A Study on the Impact of Foreign Direct Investment on Economic Development of Lao P.D.R.

NEW CONTRIBUTION OF DISSERTATION PhD student: Khamsen SISAVONG Topic: A Study on the Impact of Foreign Direct Investment on Economic Development of Lao P.D.R. Supervisor: Assoc.Prof.Dr. Nguyễn Thị Tuyết Mai Investigation into the effects of FDI on the economies of host countries is considered to be one of the two most important and most researched topics in international business (Driffield Love, 2007). This study aims to examine the impact of FDI on several economic development indicators in the context of Laos. The study is important to help Laos enjoy further economic development as well as contributes to the literature of FDI and economic growth in the context of developing countries. FDI has been suggested as a determinant of economic development in both developed and developing countries. Its important role in promoting economic growth and bringing many benefits to the economy is especially emphasized in the context of developing countries. However, the literature also provides mix findings pertaining to the effects of FDI, and there has been suggested that the link between FDI and economic development may be country and period specific. Therefore, it is important and meaningful to examine the impact of FDI inflows on economic development in Laos, which has received very modest research attention to date. By examining the relationships between FDI and various indicators of economic development, the correlation results provide empirical evidence to support the important and positive role of FDI inflows on GNI per capita, Financial Capital (Gross capital formation, the longterm debt service on external debt, and the total debt service on external debt), Level of Technology, Human Capital, and Transportation and Communication. The research has contributed to both theoretical and practical sides. From theoretical perspective, the research helps to enrich the knowledge about the important topic pertaining to FDI’s impacts on economic development in general and in the context of a developing country in particular. From practical perspective, the research findings provide significant implications to policy makers in Laos. The issue of FDI and its important role is more important for developing countries and the countries in transition like Laos because they lack capital, know how, and managerial skills. Understanding the role of FDI would help making good policies to attract more FDI for the purpose of economic development. Therefore, the results of this dissertation are expected to provide significant implications for policy makers. The results can be applied in the area of attracting the FDI flows. The dissertation can also provide recommendations for a better business conditions for investment and doing business.

KHAMSEN SISAVONG

A STUDY ON THE IMPACT OF FOREIGN DIRECT INVESTMENT ON

ECONOMIC DEVELOPMENT OF LAO P.D.R

A thesis submitted to the National Economics University

in fulfillment of requirements for the degree of Doctor of Philosophy in Economics

Hanoi, 2014

DECLARATION

I hereby declare that this dissertation is my own work and effort The dissertation has not been submitted anywhere for any award All the sources of information used have been well acknowledged

KHAMSEN SISAVONG

ACKNOWLEDGMENTS

The Vietnam – Lao Cooperative Program Doctor of Philosophy (PhD) between NEU and NUOL is very important, necessary, valuable and beneficial to our nations because this project allows Lao people to upgrade and enhance their level to Doctorate Degree

Therefore, I would like to acknowledge the leaders, Administrators, Professors

of the National Economics University of Vietnam and National University of Laos to give me this excellence opportunities to achieve my dream of PhD

I would like to express my gratitude to Prof Dr Tran Tho Dat, Assoc Prof.Dr Nguyen Thanh Ha and other professors who were in the committees for evaluation of

my dissertation in the early stages of my PhD study

I am deeply indebted to Assoc Prof Dr Nguyen Thi Tuyet Mai, my supervisor who gives me clear guidelines and contributing her advises to my dissertation

I am also grateful to Prof Dr Somkod Mangnormek, Governor of Xiengkhuang Province, member of Central Committee Party, Prof Dr Kikeo Khaikhamphithoun, Head of National Accademic of Politic and Public Administration, member of Central Committee Party, Prof Dr Thongsalith Mangnormek, Head of National Economic Research, Prof Dr Bounpong Keonoradome, President of Savannakhet University who encouraged and supported me to reach my goal of PhD

My special thanks go to my family, Sengsavanh College’s staff and my friends They are always pleased to encourage and to assist me during my PhD research

Without your supports I could not complete and realize my dream

DECLARATION i

ACKNOWLEDGMENTS ii

ABBREVIATIONS v

LIST OF FIGURES vii

LIST OF TABLES viii

CHAPTER 1 INTRODUCTION 1

1.1 Research Background 1

1.2 Rationale for the Research 3

1.3 Research Objectives and Research Questions 4

1.4 Scope of the Study 6

1.5 Contributions of the Study 6

1.6 Dissertation Structure 8

CHAPTER 2 LITERATURE REVIEW ON THE IMPACT OF FDI ON ECONOMIC DEVELOPMENT 9

2.1 Definition and Indicators of Economic Development 9

2.1.1 Definition of Economic Development 9

2.1.2 Indicators of Economic Development 10

2.1.3 Theoretical Economic Overview 11

2.2 FDI and its Impact on Economic Development 14

2.2.1 Definition and Determinants of FDI 15

2.2.2 Impact of FDI on Economic Development 30

CHAPTER 3 OVERVIEW OF ECONOMIC DEVELOPMENT AND FDI IN LAOS 51 3.1 Overview of Laos’ Economy 51

3.1.1 Economic Growth 52

3.1.2 Economic Structural Changes 53

3.1.3 Financial Sector Growth 54

3.1.5 Inflation has been effectively managed 55

3.1.7 Workforce and Employment Balance 56

3.1.8 Balancing the Sources of Funds for Development 58

3.1.9 Balancing the State Budget 60

3.1.10 Balancing Imports and Exports 61

3.1.11 Sectoral Development, Regional and International Economic Integration 65

3.1.12 Infrastructure 88

3.2 Foreign Direct Investment in Laos 90

CHAPTER 4 RESEARCH METHODOLOGY 95

4.1 Research Questions 95

4.2 Variables and Measures 95

4.3 Data Description 97

CHAPTER 5 RESEARCH FINDINGS 107

5.1 FDI and GNI per Capita 107

5.2 FDI and Financial Capital 108

5.3 FDI and Level of Technology 111

5.4 FDI and Human Capital 112

5.5 FDI and Energy and Natural Resources 113

5.6 FDI and Transportation and Communication 114

CHAPTER 6 CONCLUSIONS AND DISCUSSION 116

6.1 Conclusions 116

6.2 Implications of the Study 117

6.3 Limitations of the Study and Future Research Direction 121

REFERENCES 123

Economic Commission of Europe Economic Organization of West African States European Union

