General Review of Literatures on Theories of Foreign Direct Investment

By
Olusegun Ojo Ebenezer
Department of Economics,
University of Ibadan,
Ibadan, Oyo State,
Nigeria.

Abstract

The paper is a qualitative paper which has taken time to consider theories of foreign
direct investment (FDI) and observed the contributions of many scholars on the
foreign direct investment theories. In course of the general review of the literatures, the
paper examined the strength of each theory and it is being improved upon by the
different scholars of international trade.

1.1 Introduction
The most widely accepted definition of FDI is known as the IMF/OECD
benchmark definition because it was provided by a joint workforce of these two
international organizations with the objective of providing standards to national
statistical offices for compiling FDI statistics. The gist of the definition is that FDI is an
international venture in which an investor residing in the home economy acquires a
long-term influence in the management of an affiliate firm in the host economy.
According to the definition, the existence of such long-term influence should be
assumed when voting shares or rights controlled by the multinational firm amount to at
least 10 percent of total voting shares of rights of the foreign firm.
Aggregate FDI flows are the sum of equity capital, reinvested earnings, and other
direct investment capital; hence, aggregate FDI flows and stocks include all financial

Electronic copy available at: http://ssrn.com/abstract=2640497

transfers aimed at financing of new investments, plus retained earnings of affiliates,
internal loans and financing of cross-border mergers and acquisitions. FDI flows can be
observed from the perspective of the host economy, which records them as inward FDI
along with other liabilities in the balance of payments, or from the perspective of the
home economy, which records them as outward FDI, a category of assets.

Foreign direct investment (FDI) is regarded as a factor that drives economic

growth (Wang, 2009). Many governments from developed and developing countries
believe that FDI can help them get through stagnation and even circumvent the poverty
trap (Brooks et al., 2010). In this context, the detailed analysis of the determinants of
FDI has provided invaluable information. Various theories have been developed since
the 1960s to explain FDI. These theories proclaim a number of determinants that could
explain foreign direct investment flows, involving the micro (e.g., organisational
aspects) and macro (e.g., resource allocation) dimensions (Dunning and Lundan, 2008).
The micro dimension includes factors intrinsic to the company itself, such as
ownership advantages, cost reduction and economies of scale, whereas the macro
dimension concerns market specific factors such as barriers to entry, availability of
resources, political stability, country risk and market size, among others (Faeth,2009).
In the beginning, the theories of capital movement were used to describe the
initiation of foreign direct investment. Originally, direct investment was an international
capital movement only (Kindleberger, 1969). In fact, prior to 1950, FDI was regarded as
a subset of portfolio investment. Accordingly, it was asserted that the most important
reason for capital flows lay in the differences in interest rates. This approach stated that
when there were no uncertainties or risks, capital tended to flow to the regions where it
gained the highest return. However, this context failed to incorporate the fundamental
difference between portfolio and direct investment. Direct investment entails control.
Thus, the important theoretical shortcoming of the interest rate theory is that it does not
explain control. If interest rates are higher abroad, an investor will consider lending

