Determinant factors of foreign direct investment: some empirical evidence

Jose I. Galan and Javier Gonzalez-Benito

Introduction
The globalization of markets and internationalization of companies is a phenomenon of growing interest in current research. Given the increasing permissiveness of regulations, more and more companies are going beyond national borders and making foreign direct investments (FDI). The purpose of this paper is to study the determinant factors in Spanish FDI. Although traditionally isolated from international markets, Spain has undergone a remarkable international development over the last few years. Its integration in the European Community, the privatization of great public monopolies, government efforts and insistence and its cultural and linguistic affinity with Latin America constitute some of the contingencies that seem to have favored the international development of many Spanish firms. Studying the internationalization process involves answering three basic questions: (1) Why does a firm decide to initiate this process? (2) How (through which form) are the international activities realized? (3) Where does the firm locate its foreign activities? Rooted in the eclectic paradigm of Dunning (1979, 1980), this work tries to identify the determinant factors of each one of these three basic decisions, why, how and where, for the particular case of FDI as the form of internationalization. Thus, three questions are to be answered: why undertake FDI?, why internationalize through FDI instead of other forms?, and where to undertake FDI? This paper contributes to current research in two ways. It provides a snapshot of the Spanish situation in international markets and it constitutes a practical application of Dunning's eclectic paradigm. The paper consists of four sections. After reviewing the literature in the first section, the research model and empirical methodology is commented upon in section two. Subsequently, the main results are presented and discussed and the paper ends with a summary of the main conclusions.

The authors Jose I. Galan is a Professor in Management in the Department of Economic Analysis and Accounting at the University of Salamanca, Salamanca, Spain. Javier Gonzalez-Benito is an Assistant Professor in Management in the Department of Economic Analysis and Accounting at the University of Salamanca, Salamanca, Spain. Keywords Foreign investment, Spain, International business, Multinationals Abstract This paper reports on an empirical study based on 103 Spanish companies which have conducted foreign direct investment (FDI). Built on the eclectic paradigm, it aims at finding out the main ownership, internalization and location factors which affect such internationalization processes. The results confirm the determinant importance of factors such as the existence of specific assets of an intangible nature. They also show that transaction costs and other questions related to knowledge transfer and accumulation are relevant in the choice of FDI over alternative forms of internationalization. Current and future markets and their expected growth are the key factors for selecting a destination. In general, this paper provides evidence that what is known about determinants of FDI seems to extend to Spanish multinationals today. Electronic access The current issue and full text archive of this journal is available at http://www.emerald-library.com/ft

Theoretical framework and literature review

Theoretical foundations The literature on FDI is very extensive and is originally rooted in economics. International 269

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Determinant factors of foreign direct investment: empirical evidence

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trade theory and classical location theory are frequently referred to in early contributions (Ohlin, 1933). Nonetheless, the work of Hymer (1976) was to be a landmark in the study of FDI. The reasons given by this author for the internationalization of companies are of two kinds: variables related to the company's dimension and ownership of specific assets (scale economies, diversification and knowledge accumulation) and variables derived from the existence of market failures. From this classification of variables, two groups of theories and works can be distinguished in the literature: those framed within industrial organization (Caves, 1971; Kindleberger, 1969; Hirsch, 1980) and those focussing on the internalization process (Buckley and Casson, 1976; Hennart, 1982, 1989; Teece, 1986; Rugman, 1981, 1986). In spite of analyzing FDI from different perspectives, both approaches are complementary (Chang, 1995; Madhok, 1997). The authors within the industrial organization school set out from the hypothesis that multinational companies undertake FDI to benefit from the specific capabilities that they own, which give them certain monopolistic power (Kindleberger, 1969). Such power can become apparent in the form of innovative technological processes, patents, trademarks, financial resources, management abilities or exclusive distribution channels. Caves (1971) considers the diversification of products as the main influencing factor and Hirsch (1980) emphasizes the importance of knowledge and capabilities generated from R&D activities. On the other hand, the internalization theory is founded on transaction cost economics (Williamson, 1975, 1985) and considers that the greater the presence of factors facilitating opportunistic behavior on the part of trade partners, the higher transaction costs incurred to protect against such opportunism. Thus, the company would incline towards internationalization forms which involve a high degree of control, that is, it would prefer internalizing international activities through FDI rather than exporting or licensing, for example. Another contemporary theoretical development analyzing the origin and form of internationalization is based on the product life cycle (Vernon, 1966, 1979). According to this author, the form of entry into foreign markets depends on the life stage of the