FDI Foreign Direct Investment

IMF

IPRs

International Monetary Fund Intellectual property rights ISCED

ISIC

International Standard Classification of Education International Standard Industrial Classification

LDCs Least developed countries

ODA

OECD

National Tourist Authority Official Development Assistance Organization for Economic Co-peration and Development OLI

US the United States

VAT Value Added Tax

WTO World Trade Organization

LIST OF FIGURES

Figure 1: Economic structure 2006 – 2010 54

Figure 2 Export and Imports from 2005-2009 64

Figure 3 Average size of agricultural land per household 66

Figure 4 Average share of value added in the industrial sector 2006-2010 70

Figure 5 Structure of service sector 2006-2010 75

Figure 6 Foreign direct investment, net inflows (BoP, current US$) 92

Figure 7 Distribution of FDI in Lao PDR (US$ m) 93

Figure 8 Share of accrual FDI by country (% of total, as of August 2009) 93

Figure 9 Ten biggest foreign investors in Laos (1989 – 2012) 94

Figure 10 Graph of Correlation between FDI and GNI per capita 107

Figure 11 Graph of Correlation between FDI and long-term debt service on external debt 110

Figure 12 Graph of Correlation between FDI and level of technology 112

Figure 13 Graph of Correlation between FDI and School enrollment, tertiary 113

Figure 14 Graph of Correlation between FDI and Natural Resources 114

Figure 15 Graph of Correlation between FDI and Mobile cellular subscriptions 115

LIST OF TABLES

Table 1 Comparison between actual and targeted GDP growth rate in the Sixth Plan

(2006-2010) 52

Table 2 GDP per capita (plan vs actual) 53

Table 3 Share of labour by sectors 58

Table 4 Private domestic and foreign investment from 2006-2010 (USD billion) 60

Table 5 Export structure of Lao PDR by commodities 2005-2009 (%) 62

Table 6 Import structure of Lao PDR by commodities 2005-2009 (%) 63

Table 7 Inter-Country Comparison on Opened Trade or Integration 2006-2010 86

Table 8 Export Market Structure with Main Trade Partners, 2008 87

Table 9 Foreign direct investment, net inflows 98

Table 10 GNI per capita 99

Table 11 Gross capital formation (annual % growth) 100

Table 12 Financial capital 101

Table 13 Industry, value added (% of GDP) 102

Table 14 Human capital 103

Table 15 Oil consumption per capita 104

Table 16 Transportation and communication 105

Table 17 FDI and GNI per capita Coefficient of Correlation 108

Table 18 FDI and Financial Capital Coefficient of Correlation 108

Table 19 FDI and Level of Technology Coefficient of Correlation 111

Table 20 FDI and Human Capital Coefficient of Correlation 112

Table 21 FDI and Energy and Natural Resources Coefficient of Correlation 113

Table 22 FDI and Transportation and Communication Coefficient of Correlation 114

CHAPTER 1 INTRODUCTION

1.1 Research Background

Laos is a small landlocked country with an area of 236,800 square kilometers It shares its borders with Vietnam in the East, China in the North, and Cambodia in the South, Thailand and Myanmar in the west Two third of the country is mountainous (northern part) thus its geographic circumstances constrain both the quality and quantity of agriculture and cause difficulties to the development of trade, social infrastructure and transportation and communication links However, the country has transformed from a landlocked to a land link and cross road to other parts of the world

Laos is located in the center of energetic and prosperous region of South East Asia and possesses a high potential of natural resources, raw material and hydropower The country is divided into three main regions: northern, central and southern regions The current total population of Laos is 6.9 million (2012) with major of those live in valleys of the Mekong river and its tributaries The population density is about 27 per Sq meter Vientiane is the capital and the largest city, and its population is about 800,000 residents

After becoming independent in 1975, Laos established control over the economy through the centralized fiscal and socialist government until 1985 but during that period, the government had seen that the performance of the economy was unable to reach expected goals Economic management was weak due to the lack of skilled labor force External assistance was provided but projects were not completed at a satisfactory level In 1986, the Lao government implemented the New Economic Mechanism (NEM) to open the country and provided incentives for developers and investors and moved from a centrally planned economy to a market oriented economic model

The goals of the NEM were: Launching open market policies and the introduction of market economy principles The reform has attracted FDI projects in the agricultural, industrial, hydropower electricity, mining and the service sectors These sectors of development have played an important role in the support of the economic development in Lao P.D.R

Laos has continuously pursued significant economic and institutional reforms, aiming at improving social and economic wellbeing of its population by consistently building itself a market oriented economy Laos has achieved remarkable economic growth and macroeconomic stability It has witnessed a significant rise in public and private investment

These factors contributed to the annual average growth rate of over 6 percent per annum from 1990 to 2009 and the annual average growth rate of about 8 percent

FDI inflows in Laos have grown dramatically over the past decade and have played an important role in the growth of the world economy as well as the ASEAN Nations In the developing world, FDI has become the most stable and largest component of capital flows As a result, FDI has become an important alternative in the development finance process (Global Development Finance, 2005.)

Laos is a small and still poor country Therefore, the investment from foreign countries in terms of FDI is needed because FDI plays an important role in job creation, economic growth, capital inflow, technology transfer, human resource development, and wealth in the host country Thanks to the economic reform, the number of FDI projects and the income on international trade have increased significantly and have had a direct impact on national income as well as GDP growth

1.2 Rationale for the Research

It has been suggested that Foreign Direct Investment (FDI) inflows have played an important role in promoting economic growth in developing countries, especially in the Southeast Asian countries (Nguyen, 2008) They are the source of large capital, knowledge, expertise, technology transfer, and international market access Since the 1990's, the global flows of FDI have grown phenomenally and have become the largest source of foreign private capital to reach developing countries like Laos

The attraction of the FDI is becoming increasingly important for Laos to bring certain benefits to the national economy like the contribution to the GDP, the total investment, and the balance of payment for the host country However, the impact of FDI largely depends on the economic conditions Domestic investment, personal savings, the mode of entry (merger, acquisition, or new investment), the industry sector involved, and the country's ability to regulate foreign investment are all factors affecting the impact size of the FDI (Earth Summit, 2002)

