The Asian financial crisis of 1997 reminded many in the international community that foreign capital inflows come in different forms and that some of these forms are more desirable than or preferred over other forms. From the perspective of a recipient or host country, these different forms of foreign capital inflows have different impact on its economic development.
With several episodes of foreign debt crises by a single country or a group of countries from which to draw, the lesson has been clear that successful use of foreign loans required skillful management of the resulting debt on the part of the borrowing country. This success increases with the share of foreign loans that actually finances investment, the productivity of that investment, and the ability of the borrowing country to generate the currency in which foreign loans are to be serviced.
Foreign portfolio capital inflows are usually short-term in orientation and evidently too mobile that they can and do easily and quickly flee from a recipient country at the first sign of trouble. From past experiences, we have seen how such sudden movement in this type of foreign capital had devastating effects on countries from which they were fleeing and challenged policymakers to search for measures to minimize such effects.
The lesson is clear and the verdict is out: comparatively speaking, foreign direct investments (FDIs, henceforth) are the preferred form of foreign capital inflows. Nunnenkamp (2001) noted that FDIs are superior to other types of capital inflows because of their longer-term orientation and hence their stability, their higher likelihood of being used productively, their risk-sharing properties, and their greater likelihood of increasing the level of aggregate investment and economic development in the host country. In addition, he noted that "FDI is more than just capital as it offers access to internationally available technology and management know how", which can potentially spill over to domestic firms and result in higher productivity (quote taken from Nunnenkamp (2001), page 3).
Consequently, countries seek out this preferred form of foreign capital, FDI, thus competing fiercely against each other. This competition is further intensified by the continued globalization of markets which makes foreign capital in general and FDIs in particular even more mobile. Such mobility gives foreign direct investors, mostly multinational corporations (MNCs, henceforth), bargaining power over prospective host country governments as they choose their investment location.
At the same time, globalization has limited the policy options available to host country governments by which they could attract FDIs (Blomstrom and Kokko (2008)). For instance, the liberalization of trade in goods and services in many countries has limited national government's use of trade policy to attract FDIs. In the past, import restrictions led to FDIs that were "tariff-jumping" (Palmade and Anayiotas (2004)). These are investments that are export-oriented but are better able to access the domestic market by locating there in order to avoid the costlier import restrictions, including prohibitive tariffs. Globalization has reduced these trade restrictions and favored a movement toward more open trade and away from use of trade policies, including those that resulted in higher FDIs.
Globalization has meant liberalization of product markets as above noted but also of capital markets. As a result, host country governments that previously used exchange rate policies to attract FDIs now face pressure to limit their foreign exchange intervention and to adopt a more market-determined exchange rate system. Adding to this is the fact that the continued development of markets for financial derivatives has also equipped MNCs with many ways to reduce exchange rate risks associated with undertaking FDIs, thus diminishing the importance of exchange rate, and exchange rate policies, as a determinant of their locational decision regarding their FDIs. …