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 money abroad, but there is no logical necessity for that investor to control the enterprise
to which he or she lends the money (Hymer, 1976).
The formulation of a proper explanation of FDI was attempted in the 1960s.
Further, with the increasing role of MNCs, researchers attempted to integrate their
activities with the theories of FDI (Rayome and Baker, 1995). Since then, these theories
have highlighted different factors governing the international movement of capital. Some
theories have considered market imperfections as the reason for FDI flows while others
have considered oligopolistic and monopolistic advantages (imperfect conditions). There
are also FDI theories that relate FDI to international trade. In the following sections an
attempt is made to examine these theories.
1.2 FDI Motivating Theories
In this subsection, it is important to consider the factors that do motivate foreign direct
investment.
Geo-cultural affinity can motivate movement of foreign direct investment. This implies
that nations of the world that have the seemingly ways of life tends to move the foreign
direct investment to where their cultural background is not differ. The typical example of
this is China-Hong Kong relationship. The lion's share of Chinese outward FDI flows went
to Hong Kong. They are partly influenced by geo-cultural affinity and strategic reasons
such as raising funds in the capital market there or using Hong Kong, China, as a
springboard for channelling investment elsewhere.
Following Dunning (1998), one of the motives for a firm to actually engage in FDI
activity can go under the heading of resource seeking. As Dunning (1993) himself puts it,
this should include all the cases where enterprises are prompted to invest abroad to
acquire particular and specific resources at a lower real cost than could be obtained in their
home country (if, indeed, they are obtainable at all). Unlike Dunning, we use the term
resource to refer to naturally scarce resources.
Apart from the geo-cultural affinity and resource-seeking factors, there are market-
seeking and non- market assets seeking factors that motivate foreign direct investment.
Market-seeking factors do motivate investors to bring their capital to where there are ready-
made markets in which their products can be sold without delay and receive better returns.
Non-market asset seeking foreign direct investment is premised on the ability of the
multinational corporations to gain patent right for their products.
Foreign direct investment may be motivated as a substitute for exports to a host country.
As laid out by the model of Bucklay and Casson(1981), one can think of exports as
involving lower fixed costs, but likely involves higher variable cost of transportation and
trade barriers. Servicing the same market with affiliate sales from FDI allows one to
substantially lower these variable costs, but likely involves higher fixed cost than exports.
1.3 FDI Attracting Theories
This segment explores the theories that attract foreign direct investment into different
nations of the world.
The move towards decentralization is believed to be potentially conducive to attracting
foreign direct investment. Foreign direct investment flows to those nations of the world that
has decentralized policies. According to Antras(2003), a recent perspective on vertical FDI
has shown by the scholar that drawing on the property-rights theory of the firm, firms
undertake FDI to retain control of upstream activities given the importance of intangible
attributes of the multinational firm that underpins the existence of the firm undertaking the
investment overseas.
Hubert and Pain (2002) have concluded that financial and fiscal incentives, tariff and
lower corporate tax rates have positive effect on attracting FDI. The authors contributed
that multinational companies always prefer any nation of the world that has investment
accommodating corporate income tax, financial and fiscal incentives, and tariff as their
choice for investment.
Both Benassy-Quere et al(2007) and Cleeve (2008) have contributed that investors are
strongly motivated to put their investment in those nations where corruption is very low or
mild because low levels of corruption have been associated with greater prosperity,
institutional quality of a country and stimulation of development.
2.0 Looking for Gaps in Review of literatures on Theories of Foreign Direct
Investment
The genesis of theoretical development of foreign direct investment can be traced
to the model of Heckscher-Ohlin model which is based on the assumptions of two
countries, two factors, two commodities, returns to scale and both countries use
identical factor inputs. Heckscher and Ohlin(1933) concluded that the driving forces for
the FDI in this situation is higher returns and low cost of labour.
MacDougall (1958) established his model based on the assumptions of perfectly
competitive market. Kemp (1964) elaborated on this view of MacDougall view by
assumption of a two-country model and prices of capital being equal to its marginal
productivity. MacDougall and Kemp both stated that when there was free movement of
capital from an investing country to a host country, the marginal productivity of capital
tended to be equalized between the two countries. They found that after investment, the
output of the investing country fell without any decrease in the national income of the
country. This is because in the long term the investing country gets higher income from
its investment abroad. Apart from MacDougall and Kemp, other scholars like Simpson
(1962), and Caves (1971) also channelled their views of FDI theories towards perfective
competitive conditions.
Hymer(1976) faulted the proposition that driving force behind FDI flows is
premised on the fact that market abroad has indisputable attribute of perfection. He was
the first to consider the theory of FDI from the perspective of imperfection. The
essence of Hymers theory is that firms operating abroad have to compete with domestic
firms that are in an advantageous position in terms of culture, language, legal system
and consumers preference. Furthermore, foreign firms are also exposed to foreign
exchange risk. These disadvantages must be offset by some form of market power in
order to make international investment profitable. The sources of market power are in
the form of patent-protected superior technology, brand names, marketing and
management skills, economies of scale and cheaper sources of finance.
 According to Caves (1971), he articulated a significant feature of this theory as the
advantages that are transmitted effectively from one unit of a firm to another unit of that
firm, irrespective of the fact that they are either located in one country or in more than
one country. Apart from Caves, Graham and Krugman (1989), they also supported the
view of imperfection by stating that technological advantages possessed by UK gave
them the upper hand to be able to invest in USA.
Hymer and his supporters failed to have a complete explanation for FDI because they
failed to mention where and when the FDI takes place.
Moving away from imperfection-based theories of FDI, Aliber (1970) put forward
that FDI flow between two countries of different currency strength is possible. He
postulated that weaker currencies compared with stronger investing country currencies
had a higher capacity to attract FDI in order to take advantage of differences in the
market capitalization rate. Aliber had tested his hypothesis and found the result to be
consistent with FDI in the United States, the United Kingdom and Canada. Among
other notable studies in the same genre are Caves (1988), Froot and Stein (1991)
.Though the theory is widely supported, it is not without two faults of failing to compare
the FDI flow from weak currency nation to strong currency nation and an explanation
for investment between two developed countries that have currencies of equal strength.
Kojima (1985) improved on Alibers works. He deviated from placing emphasis on
currency-based theory of FDI. He based his proposition on firms inability to compete
domestically in Japan had compelled them to look for investment opportunities abroad.
He was of the opinion that the more efficient local firms were pushing the less
competent firms out of the local market. As a result, the weaker firms were moving
overseas, especially to other developing countries. However, Kojimas hypothesis failed
to explain the expansion of business activities in international markets by the
domestically competent firms. Also, he did not try to divide FDI into vertical FDI and
horizontal FDI respectively.
Helpman (2003) improved on the work of Kojima by dividing foreign direct
investment into horizontal FDI and vertical FDI respectively. He advocated that in the
theory of horizontal FDI, the model predicts that foreign markets are better served by
exports relative to FDI sales when trade frictions are lower or economies of scale are
higher. Helpman and others (2004) tested their hypothesis with the help of export and
FDI sales by United States firms in 38 countries and 52 industries; the results supported
their theoretical predictions. Helpmans model also based on the differences in the
factor endowments of different locations where a vertical MNC chooses to start its
production centre. The model argues that firms like to choose cost-minimizing locations
to maximize their profits. The differences in the factor endowments are associated with
the relative size of the country. The theory explains the simultaneous existence of inter-
sector trade, intra-industry trade and intra-firm trade. The theory also explains cross-
country penetration by MNCs as a result of impediments to trade such as transportation
cost and tariff.
The proposition of Helpman was improved upon by the innovation of some scholars
like (Yannopoulos,1990) and(Lipsey, 1990) that emphasised regional integrations as the
major driving force for foreign direct investment. Regional integration agreements
(RIA) have proliferated throughout the world, leading to increasing flows of production
factors across nations. This has coincided with a dramatic surge in flows towards
developed as well as developing countries. As a result, the role of RIA as a location
determinant of FDI has become a topic of intense debate in recent years. The relevant
question is whether RIAs supplement or complement FDI. RIAs typically encompass
reductions in regional trade barriers and investment restrictions.
Hence, the impacts of RIAs on FDI flows will ultimately reflect the effects that
investment and trade liberalization have on location and firm-specific advantages. The
liberalization-induced changes in relative cost among member and non-member
countries, changes in relative economic growth rates, altered investors perceptions
about country-specific political risks etc. will alter the location-specific advantages.
RIAs also have the potential to change firm-specific advantages, thereby providing
incentives for firms to undertake FDI. For example, an RIA may lead to a geographical
concentration of specific industrial activities. If those activities involve significant
agglomeration economies, then the firms with production facilities within the locations
may enjoy increased efficiency advantages compared to other firms. Therefore, if these
advantages are best exploited by establishing facilities abroad, FDI will increase to such
regions.