FDI has a substantial influence on social and infrastructure development as well as technology transfer It helps in stimulating employment, raising wages, and replacing declining market sectors, consequently having cultural and social impact

if the investment is directed toward non-traditional sophisticated product (Earth Summit, 2002)

Attracting FDI is the major concern and a desired outcome of Laos to catch

up and achieve economic growth Since investors have certain requirements to invest abroad, the host countries must posscess a standard macroeconomic environment to attract those investors to bring their capital, technology, and expertise Hence, the role of the government in devising policies and building economic infrastructure is a pre-determinant to attract FDI

Location-specific attractiveness, political and economic stability, the property and profit tax system, the market size and labor-force composition, geographic proximity, the number of competitors, freedom of entry and exit from domestic financial markets are all factors influencing the volume and the type of capital inflows to Laos In addition, energy and water resources, transportation and telecommunication infrastructure are critical elements that have a great influence on capital inflows and investments in the host countries

Given the importance of FDI especially in developing countries like Laos, theoretically as well as practically, there are however still inconclusive arguments for and against the role of FDI inflows in enhancing economic development in a country (cf., Nguyen, 2008) It has still been debate about whether FDI inflows are beneficial or not to economic development, and what governments should do to attract and use FDI inflows effectively (Kokko et al., 2003; Longani & Razin, 2001; Masina, 2002; Nguyen, 2008) In addition, it has been suggested that the relationship between FDI and economic growth may be country and period specific (cf., Adegbite & Ayadi, 2010) Therefore, this study aims to explore the impact of FDI inflows on some indicators of economic development in the context of Laos, a developing country in Asia

1.3 Research Objectives and Research Questions

This study seeks to analyse FDI inflows into Laos and to investigate their impact on the economic development of Laos It identified this impact by responding to the country's characteristics and infrastructure as determinants for

capital inflows, transfer of technology, augmentation of human capital, and other spillover benefits

The desired outcome of this research aims at confirming the linkage between FDI inflows in Laos and the economic development indicators including GNI per capita, financial capital, level of technology, human capital, energy and natural resources, transportation and communication

The major economic development theories and models such as The Stage Theory of Rostow, the Harrod-Domar model of savings and productivity of investment, the Lewis Model of Dual Economy, the Dependency Theory, and other scholarly models in the field assisted in establishing the base theory for the research

The research problem revolves around the notion that Laos is incapable to achieve economic growth Natural resources, human capital, financial capital, transportation and communication, level of technology, and leadership, are all important elements of sustainable economic growth They are the foundation for any economic development stimulation The scarcity of these resources will stall the economy and make it difficult to make growth progression

Research Questions

This research tried to answer the questions: 1) What are the relevant literature and the theoretical background on FDI and its impact on economic development? and 2) Does FDI have a significant contribution to economic development of Laos?

With regard to the impact of FDI on economic development, the research aims to answer the following specific questions:

• Does FDI have a significant role on the GNI per capita?

• Does FDI have a significant role on the country's level of technology of Laos?

• Does FDI have a significant role on Human Capital of Laos?

• Does FDI have a significant role on the Energy and Natural Resources availability of Laos?

• Does FDI have a significant role on the Transportation and Telecommunication infrastructure of Laos?

1.4 Scope of the Study

This study focuses on the role of FDI on some indicators of economic development in the context of Laos Other aspects of development such as social and environmental issues (i.e., poverty ratios of different sectors, education and health care, environment pollution and damage) are not addressed in this dissertation

This study mainly employed the data to analyse the relationships between FDI and Laos’ economic development indicators during the period 1990-2012 The analyses of correlations were used to serve the objectives of this research

1.5 Contributions of the Study

Investigation into the effects of FDI on the economies of host countries is considered one of the two most important and most researched issues in international business (Driffield & Love, 2007) This study aims to examine the impact of FDI on several economic development indicators in the context of Laos The study is important to help Laos enjoy further economic development as well as contributes to the literature of FDI and economic growth in the context of developing countries

FDI has been suggested as a determinant of economic development in both developed and developing countries Its important role in promoting economic growth and bringing many benefits to the economy is especially emphasized in the context of developing countries However, the literature also provides mix findings pertaining to the effects of FDI, and there has been suggested that the link between FDI and economic development may be country and period specific Therefore, it is important and meaningful to examine the impact of FDI inflows on economic development in Laos, a developing country which has received very modest research attention to date.

By focusing on six main research questions pertaining to the relationships between FDI inflows and various indicators of economic development, the research has contributed to both theoretical and practical sides From theoretical perspective, the research helps to enrich the knowledge about the important topic pertaining to FDI’s impacts on economic development in general and in the context of a developing country in particular From practical perspective, the research findings provide significant implications to policy makers in Laos

The issue of FDI and its important role is more important for developing countries and the countries in transition like Laos because they lack capital, know how, and managerial skills Understanding the role of FDI would help making good policies to attract more FDI for the purpose of economic development Therefore, the results of this dissertation are expected to provide significant implications for policy makers The results can be applied in the area of attracting the FDI flows The dissertation can also provide recommendations for a better business conditions for investment and doing business

Briefly, the findings of this study help to enrich the knowledge about the important topic pertaining to FDI’s impacts on economic development in general and in the context of a developing country in particular The study also provides implications to policy makers

CHAPTER 4 RESEARCH METHODOLOGY

This chapter outlines the research methodology and data sources used to answer the research questions

CHAPTER 5 RESEARCH FINDINGS

This chapter presents the key findings on the relationships between FDI inflows and various indicators of economic development in Laos over the period 1990-2012

CHAPTER 6 CONCLUSIONS AND DISCUSSION

The final chapter summarizes the research findings, provides implications, and discusses limitations of the study and offers suggestions for future research

CHAPTER 2 LITERATURE REVIEW ON THE IMPACT OF FDI ON ECONOMIC DEVELOPMENT

2.1 Definition and Indicators of Economic Development

2.1.1 Definition of Economic Development

Economic Development is the progress in an economy and is a measure of the welfare of humans in a society It usually refers to the adoption of new technologies, transition from agriculture-based economy to industry - based economy, and general improvement in living standards (Businessdictionnary.com) Similarly, the International Economic Development Council defines economic development as an “activity that seeks to improve the economic well-being and quality of life for a community, by creating and/or retaining jobs…” (smallbusiness.chron.com)

