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W H AT AT T R A C T S F O R E I G N D I R E C T I N V E S T M E N T: A CLOSER LOOK
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Nabamita Dutta and Sanjukta Roy

It is rational to assume that minimal trade barriers (tariffs and quotas), a bigger trade sector, lower interest rate regulations, freer international capital market, lower credit and labour market regulations will make investment in a country more lucrative for foreign investors. We conrm this and show the prevalence of non-linearity in the relationships. Keywords: Foreign direct investment, institutions, labour market regulations, trade barriers.

Why concerns about boosting foreign direct investments? Economists largely favour free ow of capital since that allows capital to seek the highest return. International movements of capital have many advantages they allow investors to diversify their investments and minimise associated risks, leading to efcient practices in corporate governance and restricting expropriation policies by governments. Yet, one of the main advantages of foreign direct investment (FDI) over equity investments and other private capital inows is that it is highly durable in the context of nancial crisis. This advantage of FDI makes it more benecial to host countries. In addition, FDI can provide gains to host countries in various other forms, ranging from technological advancement to generation of tax revenues and also improvement of institutions.1 The developing world and the transition economies have been quick to realise the importance of FDI inows. Over the years 1981 to 1996, the recipient countries have focused on increasing FDI investments to a greater extent than developing trade relations. During the 1990s, foreign investment grew substantially, reaching a peak in 2000, when FDI inows reached US$1.3 trillion (OECD International Direct Investment Statistics). According to Cable and Persaud (1987), a huge amount of FDI ows from OECD to non-OECD countries went to Latin American countries such as Brazil and Mexico, and Asian nations such as Indonesia, Malaysia and Singapore. More

recently, China and India have become major recipients. What matters for FDI inow: the literature so far During the 1990s, international cross-country studies investigated the impact of policy variables on FDI inows to a country. One study investigated the association between institutional uncertainty and private investment and found the association to be negative (Brunetti and Weder, 1998). Some other studies under this framework established a positive relationship between FDI and intellectual property rights (Lee and Manseld, 1996) and a negative impact of corruption on FDI inows (Wei, 1999). Gastanga et al. (1998) found that less corruption, efcient contract enforcement and low nationalisation2 risks attract greater FDI to a country. Along with the increase in the ow of FDI to the developing nation, there has been also a spread of democracy around the world. Usually, foreign investors prefer to choose nations who follow democratic norms, encourage free-market policies and foster prospective business climates. In this context, many studies explored the relationship between democracy and FDI inows. It has been shown by Rodrik (1996) that a country attracts less US capital if it has weak democratic rights. Busse (2004), Harms and Ursprung (2002) and Jensen (2003) also conrmed the positive association between

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what attracts foreign direct investment: a closer look

democratic institutions and FDI inows. Yet, Li and Resnick (2003) suggest that the association between the two is not straightforward. Democratic institutions lead to better security of property rights which, in turn, attracts greater foreign capital. But democracy itself has a negative direct impact on FDI inows. Busse and Hefeker (2007) studied the impact of political risks on FDI inows. They showed that absence of internal conicts and ethnic tensions, efcient law and order, and maintenance of democratic order are crucial determinants of FDI inows to a country. Furthermore, Kapuria-Foreman (2007) investigated the relationship between FDI and economic freedom using cross-country regression analysis. Bengoa-Calvo and Sanchez-Robles(2003) established the association to be positive between the two for 18 Latin American countries.

