarly, Xu(2000), investigating US multinational companies as a channel of international technology diffusion in 40 countries from 1966 to 1994, found that technology transfer provided by US multinationals contributed to the productivity growth in developed but not in developing countries. One of the most common explanations on these finding is that most less developed countries cannot meet the threshold requirement (e.g. human capital, absorptive ability, institution development, etc.), therefore, they may failed to gain benefits from inward FDI. Besides the threshold prediction, Kholdy (1995) carried out Granger causality tests, by using data from 10 East Asian economies, and found the causation between FDI and productivity did not exist. He suggested that FDI may generate only limited efficiency spillovers and may be a less important vehicle for technology transfer than was previously thought.

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Foreign Direct Investment and Environmental Regulation

As discussed in the last section, from the host-country‟s perspective, the benefits of FDI are not only restricted to exploit and make fully use of its resources, but also stem from the introduction of new processes to the domestic market, learning-by observing, networks, training of the labor force, and other spillovers and externalities (Alfaro, Chanda, Kalemli-Ozcan,& Sayek, 2004). Due to the „growth-development‟ benefits FDI seems to convey, different countries, especially developing countries, have made effort to attract FDI. Most countries, including both developed and emerging nations, have established investment agencies, and have policies that include both fiscal and financial incentives to attract FDI as well as others that seek to improve the local regulatory environment and diminish the cost of doing business.

Therefore, a policy-based competition for investment took place across countries around the world. One of the most important tools to ensure competitive conducted by host county in the policy race is environmental regulation. The underlying hypothesis is that environmental regulations have a significant effect on investment location and that differential regulations between two countries will induce substantial capital movements to the country with the weaker regulations. It is obviously that a firm has interest to locate its production facilities in a country with lower production costs if the firm has the choice of location (all other things being equal), and laxity of environmental regulation is conceived to reduce production cost of firms. Although anecdotal evidence that MNEs may locate to countries with a lax environmental regime, there is a scarcity of empirical evidence qualifying that environmental regulation plays a significant role in decisions whether to locate investment.

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Pollution haven

Pollution haven approach suggests that MNEs, especially those from pollution-intensive industries, prefer to extend production to countries with lax environmental regulations, where they may have lower production cost. This theory presumes that production cost differentials are a sufficient inducement for a firm to establish green-field affiliates or relocate its production facilities. Firms will relocate investments in places where they can exploit the comparative advantages for the maximum gain. Therefore, they will take into considerations not only pre-entry conditions, such as existing regulations and legislation, licensing requirement and other conditions, but also post-entry conditions, such as levels of enforcement of legislation or subsequent regulations which associate with the investors‟ interests (Gray, 2002).

Several authors, who believe the phenomena of pollution haven, concluded that a country with lax environmental regulations will tend to specialize in pollution intensive industries or at least enjoy a comparative advantage in such industries, meanwhile, such countries turn into “pollution haven” (Xing & Kolstad, 2002). This suggests that pollution intensive industries would move their production facilities in “pollution haven”, thus gain more competitive advantage. MNEs, which have already subsidiaries in such areas, would tend to increasingly expand their operation or reorganize their overseas operation, relocating production facilities to such areas from countries with higher environmental regulations. This view is widely held in the public, one case in point is that the strong disapproval to NAFTA (NORTH AMERICAN FREE TRADE AGREEMENT) from labor unions and environmental groups, who claimed that NAFTA will decrease the employment of U.S. and remain less competitiveness (Grossman & Krueger, 1991).

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cost. In lax environmental regulation country, employees would have to be paid more to live and work under a polluted condition, vice versa. Thus in equilibrium, the total costs remain the same.

While it is universally believed that lax environmental regulation will have an advantage to attract more FDI, empirical evidences on this issue are controversial and mixed. Xing and Kolstad (2002) presented a statistical test of the impact of environmental regulations on the capital movement of pollution industries. Their finding confirmed the theoretical prediction of pollution haven and showed that the laxity of environmental regulations in a host-country is a significant determinant of FDI from the US for heavily polluting industries and is insignificant for less pollution industries. The paper wrote by Mulatu, Gerlagh, Rigby, and Wossink (2010) estimated the effect of environmental regulation on industry location and compared it with other determinants of location such as agricultural, education and R&D country characteristics. The empirical results indicated that the pollution haven effects were present and the relative strength of such effects was of about the same magnitude as other determinants of industry location. However, the significant negative effects on industry location were observed only at relatively high pollution intensive industries. Similarly, Keller and Levinson (2002)‟s work, by comparing regression results for dirty and clean industries, also obtained some evidence of the pollution haven effects.