Economic development is a normative concept It means that it applies in the context of people's sense of morality (right and wrong, good and bad) The definition of economic development given by Todaro (1994) is an increase in living standards, improvement in self-esteem needs and freedom from oppression as well

as a greater choice The most accurate method of measuring development is the Human Development Index which takes into account the literacy rates and life expectancy which affect productivity and could lead to economic growth It also leads to the creation of more opportunities in the sectors of education, healthcare, employment and the conservation of the environment It implies an increase in the per capita income of every citizen (Todaro, 1994)

Economic development can also be referred to as the quantitative and qualitative changes in an existing economy Economic development involves development of human capital, increasing the literacy ratio, improve important infrastructure, improvement of health and safety and others areas that aims at

increasing the general welfare of the citizens The terms economic development and economic growth are used interchangeably but there is a big difference between the two Economic growth can be viewed as a sub category of economic development Economic development refers to government policy to increase the economic, social welfare and ensure a stable political environment Economic growth on the other hand refers to the general increase in the country products and services output (source: whatiseconomics.org)

2.1.2 Indicators of Economic Development

According to United Nations Human Development Report (2001) and report research of bbc.co.uk, some key indicators of economic development are presented

access), information network, industry establishment, techonology, financial capital flow, foreign trade, and human capital (e.g., Adegbite & Ayadi, 2010; Kotrajaras et al., 2011; Mengistu & Adams, 2007; Phimphanthavong, 2012; Prasad & Sharma, 2012)

In this study, the author examines the impact of FDI on economic development in Laos, focusing on some economic development indicators including:

- Gross National Income (GNI) per capita

The GNI per capita is the dollar value of a country’s final income in a year, divided by its population It reflects the average income of a country’s citizens Knowing a country’s GNI per capita is a good first step toward understanding the country’s economic strengths and needs, as well as the general standard of living enjoyed by the average citizen (Wikipedia)

- Financial Capital

- Level of technology

- Human Capital

- Energy and Natural resources

- Transportation and Communication

2.1.3 Theoretical Economic Overview

Rostow (1960) argued that all countries passed through the same historical stages of economic development and underdeveloped countries were at an early stage compared to the advanced world (e.g., Europe and North America) He identified societies in their economic status as passing through one of five stages: the traditional society, the preconditions for take-off, the take-off, the drive to maturity, and the age of high mass- consumption

Lewis' Dual Economy model (1954) was based on the assumption that many LDCs had dual economies with both a traditional agricultural 'informal' sector and a modern industrial 'formal' sector The traditional agricultural sector was described with low income, low productivity, low saving, and high unemployment rate The industrial sector on the other hand was technologically advanced, with high investment level operating in urban environment According to this model, surplus labor in the traditional agricultural sector should migrate to the modern sector where the high rising marginal product is Migrating surplus labor would have no effect on agricultural productivity since marginal productivity of the rural workers is close

According to the traditional model of economic development and its proponents like the Harrod-Domar growth model, the absence of the high level of savings in underdeveloped countries contended that the stimulus for economic growth could only be achieved from an outside capital provided by MFs through foreign direct investment (FDI) since they have the capabilities and the resources to provide that capital and transfer modern technology to the underdeveloped nations Harrod-Domar model suggested that the economy's rate of growth depends on the level of saving and the productivity of investment; that is, the capital output ratio The model was developed to help analyze the business cycle However, it was later adapted to explain economic growth It argues that the main ingredient of economic growth is to expand the level of investment both in terms of fixed capital and human

capital To do this, policies are needed to encourage saving and/or generate technological advances that enable firms to produce more output with less capital or lower their capital output ratio (Pool & Stamos, 1990)

Opposing the traditional model, the equity structuralist model stated that underdevelopment could only be explained in a historical context The state of underdevelopment was the result of colonization that allowed a small minority to own and control the majority of the land, the primary raw materials, and the illegitimate political power (Pool & Stamos, 1990)

Dependency theory (Pool & Stamos, 1990) on the other hand, has explained the underdevelopment based on the Marxian analysis It argues that the MFs have a negative impact on developing nations and market structure, challenging both the traditional and the structural models Because of the MFs power of economy of scale and barriers to entry (technology and capital resources), they are an obstacle to competition from the local firms in the host countries

The Dependency theory has presented the practice of transfer pricing (overpricing imports and under pricing exports) by the MFs to gain benefits at the expense of the developing countries Additionally, developing countries were targeted by MFs to transfer their economic surplus to the developed world by extracting and controlling raw materials, and accessing cheap labor markets

In his classic 1956 work, Solow proposed that the study of economic growth should begin by assuming a standard neoclassical production function with decreasing returns to capital He suggested that the rate of saving and population growth could determine the steady state of per capita income Since these variables vary across nations, they reach different levels of GDP per capita Therefore, when the rate of saving is high, the richer the country is, and when the population growth

is high, the poorer the country is (Mankiw et al., 1992)

Mankiw et al (1992) said that Solow's model was successful in predicting the effects of saving and population growth on economic development but did not predict the magnitude of that effect Therefore, they augmented Solow's model by including accumulation of human as well as physical capital to the formula of economic growth They concluded that for a given rate of human capital accumulation, higher saving or lower population growth leads to higher level of income and thus a higher level of human capital Hence, accumulation of physical capital and population growth has greater impacts on income when accumulation of population growth rates This would imply that omitting human capital accumulation biases the estimated coefficient on saving and population growth

Heady (1979) indicated that the real problem in the least developed countries

is the imbalance between the accumulation of capital and the production level These countries face a necessity to increase the exports level of their raw materials

of which their prices constantly fall, while imports of industrialized materials, technology, and other finishes products of which the prices rise up Consequently, per capita income gap between the developed nations and LDCs is always increasing, in addition to the relative increase of population growth

2.2 FDI and its Impact on Economic Development

In literature, there are various FDI theories including production cycle theory

of Vernon, strategic behaviors, industrial organization, internalization eclectic paradigm, complement theory of FDI, the theory of internationalization of FDI (OLI paradigm), the resource based theory, the business network theory, the theory of new economic geography, diversified FDI and risk diversification model, policy determinants of FDI, etc It is important to have critical points of view towards the theories relating to FDI This chapter focuses on some main issues related to FDI theories and FDI’s impact on various aspects of economic development However, the first section will present definition of FDI and the reasons for FDI