What else can be important? Though studies have investigated the impact of overall institutional quality in successfully attracting FDI, not much has been done to study specic factors which might affect the ow of foreign funds. To be specic, we argue that trade, nancial and labour market conditions in a country should have a signicant impact in determining the extent of FDI inows. Factors like high tariffs, foreign exchange market distortions, and regulation of interest rates, credit markets and labour markets can have important implications for foreign investors making decisions about investments in host countries. One of the key aspects of global integration has been complementarities between FDI and trade relations among countries. It is not important whether there is a chicken and egg relation between trade and FDI or whether both grow together. The main issues to consider are the factors that make particular locations advantageous for particular activities, for both domestic and foreign investors. Thus, the presence of trade barriers like tariffs and quotas as well as international capital controls is likely to affect FDI inows. A bigger trade sector will always attract greater FDI since a larger part of world trade is comprised of foreign investments in the form of intra-rm trade. Limiting freedom of exchange is another major barrier to FDI inows. Credit market regulations are big hindrances for FDI. Absence of credit market regulations implies that there is enough competition in the banking industry due to the dominance of private rms. It also suggests the presence of foreign banks, substantial amounts of credit being supplied to the private sector and also fewer controls on interest rates. Less availability of credit and higher interest rate regulations are not desirable for investors. Moreover, minimal business regulations mean investors face fewer constraints and, thus, they are more willing to set up their businesses in locations characterised by low levels of government intervention. They prefer the business environment to be friendly as their sole aim is to generate substantial prot from activities in the host countries. Thus, FDI ows will be negatively affected if there are restrictions of entry into a new business, if starting a new business is time consuming, or if complicated bureaucratic procedures are involved with the functioning of the market.

While the minimal presence of certain basic regulations may be desirable, this may not be true for the labour market. It seems obvious that initially high regulations would imply lower FDI inows. However, as regulations are relaxed, FDI ows go up but only up to a certain point. As Palokangas (2003) shows, a minimal amount of labour market regulation may result in less negotiation power for the foreign investors with labour unions, which may not be advantageous for the former. In the absence of stable labour market organisations, binding wage contracts and other institutional arrangements that support the reliability of wage contracts, a greater portion of FDI prots can be expropriated by the local elites. The fewer the labour market regulations, the greater can be the institutional inefciencies leading to unreliable wage contracts which may not be preferred by foreign investors. Thus, an optimal amount of regulation may be preferred by foreign investors. Beyond a certain threshold less regulation may actually lower FDI inows to a country. Experiences across the globe Looking into raw data and experiences of countries across the globe we nd support for our argument. Bangladesh Bangladesh experienced really low FDI inows in the mid-1980s. This corresponds with the period when the country had extreme trade restrictions tailored towards inward orientation and policies towards export promotion and import substitution. Since 1992, however, the economy embarked on its liberalisation regime and accordingly FDI ows started. This is reected in the data of components of the Economic Freedom Index from the Fraser Institute which shows that since 1992 the score for the index of tariff restriction went up from 0.6 to nearly 5,3 while FDI inows as a percentage of GDP went up from 0.11 to nearly 1. The score for the trade sector4 has gone up from 0 to 3.5. However, we do not nd impressive improvements in the scores for international capital market restrictions, interest rate regulations and credit market regulations. This is supported by country-specic problems like lack of transparency and the presence of high levels of corruption that have led to the dismal situation. These have made the country inefcient in reaping the benets of the increased inow of foreign funds. Furthermore, the World Bank still rates the country as having the highest trade barriers in South Asia. Senegal Looking at the data for Senegal, we nd that over the period 1984 to 2002, restrictions have not been relaxed signicantly so as to make the country more attractive for foreign investment. As the data show, FDI inow as a share of GDP has gone up slightly from about 1.2% to 1.5%, with intermittent years showing negative numbers. Accordingly, indicators of regulations in trade, credit and labour markets show little improvement over the 19-year period. The facts from the raw data are supported by the observations of the World Bank (2005) which points outs that Senegal has the lowest levels of