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regulation did not have an adverse impact on FDI inﬂows. In other studies by Friedman, Gerlowski, and Silberman (1992), Eskeland and Ann (1997), and Wheeler (2000) also concluded that their results did not support the theoretical prediction that environmental regulations can affect FDI flows.

Race to the bottom and race to the top

The race to the bottom approach is a subset of the pollution haven phenomena. A government considers that laxity of environmental regulation will improve its competitiveness for FDI. Therefore, a country with high environmental regulation, compared with other countries, will deregulate its regulation. However, there is a lack of empirical evidence to support the race to the bottom2.

As a countering theory to the race to the bottom theory, the race to the top theory postulates that stronger environmental regulation can improve competitiveness in the marketplace by fostering innovation and efficiency, thus attracting more investors. Therefore, governments compete to improve the environmental regulation. However, one weakness of this theory is that it occurs mainly in high technology and energy-intensive sectors (Gray, 2002). Some case studies provided evidence of this theory. In any case, the host government is selective in inducing the types of investment, refusing or restricting the relocation of polluting intensive industries. China is a case in point, where the government‟s schedule for foreign investment prefers industries that include coal-fired power plants adopting clean combustion technology (OECD, Environmental Issues in Policy-based Competition for Investment:A Literature Review, 2001).

Regulatory chill

Regulatory chill approach can be understood that countries refrain from enacting stricter environmental standard in response to fears of losing a competitive edge against other countries in attracting FDI (Gray, 2002). This theory also presumed that

2_{These empirical studies are well analyzed in a study conducted by the Organization for Economic Cooperation}

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the pollution haven phenomena are existed and seriously concerned by various governments, especially those governments from developing countries. As a result, environmental regulation can get “stuck in the mud”, since governments will be unwilling to enforce stringent regulation, concerning for losing employment and tax revenue. These phenomena have been more commonly observed in developing countries. For instance, Moroccan and Tunisian governments have shown reluctance to enforce the stringency of regulation of the phosphate industry in response to the possibility that these companies may flee to countries with lower environmentally regulatory scope (Vogel, 1995). However, the incentives that force policymakers to modify regulations are not only derived from aiming to attract FDI but also other reasons that render governments keep the regulations unchanged.

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speciﬁcation, data issues, definition of the regulatory variable, and the control variables included all have a considerable inﬂuence on the empirical results.

Moreover, these empirical findings have done little to change the public concern. A opinion survey found 67% if respondents felt that the high environmental standards threatens US employment and induce US companies to relocate abroad, where enjoy a lower environmental standard (Brunnerrmeier & Levinson, 2004). Therefore, numerous researchers are motivated to re-examine this issue, aiming at addressing the above mentioned shortcomings by improving methodology, measurement, data, etc. however, with these improvements, the results of these studies failed to find pronounced conclusion either, the overall evidence is relatively weak and does not survive numerous robustness check (e.g., the study conducted by Smarzynska & Wei, (2001),(Xing & Kolstad, (2002)).

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FDI and Environmental Regulation: A New Framework

Anecdotal theoretical evidence suggested that stringent environmental regulation deterred FDI inflow. The argument is that a firm prefers to locate its production facilities in a country with lower production costs if the firm has many various location choices, all other things being equal (Xing & Kolstad, 2002). MNEs can take advantages by establishing production facilities in areas with lax environmental regulation and the biggest benefit is supposed to enjoy low business costs for environmental compliance. However, empirical evidence on this argument is ambiguous. Empirical evidences on whether environmental regulation can affect investment decisions are limited. In this paper, I develop a new theoretical framework to settle down this research puzzle.

As discussed in the section two, many researchers, who agree with the argument that “pollution haven” hypothesis is valid, tried to find the reason why empirical evidence cannot be discovered. Most of them attributed the problem to the methodology used in the previous works. However, even after improving and/or changing the methodology, the puzzle is still unsolved. While previous literature focused on revising the methodology or using new measurement, this paper argues that the root of the problem, which leads to the research puzzle, is not mainly lying in the methodology but in the characteristics of host-countries. There are more than two hundreds countries and regions in the world, and each of them is at different stage of development. The determinants of FDI flows are dissimilar across countries3, because each investment has its own interests. As countries develop into different stages, the motives, modes and extent of MNE involvement vary considerably (Dunning & Narula, 1994). What‟s more, a country‟s investment condition will interact with neighbor countries‟ investment conditions as well. Therefore, we suggest that the

3

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extent of impacts of environmental regulation on inbound FDI depends on the factors of stage and spatial, which are neglected in previous literatures.