2.2.1 Definition and Determinants of FDI

2.2.1.1 Definition of FDI and reasons for FDI inflows to developing countries

of influence by the direct investor on the management of the enterprise Ownership

of at least 10% of the voting power, representing the influence by the investor, is the basic criterion used

Inward stocks at a given point in time refer to all direct investments by residents in the reporting economy, while outward stocks are the investments of the reporting economy abroad Corresponding flows relate to investment during a period of time Negative flows generally indicate disinvestments or the impact of substantial reimbursements of inter-company loans

non-The FDI index gauges the restrictiveness of a country's FDI rules through four types of restrictions including foreign equity limitations, screening or approval mechanisms, restriction on key foreign employment, and operational restrictions

The OECD FDI regulatory restrictiveness indexes presented here demonstrate that the service sector tends to have higher FDI restrictions across countries, followed by primary sectors The manufacturing sector remains the most opened economic sector

In the same line, according to investopedia.com, FDI refers to an investment

in another country FDI differs substantially from indirect investment such as portfolio flows, wherein overseas institutions invest in equities listed on a nation's stock exchange Entities making direct investments typically have a significant degree of influence and control over the company into which the investment is made Open economies with skilled workforce and good growth prospects tend to

attract larger amount of FDI than closed, highly regulated economies

When analyzing FDI, it is important to differentiate it from Foreign Portfolio Investment (FPI) FPI is passive, non-fixes holdings of foreign stocks, bonds, or other financial assets Investors look for profit from the rate of return on their investment and no management control is assumed It is noted that the most accepted definition of FDI is the one given by the International Monetary Fund (IMF) IMF defines FDI as the acquisition of at least 10% of the ordinary shares or voting power in an enterprise by nonresident investors, and direct investment involves a lasting interest in the management of an enterprise and includes reinvestment of profits (cf., Agrawal & Khan, 2011) Therefore, the distinguishing feature between FDI and FPI is that FDI has some form of control over operation and influence over decision, but with control comes risk and commitment Risk is something which multinational enterprises (MNEs) prepared to take MNEs can be defined as “companies headquatered in one country but having some upstream and/or downstream operations in other countries” (Lee & Rugman, 2009; p 62) So, those organizations which conduct FDI in other countries can be classified as MNEs

Reasons for FDI inflows to developing countries

Yoonbai (2000) examined the reasons behind the flow of FDI in countries like Korea, Malaysia, Chile, and Mexico The research found that this flow was influenced by two factors on a global level: recessions faced by many industrialized economies and the global interest rate drop Internal factors like (a) country-specific productivity shocks, (b) demand shocks, (c) inflation shocks,(d) monetary shocks,

(e) credit worthiness because of macroeconomic stabilization, (f) widespread liberalization of financial market, and (g) a successful resolution of debt problems were found relatively less important

A study by Ito and Rose (2002) explaining the nature of international competition among MFs in the tire industry and the determinants of an MFs decision to establish a subsidiary in a foreign country showed that the number of competitors, the host country characteristics, and the foreign experience of the firm defined the pattern and location of the firm investment Oligopolistic reaction and FDI theories with binomiallogit and logistic regression models were used in the study The data sample included eight major tire firms; (Bridgestone, Continental, Dunlop, Firestone, General, Goodrich, Goodyear, Michelin, Pirelli, and Uniroyal), and a total of 939 observations for the years 1982, 1987, and 1992 It was also found that factors associated with FDI decision are (a) location-specific attractiveness, (b) political and economic stability, (c) low corporate tax, (d) large market size, (e) geographic proximity, (f) size of the foreign market, (g) number of competitors, and (h) anticipation of profit

An earlier cross-country data analysis using representative countries from Asia and Latin America (Calvo, Leiderman, and Reinhart, 1996) also outlined the causes of the capital inflows to developing countries in the 1990s, and the macroeconomic effects on them because of this inflow The concluded causes were (a) the sustained decline in the world interest rate which motivated the investors to the high-investment yields and improving economic prospects of Asia and Latin America's economies, (b) the 1990s recessions in the U.S., Japan, and many countries in Europe made the profit opportunities in developing countries appear more attractive, (c) the trend toward international diversification of investments in major financial centers and toward growing integration of world capital markets, (d) the significant progress that many heavily indebted 12 countries made toward

improving relations with external creditors as well as adopting sound monetary and fiscal policies with trade liberalization

The Earth Summit (2002) indicated that the most heavily indebted and low- income countries are mostly dependent on bilateral and multilateral financial aid to carry on their development strategies However, since the 1990s the global flow of FDI has grown phenomenally and has become the largest source of foreign private capital to reach developing countries

Albuquerque (2003) examined the volatility of the FDI inflows to developing countries compared to other forms of financial inflows Research showed that there was substantial evidence that FDI flows are less volatile than other forms of financial flows to developing countries, for example, the Latin America debt crises

in 1980 The FDI collapsed but other forms of capital inflows fall was seven times greater Mexico's debt crisis in 1994 is another example, where FDI fell in 1996

by 27%, while other forms fell by 89% for portfolio equity and by 45% for debt flows

The level and relative importance of FDI has fluctuated over time, and was high in the early parts of the 20th century, low in the middle part and growing high towards the end Recently, there has been increase in FDI to developing countries, though concentrated in a few regions and countries Inward FDI to developing countries has always been concentrated in a handful of countries, in part reflecting their economic wealth, but also reflecting the ability of countries to create the conditions to ensure efficiency and strategic asset for FDI needs including good quality of human resource and technological capabilities

There has been a marked shift towards liberalization of FDI regime, and FDI

is regarded more favorably No longer can it be assumed that FDI is mainly negative (as it may have been a dominant perception in the 1970s ) Appropriate

policies benefit from FDI include building up local human resource and technological capacities to capture productivity spillovers

Renewed confidence in the positive benefits of FDI has led many countries that were restricting FDI in the 1990s and 1980s to be more open towards FDI in 1990s (Safarian, 1999) and beyond Governments are liberalizing FDI regimes as they associate FDI with positive effects for economic development in their countries (e.g., Lall, 2000s) Much of potential for economic development was not realized 3-

