What Determines FDI?

I’m kinda busy today, so not much commentary on this one, but in a new working paper, IMF researchers examine the determinants of FDI across a selection of advanced and developing countries (Malaysia included):

Determinants of Foreign Direct Investment: A Sectoral and Institutional Approach
Walsh, James P & Yu, Jiangyan

Using a dataset which breaks down FDI flows into primary, secondary and tertiary sector investments and a GMM dynamic approach to address concerns about endogeneity, the paper analyzes various macroeconomic, developmental, and institutional/qualitative determinants of FDI in a sample of emerging market and developed economies. While FDI flows into the primary sector show little dependence on any of these variables, secondary and tertiary sector investments are affected in different ways by countries’ income levels and exchange rate valuation, as well as development indicators such as financial depth and school enrollment, and institutional factors such as judicial independence and labor market flexibility. Finally, we find that the effect of these factors often differs between advanced and emerging economies.

Some interesting conclusions from the paper:

1. Determinants of FDI flows across sectors and between advanced and developing economies is different;
2. FDI intended for the primary sector (resource extraction e.g. oil) don’t have a strong relationship with either macro or qualitative variables;
3. FDI for the secondary sector (manufacturing) is strongly influenced by income per capita (negative) and a weak exchange rate (positive); the qualitative variables that matter are labour market flexibility and deeper financial systems, strongly so for developing countries in the sample;
4. FDI for the tertiary sector (services) depends on trade openness and a strong exchange rate; institutional factors that matter are an independent judiciary (only significant for advanced economies) and improved infrastructure;
5. While school enrollment has an impact, the effect is weak;
6. Corruption and political stability weren’t included due to measurement issues, so no conclusive evidence is available from this paper.

It’s interesting to note the strong difference in the factors affecting FDI flows to the secondary sector against the tertiary sector. Malaysia’s heyday in attracting FDI to manufacturing conforms nicely with the findings of this paper – low incomes, low exchange rate, and a relatively well developed financial sector.

But the macro conditions are slowly changing to favour investment in the tertiary sector, although we obviously still have some hurdles to overcome here. One thing that we don’t have, and won’t have for some time, is a large domestic market, which will remain an impediment to FDI in services (kudos to Gundrohiker for pointing out that possibility to me).

Technical Notes:

Walsh, James P & Yu, Jiangyan, "Determinants of Foreign Direct Investment: A Sectoral and Institutional Approach", International Monetary Fund, Working Paper No. 10/187, August 2010