traded products. When maturity is reached the company loses market share and feels the need to go abroad and establish production centers in other countries. Apart from these classical theories, many other works focussing on the study of particular variables and factors influencing FDI can be found in the literature. They adopt different conceptual frameworks to study the determinant factors of FDI. It is worth mentioning the developments about competitive reaction (Knickerbocker, 1973; Graham, 1978, 1989); the study of networks and supplier-buyer relationships (Mattson, 1985); the analysis of government rules, political stability and other variables related to the host market (Nigh, 1985; Fatehi-Sedeh and Safizadeh, 1989); the examination of the importance of fluctuations in currency markets (Alibert, 1971); and, the research on effect of tax policies in origin and host markets (Alworth, 1971; Gersovitz, 1987; Jun, 1989). In parallel with this group of papers and based on the behavioral conception of the firm (Cyert and March, 1963), the Uppsala model was developed (Johanson and Wiedersheim-Paul, 1975; Johanson and Vahlne, 1977, 1990). This approach describes the internationalization process as an incremental learning process through which a company accumulates and integrates the knowledge acquired in foreign markets (Johanson and Vahlne, 1977; Root, 1987; Melin, 1992). The Uppsala model considers FDI as a subsequent step to exporting and attributes this incremental process to the difficulties in obtaining information about operations in foreign markets. Such difficulties are derived from, for example, cultural, linguistic and institutional differences between countries. This evolutionary view of the internationalization process therefore argues that companies acquire more commitment to foreign markets insofar as they accumulate experience and knowledge. The eclectic paradigm All the above commented works tackle different aspects and determinant factors of FDI. Some of them focus on identifying and explaining the motivators of FDI and others analyze the selection of FDI as internationalization form or study the variables affecting the location of investments.

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Notwithstanding the important contributions provided by these works, all of them approach partial elements of the problem. One attempt to integrate all the previous factors into a single scheme was the eclectic paradigm of Dunning (1979, 1980). This author synthesizes previous theories under a conceptual scheme, which is subsequently reformulated (Dunning, 1988, 1995, 1997). His developments, along with the complementary works of Hennart and Park (1994) and Buckley and Casson (1998), constitute the conceptual framework of this research. The eclectic paradigm, also known as the OLI paradigm, proposed that the undertaking of FDI is determined by the realization of three groups of advantages: (1) Ownership advantages are specific to the company and are related to the accumulation of intangible assets, technological capacities or product innovations. (2) Internalization advantages stem from the capacity of the firm to manage and coordinate activities internally in the value added chain. They are related to the integration of transactions into multinational hierarchies through FDI. (3) Location advantages refer to the institutional and productive factors which are present in a particular geographic area. They arise when it is better to combine products manufactured in the home country with unremovable factors and intermediate products of another location. FDI will take place when the three kinds of advantages come together. In this sense, and according to the reasoning of Hennart and Park (1994) and Buckley and Casson (1998), all the advantages are interconnected and affect indistinctly the likewise interconnected decisions of ``why'', ``how'' and ``where'' to internationalize. Nonetheless, as will be commented upon in the next section, this paper presents an individual and simplified treatment of decisions and advantages, arguing that ownership advantages mostly determine the ``why'' decision, internalization advantages mostly determine the ``how'' decision and location advantages mostly determine the ``where'' decision. The OLI paradigm is dynamic. The continuous incorporation of new companies

to the internationalization process and the changing and more and more receptive policies in developing countries are giving rise to new trends in the way of carrying out FDI (Dunning, 1997; Dunning and Narula, 1996). The importance of ownership advantages such as the existence of technological assets (Grubaugh, 1987; Pearce, 1989; Kogut and Chang, 1991) and marketing assets (Kumar, 1990) has been extensively supported. The influence of these factors in the form of FDI chosen by the company has also been explored (Gomes-Casseres, 1990; Barkema and Vermeulen, 1998). The relevance of internalization advantages and, specially, transaction costs has been dealt with in the literature (Erramilli and Rao, 1993). Some other works focus on institutional (Contractor, 1990; Gomes-Casseres, 1990) and cultural (Hennart and Larimo, 1998) factors. Finally, the research of Hennart and Park (1994) and Dunning (1998) is particularly pertinent for the study of location advantages.

