Determinants of Foreign Direct Investment

Abstract

As the world economy becomes integrated and foreign investment becomes liberalized, most governments compete to attract foreign direct investment (FDI) to their country based on the belief that foreign firms bring advanced technology, create jobs, and boost economic growth. Also, since FDI is one of the most stable capital flows, unlike capital flows in the stock and bond markets, it holds particular importance for developing countries. For these reasons, the determinants of FDI have been broadly studied from a variety of perspectives. Since FDI is determined by the behavior of multinational companies (MNEs), the motive behind the investment from the perspective of the investing firm is relevant. The first motive for FDI is to serve the local market by substituting exports from home to host country, called horizontal FDI. In this case, local market size and purchasing power strongly impact the location choice of MNEs. The second motive for FDI is to gain access to production factors including natural resources, raw materials, and human resources, called vertical FDI. In this case, availability of resources and lower factor costs play important roles. The third and last type of FDI is to relocate certain parts of production, produce goods, and then export them to third countries, which is called export-platform FDI. Since the main reason firms seek export-platform FDI is to save production and trade costs, low labor costs, lax market regulations, and trade openness are crucial determinants.