What are main factors attracting FDI in the context of

ASEAN integrations - some empirical findings1

(Preliminary draft please do not quote)

Abstract:

ASEAN's experience in the last three decades has shown that opening the economy, especially
attracting foreign direct investment (FDI) help those countries quickly gained important social-
economic achievements and become one of the promising dynamic regions in the worlds. FDI
inflow is also strongly believed to play a major role in emerging market economies, thus could
help ASEAN new members reduce development gaps with old members. Such development
gaps among Southeast Asian nation could hinder the effort of building ASEAN Economic
Community (AEC) by 2015. However, ASEAN seems to lose their "special advantages of
potentially new market, abundant labor force, cheap labor costs and preferential investment
policies. Our paper assumes that in the process of regional integration ASEAN as a
homogeneous region and the special advantage factors such as "cheap labor cost" in this region is
assumed to be equal among its members. FDI inflows by country recognized in relation to the
total amount of FDI flows into the region. With this assumption, using regression random effects
model (REM), the paper measured a number of factors that influence FDI inflows in the region
such as cheap labor force, economic growth, population size, political stability etc. The research
results show that, beside traditional factors, institutional quality (e.g. control of corruption) need
to be paid more attention in ASEAN region in the long-run.

Key words: ASEAN integration, FDI inflows, FDI impact factors, institutional quality
JEL Classification : O12, O19, 03, P2, P3, K4

1
Paper prepared for AEC , 28 30, October 2013.

1
Introduction

Foreign direct investment (FDI) inflows have major impact on the economic development of
ASEAN countries. Through FDI, the countries of Southeast Asia have rapidly gained important
achievements and become one of the most dynamic regions in the world. Although there are
some concern of negative effects (e.g. great competition for local businesses, adverse impacts on
environment, sensitivity and economic instability involving foreign elements), but no one could
deny the enormous benefits of FDI for the region. New FDI inflows could help ASEAN
economic development with risk sharing, trade enhancement, easy access to foreign markets and
technology transfer. Attracting FDI associated with multi-national business operations is one of
fundamental goal of ASEAN members during the process of economic integration and also as
the important objectives of the ASEAN Economic Community.

ASEAN region is considered to be an attractive destination for foreign investors as the region
has a lot of advantages to attract FDI (cheaper input factors, especially labor costs and natural
material costs, economic growth at a fair-rapid rate and many preferential investment policies).
However, considering long-term FDI attraction, based on low-cost incentives policy is not a
smart choice due to a gradual loss of this advantage. Many evidence show that China economy is
now also facing difficulties in attracting investment as its labor costs rise gradually2. At the same
time, the investment incentives policy accounted for significant expenses in the state budget in
the long term then threat macro stability 3. Therefore, promoting FDI based on labor quality,
infrastructure and institutional quality (including contract enforcement, property rights
protection, control of corruption ...) need to be paid more attention in the new era of economic
development and integration in ASEAN. With such assumptions, the objective of this study was
to assess the level of effecting factors to FDI inflows in ASEAN region during past two decades.
The next part of our paper review factors effecting FDI in ASEAN region, then the methodology

2
The difficulty in finding work has pushed wages in some areas by 40% each year. Other costs such as compliance with
environmental regulations and labor, and commodity prices also led to increased investment in China less attractive.
3
E.g. According to the research group of the Institute of Economic Research Central Management (CIEM), the cost incurred to
implement preferential policies for foreign direct investment accounted for about 0.7% of GDP of Vietnam. "The cost of
investment incentives" view 01/10/2011 (http://www.vssc.com.vn/News/2011/1/10/158601.aspx).

2
and data will be provided. Some empirical findings and discussion will be presented before we
have some concluding remarks.

