There is increasing recognition that understanding the forces of economic globalization requires looking first at foreign direct investment (FDI) by multinational corporations (MNCs): that is, when a firm based in one country locates or acquires production facilities in other countries. While real world GDP grew at a 2.5 percent annual rate and real world exports grew by 5.6 percent annually from 1986 through 1999, United Nations data show that real world FDI inflows grew by 17.7 percent over this same period! Additionally, MNCs mediate most world trade flows. For example, Bernard, Jensen, and Schott find that 90 percent of U.S. exports and imports flow through a U.S. MNC, with roughly 50 percent of U.S. trade flows occurring between affiliates of the same MNC, or what is termed "intra-firm trade". (1)
Despite the obvious importance of FDI and MNCs in the world economy, research on the factors that determine FDI patterns and the impact of MNCs on parent and host countries is in its early stages. The most important general questions are: what factors determine where FDI occurs, and what impacts do those MNC operations have on the parent and host economies? As I discuss in a recent survey of the empirical literature addressing the first question--the determinants of FDI decisions--the answers are not straightforward. (2) In particular, the literature has shown that we cannot simply conclude that factors such as exchange rates or tax policies have an unambiguous general impact on FDI patterns. Instead, meaningful insights come from developing hypotheses about, say, when a factor should matter for FDI, or even just a particular form of FDI, and then finding creative ways to test these hypotheses in the data.
Exchange Rates and FDI
One good example of this is the effect of exchange rate movements on FDI. For years, the conventional theory was to compare FDI to bonds, for which exchange rate movements do not affect the investment decision. A depreciation of the currency in the host country reduces the amount of foreign currency needed to purchase the asset, but it also reduces the nominal return one receives in the foreign currency. Thus, the rate of return for the foreign investor does not change. Empirical studies of FDI seemed to confirm this, often finding insignificant effects of exchange rates. In contradiction to this, the popular press often points to host-country exchange rate depreciations as a contributing factor to inward foreign investment booms, and worries about the selling of key national technological assets.
I find a resolution to this puzzle by considering FDI that involves firm-specific assets (such as patents or managerial skills)--the type of assets previous literature established as crucial to formation of MNCs and FDI. (3) Such assets are typically intangible and easily transferred across a firm's operations. Thus, the purchase prices of such assets through FDI are in the host-country's currency, but returns can be generated anywhere the firm operates and are not necessarily tied to the home country's currency. This means that host-country currency depreciations theoretically can lead to increased acquisition of FDI, particularly of firms that have firm-specific assets. This hypothesis is strongly confirmed for a panel of acquisitions of U.S. firms by Japanese and German firms and provides evidence for the notion in the popular press that currency depreciations ease foreign firms' purchases of U.S. host-country technological assets.
Taxes and FDI
Another factor that the literature finds does not affect FDI in a straightforward manner is tax policy. MNCs are potentially subject to taxation in both the host and parent country. However, most parent countries have policies to reduce or eliminate double taxation of their MNCs. James R. Hines, Jr. and co-authors have shown that the way in which parent countries reduce double taxation on their MNCs (for example, allowing credits or deductions) can have quite different implications for FDI activity. …