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Discuss the reasons for Foreign Direct Investment. Are any of the reasons more prominent?

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In the recent years, Foreign Direct Investment (FDI) policies have become one of the central economic policies for the developing countries. Foreign direct investment is defined as a company from one country making a physical investment or an acquisition of a foreign firm that has a lasting management interest in a company outside the investing firm’s home country.

An extensive definition of FDI is provided by the OECD. According to this definition, founding an enterprises and setting-up a product plant in a foreign country is called a foreign direct investment. Empirical studies on the impact of FDI on economic growth have shown positive impact in the host countries. This essay will evaluate the various reasons for Foreign Direct Investment, the explanation for a steady growth in FDI over the past ten years and the positive effects FDI can have in the host countries while using empirical evidence for arguments on the negative effects.


In the nineteenth century, foreign investment was prominent, but it mainly took the form of lending by Britain to finance economic development in others countries as well as the ownership of financial assets. However, articles by Godley (1999) analyses some cases of FDI in British manufacturing industry prior to 1980 which shows that from 1980 the bulks of FDI was primarily from the industrial good sector. Godley also shows that investors in Britain prior to 1890 were primarily in the consumer goods sector, and that they mostly failed because they were focused and driven entirely by concern about enhancing access to the British market. In the years after the Second World War global FDI was dominated by the United States, as much of the world recovered from the destruction brought by the conflict. The US accounted for around three-quarters of new FDI (including reinvested profits) between 1945 and 1960. Since that time FDI has spread to become a truly global phenomenon. FDI has grown in importance in the global economy with FDI stocks now constituting over 20 percent of global GDP. The last two decades of the 20th century witnessed a dramatic world-wide increase in foreign direct investment (FDI), accompanied by a marked change in the attitude of most developing countries towards inward FDI.


The above is highlighting the distribution of FDI flows in the developing countries from the years 1991 to 1996. From the data we can see that the highest distribution of FDI flows was in East Asia and pacific, and Latin America followed thereafter. Furthermore the figure below illustrates the level the FDI has increased from 1980 to 2002.



The above table illustrates the 5 countries that were highly active in FDI, as you can see from the results, the country that heavily invested in foreign investment is United States, and right behind was United kingdom.


Reasons for FDI

Most theoretical and empirical models of MNEs’ behaviour or FDI implicitly or explicitly draw upon the so-called OLI approach pioneered by Dunning (1977, 1981), which relates cross-border investment to three main motives – ownership, location and internalisation.



Investments which seek to acquire factors of production that is more efficient than those obtainable in the home country of the investing firm. In some cases, these resources may not be available in the realm of their own economy (e.g. cheap labour and natural resources). In developing countries the issues that typifies FDI is to seek economies of scale, for example seeking natural resources in the Middle East and Africa and cheap labour in the areas of Southeast Asia and Eastern European countries. Investments that seek such endowments are referred to as resource seeking FDI (Dunning, 1996).


Market seeking FDI is motivated by the intention to supply a market that until then had been supplied with exports with locally produced goods. It is not the differences in factor prices that lead to this move, but rather the appraisal of proximity to the foreign market versus the advantages of concentration of the production process at one location. Whenever the advantages of proximity outweigh those of concentration, FDI will appear to be a rational choice (Markusen/Venables 1998). FDI of this kind may also be employed as defensive strategy; it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one.



One of the most important determinants for resource seeking FDI is the availability and wage rate of unskilled labour work. Labour cost has always been argued to be a major component of total production cost and of the productivity of firms. Frequently, to attract such production, host countries have set up free trade or export processing zones (Dunning, 1993).  For example, Low cost labour was the main motivation which attraction of FDI in china in the mid 90s (Graham and Wada, 2001).

Size economies of scale

A significant presence of MNEs can bring about fundamental changes in industrial structure, particularly for smaller and medium sized countries. If foreign MNEs operate in sectors that are imperfectly correlated with those dominated by indigenous firms, FDI can help create a better diversified economy. Lall, 1990 as quoted by Dunning (1996) the experiences of four newly industrializing countries shows that economic success can be highly relied on TNCs (as in Singapore)or less reliance( as in South Korea).

Human Capital

Foreign direct investors are also concerned with the quality of the labour force in addition to its cost. In fact the cost advantages accrued by lower wages in developing nations can well be mitigated by lowly skilled workers. A more educated labour force can learn and adopt new technology faster and is generally more productive. Higher level of human capital is a good indicator of the availability of skilled workers, which can significantly boost the location advantage of a country.

Root and Ahmed (1979), Schneider and Frey (1985), Borensztein et al, (1998), Noorbakhsh et al. (2001) and  Aseidu (2002) found that the level of human capital is a significant determinant of the location advantage of a host country and plays a key role in attracting FDI. We control and test for the impact of labour quality, using the general secondary education enrolment rate (SER) available from the country’s Central Statistical Office, Labour division.