In this reasoning, we develop a new theoretical framework, which is presented in Figure 1, the significance of relationship between environmental regulation and FDI inflow is moderated by two factors: neighbors‟ environmental regulation stringency, which is considered as spatial effects, and level of economic development. We hypothesize that the important role play by environmental regulation stringency in attracting FDI inflows varies in the process of economic development. At the less developed and the developed stages, environmental regulation can significantly affect FDI inflows, while in the middle stage of development environmental regulation has less effect on FDI inflow (See Figure 2). The two moderators will be fully discussed in the following paragraphs.

Figure 1: the new framework

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FDI

High Developed stage

Developing stage

Less developed stage

Low

Low Environmental regulation High

Development stages and determinants of FDI inflows

Given that countries face more distinct heterogeneity in endowments, geography, markets, institutions, and policies than regions, we expect that the potential for environmental regulation interaction, internationally, is more pronounced. Moreover, the implication of this paper is supposed to produce useful guidelines for policymakers in different countries. Therefore, in this part we will discuss the moderate effect of economic development under the background of a country‟s evolutionary process rather than a region or state‟s evolutionary path.

Before starting to discuss the moderate effect of economic development, we need to define the concept of economic development. It is very common to mistake economic growth as economic development. While economic growth simply refers to quantitative growth in per capita GDP, economic development not only takes

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quantitative growth into account, but also emphasizes qualitative improvement. Qualitative improvement may include the improving infrastructure, rising share of industry, increasing percentage of urbanization and increased self-esteem (Dong-Sung & Moon, 1998).

In general, the process of economic development is regard as an optimal sequencing of development, which started from the initial stage that usually be labeled by notions such as labor-intensive, low-skill manufacturing or natural resource based, and moved on to the subsequent stage of relatively physical capital-intensive industrial activities and finally to the more advanced stage of human capital-intensive growth (Ozawa, 1992). According to this economic development stage approach, each country can be considered as being on a continuum within one of these developing stages, and as it moves forward, its characteristics are changed, and it faces new series of competitive tasks (e.g., compete for FDI) in the world economy and leaves less skilled activities to countries at the lower stage of economic development (Nam, 2002). In order to find out how evironmental regulation stringency affect FDI inflow unfer the moderate effect of economic development, we need to distinguish different stages of economic development firstly.

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education index)- to classify different stages of economic development, which has the advantage of operationlization. Their model desctibe four development stage: less developed, developing, semi-developed, and developed (See Figure 3).

Figure 3

Source from: Dong-Sung & Moon(1998)

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traditional models were limited. Instead, we need to focus on all the factors and figure out which factor is more important in which stage of development.

However, rather than classifying development stages into four groups as Dong-Sung and Moon did, we categorize them into three stages: less developed stage, developing stage and developed stage. The reasons for this kind of categorization will be elaborated in the following paragraphs. At the same time, we will discuss the characteristics of host-country and determinants of FDI inflows under the setting of different economic development stages, and produce our propositions about how environmental regulation can affect FDI inflows at different situations.

Less developed stage

In the environmental regulation and FDI literature, researchers consistent on the argument that the stringency of environmental regulation has influence on production cost, thus affect firm‟s investment decision. Countries in less developed stage are characterized by both low quantity and low quality of development (Dong-Sung & Moon, 1998). In countries with low levels of development, economic growth is determined mainly by the mobilization of primary factors of production: land, primary commodities, and unskilled labor (Porter, Sachs, & Mcarthur, 2008). These countries may have abundance natural resources and/or low-skill workers but their incomes are low, production capabilities are quite limited, and the natural and/or labor resources are not efficiently exploited and used. Moreover, because of the underdeveloped economy, the domestic firms are mainly small companies and generate less economic activities, governments receive less revenue, thus, are lack of capital to improve infrastructure, stimulate their markets and move their economy into upper stages.

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countries are defective and rarely substantial enough to provide adequate financing for the corporate sector. Therefore, inbound FDI are more crucial for countries categorized in this stage. In other words, FDI will be the key for them to start the engines of growth. As mentioned in the section two, FDI help economic growth in several ways, for instance, FDI can exploit natural resources in these underdeveloped countries and improve labor skills. By integrating the capital and technology of multinational firms into the natural resources and labors, these less developed countries can take the first step to move forward.