4 decades ago because many countries have severe restrictions toward foreign ownership, and many of quality local capabilities were not in place This is gradually changing Almost all countries now actively welcome FDI

They have liberalized their investment regime, but at different points in time South – East Asian economies: in 1960s, Hongkong {China}, Singapore, Malaysia were first, while other Asian countries (Republic of Korea, China and India) and Latin America countries began to liberalize in 1980s and 1990s (even the Republic

of Korea, which had previously restricted FDI and imported technology through licensing, decided after the Asian crisis in 1997 to open more to FDI for the capital and technology it could bring) Many African countries followed only in 1990s Countries now actively try to attract FDI and have established FDI promotion agencies for this, thereby aiming to change an FDI screening task into true FDI promotion The proliferation of other tools included incentives, expert processing zones, Science parks, etc Restrictions on FDI on the other hand have declined as competition for FDI increased: there has been a decrease in the inclined as performance requirements (UNCTAD, 2003)

2.2.1.2 Determinants of FDI

It has been considered that imperfections in market throughout the world create the desire to invest in other countries, and therefore, firms conducting FDI are opportunists who are continually looking for possibilities to explore Firms are

identified three main factors including 1) supply factors, which include reduced production cost, more favorable location, lower distribution costs, better availability

of natural resources and access to technology; 2) demand factors, which include better marketing power through a presence on the ground, protection of a brand name through a better monitoring and closer proximity to business customers; and 3) political factors, which are the benefits of avoiding set trade barriers as well as tax and economic incentives from host governments The presence of just one of the aforementioned reasons supports the decision to engage in FDI rather that pursuing an alternate means of serving a foreign market, such as exporting, licensing or franchising

Firms who choose to invest abroad are commonly more competitive than their peers, who remain satisfied with a domestic market Not all firms choose FDI,

as it is inherently risky due to the degree of unknown when operating in a foreign market However, increased risks mean greater incentives, and those firms who manage to become more successful of a result of their FDI activities receive large reward (United Nations, 2006)

There have been a number of theories and approaches that help explain the motivations of FDI and identify FDI’s determinants The following will present some of these

Internalization

Internalization was conceptualized by Ronals Coase (1937), who found that FDI and associated internalization take place when transaction costs, i.e the cost of negotiating, enforcing and overseeing a contract, are high and in such cases firms internally can be suitable substitute for market Alternatively, when these costs are low, this positively supports the case for working in partnership with other firms, being parts of the market, and using mutually beneficial licensing and franchising agreements The firm is left to decide whether it is more cost effective to own and

run a facility oversea (internalize) or it is better to establish a contract with a foreign firm to run, license or franchise on their behalf (Wall & Rees, 2004) The internalization theory developed from the imperfections in the market Internalization can be seen as a form of vertical integration, where the firms takes ownership of duties and/or goods that it formerly relied on a third party to provide Hood & Young (1979) argue that it is not just the ownership of a firm’s specific asset that gives it its advantages, which is the process of being able to internalize the asset, rather than selling it, which gives the MNE its overriding advantage Overall, knowledge provides a firm with a monopoly advantage and only through discriminatory pricing, instead of licensing for example, can MNEs capitalize fully

Transactions with other firms consume time, and additional costs can be incurred during searching periods and in uncontrollable events Therefore, replacing these market inherent obstacles with internal processes can reduce insecurity The internalization argument provides reasons why firms prefer FDI in some circumstance to importing and exporting, and why they may refrain from licensing

or franchising (Moosa, 2002) The internalization argument does not appear to have any theoretical foundations, and Rugman (1986) supports this by stating that due to its generality, internalization can be seen as more of an approach than a theory Also, with internalization, centralization is promoted This may not be beneficial in all firms, especially those that are innovative (ibid)

The costs of internalization need to be taken into consideration: more accounting and ownership of information is required; the costs of communication increase; and the dislike of MNEs in some host countries cause political discrimination that could affect the firm adversely All of these costs need to be justified (Hood & Young, 1979) MNEs have to consider the full picture when making future FDI decisions and as Grosse (1985) put it, MNEs are complex and that the internalization principle features are a small part of a larger picture in the

FDI decision making process Nevertheless, FDI evidence across many countries is

in general supports of the hypothesis of firm’s preference for FDI (Moosa, 2002)

Eclectic paradigm

The eclectic paradigm, constructed by Dunning (1981) proposes three determinants of FDI of which each relates to advantages of conducting direct investment as a preference to other methods of serving foreign customers (Bende – Nabende, 1999) The three variables of the eclectic paradigm are ownership, location, and internalization (OLI), and these act like a three legged stools, of which each leg is equally as important as the other (Dunning, 2000) Dunning asserts that firms will become involved in FDI when all three factors are present

Ownership advantage (O): A unique advantage must be present which can counter the disadvantage of competing with firms on their home grounds A firm can gain this by having one of three forms of assets Two main advantages arise from having one of the aforementioned: First, a firm will have more effective production and marketing, and second, a firm will have an international, competitive advantage due to having a string ownership advantage over the local firms (Bende- Nebende, 1999; Griffin & Putsay, 2002)

Location advantage (L): There must be increase in profitability from exploiting a firm’s ownership advantage in a different location rather than in its domestic market, and this may come in the form of economic, market, cultural, or prospect benefit (Wall & Rees, 2004 ) The advantages of the location can either be used to directly serve the foreign market or as a convenient base from which to export The location advantage needs to be considered in relation to the current state the host country as well as the foreseenable development path of the home country (Bende – Nebende, 1999)

Internalization advantages (I): There must be increasing benefits from having full control over the foreign business rather than using an independent local firm to

carry out those duties There are a rang of situations where internalization can be beneficial, from circumstances where local firms cannot be trusted either for tarnishing the brand of a firm or being incapable of performing the required duties, through to being overpriced (Griffin & Pustay, 2002) With internalization, firms have the opportunity to fully exploit the ownership advantages Firm advantages commonly revolve around their knowledge of making a product or provide a service, and internalization provides opportunity to keep that particular information secure, as this could be the core of their competitiveness (Czinkota, Ronkainen and Moffett, 2005)