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FDI among sub-Saharan African countries. It lacks the infrastructure to engender investor condence and suffers from serious constraints on the investment climate, high levels of corruption, as well as a lack of adequate educational and training facilities to develop human capital. Thus, although Senegal has undertaken various reforms in the past decade, it still needs to go a long way to reap and sustain the resulting benets. Turkey After Bangladesh and Senegal, we examine the case of Turkey. As noted in a study documented by Ayalp et al. (2004), Turkey has suffered from low levels of FDI inows compared with its potential. This can be attributed to political instability, macroeconomic volatility, corruption and bureaucratic hurdles to name a few. The study estimates that though Turkey has the potential to draw in FDI worth US$35 billion, it is merely able to attract US$1 billion. This loss is primarily attributed to apathetic government policies which fail to give adequate attention to the importance of making Turkey attractive to foreign investors. The data also support these facts. FDI inow as a share of GDP in Turkey rose from 0.18% in 1984 to 0.62% in 2002. At the same time, policies on trade, credit market and labour market regulations have improved signicantly, although there is scope for substantial further improvement. Iran As for Iran, the data depict that it has a very low share of FDI inow relative to its GDP. Though it has low levels of tariff restrictions, its situation with respect to international capital market controls and credit market regulations is depressing. As documented by Ilias (2008), Iran banned foreign banks and nationalised all its indigenous banks after the 1979 revolution, and to date Irans nancial market continues to be heavily dominated by large national banks. These state-owned institutions have a record of poor performance as nancial intermediaries and are burdened with excessive regulations. Moreover, Irans nancial market is still dominated by informal trust-based transactions or Hawala.5 The poor state of Irans nancial market is also often attributed to the countrys strained relations with the USA. Overall, the low levels of FDI in Iran are due to the political instability, stringent domestic regulatory environment, reluctance of the government to allow foreign investors and Irans poor international relations. A simple regression analysis Data sources The data on FDI are taken from United Nations Conference on Trade and Development (UNCTAD, 2002). The measure used is FDI inow as a percentage of GDP. The control variables include GDP growth, ination rate, exchange rate, population and trade openness.6 The data source for these is the WDI database (World Bank, 2006) and Penn World Tables. In this study we consider the contribution of specic components of economic freedom in attracting FDI into an
14 12 FDI inflow over GDP 10 8 6 4 2 0 2 15 10 FDI inflow over GDP 5 0 2

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4 Tariffs

10

0 0 5 2 4 6 8 10

10

Credit regulations

Figure 1: The impact of tariffs and credit market regulations on FDI for Bolivia

economy. The components considered are pertaining to trade, labour and credit market regulations and are taken from the Fraser Institute (2002). The reason for isolating these three components lies in the simple intuition that foreign investors nd a country lucrative for investment when the country has a free-trade policy with lower levels of trade restrictions, a labour market free from regulations and other governmental policy restrictions and a well-developed, creditor- and investor-friendly nancial sector. Each of the above-mentioned components consists of an aggregate score broken down into several sub-categories. The components of trade market regulations considered are non-tariff trade barriers, size of the trade sector relative to the expected size, and international capital market controls. Credit market regulations consist of ownership of banks, foreign bank competition, credit provided to the private sector and interest rate controls. Hiring and ring regulations, conscription (i.e. military service) costs and minimum wages are the major components of labour market regulations. We have used sub-components from these components or the aggregated score of the components themselves, based purely on the availability of data. The analysis is based on a panel of 97 countries over a period of 19 years (19842002).7 Results Before running the analysis, the raw data for some countries have been plotted graphically (see Figures 13). They clearly show the presence of non-linearity.

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what attracts foreign direct investment: a closer look

3 FDI inflow over GDP 2.5 2 1.5 1 0.5 0 0 1 2 3 Tariffs 3 FDI inflow over GDP 2.5 2 1.5 1 0.5 0 0 0.5 1 1.5 2 2.5 3 3.5 4 5 6

Credit regulations
Figure 2: The impact of tariffs and credit market regulations on FDI for Sri Lanka