As we know that the only advantages that less developed counties have are natural resource and/or low-cost labors, FDI inflows, which aim to take these advantages, must be invested by MNEs from labor-intensive, low-skill manufacturing or natural resource industries. Since these industries (e.g., iron and steel, leather tanning and fertilizers) are relatively pollution intensive, costs from compliance to environmental regulation takes a considerable component of production costs. For this reason MNEs from such industries will pay more attention to the cost on pollution compliance (i.e., the enforcement and stringency of environmental regulation). From this perspective, the stringency of environmental regulation seems to be an important determinant of FDI inflows, when other conditions (e.g. natural resource and low labor cost) are similar among countries in the less developed stage. If all of these countries are eager for FDI to develop their economies through implementing lax environmental regulation, the “race to the bottom” phenomenon may occur.

Proposition 1: environmental regulation has a negative effect on FDI inflows in less developed country.

Developing stage

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model, they are regarded as the poorest country and have not started developing yet, while countries in the developing stage, as their name imply, are dynamic, industrializing, and moving forward in terms of both quantity and quality of development rather than stagnated (Dong-Sung & Moon, 1998). According to Dong-Sung and Moon‟s way to classify development stages, they divide the developing status that between the polar stages into two specific groups: developing stage and semi-developed stage. Nevertheless, the differences between these two stages are barely visible, so that in this paper we regard them as the same group-the developing stage.

Compared with countries at less developed stage, investment conditions are much better in this stage. They have improved basic infrastructure (e.g. roads, transportation, and financial market) and trained workers etc. However, low production cost is still the main determinant of location decision of foreign firms which are labor-intensive. In order to ensure continuous growth, just developing initial industries (e.g. natural resource- and labor-intensive industry) is not enough. The government must make a significant effort to upgrade industry through learning and transferring technology from multinational firms, and FDI. Various means, such as joint ventures and outsourcing arrangements, can help these countries to integrate the national economy into international production system, and to enhance economic growth by harnessing global technologies to local production.

In this reasoning, the industrial emphases will be changed by policymakers from natural resource- and labor-intensive to high-tech industries. Various macroeconomic policies, aiming at attracting more FDI that has the function of promoting technology transfer, will be implemented at this stage of economy. MNEs who are the subjects of such policies prefer to relocate facilities in these counties, taking the advantages of these specific policies. Corresponding to the effects of other policies, the effects from lax environmental regulation decreased.

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booming up and thus attract more MNEs engaged in these sectors. The services sectors are less affected by environmental regulation than the primary sectors, which have played an important role in earlier periods.

Proposition 2: environmental regulation insignificantly affects FDI inflows in a developing country, other macroeconomic policies are more related to FDI inflows than environmental regulation.

Developed stage

Countries from this stage have high achievements in terms of both quantity and quality of development. Economic growth is associated with a shift from primary and manufacturing sectors to service sectors, leading to a decrease of the pollution intensity. Moreover, the higher incomes in the developed countries generate a greater demand for clean air and water (Diertzenbacher & Mukhopadhyay, 2007).

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Instead of driven by market-seeking or resource-seeking, multinational companies prefer to invest in developed countries for the reasons of market-and efficiency-seeking as well as knowledge exploiting. Therefore, developed countries can attract FDI by using their advantages of good environment qualities and high environmental standards.

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Spatial spillover effects and FDI inflows

While affected by endogenous factors such as the development stage, the relationship between regulation and FDI inflows is also influenced by other exogenous factors. As far as I know, little effort has been made in the previous literature to incorporate spatial effects into the analysis of determinants of inbound FDI. Moreover, in general, the influences of neighborhood‟s policy strategic behavior are more considerable than those of a country from the other side of earth.

What‟s more, if neighborhood environmental regulation does matter FDI flows, the ignorance of such effects will lead to inefficient production of standard econometric techniques, and biased estimates (Anselin & Griffith, 1988). This is probably one of the reasons why previous studies failed to find robust evidences on the issue of environmental regulation and FDI. On these grounds we incorporate the spatial effects in our new framework.

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countries. Firms such as chemical companies and paper factories, which aimed at searching for low costs on complying with environmental regulation, will tend to move to neighbor countries that imply lower environmental standard, vice versa. However, firms from new industries that produce pollution control and monitoring equipment may, on contrary, relocate facilities to neighbor countries that implement higher environmental regulations.

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The interaction of stage and spatial factors on FDI inflows

In the beginning of last section, we have argued that the significant relationship between environmental regulation and FDI inflows is supposed to be found in countries in less developed or developed stages only. Although there has been a growth in the global FDI flows, especially, into developing countries, the importance of environmental regulation is moderated by other factors such as market size and high GDP. As we have discussed the two moderators-stages and spatial-separately in the former sections, the following paragraphs will discuss the interaction between these two factors.