The three elements of Dunning’s eclectic theory have been assembled using the supports of other theories, namely Sermon’s product life cycle, Hymen’s ownership advantage, and internalization by Coase When combined, they bring together separate areas, which allow them to provides greater and more detailed criteria to judge the suitability of FDI Therefore, eclectic paradigm has three times the power of each of the theories which make it up Dunning (1997) also suggests four type of seeking behavior that stimulate firms to engage in FDI These include resource seeking to attain physical or human resources, market seeking to use or get close to a foreign market, efficiency seeking to gain access to more efficient labor

or technology, and strategic assets seeking to acquire resources and capabilities that help to capitalize on competencies or to prevent an asset being lost to a competitor Traditionally, FDI was motivated by lower cost of production overseas with the view of exporting to serve other markets rather than serving domestic market, but reasons for investing abroad vary tremendously More recently, FDI has been undertaking to serve domestic markets, and this is particularly evident in developing countries (IMF, 2003)

The eclectic paradigm does justify the who, where and how of FDI, but unlike the product life cycle theory, the eclectic paradigm is incapable of indicating exactly when a firm should invest overseas If its plans are delayed, a firm may find

itself beaten by other investors because local partners are scarce or natural resources are limited Also, if the country has a small market, the firms who move first could saturate the market and confrontation could result in reduced profitability for a firm Timing is an important consideration When firms move into developing countries and fail to consider, it could mean that a firm invests after the optimum time (Ramasamy, 2003) Foreign investment does not happen instantly, but once the commitment has been made it may be irreversible After investment, and while waiting for operations to commence, a firm’s golden benefits of a market may slide away This could cause a knock-on effect and result in delays in entering the next market, as all of this affect the firm negatively when compared to proactive competition

Complement Theory of FDI

The complement theory, as synthesis of the Heckscher-Ohlin model, the Rybczinski theorem, Linder’s hypothesis, and the Vernon product cycle hypothesis, was developed by Kojima in the late 1970s Kojima’ thesis offers an alternative hypothesis to Mundell’s substitution Theory (Ozawa, 1979) He argued that FDI originates from the comparatively disadvantaged industries of the home country, which are potentially comparatively more advanced industries in the host country, depending on the different stages of economic development in home and host countries

Kojima’s approach predicts that export-oriented FDI occurs when the source country invests in those industries which have a comparative advantage in the host country FDI is considered as the transfer of superior production function to replace inferior ones in the host country (Kojima, 1975)

Thus, Kojima derived the result that export-oriented FDI is welfare improving and trade creating since it can promote both host countries’ and source countries’ export, in particular, Japanese export business to market distortion

created by government policies in the developing countries (Tsurnmi, 1979) Obviously, besides Asia, this can be extended to other transition countries

The Resource-Based Theory

Summarizing multiple MNCs’ incentives, Behrman (1972) proposed and developed a typical FDI This classification is based on industrial organization theory and corporate governance According to Behrman, MNCs are always seeking one of four types of results: resources, markets, efficiency (global Sourcing FDI), and strategic assets However, because ownership and internalization advantages are supply-side factors, they are not considered by Behrman The resource-based theory

of the firm (Bamey, 1991; Grant, 1991; and Davidow, 1986) creates a methodical basis for MNC investment strategy to achieve competitive advantage by understanding the external forces that strongly effect an organization (Lindelof and Lofsten, 2004)

Accordingly, MNCs aim to possess resources that are rare, unique, and limited to beat their competitors The resource-based theory has been developed to explain how organizations achieve sustainable competitive advantage (Caldeira and Ward, 2003) Accordingly, firms must look for unique attributes that may provide superior performance (Barney, 1991; Caldeira & Ward, 2003) This theory focuses more on the advantages associated with the complexity of managing multiplicity of activities and functions in a volatile but innovated global economy (Dunning, 2000) The finding of Tondel (2000) supports a hypothesis of market-seeking and resource-seeking investments prevailing in Central and Eastern Europe and former Soviet republics Kudina and Jakubiak (2008) also find that market-seeking orientation has the most positive effect on investment performance, followed by skilled labor and cheap input orientation countries

Resmini (2000) argues that a statistically significant position between FDI and market size, wage differential, the stage of the transition process and the

openness of the economy However, MNCs emerging in the transition economies with the government as main stakeholder are limited in the natural-resource – seeking activity of foreign investors This situation especially contains characteristics of rent – seeking countries (Filippov, 2008) The rent-seeking empires of the oligarchs become monopolist on the domestic resources market As a result, foreign investors should seek labor and efficiency and form horizontal FDI patterns This may partially explain the predominance of horizontal FDI pattern in transition economies

The Theory of New Economic Geography

According to the theory of new economic geography (Krugman, 1991, 1999), the ‘home market effects’ interprets agglomeration as the outcome of the interaction of increasing returns, trade costs and factor price differences If trade is largely shaped by economies or sales, as Krunman’s theory argues, then those economic regions with most production will be more profitable and will therefore attract even more production and FDI In other words, instead of spreading evenly around the world, production will tend to concentrate in a few countries, regions or cities, which will become densely populated but will also have higher levels of income

In line with Krungman and Vendables (1994), Damijan and Kostve (2008) find very strong evidence that in most of the transition countries analyzed, trade liberalization has caused a declined and divergence in relative regional wages, but the relative wages then adjusted toward the stock mainly through economic geography factors For instance, in Central and Eastern European countries, important inter-regional relocation of manufacturing activity have taken place after trade liberalization with the EU, and inward FDI mostly to the capital and border regions has help to the foster these adjustment processes However, since economic integration with EU provides important opportunities for individual regions, it can also have severe polarization effects In fact, such a polarization can be observed in

all transition countries For example, Ledyaeva, and Linden (2006) note that the central region of Russia has a rather high value of accumulated FDI per capita compared with other regions In fact, it accumulated almost 40 percent of total FDI stocks in Russia and has the highest FDI per capita

According to Pan – European Institute estimate (Pan – European Institute report, 2004 ), out of the 20 Russia receiving the most FDI; 11 of them have cities

of more than a million inhabitants Hence, big city advantages like high levels of business infrasture and large market size are important factors of inward FDI Ledyaeva and Mishuna (2006) analyze FDI distribution in Russian regions and show that only a fraction of aggregated profit in a particular region is robustly related to regional distribution of investment in Russia, which is unfavorable and only high profit can compensate for the risks and attract investors

