An Analysis of Host Country Characteristics That Determine FDI in Developing Countries: Recent Panel Data Evidence

Article excerpt

Abstract

This paper analyzes a range of host country characteristics that determine foreign direct investment (FDI) flows to developing countries, using panel data on 72 countries for the period 1970-2008. Keeping in view the endogeneity problem of the chosen host country's characteristics, the model is estimated using the General Method of Moments (GMM) technique. The analysis shows that gross domestic product (GDP), economic growth, and per capita income positively affect FDI-a result consistent with the market-seeking behavior of multinational corporations (MNCs). Furthermore, we find that remittances have a significant and positive impact on FDI. On the other hand, inflation and the balance of payments deficit have negative effects on FDI. MNCs are attracted to host countries that are outward looking and follow trade-promoting policies. This is confirmed by the positive effect of openness on FDI flows to developing countries. The study also finds that the effect of military expenditures on FDI is negative and significant. Finally, our analysis finds that the real exchange rate has a significantly negative impact on FDI.

Keywords: Investment, panel data, developing countries, FDI, GMM.

JEL Classification: F21.

(ProQuest: ... denotes formulae omitted.)

I. Introduction

Most developing countries experience a shortage of capital, which is reflected in their respective savings-investment and import-export gaps. This implies that developing countries have insufficient savings/foreign exchange to finance their investment needs. To bridge this gap, they need an inflow of foreign capital. Foreign direct investment (FDI) is thus an important source of capital for growth in developing countries.

In the 1960s and 1970s, many countries maintained a cautious and sometimes negative position towards foreign investment. In the 1980s, however, attitudes shifted radically toward a more welcoming policy stance. This change was due mainly to the economic problems facing the developing world. While FDI has surged, other forms of capital flows to developing countries have diminished: Aid has declined continuously as a share of capital inflows since the 1960s, while commercial loans, a major source of capital flows in the 1970s, have virtually disappeared since the debt crisis of the 1980s.

It is generally assumed that FDI contributes to economic growth and restructuring in developing economies. However, there is increasing competition between developing (and developed) countries to attract FDI flows to enter into, or consolidate their position within, an increasingly integrated world production, trading, and investment system. In this study, we focus on the inflow of FDI, using panel data for 72 developing countries. In order to overcome constraints to the supply of FDI, we aim to identify the determinants of FDI inflows.

The rest of the paper is organized as follows: Section II provides a literature review. Section III explains the model and framework of analysis used. Section IV describes the dataset and construction of variables. Section V presents our findings from the empirical analysis, and Section VI presents a summary with some policy implications.

II. Literature Review

The earlier literature describes the determinants of FDI theoretically without giving empirical results (for example, Lall 1978). Later studies based on empirical analysis have increasingly appeared in the literature. These studies differ from earlier studies on the basis of theory. Initially, pure economic theory, i.e., that of international trade and the theory of the firm, were adopted as the theoretical base for empirical studies of FDI determinants. These theories assume the presence of perfect competition and an identical production function, and attribute FDI flows to the difference in interest rates across countries. However, this does not explain the large volume of FDI flows across countries. …