Factors attracting foreign direct investment in ASEAN region

Reviewing previous studies, there are many authors analyzing the determinant factors of the
level of FDI inflows (Artige & Nicolinie 2006, Meon and sekkai 2007, Bevan & Estrin 2000 and
Peter (2001). As the objective of our paper is to determine the specific factors that attract FDI in
general and FDI in ASEAN, we use the approach of Peter (2001) to draw those factors as the
basis for FDI competitiveness as below:

Country indicators Market size

Institution indicators
Economic indicators
Sector indicators
The level of Openness
Infrastructure
Distance with home country
Regional market link
Natural resources
Law and social norms
Regulation enforcement
FDI incentives related policies
Education and human capitals
Political stability
Labor costs and productivity
Macro economic stability
Economic growth rate
Level technology
Balance of payments
Inflation
Scale industrial sectors
Competitiveness

3
 Level of subsidy for domestic sectors

Many studies show that cost saving is the most important factors for the decision of FDI
enterprises (Yoon, 2007) into the ASEAN region. In the past decades, international investors are
attracted by the abundant large natural resources and cheap labor forces in the ASEAN countries.
For example, considering a few case studies of Malaysia, the foreigners have been flocking to
the country to exploit the abundance of oil, gas, rubber, wood, etc. (Nguyen Manh Toan, 2010).
However, in recent years the trend seems to have faded. Natural resources factors appear weak
compared to the other factors such as political stability, market potential, and preferential tax
policies.

Most ASEAN countries except Singapore and Burney are countries with relatively low or very
low labor costs. For example, wages in the two major cities in Vietnam, Hanoi and Ho Chi Minh
City respectively only about 60 and 70% of salary and wages in Beijing, China (Phuc, VH,
2005). Wages and salaries in Jakarta even half the amount of that in Beijing (JETRO, 2002).
Therefore, compared with China (especially with the pace of rapid economic development of
China) labor costs in Vietnam and Indonesia are now much cheaper.

Some recent empirical studies did not only focus on low cost incentives but a set of factors
attracting FDI in Southeast Asia. Normaz (2009) used a model of attraction factors to consider
major factors attracting FDI inflows during the period 1995-2003. Using data of 18 countries to
invest into 09 ASEAN countries (except Cambodia), Normaz shows that besides economic
factors, market size, exchange rate, quality of infrastructure and labor costs affect FDI inflows.
He also found other significant institutional factors such as trade policy and transparency
contribute to FDI development in ASEAN. Tajul and Hussin (2010) carried out a study on the
effect of institutional quality on FDI flows to ASEAN region from 1996-2008 also showed an
improvement of institutional quality is an important factor to attract new FDI flows. Most
recently, Hong Hiep Hoang (2012) reviewed FDI in ASEAN countries during the period of
1991-2009 and found that, beside the traditional factors as market size, openness of the
economy, infrastructure and exchange rate, political risk and institutional quality also play an
important role on attracting foreign investors.

4
Apart from above mentioned factors, market size with high purchasing power, abundant labor is
an important advantage of ASEAN region which help attracting foreign direct investment
(Benacek Gronicki, Holland, and Sass, 2000). A total population of 10% of the world population
along with rapid economic growth (even during financial crisis period from 2008 to 2009, many
countries in the ASEAN region remains a growth rate of 6% - 8 %)4 could make ASEAN to
become an ideal investment location for any international company seeking to dominate new
markets.

Regarding policy incentives to attract FDI into ASEAN region, the policy of tax incentives,
credit support with governmental guarantee, and free trade policies were among the most
important strategy of ASEAN countries. Research by the World Bank also shows the same trend
of improving investment incentives in all over the world (World Investment Report, 2012) in last
decade. Especially, the WB researchers show the trends toward liberalization and promotion was
always superior to the trends of regulation/restriction as in the diagram bellows:

4
According Finance and Macroeconomic Suveilance ASEAN and IMF World Economic Outlook Database (2009), the economic
growth rate in 2008 of the entire ASEAN region which is 4.4% of Cambodia's growth is 6%, Indonesia 6.1%, Laos is 8.4%.

5
 Figure 1: Investment regulatory change 2000 - 2011

Source: UNCTAD 2012.

Such a trend of study focusing on institutional quality and environment could be explained by
the fact that institutional conditions are important in order to minimize the risks when business
operating in the region beyond the control of foreign investors. Any regulatory and policy
instability as same as political conflict will also psychologically affect the decision of investors
that could not only prevent new investment flows but also make the out flows of FDI to a better
location.