Suggesting regional homogeneity of FDI factors for transaction economies, Deichmannetal (2003) examine the extent to which none-spatial determinants of FDI are affected by spatial proximity Thus, within the group of transition factors,

we can also distinguish some regional subgroups according to historical, economic and cultural conditions

Diversified FDI and risk diversified model

A large stream of empirical contributions have analyzed the role of risk factors on explaining FDI patterns and MNCs, incentive to invest abroad (Miller and Pras, 1980; and Caves, 1996) Faeth (2009) noted that while horizontal and vertical patterns of FDI can be explained well by the transaction- cost approach and knowledge – capital model, diversified FDI, which is growing in importance, cannot be explained, as it is considered a minor factors of MNCs’ desire to spread investment risk Firms’ risk aversion, which has been considered a minor factor of FDI, is gradually emerging as one of the main determinants of FDI Rugman’s diversification to hypotheses has been widely supported by empirical evidence In

contrast to horizontal and vertical patterns, conglomerates arise as a response to high risk business environments Kopites was the first to describe this form of MNC

in 1979 Bettis (1981) suggested that firm achieved better performance because of openness to the possibility of differentiation and segmentation based on identified risk factors

Policy determinants of FDI

The earliest study by Bond Samuelson (1986), Black and Hoyt (1986), Haufler and Wooton (1999), and Haland and Wooton (1999) argued that there are strong links between MNC strategy and government policy in the host countries Empirical studies show that an MNC’s decision to invest can be influenced by factors such as information asymmetry, structure of the host economy, market size, market evolution, openness, the level of infrastructure and the level of political, economical and financial risk (e.g see Resmini, 2000)

Altomonte (1998) obtained evidence by including variables measuring the Institutional and economic uncertainty under which the investment is made In the context of institutional and risk factors, we can identify a dual role of government in transition countries The government is not only interested in attracting FDI but can also provide large support for domestic MNCs, being a key stakeholder in them This phenomenon has been explored in a wide empirical literature (Brouthers & Bamossy, 1997; Cass, 2007; Drahokoupil, 2008)

Deicmann, studying the origins of FDI in Poland (2004) and in the Czech Republic (2010) finds that origin effects and government promotion abroad play an implicit contradictions that complicate FDI into transition economies Using political leverage (an administrative resource like close ties to the government or lobbying in Parliament) and domestic media leverage, emerging MNCs protect and promote their business, but also successfully compete with

foreign companies within the host market and regional markets (Khanna & Yafeh, 2008)

Changes in the determinants of FDI

The way that FDI affects growth and development depends, for an important part, on the type and volume of FDI Thus, when understanding the impact of FDI,

it is importance to understand what attracts FDI, how this has changed over time, and what these changes in determinants and type of FDI mean for differential growth prospects The main determinants of inward FDI can be divided in to several categories, and relate to:

- General policy factors (e.g political stability, privatization)

- Specific FDI policies (incentives, performance requirements, investment promotion, international trade and investment treaties)

- Macro economic factors (human resources, marketing size and growth)

- Firm specific factors (e.g., technology): For instant, ICT development have had a profound impact on the way companies structure their international activities Most importantly, it has facilitated a more competitive environment for any given activity

There have been treads in all of these factors over the past decades and between them They can explain large parts of why FDI has gone more to some countries and regions than others There has also been changes in their relative importance The main point is that, and we will also see later, factors that have become increasingly important in attracting FDI (building up appropriate and good quality, local capabilities are also increasingly important in marketing FDI work for economic development)

2.2.2 Impact of FDI on Economic Development

FDI has been considered to be one of the most important drivers in upgrading the country-specific resources as well as the firm-specific capabilities of host countries FDI’s contributions to the development of host countries can be implemented through several channels such as transferring financial resources directly to the FDI recipient countries, technological and managerial spillovers to local firms of the host countries, and/or helping host countries join the global trading, investment and technology networks of foreign MNEs The importance of FDI to the development of host countries has recently increased due to the role

‘flagship’ of MNEs, who are considered the main FDI implementors (cf., Lee & Rugman, 2009)

In the following sections, first the author review previous studies on the impact of FDI on economic growth and some other aspects of economic development, mainly in the context of developing countries After that, a review of the studies on the impact of FDI on economic development through human capital and technology is provided Finally, the author presents FDI and its spillover effects

2.2.2.1 Impact of FDI on economic growth and other economic development aspects

New growth theorists, Levine and Renelt (1992) have identified investment, including FDI as one of the main determinants of economic growth (Adegbite & Ayadi, 2010 According to UNDCTAD (1999), much have been written about relationship between FDI and development The author reviews the main impact areas and suggest there have been major changes within these, with an emphasis on FDI relates to economic growth (we do not deal separately with equality and poverty) There are several areas through which FDI affects development (UNCTAD, 1999), including: Employment and incomes, capital formation, market

access, structure of skills, technology and skills, fiscal revenues, political, cultural, and social issues

FDI affects economic growth through all of the above channels FDI can raise economic growth by increasing the amount of factors or production (by increasing capital or employment, directly in local suppliers and competitors), in the traditional growth accounting context, or increasing efficiency by which these factors are using (by using superior technology, or locating in high productivity areas, or through productivity spillovers), as expressed in the literature in endogenous growth (e.g Aghion and Howitt, 1988) where FDI represents the port through which new ideas are gained In the long-run, FDI induced productivity to local capabilities, while FDI induced building up of factors may only raise growth temporarily (e.g by establishing a garment assembly factory)

Those countries whose local capabilities have been enhanced because of FDI (e.g in Singapore and island, where local suppliers have become global exporters) have also been able to benefits most from FDI in the long- term However, those countries that attracted FDI in the apparel sector because of trade policy distortions (due to the multi Fiber Arrangement quotas which governed world trade in textiles and clothing until 2005) without building up local capabilities or linkages, may have derives fewer long – term benefits from FDI For instance, there are now fears that investors in Lesotho would withdraw, at a time that much apparel capacity is relocated to China

It has been argued that FDI enhances long run economic growth via technological progress, capital accumulation and human capital augmentation (Chee

& Nair, 2010) Gao (2005) investigated the interrelationship between FDI and growth Using a two-country model in which FDI and growth are endogenous, he found that both FDI and growth respond endogenously because of the change in the world economic integration