Size economies of scale

A significant presence of MNEs can bring about fundamental changes in industrial structure, particularly for smaller and medium sized countries. If foreign MNEs operate in sectors that are imperfectly correlated with those dominated by indigenous firms, FDI can help create a better diversified economy. Lall, 1990 as quoted by Dunning (1996) the experiences of four newly industrializing countries shows that economic success can be highly relied on TNCs (as in Singapore)or less reliance( as in South Korea).

Technology transfer

A key feature of the open door policy has been the encouragement of foreign direct investment in the economy. A major advantage claimed for allowing FDI has been that it is an effective way for gaining access to advanced technology, as the partner in the various forms of venture possible has a vested interest in successful outcome. Their result showed that FDI is an important vehicle of technology transfer, contributing more economic growth than domestic investment where they make a case of minimum threshold stock of human capital necessary to absorb foreign technologies and linkage between FDI and human capital and domestic investment are crucial to achieve the economic growth. Chung et al (2003). Technology transfer occurs when there is contact between foreign and local firms. Japanese auto transplants increased production process in North American significantly influenced the industry’s productivity growth during this period (1982-1991).

The Critique of FDI

Host Government Policies

Some of the main reasons why MNEs may chose to provide services as well as first time manufacturing are due to decision attributable to competitive pressure from firms that has already set up establishment abroad hence to increase producing facilities in order to retain their business they need to follow them abroad. However, undoubtedly the single most important reason for market-seeking investment remains the action of host governments encouraging such investment (Dunning, 1993, 59).  

The Hungarian legislation in 1991 established objectives for majority privatisation of industry and majority export and import trade with the West by 1994 (Frydman et al., 1993). Considerable progress has been achieved; the private sector contributions to GDP increased from around 5 percent in 1980 to 40 percent by June 1993 and the trade targets have been fully achieved (PlanEcon, 1993; Vanous, 1992). Hence, Hungary is not only better prepared to attract foreign investment than other Central and Eastern European states; it also has a relatively entrepreneurial atmosphere which Westerners find familiar and conducive to their requirements (Young, 1993). Furthermore, additional incentives for foreign direct investment have been put in place by the Hungarian government. These include favourable foreign investment legislation, financial aid relating to the establishment of infrastructure around plants, a range of tax concessions on initial investments and reinvested profits and freedom to repatriate capital and profits (Buckley and Ghauri, 1994; Gutman, 1992; Hare, 1993; Young, 1989).

Political instability

We also added political instability (POL) following works from Schneider and Frey (1985), Edwards (1990), Loree and Guisinger (1995), Hanson (1996), Jaspersen et al. (2000) and Aseidu (2002). In fact political stability, especially for the case of African states, is a significant factor in the location decision of Multinational Corporations (MNCs). Political instability and the frequent occurrences of disorder ‘create an unfavourable business climate which seriously erodes the risk-averse foreign investors' confidence in the local investment climate and thereby repels FDI away’ (Schneider and Frey 1985). We use a political risk rating as provided by the International Country Risk Guide (1999) as a proxy. The rating awards the highest value to the lowest risk and the lowest value to the highest risk and provides a mean of assessing the political and institutional framework of the countries5 (see ICRG, 1999).



Jha (1999) shows that FDI had have mixed environmental effects in India. Negative environmental impacts from foreign investors were particularly common in 1980s, leading to a heated politics and anti FDI stances among environmental organisations especially after the industrial accident in Bhopal 1984. More recently, she suggests, the environmental performance of FDI has improved but the sustainability of their activities is still debated. She Bhopal (2002) estimated the impact on sulphur dioxide concentration in over 80 his expectations, he found a negative correlation between economic growth and pollution, meaning a larger scale of production was associated with a decrease in air pollution concentration FDI can also be blamed for having negative effects in the host countries.

Greater efforts need to be made to assess the linkages between environmental impacts and FDI, although it may be difficult to isolate FDI impacts from other activities. Authorities and businesses can apply Environmental Management Systems (EMS) to assess the potential impacts of FDI ventures

Research has also focused on how political stability of host countries influences FDI. For example, Bennett and Green (1972) argued that political instability provides a more hostile environment for foreign corporations, hence discouraging their investment. Basi (1963) and Ahargoni (1966) found that executives report political instability as the most important variable influencing their foreign investment decisions, aside from market potential.

While these studies have focused on FDI in Third World countries, Welfens (1993) suggests that in transition economies like Central and Eastern Europe, a set of credible political institutions, and stabilizing monetary and fiscal policies are also needed to attract FDI. Therefore, an OECD (1994) study proposed that the frequency of changes in a country’s legal policies and bureaucratic/ administrative barriers decisively shape investment choices. However, these studies were primarily speculative and did not quantify the effects of political, fiscal and legal stability on FDI flows in Central and Eastern Europe. More recent evidence also undermined the importance of political stability as a determinant of FDI. For example, studying FDI in the motor vehicle industry from 1948 65, Bollen and Jones (1982) found that the effect of political instability was much weaker than suspected.