Research model and empirical methodology

Research model According to the scheme proposed by the eclectic paradigm, there are three groups of factors affecting foreign direct investment. In consequence, the model proposed (Figure 1) is composed of three groups of factors (ownership, internalization and location) which are essentially those determining the decision to enter foreign markets. It is argued that these groups affect the ``why'', ``how'' and ``where'' decisions, respectively, so that three premises were assumed to structure this research:
Figure 1 Model of determinant factors in the key decisions in the internationalization process

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P1: The ownership factors influence the ``why'' decision in the internationalization process. P2: The internalization factors influence the ``how'' decision in the internationalization process. P3: The location factors influence the ``where'' decision in the internationalization process. Although these three premises are assumed in the design of the research, the analysis of data will provide certain information about their validity (see degree of adequacy below). Nonetheless, it must be taken into account that this model to a great extent simplifies the reality. One can immediately realize that the three decisions are very interconnected and are not made separately, so that each group of factors would actually influence the whole decision process. Thus, this model should be thought of as an initial approach to the phenomenon which requires further developments and provides preliminary evidence of the behavior patterns of internationalized companies. This approach has already been used in previous regional research (Galan et al., 1999). The three key internationalization decisions should be slightly transformed when the particular case of FDI is concerned: (1) Why undertake FDI? (2) Why internationalize through FDI instead of other forms? (3) Where to undertake FDI? They are not necessarily made in this order. Rather they are probably jointly made since there are important links between them. Research methodology The survey was considered the most suitable research design for obtaining empirical evidence on the influencing factors in FDI decisions. The objective population was extracted from the Dun & Bradstreet international database. The search procedure consisted of looking for companies whose parent company was Spanish, selecting the 700 largest parent companies and removing those which are in turn branches of foreign companies or are not joint-stock companies. The survey was then applied to the 585 resulting firms, which can be thought of as the largest Spanish joint-stock companies which have undertaken FDI.

After an exhaustive analysis of the literature, those factors that were to be included in each group (ownership, internalization and location) were selected. Each company was asked to value each of the factors they considered relevant from zero to five according to the importance they had for their decisions on FDI: why to undertake FDI, why FDI and not another form and where to direct investments respectively. They were also asked to choose a unique determinant factor within each group. A total of 103 (17.6 per cent) firms returned the questionnaire duly completed. A simple but illustrative methodology was used to analyze the data. Three measures were built for each of the factors: (1) Degree of relevance of the factor: Average score given to each factor by the companies in the sample. A linear transformation was applied in order to make it range from zero to ten. This measure allows us to know the importance of each factor for each of the decisions. (2) Degree of determination of the factor: Percentage of firms which have chosen this factor as the determinant one. It allows us to identify the main factor influencing the decision. It is expected that those factors with the highest degree of determination will have a high degree of relevance as well. (3) Degree of adequacy of the factor: Percentage of companies which have allotted one point at least to this factor, that is, which have recognized it has a certain degree of relevance. It allows us to know to what extent the selection of factors was adequate, that is, it tells us whether the chosen factors are usually taken into account by firms before making a decision, even though they are not considered very relevant afterwards.

Results and discussion

Descriptive analysis Within the Spanish environment, the companies in the sample tend to be very large. Fifty-six of them have a turnover of more than 60 million euros, 23 are between 15 and 60 million euros, 20 between 3 and 15 million euros and four bill less than 3 million euros a year. If independence between size and survey response is assumed, the results seem to