In recent years, ASEAN gain important development process toward common FDI policies with
the foundation of ASEAN Investment Area (AIA) Agreement signed in October 1998. This
agreement is a significant milestone to promote FDI in ASEAN member countries, from both
internal and external sources. It also help to transforming ASEAN into the most competitive and
attractive region for doing investment and business. Besides, ASEAN Free Trade Area
Agreement (AFTA) is the most important and advanced tool of the ASEAN Economic
Community (AEC) to strengthen economic integration and also increase incentives for FDI
inflows. It is the fact that FDI inflows into ASEAN region increase dramatically recent years as
shown as table below

6
 Table 1: FDI net inflows to ASEAN region from selected partners

Value
Partner country/region
2009 2010 20112/ 2009-2011

ASEAN 6,300.2 14,322.7 26,270.7 46,893.6

USA 5,704.3 12,771.6 5,782.7 24,258.5

Japan 3,789.9 10,756.4 15,015.1 29,561.4

European Union (EU) 8,063.1 17,012.1 18,240.5 43,315.7

China 1,852.6 2,784.6 6,034.4 10,671.6

Republic of Korea 1,794.0 3,764.2 2,138.3 7,696.5

Australia 993.0 2,584.9 1,338.0 4,915.9

India 616.4 3,351.5 (1,848.5) 2,119.4

Canada 720.3 1,393.0 985.4 3,098.8

Russian Federation 139.8 60.3 21.6 221.6

New Zealand 98.9 3.4 13.4 115.7

Pakistan 14.3 30.0 13.5 57.9

Total selected partner
countries/regions 30,086.7 68,834.8 74,005.1 172,926.6

Others 16,810.0 23,443.8 40,105.5 80,359.4

Total FDI inflow to ASEAN 46,896.7 92,278.6 114,110.6 253,286.0

Source: ASEAN FDI Statistics Database

In each ASEAN countries, regulatory and policy framework was also very supportive for FDI
inflows. Singapore is one best example where issued the investment legislation earliest in1965 to
attract FDI inflows. The law was amended in 1967, 1971 in order to institutionalize policy
incentives for foreign investors in the key industries. By the early 80s, Singapore was amended
and supplemented laws to encourage large FDI investment and tax exemption for the loss-

7
making company. Thailand investment law was issued in 1970 and the government improved
this law in 1986 with the exemption for corporate tax and export tax for FDI project having
export oriented production. In order to encourage foreign investment, Malaysia has also set
many referenced conditions and policies in its law during the years of 80s. Since 1987, when the
first Law on Foreign Investment was promulgated, Vietnam has undergone five of its revisions
(in 1990, 1992, 1996, 2000 and 2005). Law on Foreign Investment in Vietnam has improved
gradually, creating a legal framework based on the new guidelines and policy to open market
economy into international economic integration of the Communist Party that significantly
attracting foreign investment into Vietnam.

Beside policy incentives, control of corruption became an important issue in research on

institutional factors influencing FDI recently. Wei Research (2000a) considers the effects of tax
and corruption to FDI flows using bilateral FDI data from 12 countries to 45 host countries. The
author pointed out the high tax rate on multinational companies and high levels of corruption
will decrease in FDI flows. Wei also pointed out that the decline of FDI inflows caused by
corruption is greater than the negative impact of corruption on the other capital inflows (Wei,
2000b). Using data of 18 countries investing in 9 ASEAN countries (except Cambodia) Normaz
(2009) concluded that besides economic factors, market size, exchange rate, quality of
infrastructure and labor costs affecting FDI inflows to the region, there is also other factors such
as trade policy and transparency (related with control of corruption) also encourage investment
in ASEAN. Therefore to measure institutional quality that effect FDI in the long-term, it is
rationale to consider control of corruption rather than policy and regulatory incentives that only
have short-term impact.

In general, a number ASEAN advantages such as market expansion, cost reduction, the
availability of natural resources have play an important role in the past to motivate FDI inflows.
That motivation could be explained by a set of factors attracting FDI flows into ASEAN region:
political stability, market size, economic growth, abundant labor force, labor costs, and cheap
input factors. In the next part of our paper, these factors will be considered as endogenous factors
in the modeling explain FDI inflows in ASEAN region in comparison with regulatory and policy
incentives as well as institutional quality with the focus of corruption control.