Our regression results8 indicate that, across the board, the ratio of FDI inows to GDP has a strong relation with Regulations. The implication is that as restrictions are lowered (a higher score), more FDI ows in to the respective nations. The rst sets of components pertain to the regulations in the trade sector. Of this the rst component Taxes on International Trade (comprising revenue from taxes on international trade as a percentage of exports and imports, mean tariff rate and standard deviation of tariff rates9) has a signicant impact on FDI inows. Similarly, we nd that Size of the Trade Sector Relative to Expected, International Capital Market Control and Interest Market Regulation also matter for FDI inows. Credit Market Regulations and Labour

Market Regulation, though they have the expected sign, do not achieve statistical signicance. We investigate the FDI inowregulations linkage further by looking for any possible non-linearity in their association.10 A non-linearity (concave or convex) would mean that for similar changes in restrictions, the change in the rate of FDI inows varies. The square of Regulations is introduced to gauge its potential non-linear impact on FDI inows. Our results suggest that when restrictions are high (lower value of the indices), the level of FDI inow is low. However, when the restrictions are relaxed (implying higher values of the indices), the inow of FDI goes up and at an increasing rate. We nd the presence of non-linearity as expected. The coefcients for the linear term are negative while that for the squared Regulations is positive. The results are very signicant for all types of regulations considered here, except for the index for labour market controls. The labour market regulation, however, is signicant when we consider alternative robust regression techniques.11 For these we nd a concave relationship12 between labour market restrictions and FDI inows. This means that while decreasing labour market regulations do raise FDI inows into a country, after a threshold the relation turns negative. This could primarily be explained by the fact that while too many regulations in the labour market would make a country unattractive to foreign investors, an optimal level of regulation is still desirable. This would keep the sector organised, yet exible for foreign players. Absolutely no regulation in the labour market would make it unorganised and be a more difcult environment for foreign investors. This can be substantiated by the views of Whyman and Baimbridge (2006) who explain through an example that
decentralisation of wage formation may facilitate pay structures best suited to the incentive structures sought by individual managers, yet the rise in pay diversity in the labour market as a whole, together with the removal of the moderating effect of peak level bargaining partners, might provoke increased industrial unrest and hence damage macro-exibility.

This is also supported by raw data. Countries such as Australia, China, Colombia and the Dominican Republic show high ratios of FDI inow to GDP and a moderate-to-low score for labour market regulation. Interestingly, for all these countries, the other indices of regulations have signicantly higher scores. Conclusion Our analysis reveals that liberalised trade, nancial and labour sectors greatly inuence the inow of FDI into an economy. A convex relation reveals that not only is the impact on FDI positive, but also exhibits increasing returns to reduced regulation. While higher restrictions would increasingly pull down the FDI inow, lower levels of restrictions bring in increasingly higher levels of FDI. The results demonstrate that while trade and some nancial regulations have a convex relationship with respect to FDI inow to a nation, labour market regulations have a concave relationship. Thus, the results imply that though investors prefer almost no form of

2.5 2 FDI inflow over GDP 1.5 1 0.5 0 0 0.5 1 Labour regulations 1 2 3 4 5 6

Figure 3: The impact of labour market regulations on FDI for Niger

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trade and nancial regulations, they are attracted by some degree of labour regulation. The implications are important for policy-makers, especially in the current era of global integration. This is particularly true for developing economies that would benet from FDI for their process of development. Policies should be targeted towards the trade, nancial and labour sectors to make them friendly for foreign investment. Accordingly, countries should free themselves from unnecessary government regulations, bring in transparency in bureaucracy, tackle corruption, improve the investment climate, generate investor condence, invest more in human capital and encourage a work-ethic among the population in general. Appendix: detailed description of the proxies for regulations Source: Economic Freedom of the World 2008 Annual Report Taxes on international trade (i) Revenue from taxes on international trade as a percentage of exports and imports. A score of 10 is given to nations with no taxes. (ii) Mean tariff. A score of 10 implies no tariff imposed. (iii) Standard deviation of tariff rates: a score of 10 implies the country imposes uniform tariffs. Regulatory trade barriers (i) Non-tariff trade barriers. (ii) Compliance cost of importing and exporting: data source used is World Banks Doing Business data. Higher ratings are assigned to countries where less time is required. Size of the trade sector relative to expected Actual size of the trade sector was compared with expected, which was derived based on regression analysis. Higher ratings are allocated to countries with larger trade sectors. International capital market controls (i) Foreign ownership/investment restrictions: extent of foreign ownership and whether laws favour FDI in the country. (ii) Capital control: source is the IMF which reports up to 13 different types of controls. The 0 to 10 rating is based on the percentage of capital controls not levied as a share of the total number of capital controls listed by us. Credit market regulations This index is composed of the following categories: (i) Ownership of banks is comprised of the percentage of bank deposits held in privately-owned banks. Countries