Some research on FDI determinants also suggested that legal characteristics of host countries, in form of foreign investment policies, could facilitate or deter investment inflows (Stoever 1986, Hein 1992, Wint 1992). In some Central and East European transition countries national policies on FDI may provide incentives to foreign investment through tax breaks, exemptions from certain import duties, establishment of free economic zones, and prevention of double taxation. In other countries, FDI is discouraged through a requirement of an investment permit or registration, high degree of screening or sector restrictions and barriers (Alter and Wehrle 1993).

Source: Survey Data

* Index is formed by taking weighted average of number of response by assuming following numerical values: strong positive impact = 2, positive impact = 1, no effect = 0, negative effect = -1, strong negative impact = -2, . By construction, index ranges from -2 to +2. A positive value implies positive impact, and a negative value implies negative impact.

The survey was carried out to asses the impact that FDI has on Sri Lanka.


The survey clearly indicates support for the Dunning and Rojec (1993) view that initial FDI is driven by market and resource-seeking motives. Since 1979, China has begun to open its front door to the foreign investors. Through the two decades, the institutional infrastructure towards FDI in China has experienced a fundamental change and China has become one of the most important destinations for foreign direct investment in the world. In the early stages of China’s FDI inflows, vast majority of the FIEs were joint ventures between Chinese firms and MNEs, which were mainly formed by developing countries, China attracted a record $52.7bn (£32.9bn) in foreign direct investment (hereby referred to as ‘FDI’) in 2002. The Chinese government made it easier for foreign companies to expand in China and entry into the World Trade Organisation (WTO) in 2001 has resulted in liberalisation in some industries.

Zhou found that FDI into China brought the income level up considerable. Foreign-owned investments paid higher wages than state employers, in many cases due to some jobs requiring skilled labour. Alongside the menial, labour intensive work in China, skill-based technology was also incorporated (Zhou, 2001). Cities with better market infrastructure, like Shanghai, Jiangzhou, have be the hottest destinations for the increasing FDI from developed countries and the role of cultural ties would be a much less consideration in the future, mercerisation of the investment environment would be an important factor in investment decision.

While inflows to developing countries as a group almost quadrupled, from less than $20 billion in 1981–1985 to an average of $75 billion in the years 1991-1995, inflows into Africa only two folded during that period. As a result, Africa’s share in total inflows to developing countries dropped significantly cultural ties would be a much less consideration in the future, mercerisation of the investment environment would be an important factor in investment decision.

While inflows to developing countries as a group almost quadrupled, from less than $20 billion in 1981–1985 to an average of $75 billion in the years 1991-1995, inflows into Africa only two folded during that period. As a result, Africa’s share in total inflows to developing countries dropped significantly


Based on 217 recent service FDI projects, OCO consulting investigated the main drivers of FDI projects in services. As presented in the graph, there are different reasons to invest in Western or Eastern Europe. Skilled workforce availability and proximity to markets or customers are still the strengths of Western European countries. Eastern Europe on the other hand benefits especially from its domestic market growth potential and lower costs.

There are several reasons for a country to encourage FDI. First of all, FDI helps countries to access foreign markets, because of a transfer of know-how and technology to domestic companies. Secondly, FDI is an important way of financing and it helps the country to cover certain deficits it may have. On the one hand, FDI can also create employment and increase productivity abroad. Consequently, FDI contributes to the economic expansion of worldwide economies. On the other hand, FDI can also cause a number of difficulties. In small economies for example, some foreign companies may tend to dominate the market.

The more prominent reason for FDI

As stated above, we know that there are many drivers of FDI, and some are more prominent then others, from some of the prominent are, economic growth for the host country, FDI do not just work in benefit of their own investment, but also in the benefit of the society and host country, and the environment. Some of the ways that FDI’s increase economic growth are through a rise in human capital; this is done through the development of the education infrastructure of the host country, therefore creating a skilled labour force for the FDI to utilise. Having increased the labour force, the FDI would also increase employment opportunities and create many jobs for the host country    


The dramatic spread of FDI in the 1990s was an important development that will have long-term value. The immediate benefits in the form of higher levels of domestic investment have largely materialized but other expected benefits—more rapid productivity growth and better corporate governance—have been slow to accrue in a broad range of settings and appear to have been significant mainly where domestic absorptive capacity is already high.

Both economic theory and recent empirical evidence suggest that FDI has a beneficial impact on developing host countries. But recent work also points to some potential risks: it can be reversed through financial transactions; it can be excessive owing to adverse selection and fire sales; its benefits can be limited by leverage; and a high share of FDI in a country's total capital inflows may reflect its institutions' weakness rather than their strength. Though the empirical relevance of some of these sources of risk remains to be demonstrated, the potential risks do appear to make a case for taking a nuanced view of the likely effects of FDI. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.

Foreign direct investment can offer a lot of advantages to a country. However, there is no perfect way to invest abroad. It is important for a company which is interested in investing in another country that it takes into account all relevant factors for a successful investment. We can say that Eastern Europe has risen enormously over the last years because of its growth potential while Western Europe stays interesting for investments because of its educated workforce and it market proximity.


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