8
Research Methodology and Data

Consideration of a set of factors that impact on the ability to attract foreign direct investment
from countries with similar economic conditions in the ASEAN region, we adopt a model based
on the panel data of the 7 countries in the region (including Cambodia, Laos, Indonesia,
Thailand, Malaysia, Vietnam, Philippines) during the period of 1996 - 2011. Four countries in
ASEAN namely: East-Timor, Brunei, Singapore and Myanmar are not included in the model due
to the lack of data from East-Timor and Brunei. Singapore and Myanmar are the two countries
with its characteristics relatively different compared to other countries in the region. Singapore is
the country's with impressive economic conditions and is also the most developed countries that
attracted nearly 50% of FDI inflows in ASEAN region.

Figure 2: Share of FDI stock in ASEAN

Sources: UNCTAD Statistic quoted in Hoang Hiep Hong (2012)

Therefore, considering the extent of those countries with similar economic conditions in
ASEAN, Singapore has a relatively large difference conditions.

9
With panel data, our paper use impact assessment model as follows:

Log(FDI)it = 0 + 1 CCit + j +uit

In particular, i represent the unit of observation (7 countries in the ASEAN region), t represents
time (from 1996 to 2011). The dependent variable is FDI in each country in each year are
expressed as logarithm.

As analyzed in above section, the most important factor reflecting institutional quality effecting
long-run FDI inflows in ASEAN is Control of Corruption (CC). Therefore we use CC (Control
of Corruption) as measured by the rank of the ability to control the country's corruption with
level 0 is the lowest and 100 is the highest. With the assumption of a negative impact of
corruption on FDI, CC is expected to have an impact with same direction with FDI inflows.

To assess the authenticity of the impact of corruption on FDI inflows into ASEAN region
especially with higher level of regional integration (e.g. with the establishment of AEC ), our
study considers to control the impact of low-cost advantage by assuming that, in seven selected
ASEAN countries, cheap-cost factors (including costs of labor and raw material) are identical.
That means these countries are considered to have the same relative cheap-cost factors.
Meanwhile, our paper also considered some other factors into our modeling as control variables
namely: economic growth, size of population (population growth), the average longevity
(variable representing a relative market size), labor force, openness of the economy (the ratio of
export turnover/GDP), infrastructure (telephones per 100 people), labor quality (Enrolment of
secondary school), and political stability. They are expected to have a positive impact (on the
same way) to the scale of FDI inflows.

We also considered inflation as a meaningful explanatory variable, especially in Vietnam

situation, which causes macroeconomic instability and may increase uncertainty of business.
Consequently, inflation is expected to have an impact on FDI flows in the opposite side. The
ASEAN integration still keeps silent on an issue of having common currency so that the
exchange rate also affects FDI at least in medium term. The increase in the exchange rate
corresponding to the depreciation of the domestic currency in each selected ASEAN countries
which lead to encourage export activities as well as stimulate foreign investment. Thus, the

10
 impact of exchange rates on FDI flows is expected to be in the same way. Table below lists all
considered factors and variables and its data sources being integrated into our model.

Table 2: List of explanatory variables, expected signs and sources of data

Variables Explaining of Variables Expectation of Data Sources

variable sign

(GDP) Economic Growth + WGI database

Corruption (CC) Control of Corruption by P-Rank + WGI database

(Percentile rank among all
countries (ranges from 0 (lowest)
to 100 (highest) rank)

Political Stability Political Stability and Absence of + WGI database

(PS) Violence by P-Rank (Percentile
rank among all countries (ranges
from 0 (lowest) to 100 (highest)
rank)

Labor force Total labor force + WDI database

(log(LAB))

Openness Total of export and import + WDI database

volume/ GDP

Infrasture (INFRAS) Telephone per 100 people + WDI database

Inflation (CPI) Consumer price index - WDI database

Labor skill School enrolment, secondary (% + WDI database

Gross)

Exchange rate (EX) Official Exchange Rate + WDI database

11
Population Growth Population growth (annual %) + WDI database

Life expectation Life expectancy at birth, total + WDI database

(LIFEEX) (years)

Source: compiled by the authors via WB and other Secondary data

Regression of panel data is likely to remain group effects and/or time effects which may be fixed
or random one. Our paper therefore conducted Hausman test to find whether to use the fixed
effects model (FEM) or random effects model (REM). The results showed that the use of REM
model is more appropriate than the FEM model with our research.