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whose privately-held deposits ranged between 95% to 100%, received a rating of 10. This index varied between 0 and 10. (ii) Foreign bank competition: countries which approved almost all foreign bank applications and have a dominance of foreign banks in their banking sector receive a higher rating. (iii) Private sector credit: this is based on the percentage of domestic credit consumed by the private sector. As the percentage increases, the rating gets closer to 10. (iv) Interest rate controls/negative interest rate: a country with interest rate determined by the market, stable monetary policy, and positive real deposit and lending rates received higher rating. This ranged between 0 and 10. Labour market regulations This component is based on the following categories: (i) Minimum wage: countries with higher mandated minimum wages relative to average value added per worker are given lower ratings. (ii) Hiring and ring regulations: the index ranges from 1 (if regulations are impeded) to 7 (if determined by employers). (iii) Centralised collective bargaining: the index ranges from 1 (if wages are set by a central bargaining process) to 7 (if they are set by individual companies). (iv) Mandated cost of hiring: this is based on hiring cost as a percentage of salary. The index ranges from 0 to 10 with higher values representing lower hiring costs. (v) Mandated cost of worker dismissal: this is based on dismissal cost. The index ranges from 0 to 10 with higher values representing lower dismissal costs. (vi) Conscription: countries with longer conscription periods received lower ratings. Acknowledgement We are thankful to Russell Sobel for indispensable comments and suggestions.
1. To quote Douglass North (1991), Institutions are humanly devised constraints that shape human action. He continues to emphasise that institutions reduce uncertainty by establishing a stable infrastructure which, in turn, facilitates enhanced human interaction. 2. Nationalisation refers to the act of transferring an industry or asset into public ownership, generally against the will of the owner. 3. On a scale of 0 to 10, 10 reects no tariff restrictions. 4. Here also the scale is from 0 to 10 with higher ratings being given to countries with a larger trade sector. 5. This system exists in the Middle East and other Muslim countries. It does not involve any record of transactions, and no promissory instruments are exchanged between the parties involved. 6. The choice of control variables are based on the studies by Froot and Stein (1991), and Garibaldi et al. (2001) and Nonnenberg and Mendona (2004). 7. Using a pooled ordinary least squares (OLS) approach. 8. The benchmark equation is FDIit = b0 + b1Regulationsit + b2Xit + b2Regional + b4Zt + et. Here FDIit is the ratio of FDI inow over GDP for country i at time t. Xit represents the covariance matrix of control variables. The control variables are annual growth of GDP, ination, exchange rate, trade openness and population. Regional represents the vector of regional dummies and Zt is the vector representing the time dummy. 9. A detailed description of each of the sub-components is provided in the Appendix.

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10. The regression for explaining non-linearity is: FDIit = b0 + b1Regulationsit. 11. We run feasible generalised least square (FGLS) estimates for robustness of our results. This is done to render more efcient results (the need for which is conrmed by the DurbinWatson test, which veries the presence of autocorrelation). We also run robust regression to take care of possible outliers. 12. See Figure 3 for validation.

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2009 The Authors. Journal compilation Institute of Economic Affairs 2009. Published by Blackwell Publishing, Oxford