To start with, we suggest that a host-country is in the less developed stage. As we discussed before, the economic structure in such country is primary sector which is more sensitive to the change of environmental regulations than service sector. The inbound FDI to these countries is motivated by exploiting asset and economic rent, because the human resources, technological capabilities and organizational skills that these countries (or their firms) possess are, in general, relatively low-technology and/or natural resource-intensive sectors. These characteristics have become “generic” in a long time. Tools are limited, which are available to be used by these countries to attract worldwide investment, particularly that which provides opportunities for indigenous spillovers of technology and organizational capability (Narula & Dunning, 2000). Moreover, unlike developing and developed countries, countries in less developed stage have no or less service industry and new industry that are less sensitive to environmental regulation stringency and some firms are even prefer high environmental standards.

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regulation stringency neighbors are even worse. From the perspective of foreign investors that invest in one region at first time, they will obviously choose the country with laxer environmental regulation to do business, other things being equal. Additionally, a worse situation is that FDI which have relocated in the host-country in early time will move their facilities into neighbors. Therefore, it may not only loss first come mobile foreign investment when compete with neighborhoods, but also face the circumstance that some firms move away from this country and relocate into neighbors.

Proposition 4: a less developed country has disadvantages (advantages) over the neighbor countries with lower (higher) environmental regulations for attracting FDI inflows.

Secondly, we want to find out how changes of neighborhoods‟ environmental regulation stringency affect a host-country that in the developed stage. As we know, developed countries possess competitive advantages in skill-intensive and created-assets (Narula & Dunning, 2000). FDI in developed countries are primarily market- and efficiency-seeking rather than resource-seeking. Service sector forms the essential part of economic structure, with less primary and manufacturing sector in developed country. Moreover, with high income and high education level, people concern more about their living standard and the environment. Therefore the increased environmental awareness amongst consumers results in higher demand for green or eco-labeling products. Moreover, countries with high income are expected to take more responsibility to protect environment, and one of the measurements to realize their responsibility is carrying out high standard environmental rules.

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benefit from relatively lower stringency of environmental regulation, because other costs such as wages and material price are much higher than neighbors in developing or less developed stages. Therefore, the host-country will not only lack competitiveness for attracting resource-seeking FDI but also loss advantages to attract efficiency- and market-seeking FDI. Firms from new industries, which may emerge producing such as pollution control and monitoring equipment and eco-labeling products, will prefer to invest in developed countries with relatively high environmental regulations, other things being equal. What‟s worse, firms that have advantages in settings of strict environment will tend to move away from the previous host-country and relocate into neighbor countries which carry out higher environmental standards.

Proposition 5: a developed country has advantages (disadvantages) over the neighbor countries with lower (higher) environmental regulations for attracting FDI inflows.

Table 1

Less developed country Developed country

Neighbor countries with lower ER

disadvantage Advantage

Neighbor countries with higher ER

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Conclusion

Much research in the issue of FDI suggested that it can boost economic growth. FDI-based development strategies are now commonly applied by most countries. Even though the global FDI flows increased substantially since last decades, the competition among countries for such investment was also aggravated. Policy instrument such as environmental regulation has been regarded as an important tool to induce FDI, especially those provide opportunities for indigenous spillovers of technology.

In general, it is believed that stringent environmental regulation will impede FDI inflows, while lax environmental regulation will exert advantage over attracting FDI inflows. This argument is further developed into a famous hypothesis-the pollution haven hypothesis. However, this hypothesis is yet lacking of significant statistical empirical evidence. While previous researches investigate the pollution haven hypothesis with a variety of approaches, focusing on different samples, methodologies, the main empirical result appears to be largely unchallenged.

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regulations for attracting FDI inflows.

Contrary to the common perception that lax environmental regulation can improve competitiveness for FDI, our new framework suggested that stringency of environmental regulation plays different ways in countries with diverse developing stages. Implications which stem from the new framework are considerable for policymakers. Before passively resorting to attracting inbound FDI by deregulation environmental standard, government should have realized its country‟s level of development and taken neighbor countries‟ environmental standard stringency into account. Even though the tool of environmental regulation is less useful in developing countries than the rest of two, it can be applied to attract more right kind of FDI, that is to say attracting inward FDI which is from market-seeking, efficiency-seeking and other asset-exploiting activities, rather than from resource-seeking activities.

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