Factors that affect foreign direct investment (FDI)

Readers Question: why some countries are more successful in attracting Foreign Direct Investment than others?

Foreign direct investment (FDI) means companies purchase capital and invest in a foreign country. For example, if a US multinational, such as Nike built a factory for making trainers in Pakistan; this would count as foreign direct investment.

In summary, the main factors that affect foreign direct investment are

• Infrastructure and access to raw materials
• Communication and transport links.
• Skills and wage costs of labour

Factors affecting foreign direct investment

1. Wage rates

A major incentive for a multinational to invest abroad is to outsource labour-intensive production to countries with lower wages. If average wages in the US are $15 an hour, but $1 an hour in the Indian sub-continent, costs can be reduced by outsourcing production. This is why many Western firms have invested in clothing factories in the Indian sub-continent.

• However, wage rates alone do not determine FDI, countries with high wage rates can still attract higher tech investment. A firm may be reluctant to invest in Sub-Saharan Africa because low wages are outweighed by other drawbacks, such as lack of infrastructure and transport links.

2. Labour skills

Some industries require higher skilled labour, for example pharmaceuticals and electronics. Therefore, multinationals will invest in those countries with a combination of low wages, but high labour productivity and skills. For example, India has attracted significant investment in call centres, because a high percentage of the population speak English, but wages are low. This makes it an attractive place for outsourcing and therefore attracts investment.

3. Tax rates

Large multinationals, such as Apple, Google and Microsoft have sought to invest in countries with lower corporation tax rates. For example, Ireland has been successful in attracting investment from Google and Microsoft. In fact, it has been controversial because Google has tried to funnel all profits through Ireland, despite having operations in all European countries.

4. Transport and infrastructure

A key factor in the desirability of investment are the transport costs and levels of infrastructure. A country may have low labour costs, but if there is then high transport costs to get the goods onto the world market, this is a drawback. Countries with access to the sea are at an advantage to landlocked countries, who will have higher costs to ship goods.

5. Size of economy / potential for growth

Foreign direct investment is often targeted to selling goods directly to the country involved in attracting the investment. Therefore, the size of the population and scope for economic growth will be important for attracting investment. For example, Eastern European countries, with a large population, e.g. Poland offers scope for new markets. This may attract foreign car firms, e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer class. Small countries may be at a disadvantage because it is not worth investing for a small population. China will be a target for foreign investment as the newly emerging Chinese middle class could have a very strong demand for the goods and services of multinationals.

6. Political stability / property rights

Foreign direct investment has an element of risk. Countries with an uncertain political situation, will be a major disincentive. Also, economic crisis can discourage investment. For example, the recent Russian economic crisis, combined with economic sanctions, will be a major factor to discourage foreign investment. This is one reason why former Communist countries in the East are keen to join the European Union. The EU is seen as a signal of political and economic stability, which encourages foreign investment.

Related to political stability is the level of corruption and trust in institutions, especially judiciary and the extent of law and order.

7. Commodities

One reason for foreign investment is the existence of commodities. This has been a major reason for the growth in FDI within Africa – often by Chinese firms looking for a secure supply of commodities.

8. Exchange rate

A weak exchange rate in the host country can attract more FDI because it will be cheaper for the multinational to purchase assets. However, exchange rate volatility could discourage investment.

9. Clustering effects

Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is that they can benefit from external economies of scale – growth of service industries and transport links. Also, there will be greater confidence to invest in areas with a good track record. Therefore, some countries can create a virtuous cycle of attracting investment and then these initial investments attracting more. It is also sometimes known as an agglomeration effect.

10. Access to free trade areas.

A significant factor for firms investing in Europe is access to EU Single Market, which is a free trade area but also has very low non-tariff barriers because of harmonisation of rules, regulations and free movement of people. For example, UK post-Brexit is likely to be less attractive to FDI, if it is outside the Single Market.

Evaluation

There are many different factors that determine foreign direct investment (FDI) and it is hard to isolate individual factors, given there are many different variables. It also depends on the type of industry. For example, with manufacturing FDI, low wage costs tend to be the most important, as they are a labour-intensive industry. For the service sector, FDI, macro-economic stability and political openness tend to be more important.

Also, it depends on the source of FDI, American firms may value political openness more than Chinese firms. Or American firms may have a preference for countries where English is spoken more.

UK – Post Brexit

If the UK leaves the Single Market, there will be two factors which make the UK less attractive as a place for FDI

1. Outside Single Market – the possibility of tariffs or greater barriers to trade with rest of Europe. Even if tariffs to EU are low (World trade rules) there is a considerable significance of being outside Single Market which may put off firms, who prefer the security of being in a country committed to Single Market
2. Access to labour. The UK economy has benefited from migrant labour, e.g. construction sector has a high percentage of Eastern European workers. Without free movement of labour, there may be a greater unwillingness to invest in UK.

On the other hand, the UK may seek to attract inward investment, through the aggressive cutting of corporation tax

Related

• Advantages of FDI
• Political stability and FDI

External links

• IMF report on Foreign Direct Investment