Results and discussion

With the method of estimating random effects model (REM), our regression results shown in
Table 3 below:

Table 3: Results of regression random-effects model (REM)

Dependent variable: Log(FDI)

Log FDI= F(GDP growth, CC,PS, log(LAB), Openness, Infras,
log(EX), CPI, Population growth, Lifeex, labour skill)
Random effect
Economic Growth (GDPgrowth) 0.150614
(0.0001***)
Control of Corruption (CC) 0.037985
(0.0048***)
Political Stability (PS) 0.016729
(0.0247**)

12
 Labor force total ( log(LAB)) 0.873525
(0.0000***)
Openness 0.001805
(0.7579)
Infasture (INFRAS)= Tell/100 people 0.087085
(0.0042***)
Consumer price (CPI) 0.028018
(0.1227)
Labor skill (school enrollment of secondary) -0.021487
(0.1781)
Exchange rate (log(EX)) 0.000174
(0.0000***)
Population growth 0.547872
(0.0444***)
Life expectation (LIFEEX) 0.225472
(0.0309**)
R2 = 0.84
* Significant at 10%; ** significant at 5%; *** significant at 1%

The table shows the results for the explaining variables included in the model is fairly good
explanation for the dependent variable (R2 = 0.84 means that the variable FDI is explained of
about 84% by the independent variables in the model).

The factors like market scale (represented by GDP), economic openness (OPEN), and labor force
(log (LAB)), political stability (PS) is on the same way with FDI inflows. Among them, labor
force expressed the strongest impact on attracting FDI which is reflecting in the regression with
relatively high coefficient. Total labor force increased 1% led to increased FDI growth rate
average of 0.873525 percentage points. Variable representing the quality of human resources
(Labor skill) is not statistically significant, meaning that human resources quality in ASEAN is
less attractive to investors. It confirmed our previous argument that FDI inflow in ASEAN has

13
been motivated by cheap but low skill labor forces. Our result is also consistent with the results
of some previous studies (e.g. PCI Vietnam Report, 2011).

Our study pay attention on institutional quality with the focus of corruption control (CC) to the
FDI in ASEAN and found that, higher level of corruption (i.e. ability to control of corruption fell
1 ranking) will lead decrease of FDI with an average of 0.037985 percentage points. This results
well demonstrates our hypothesis that corruption negatively impacts on FDI inflows into the
ASEAN region. The regional institutions as well as individual government in ASEAN thus
should more actively control of corruption. Our research result is also entirely consistent with the
work of Normaz Wana Ismail (2009) and Tajul Aiffin Masron and Hussin Abdullah (2010).

Conclusion

According to the OECD (2002), FDI is a major catalyst for economic development with the
potential of contributing towards both economic growth and improved living standards. FDI
Inflow has had a major impact on the economic development of the countries in the ASEAN
region and ASEAN nowadays becomes one of the most dynamic economic regions in the world.
However, the causal link that is often depicted between FDI inflows and economic development
condition is not necessarily straight forward.

Our study included a review of the impact of identical factors affecting the scale of FDI in the
ASEAN region. Using regression random effects model (REM) for 7 selected ASEAN countries,
our paper measured the negative impact of institutional quality represented by level of corruption
on FDI inflows to ASEAN in nearly past two decades. We also confirmed that there are a
number of factors that positively affect FDI in the region, most notably is the labor force,
economic growth, population size, political stability. Our research results show that to attract
FDI in the long-term, ASEAN need pay more attention to institutional quality rather than other
traditional factors and policy incentives. In the process of ASEAN integration and as
consequences of economic growth in the region, the advantages of cheap-cost factors and
investment policy incentives will fade while the impact of institutional quality related to business
transaction costs will increase more obviously.

