This section focuses on why firms engage in FDI, and possible factors that determine whether firms invest in a country or not. Understanding what determines where and why firms invest is an important factor for attracting FDI and benefiting from it.

Early theories stated that the reason why firms engage in international production through FDI is to reduce transaction costs, and to gain economic and strategic advantage by exploring their assets in several markets. The “internalisation theory” explains that a company will exploit its assets abroad by opening or acquiring a subsidiary firm when the net benefits of integrating domestic and foreign activities within the firm are likely to exceed those offered by trade or contractual agreements.

The internalisation framework further explains that business activities are linked to flows of intermediate products, knowledge, technological expertise, and skills embodied in goods and human capital. It is further argued that external markets tend to be inefficient because specification and pricing of the above-mentioned assets is difficult. Therefore, there is an incentive for firms to develop own international organizational structures through FDI in order to coordinate international activities and exploits its internal assets.  

The “OLI” theory developed by Dunning combines the internalisation framework with specific ownership and location advantages. This approach seeks to offer a general framework for determining pattern and degree of both foreign owned production undertaken by a country’s own enterprises and also that of domestic production owned by foreign enterprises. In the “OLI framework”, it is suggested that the direct investment position of a company is determined by three sets of factors; ownership, location, and internalisation advantages. The ownership advantage is firm specific, and could be a product or production process to which other firms do not have access, such as a patent or blue print. The location advantage must make it more profitable to produce in the foreign country than to produce at home. Finally, the firm must have an internalisation advantage (see above).       

Once the firm has decided to engage in FDI, the “entry choice mode” explains whether the FDI will take the form of a wholly owned foreign entity, joint venture, or licensing. Characteristics of the host country may influence the choice of entry mode. If the host country market is large, it may be difficult for a firm to enter on its own, since the investment may require resources for local sales networks, and after sales activities etc. In addition, host government policies, mainly in developing countries, may force foreign investors into joint ventures or licensing agreements.

Attempts to explain the inter-allocation of FDI in developing countries often involve both economic and political variables. Most evidence suggests the importance of both sector-specific comparative advantages and a favourable investment climate. Sector specific comparative advantages may encompass natural resources, low labour and factor costs, and market size. The term investment climate covers both policy-induced incentives and general business environment. Policy incentives include everything from straightforward incentives, such as cash grants, tax holidays, and cheap access to land, to various disguised subsidies. General business environment, on the other hand, involves various factors that influence investment decisions such as political stability, macroeconomic environment, clarity of rules governing FDI, and the attitudes of the host country towards foreign enterprise participation. Policy incentives and general business environment are linked since profit related incentives might only be relevant if the general business environment is favourable for making profit. There is however an emerging consensus that policy incentives only have marginal effects; fundamentals are more important. 

Determinants to attract FDI also depend upon the production processes existent in the host country. In response to changes in the global environment, such as technological progress, liberalisation of investment, and enhanced competition, new corporate strategies have evolved, which have affected the way international production systems are organised. International production systems have become more integrated moving from “simple” to “complex” integration. “Simple” integration involves international production where the production activities of the parent company to some extent rely on the foreign affiliate or the foreign subcontractor. “Complex” integration on the other hand involves production systems in which any foreign affiliate may perform functions for the company as a whole. For example, “simple integration” can be seen for firms producing athletic shoes, who usually only use the foreign subcontractor for certain components of the final product, such as producing the shoelaces, or other specific components of the shoe. “Complex integration”, on the other hand, can for example involve a firm in the automobile sector, which locate the whole production system in the recipient country, and were the foreign affiliate finishes the final product.  

The fact that FDI can take place in any part of the value added chain has implications for attracting FDI, and the level of development of the production processes and structures in a country can therefore largely determine whether a country will attract FDI or not.    

Below, a selection of the research on the determinants of FDI is presented: 

Determinants of FDI in Developing Countries: Has Globalisation changed the Rules of the Game?, Peter Nunnenkamp, Kiel Institute for World Economics Working Paper 1122, July 2002

This working paper argues that traditional market-related FDI determinants, such as the macroeconomic environment, the size and growth of its market, the quality of its physical infrastructure and the skill composition of its human resources, are still dominant factors. Among the non-traditional FDI determinants, only human capital gained importance. On FDI and trade, the author states that the tariff jumping, whereby foreign investors establish themselves in the country to avoid border taxes has been outdated since a long time.

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On the Determinants of Foreign Direct Investment to Developing Countries: Is Africa Different?, Elizabeth Asiedu, Volume 30, Issue 1, January 2002, Pages 107-119

This paper explores whether factors that affect Foreign Direct Investment (FDI) in developing countries affect countries in Sub-Saharan Africa (SSA) differently. The results indicate that:

• a higher return on investment and better infrastructure have a positive impact on FDI to non-SSA countries, but have no significant impact on FDI to SSA;

• openness to trade promotes FDI to SSA and non-SSA countries; however, the marginal benefit from increased openness is less for SSA. These results imply that Africa is different, suggesting that policies that have been successful in other regions may not be equally successful in Africa.

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Determinants of, and the Relation Between, Foreign Direct Investment and Growth: A Summary of the Recent Literature, Lim, Ewe-Ghee; Middle Eastern Department, Working Paper No. 01/175, November 2001

This paper summarises recent arguments/ findings on two aspects of FDI: its correlation with economic growth and its determinants. The first part focuses on recent literature regarding positive spillovers from FDI. The paper finds that while substantial support exists for positive spillovers from FDI, there is no consensus on causality. On determinants, the paper finds that market size, infrastructure quality, political/economic stability, and free trade zones are important for FDI, while results are mixed regarding the importance of fiscal incentives, the business/ investment climate, labour costs, and openness.

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OECD GLOBAL FORUM ON INTERNATIONAL INVESTMENT, New Horizons and Policy Challenges for Foreign Direct Investment in the 21st Century 26-27 November 2001, Mexico City, Mexico.

This paper addresses two interrelated issues of concern to developing countries; factors which determine FDI flows and the preconditions for the efficient utilisation of FDI in the development process. The paper does not encompass conclusions, but identifies some of the issues on FDI and reviews the major insights from the vast literature on the subject. Its objective is to identify issues for discussion and not present settled conclusions.

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FDI locational determinants and the linkage between FDI and other macro-economic factors: Long-run dynamics in Pacific Asia, A. Bende-Nabende, J. L. Ford, S. Sen and J. Slater, November 2000

This study builds on the existing literature by investigating the long-run locational determinants of FDI flows to Pacific Asia under the broad categories of cost-related, investment environment improving, macro-economic and the political ideology factors of the host country. It also investigates the linkage between FDI and other macro-economic factors. The results demonstrate that the cost-related factors are the dominant determinants of FDI. In particular, the dominance of real wage rates and human capital suggests that the ‘under-priced’ skilled (semi-skilled) labour is the driving force behind FDI. The results for the linkage between FDI and other macro-economic factors, although generally inconclusive, suggest that FDI has stimulated human capital in the region.

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