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support the importance of size for FDI activities and the existence of a minimum size to enter foreign markets. To reach such a conclusion it must be taken into account that, according to the procedures followed to select the objective population, all the joint-stock companies which have conducted FDI and invoice more than 3 million euros a year have received the questionnaire. With regard to the form of FDI chosen by the companies in the sample, most of them (85 per cent) have preferred to settle on fully owned branches in at least one of their incursions abroad. Of companies, 45 per cent chose to establish joint ventures along with selected partners, 33 per cent decided to totally acquire existing firms in other countries and 27 per cent took over foreign companies through partial acquisitions. Only 23 per cent of the companies sometimes carried out FDI to acquire minority shares of foreign firms. Although total amounts invested should be known to be precise, the data support the idea that Spanish companies prefer endogenous growth (greenfield settlements) to exogenous growth (acquisitions) or co-operation (joint ventures). Six geographical areas have been distinguished in this research: the European Community, Eastern Europe, North America, Latin America, Asia and rest of the world. The companies in the sample were asked to select those zones in which they had made FDI and to arrange them according to the volume of investment made. Table I shows the percentage of companies which chose each area for their international activities and the percentage of companies which chose each area as prior destination. Since some companies gave the same importance to different destinations the sum of the percentages does not equal 100 per cent. Almost all the companies (94. 17 per cent) have directed their investments to countries within the European Community. This scenario, along with Latin America, is the preferred destination of Spanish
Table I Main destinations for Spanish FDI

companies, perhaps because the physical distance is shorter and cultural barriers are easily overcome. Percentages do not show significant differences between the other locations, which are chosen by less than half of the companies and rarely as their main objective. As far as the activity of companies is concerned, there are 64 manufacturers, seven energy and water providers, eight construction firms, five financial companies and 19 involved in other kinds of services. It is worth highlighting that service companies constitute an important part of the sample. Thus, conclusions should not only be restricted to manufacturing companies. Determinant factors of Spanish FDI Ownership factors: why undertake FDI? Data in Table II show that the ownership factors with the highest determinant power are related to the existence of specific intangible assets in the internationalized company. Thus, the decision to enter foreign markets is especially prompted by the experience accumulated in local markets and the ability to learn from such experiences, the technological and innovative capabilities, the international vocation of top managers and the search for synergies and scope economies derived from the joint administration of diverse resources owned by the company. On the other hand, the factors with the lowest determinant power (less than 3 per cent) are the human potential, the establishment of agreements with foreign companies, the availability of government grants or trade agreements between countries and the existence of a prosperous financial structure. Three factors therefore emerge from the previous analysis and should be pointed out: the growing importance of scope economies against scale economies, the significant impact of specific and intangible assets and the scarce determinant power of agreements and co-operation. With respect to the relevance of factors, that is, the average score assigned to each factor by

European East Community Europe Per cent of companies at this destination Per cent of companies that choose it as prior destination 94.17 68.93 41.75 2.91

North America 47.57 4.85

Latin America 64.08 27.18

Asia 46.60 4.85

Rest of the World 50.49 5.83

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Table II Measures of determination, relevance and adequacy for ownership factors Ownership factors Technological and innovative capabilities Reputation and public image Human potential Experience in the national market Products superior to the competition Low costs of production for large volumes (scale economies) Government grants and trade agreements with other countries Agreements with foreign companies International vocation of top managers Prosperous financial structure Existence of advantages (synergies) derived from the joint management of diverse resources Determinationa Relevanceb Adequacyc 20.39 4.85 2.91 22.33 7.77 6.80 2.91 1.94 15.53 1.94 12.62 6.72 6.27 6.10 7.59 6.17 5.15 2.68 2.50 6.68 6.29 5.81 88.35 88.35 88.35 92.23 89.32 83.50 58.25 44.66 93.20 90.29 83.50

Notes: aPercentage of firms which chose the factor as determinant. bAverage score given to the factor (based on 10). cPercentage of firms that scored the factor

the companies in the sample, the data in Table II reveal that there are three factors which, in spite of not being specially determinant, reach high relevance and are specially taken into account. Two of them, the reputation and external image of the company and the human potential, are intangible, whereas the other, prosperous financial structure, refers to the availability of capital to face investments. In addition to having scarce determinant power, international agreements and government initiatives also seem to have little relevance for the decision to undertake FDI. The adequacy of factors is fairly high for all the cases (higher than 80 per cent) except for two: agreements with foreign companies and government grants and international cooperation. This means that the selection of factors has been appropriate and that, independently of the importance allocated to each, most of the factors are considered for the decisions made. It also reveals certain homogeneity as regards the portfolios of factors analyzed by Spanish companies before going international. Internalization factors: why internationalize through FDI instead of other forms? According to the model proposed, this section is devoted to the study of those factors motivating the selection of FDI instead of other alternative forms of internationalization: exports or licensing. In this respect, the literature recognizes the main role played by market failures and transaction costs. Table III provides the indexes for each one of the factors considered in the analysis.

