Theories of FDI
The existing literature distinguishes between three types of theories concerning the relationship of FDI to economic development: the dependency theory, classical theory, and middle path theory (Toone 2013; Gammoudi et al. 2016). The dependency theory builds on a Marxist foundation that perceives globalization through the prism of exploitation of cheap labor, expansion of market capitalism, and exchange of primary resources in return for obsolete technological know-how from more developed countries. Advocates of the dependency theory hold that the potentially negative influence of FDI on development outcomes in less developed countries can be substantiated as follows. (i) The rewards of FDI are not equitably distributed between host countries and multi-national corporations (MNCs) because the latter get the lion’s share of the various benefits. Moreover, by exploiting profit-making avenues in less developed countries and sending the profits to their rich home nations, foreign investors crowd out local assets that would otherwise have been utilized to fund local development (Jensen 2008). (ii) MNCs also create instability in domestic economies by distorting domestic investment. MNCs use capital-intensive technologies that increase unemployment, increase income-inequality, and change the tastes of customers by undermining local values (Taylor and Thrift 2013). (iii) Often, the citizens of the under-developed host countries are excluded from reaping the fruits of FDI because of alliances between the local politico-economic elite and foreign investors (Jensen 2008).
In contrast, proponents of the classical theory maintain that FDI can be beneficial to the domestic economies of less developed countries through a number of mechanisms: improvement in the balance of payments; transfer of capital, skills, and advanced technologies; growth of foreign exchange earnings; expansion of the tax base resulting from exports related to FDI; integration of the domestic economy into international markets; and development of domestic infrastructure (Toone 2013). The literature on FDI spillovers, which has been documented substantially, provides insight that spillover effects take many forms, including better working methods, good management skills, more employment, domestic financial development, and higher productivity gains (Javorcik 2004; Asongu and De Moor 2017).
The “middle path” theory is a combination of the two preceding theoretical approaches. In essence, the middle path is a cautious theory that focuses on the development consequences of foreign direct investment. Dependency theory focuses on the obvious negative effects from FDI, while classical theory points out the rewards, especially if initial conditions needed for the benefits of FDI are satisfied by the developing domestic economies (Asongu 2017a; Gammoudi et al. 2016). Proponents of the middle path seek the convergence of these theories by emphasizing the importance of a mixture of regulation (i.e., intervention) and openness. This combined approach addresses both the cautions presented by dependency theory that require heavy government intervention and regulation, and the rewards described by classical theory’s advocacy of openness. In a nutshell, according to the middle path, the goal of the domestic economy is to attract FDI while adopting policies that reduce the negative effects of FDI.
There are fundamental determinants of FDI that are acknowledged by all of the versions of the contending theories, notably policy indicators (e.g., tax, trade, privatization, and macroeconomic policies), business dynamics (e.g., incentives for investment), market-related factors (e.g., market structure, market growth, and market size), resource-oriented determinants (e.g., technology availability, labor costs, and raw materials), and drivers toward economic efficiency (e.g., labor productivity, and transportation and communication costs). Our study builds on these common denominators to assess FDI determinants in the fast-growing economies in the BRICS and MINT countries. This approach allows us to examine the motivations of MNCs when deciding to adopt locations for their FDI efforts.
Over the years, the motivations of multi-national enterprises for engaging in FDI have been rationalized from several theoretical viewpoints, including neoclassical trade theory, market imperfections, product lifecycle theory, and eclectic paradigms. Neoclassical trade theory builds on the Heskscher-Ohlin model, which asserts that trade opportunities and capital flows between two countries depend on the relative endowment of factors of production. The implication is that multi-national enterprises invest in countries to take advantage of higher returns on investment or low production costs. In comparison, the market imperfection theory argues that because markets are imperfect, multi-national enterprises are able to locate their businesses or production activities in these countries to exploit economies of scale, ownership advantages, and government incentives (Kindlerberger 1969; Eiteman et al. 2007). Furthermore, the theory asserts that market imperfections in underdeveloped countries propel multi-national enterprises to internalize their operations in those host countries as the most economical means of safeguarding their intangible assets (Buckley and Casson 1976; Hennart 1982; Shapiro 2006).
The product lifecycle theory developed by Vernon (1966) asserts that the lifecycle of a product has four stages: introduction, growth, maturity, and decline. Furthermore, lifecycle development follows a pattern, whereby new products are introduced first in advanced countries and then diffused over time to developing countries. Therefore, the stages of the product lifecycle influence the decision of a multi-national enterprise either to export the product or set up a production facility in the foreign market. The goal of the MNC is to achieve lower production costs while catering to the growing demand for its product in both the foreign market and the home market at a competitive price. Finally, the eclectic paradigm, developed by Dunning (1988, 1993, 2000) is perhaps the most comprehensive theoretical viewpoint for rationalizing the decisions of multi-national enterprises to engage in FDI. The eclectic paradigm framework holds that the scope, geography, and industrial components of FDI by multi-national enterprises are influenced by the interaction of three sets of interdependent variables. These variables are themselves composed of the sub-components of three areas of focus: strategic advantages in ownership, location specificity, and internalization (OLI).