Salike (2010) faulted (Yannopoulos,1990) and(Lipsey, 1990) because they failed to

account for reasons for different impacts of FDI on regions. Salike noted that to identify
and assess the connections between RIAs and FDI it was essential to consider the
motives and modes of FDI from the intra-regional (internal) and inter-regional
(external) perspectives. Salike identified two important motives of FDI (tariff jumping
and internalization) and two channels of FDI (vertical and horizontal).The two views of
the motives for FDI will provide contradictive results regarding the effects of RIAs on
intraregional flows of investment. If the motive for FDI is tariff jumping, horizontal FDI
flows will decline because exporting from the home country will be relatively more
attractive than FDI. However, if internalization is the motive, RIAs will create an
incentive to increase investment as it will help to exploit the intangible assets of firms
more efficiently. This is especially true for vertically integrated FDI, where the
operations of MNCs are specialized according to the location advantages of the host
countries. With regard to interregional investment FDI flows, both the two motives and
the modes will lead to higher investment flows from outsiders into the region as a result
of RIAs, either because of fears about future protection or the perception of an enlarged
market.
Salike theorized that the combined effects on FDI would depend on the intensity
and mix of investment coming from inside and outside the region. In other words, if
interregional investment is predominant RIAs will boost investment. But if intraregional
FDI is dominant, the effect could be negative. It should be noted that even if the modes
and motives are same for countries within the same RIAs, not all countries may benefit
to the same extent as those from different RIAs. Countries with relatively higher
education levels and financial stability have a tendency to attract a larger share of FDI at
the cost of other RIA members.
The RIAs movement of FDI is not without shortcoming because it explained the
movement of investment from developed economies/regions to other
economies/regions. RIAs-based theory of FDI fails to capture the phenomenon of
investment from developing countries to other countries (especially developing nation).
Aggarwal and Weekly (1982) worked on Third World Country Multinational
Companies(TWMNCs) that moved their FDI to other nations of the world. As it is
glaring that TWMNCs brought technology from developed nations, they started
exporting to other nations after establishing at home. When TWMNCs gain control of
foreign market, they then set up affiliates and stop exporting.
The action of TWMNCS is premised on the following reasons: (i) Lower overheads and
expatriate costs (ii) Familiarity with local conditions (iii) Less-threatening position.
2.1 CONCLUSION
The theories of Foreign Direct Investment (FDI) have metamorphosed over time
with its reference point of moving from autarky form of economy to international
economy. This is traceable to the works of Adam Smith and David Ricardo that
propounded principle of absolute advantage and comparative cost advantage
respectively. Using the assumptions of the principles, Heckscher and Ohlin based their
theory of factors endowment differences that resulted in trade. Some scholars built on
this starting point by assuming imperfect market conditions while some assumed perfect
conditions for the major driving force for FDI. Some other reasons behind FDI inflows
or outflows can be discretionally categorised under both perfect and imperfect
conditions.
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