Three of them seem to be determinant in the selection of FDI against other alternative forms: previous experience in the host market through exportation, the need to directly operate and control strategic resources such as technology, knowledge or image, and the need to produce in proximity to the customer (impossibility of exporting). Two other reasons also reach certain determinant power. First, the intention to diversify the risks derived from concentrating production and, second, the need to follow traditional customers. On the contrary, there is a group of factors which rarely determine the form of internationalization. They are related to the imperfections of currency markets, the existence of tariffs against foreign goods, the costs of searching for and selecting partners, the costs of supervision and negotiation of trade contracts or the costs of rupture of such contracts (transaction costs in the sense of Williamson, 1975). These data reveal the low importance of transaction costs as compared to other factors such as the internal protection of strategic assets. Although these results apparently contradict the postulates of internationalization theory, it must be taken into account that transaction costs are implicitly associated with the most determinant factors. In the case of the experience in the host market through exportation, it contributes to reducing uncertainty so that the costs of searching for information and negotiating and controlling contracts can to a great extent be reduced. That is, protection against the consequences of opportunism and bound rationality is less

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Table III Measures of determination, relevance and adequacy for internalization factors Internalization factors Experience in foreign markets (previous exportations) Need to follow traditional customers High transportation/logistics costs Need to manufacture close to the customers To operate and control the strategic resources internally (technology, know-how, image, ...) To avoid currency fluctuations Desire to differentiate products To follow competitors To avoid tariffs against foreign goods in the new markets To minimize the risk of concentrating production To avoid the negotiation and supervision costs of exporting and licensing To avoid costs of contract breaking with distributors, franchisees or licensees To avoid costs of searching for and selecting partners in foreign markets Determinationa Relevanceb Adequacyc 27.18 7.77 2.91 21.36 24.27 0.00 2.91 2.91 0.97 7.77 0.00 0.97 0.97 6.37 4.47 3.40 5.11 5.84 2.35 3.13 3.40 2.97 3.92 2.12 2.08 2.85 81.55 74.76 66.02 71.84 79.61 56.31 66.02 66.99 58.25 66.02 51.46 44.66 57.28

Notes: aPercentage of firms which chose the factor as determinant. bAverage score given to the factor (based on 10). cPercentage of firms that scored the factor

expensive when previous exportation has been carried out. In the case of the need to operate and control strategic resources internally, transaction costs are also implicitly taken into account. Risk of opportunism would be extremely high if strategic assets were left in the hands of foreign producers through licensing, for example. The costs of negotiation, completion and supervision of contracts would be very high and, even so, the company might not manage to preserve the quality of their products and the integrity of their assets. Thus, companies do not seem to identify transaction costs in their pure and theoretical conception, but such costs are indirectly evaluated and minimized through other factors. The analysis of the relevance index does not provide much additional information since to a great extent it resembles the determination index. It is worth mentioning that the low importance given to the avoidance of tariffs against foreign goods and fluctuations in currency markets might be due to the fact that the European Community is the main destination for most of the companies in the sample. The adequacy rates are lower this time than what they were for ownership factors. This means that, in general, each company considered just a few of the factors so that two conclusions might be possible: the portfolio of factors included in the survey has not been

adequately chosen or few factors, in fact, influence the decision of each company. We tend to favor the second possibility since, for example, service companies are probably constrained by the need to produce close to the customer and few other factors can affect this irremediable need. Location factors (where): where to undertake FDI? As regards the selection of a location to direct FDI initiatives, two interconnected factors stand out from the others in determination and relevance levels: the size of the host market and its potential for growth (Table IV). A third factor, the degree of competence in such a market, is also quite relevant. The more intensive the competition, the less attractive the market. Thus, factors related to the opportunities of foreign markets dominate the location decision. Some classical factors such as labor and transportation costs, which are frequently referred to in location theory, appear with a certain degree of relevance on a second level. Some other factors that might be included in this secondary level are related to infrastructure, industrial concentration, availability of workforce, political stability and cultural affinity. They all exceed four in the relevance measure. The adequacy index for location factors reaches higher levels than for internalization factors but it does not equal ownership factors.