Review of related literature
A substantial number of empirical studies have explored the determinants of FDI in developing countries. Studies that focused on a single country often used time-series analysis, while multi-country studies often employed panel data analysis (Asiedu 2002; Biswas 2002; Jadhav 2012; and Rogmans & Ebbers, 2013). The choice of dependent as well as explanatory variables also differed depending on the countries examined. For the dependent variables, studies used the unidirectional FDI inflow to host countries (Rogmans & Ebbers, 2013), net FDI inflow (Jadhav 2012), ratio of FDI inflow to GDP (Suliman and Mollick 2009; Lehnert et al. 2013), and ratio of net FDI flows to GDP (Asiedu 2002). The choice of explanatory variables varied as well, although some variables have been used consistently. For instance, market size (often represented by real GDP or real GDP per capita) was employed by many empirical studies (Cheng and Kwan 2000; Moosa and Cardak 2006) because it captures the demand for goods and services in the host country. Other explanatory variables often used include the level of trade openness, growth rate, an indicator for infrastructure availability, inflation, and availability of natural resources, as well as indicators that capture political risk and institutional strength (Asiedu 2002; Moosa 2002; Moosa and Cardak 2006; Jadhav 2012; Sichei and Kinyondo 2012; Rogmans & Ebbers, 2013). UNCTAD (2002) classifies these variables into the five major groups shown in Table 2. Nontraditional variables such as type of regime in the host country (e.g., democracy, autocracy, monarchy), regime duration, and risk of expropriation of private investment have also been used in some studies (Biswas 2002).
Jadhav (2012) explored the role of economic, institutional, and political factors in attracting FDI to BRICS economies using panel data for the ten-year period 2000–2009. The findings of the study indicated that the market size, openness to trade, and rule of law played significant roles in attracting FDI to BRICS, while natural resource availability had a negative impact, implying that FDI in BRICS is largely market-oriented. Jadhav and Katti (2012) observed that effective governance and regulatory quality had a positive impact on FDI inflow in BRICS, while political instability, voice and accountability, and control of corruption had negative effects. Similarly, using data from 1975 to 2007, Vijayakumar et al. (2010) employed panel analysis to examine the determinants that bring FDI to BRICS. They observed that market size, labor cost, infrastructure, and gross capital formation contributed positively to FDI inflow, while the effects of trade openness and inflation were insignificant.
Asiedu (2002) examined the determinants of FDI in developing countries with special focus on Africa. Building on the observation that developing countries in sub-Saharan Africa (SSA) attracted very little FDI in the 1990s despite economic reforms, the study sought to understand whether the determinants of FDI in developing countries in other regions were different from those in SSA. They employed panel data for 71 developing countries for the years 1988–1997. The results showed that low infrastructure development and low return on capital, as well as the unfavorable geographic location of many SSA countries, were responsible for the limited FDI inflow. Similarly, Asiedu (2005) examined the role of natural resources, market size, government policy, institutions, and political instability in attracting FDI to countries in SSA.
Rogmans and Ebbers (2013) examined the determinants of FDI in the Middle East and North Africa (MENA) region using panel data from 1987 to 2008. They observed that natural resources endowment contributed negatively to FDI inflows while trade openness had a positive effect. The study suggested that the negative contribution of natural resource endowment to FDI resulted because countries that are highly endowed are more likely to have protectionist policies, thereby limiting potential FDI from resource-seeking MNCs. Hayakawa et al. (2013) investigated the effects of various components of political and financial risk on FDI inflow using panel data for 89 developing countries for the period 1985–2007. They observed that internal conflict, military politics, corruption, and bureaucracy influenced FDI flow negatively, while lower financial risk had no significant impact. Cleeve (2012) used panel data to examine the role of several institutional factors and political stability in attracting FDI to 40 countries in sub-Saharan Africa. In addition to institutional variables included in many other previous studies, Cleeve’s study considered ethnic tensions, religious tensions, and disaggregated conflicts when examining internal and external factors.
A summary of results from earlier studies that examined the determinants of FDI can be found in Asiedu (2002), Moosa (2002), and Moosa and Cardak (2006). Other studies that explored the determinants of FDI include Sekkat and Veganzones-Varoudakis (2007), Ranjan and Agrawal (2011), and Buchanan et al. (2012). Rjoub et al. (2017a) investigated the impact of FDI inflows on economic growth in landlocked countries in Sub-Saharan Africa to establish a positive nexus between the two variables. Rjoub et al. (2016) assessed the connection between FDI and economic growth in Latin American countries to document that economic growth is affected positively by FDI inflows.