14
References

Artige L. and R. Nicolini (2008), Evidence on the Determinants of Foreign Direct Investment.
The Case of Three European Regions, CREPP Working Papers.

Bardhan P. (1997), Corruption and Development: A Review of Issues, Journal of Economic

Literature, Vol. 35, No. 3, pp. 1320-1346.

Beck P.J. and Maher M.W. (1986), A Comparison of Bribery and Bidding in Thin Markets,
Economic Journal, Vol. 20, No. 1, pp. 1-5.

Benacek, V., Gronicki, M., Holland, D., Sass, M. (2000). The Determinants and Impact of
Foreign Direct Investment in Central and Eastern Europe: A comparison of survey and
econometric evidence, Transnational Corporations, Journal of United Nations, vol.9, no.
3, New York.

Hoang Hiep Hong (2012), Foreign direct investment in Southeast Asia: Determinants and
spatial distribution, Centre of Studies and Research on International Development
University of Auvergn, CNRS.

Jaumotte (2004), Foreign Direct Investment and Regional Trade Agreements: The Market Size
Effect Revisited, IMF Working Paper, WP/04/206

JETRO (2002), Survey of Wage in Asian 3/2012, The Japan External Trade Organization.

Lui Francis T. (1985), An Equilibrium Queing Model of Bribery, Journal of Political

Economy, Vol. 93, No. 4, pp. 760-781.

Mauro P. (1995), Corruption and Growth, The Quarterly Journal of Economics, Vol. 110, No.
3, pp. 681-712.

Nguyn Mnh Ton (2010), Nhng yu t thu ht FDI vo cc a phng ti Vit Nam, Tp
ch khoa hc v cng ngh- i hc Nng, S. 40, tp. 3, tr. 270-276.

15
Normaz Wana Ismail (2009), The Determinant of Foreign Direct Investment in ASEAN: a Semi-
Gravity Approach. Transition Studies Review, 16, pp. 710-722.

North, DC (1990), Institutional Change and Economic Performance. Cambridge, University

Press.

Peter Nunnenkamp (2001), foreign direct investment in developing countries: What

policymakers should not do and what economists don't know, Kieler Diskussionsbeitrge,
No. 380,http://hdl.handle.net/10419/2616

Phuc, V.H. (2005), Interview with H.E. Minister V Hng Phc. Ministry of Planning anh
Investment of Vietnam. Business in Asia. Com. May 26, 2005.

Runkel & Associates (2005), Vietnam at a glance. Vietnams business Outlook for early 2005

Tanzi, V. (1998), Corruption around the world: causes, consequences, scope and cures, IMF
Working Paper 98/63, Washington, International Monetary Fund

Tajul Ariffin Masron and Hussin Abdullah (2010), Institutional Quality as A Determinant for
FDI inflows: Evidence from ASEAN. World Journal of Management, 3, pp. 115 128

Tanzi V. and Davoodi H. (1997), Corruption, Public Investment, and Growth, Fiscal Affairs
Department, WP/97/139, International Monetary Fund.

UNCTAD (2004), World Investment Report: The shift toward services, New York, United
Nations Publication

VCCI (2012), Provincial Competitiveness Index 2011, Policy Research Reports, USAID/VNCI,
No. 16

Voyer and Paul (2004), The Effect of Corruption on Japanese Foreign Direct Investment,
Journal of Business Ethics, Vol. 50, No. 3, pp. 221-224.

Wei, S. (2000a), How Taxing Is Corruption on International Investors. Review of Economics

and Statistics 82: 1-11.

16
______ (2000b), Local Corruption and Global Capital Flows.Brookings Papers on Economic
Activity 2: 303-46

Voyer, P., and Beamish, P. (2004), The Effect of Corruption on Japanese Foreign Direct
Investment. Journal of Business Ethics 50: 211-24

Yoon, D. R. (2007), Koreas Outward FDI in Asia: Characteristics and Prospects. Paper
presented at ICRIER Workshop on Intra- Asia FDI flows: Magnitude, Trends, Prospects
and Policy Implications, April 25-26, New Delhi, India.

17