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Table IV Measures of determination, relevance and adequacy for location factors Location factors Low labor costs (workforce) Low transportation/logistics costs (supply and distribution) Low cost of raw materials, energy and water Availability and low costs of land Large size of host market Growing demand in host markets (potential growth) Low level of competition in host markets Good infrastructures High industrial concentration (industrial parks, technological networks, ...) Availability and high quality of workforce Access to reliable and co-operative suppliers Political stability Standard of living and public services Attitude of the community towards the firm Tax reduction incentives in host markets Grants and tax reductions in the matrix country Less strict environmental laws Cultural affinity International trade agreements Technologically advanced country (learning opportunities) Determinationa Relevanceb Adequacyc 2.91 3.88 0.00 0.97 20.39 44.66 6.80 2.91 2.91 1.94 2.91 0.00 0.00 0.97 0.00 0.97 0.00 3.88 1.94 1.94 3.59 3.09 2.56 2.62 7.13 7.53 5.57 4.21 3.36 4.39 3.73 4.93 3.46 3.81 2.85 2.78 1.65 4.08 3.01 3.18 65.0 65.0 59.2 57.3 90.3 88.3 86.4 71.8 70.9 77.7 67.0 78.6 68.9 69.9 61.2 61.2 48.5 73.8 61.2 65.0

Notes: aPercentage of firms which chose the factor as determinant. bAverage score given to the factor (based on 10). cPercentage of firms that scored the factor

Although each factor is considered important by many companies, few of them give importance to the whole portfolio of factors. Rather they choose different combinations of relevant factors and eliminate the others. Worth highlighting is the fact that the existence of permissive environmental laws has the lowest adequacy level. It is taken into account by 48 per cent of the companies, which attribute very little importance to this factor. On the contrary, the previously mentioned factors related to market characteristics and opportunities are valued by more than 85 per cent of companies.

Conclusion
This paper has provided empirical evidence of the main factors affecting the key decisions related to the undertaking of FDI by Spanish joint-stock companies. After reviewing the main theoretical approaches to internationalization issues, special attention was paid to the eclectic paradigm of Dunning, which constitutes the conceptual framework of this paper. Such a framework distinguishes between three interconnected questions that should be answered before internationalizing:

why to go abroad, how to do it and where to go. In the case of internationalization through FDI, the questions can be slightly transformed: why to conduct FDI, why to choose such an internationalization form and where to locate investments. A sample of 103 companies was studied in order to identify the factors determining the answers to these questions. Knowing the determinant factors of FDI can be very useful for managers since it helps them to define and lead future behavior in foreign markets. Furthermore, the systematic approach introduced in this paper is also important for academics since it means an empirical adaptation and testing of Dunning's paradigm. Such an approach can be easily reproduced in other environments and populations, thus facilitating comparisons between regions or countries. Finally, this work can be helpful for governments and public policy since it provides some clues about the best way of fostering FDI. The main conclusions reached with this research can be summarized as follows: . Spanish joint-stock companies prefer internal growth (new branches) to external growth (acquisitions) or co-operation when they enter foreign markets.

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The countries in the European Community and Latin America are the main receptors of Spanish FDI. This supports the importance of cultural affinity for internationalization. Although most the companies undertaking FDI are manufacturers, the presence of service companies is significant. With respect to the ownership factors motivating FDI, the analysis shows the great importance of specific and intangible assets. The experience in national markets, the availability of technological and innovative capabilities or the international vocation of top managers spur companies to cross the borders of national markets. Scale economies and, especially, government incentives hardly influence the behavior of companies. The selection of FDI as the form of internationalization is mainly motivated by the need to directly control intangible assets and previous experience through exportation. Thus, FDI seems to be the logical consequence of successful exporting rather than an incompatible alternative. Furthermore, the importance of transaction costs, although it is not directly recognized, remains implicit in the most relevant factors. Contractual costs would be very high when specific assets are involved so that companies prefer to internalize operations. Of course, it should be mentioned that the main reason for service companies to undertake FDI is the need to produce close to the customer. As regards the location factors and the selection of a destination for FDI, the current and future expectations generated by markets' characteristics dominate the decisions. Other features such as the availability of infrastructures or workforce, transportation costs or political stability are also relevant but remain on a second level. Furthermore, as mentioned earlier, cultural affinity is considered an important factor by a significant number of companies.

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