Analysis The Factors That Determine Fdi Inflow Economics Essay

This essay intends to analyze the factors influence FDI inflow activities in China. The analysis follows the Dunning’s classic FDI model, i.e. Eclectic (OLI) Paradigm. Based on Dunning’s theory, combining the China’s unique national characteristics, there are three general catalogs for factors that influence FDI activities in China: economic, political and cultural. Economic factors mainly focus on market size, market growth and labor cost. Political factors mainly analyze the effects brought by International FDI policy (Bilateral Investment Treaties), fiscal policy (tax policy) and Intellectual property protection policy. It also draws attention on the local cultural characteristics which affect the decision on FDI from MNEs. It is believed that the successive high growth on Chinese economy leads to the importance of market-seeking orientation on FDI in China. Nevertheless, other factors (political and cultural factors) still play vital roles in FDI decision in China.

Keywords: Foreign Direct Investment; China; Eclectic Paradigm.

Executive Summary

Dunning’s internalization theory and Eclectic (OLI) Paradigm provide a roadmap for analyzing FDI activities. For analyzing China as one case, three general factors are classified: economic, political and cultural factors. Specifically, Economic factors mainly focus on market size, market growth and labor cost. Political factors mainly analyze the effects brought by International FDI policy (Bilateral Investment Treaties), fiscal policy (tax policy) and Intellectual property protection policy. It also draws attention on the local cultural characteristics (linguistic, cultural and geographical proximity) which affect the decision on FDI from MNEs. Since the successive high GDP growth in China, the purchase power of consumers increase significantly, thus the market size and growth expand at a high rate. It is concluded that economic factors (market-seeking and labor cost) is the main driver for FDI in China. Nevertheless, the political and cultural factors have vital influence on the FDI activities in China as well.

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Table of Contents

Introduction

Since the opening and reform policy issued in 1978, Foreign Direct Investment (FDI) inflow has contributed significant proportion to the economic development in China. The FDI inflow is defined as the direct investment from foreign companies to host countries in order to gain certain lasting interest. China has been one of the largest FDI recipients countries since 2007, with a cumulative FDI of $760 billion (Morrison, 2008). FDI inflow pushes the acceleration of economic development for China effectively because it provides significant external stimulation, especially after China jointed WTO in 2001.

There are three main features of current FDI pattern in China. Firstly, the FDI activities mainly concentrate in China’s eastern coastal areas. Secondly, manufacturing sector has been the major FDI recipient sector in China, especially the labor-intensive and relatively low-technology products attract more FDI than others. Thirdly, most of the providers of FDI in China are from developing Asian areas, such as Hong Kong and Taiwan.

The traditional determinants for FDI are derived from internalization theory and Eclectic (OLI) Paradigm (Dunning, 1998). Internalization theory mainly explains FDI as a firm operation activity that minimizes transaction costs through combining all business process, i.e. internalize external sources in order to avoid external business fluctuation. Dunning’s Eclectic (OLI) Paradigm explains the FDI activity more comprehensively. Internalization theory mainly focuses on foreign firm’s perspective, nevertheless, Eclectic Paradigm also contains the recipient county’s perspective, such as ownership, location, internalization advantages. In this case, China’s location advantages, for example, market growth and size, labor cost and quality, tariff, and logistic, have been the key elements for attracting FDI from multinational enterprises (MNEs).

More specifically, this essay identifies several factors that determine the FDI activities in China, mainly from three aspects: economic, political, and cultural. Market size, market growth, and labor cost are considered as essential economic factors. Tax policy, Bilateral Investment Treaties (BITs), and intellectual property protection policy are classified as political factor. The last part discusses the importance of cultural effect, which plays a significant role in attracting FDI in China.

Section 1: Economic factor

1.1 Market size and market growth

One important reason drives FDI from MNEs to China is due to the market-seeking oriented property of FDI. The current market size and underlying potential market growth are two key elements for this market-seeking FDI. Market size could be treated as an indicator of market capacity and the potential on future economies of scale and scope. Usually, GDP or GDP per capita is employed as measurement of market size. Theoretically, large market size indicates low marginal production and distribution cost regarding with the economies of scale and scope. The empirical evidences have found a positive relationship between FDI inflow and host country’s market size (Herzer, et al, 2008). Zhang (2001) also proves that market size factor is the priority for FDI from other Asian counties to China.

Furthermore, according to Dunning’s OLI Eclectic Paradigm, host countries with larger market size (market base), faster economic growth (market growth potential) could offer a better platform (i.e. opportunity and development) to attract MNEs executing their FDI, exploring their ownership and internalization advantages. Host country’s continuous high economic growth not only provides MNEs’ entry opportunity but also raises the foreign investors’ expectation on host county’s long term development (i.e. stable high growth could be more attractive). In the past decade, China experienced exceptionally rapid growth in GDP. This strong performance in domestic economic growth enhances the purchasing power of consumers, which effectively enlarges the consumption market base. Although the GDP per capita of China still remains at a relatively low level compared to the developed countries, high growth has already provoked the market-seeking FDI activities to a certain extent. And China is believed to attract more FDI by the successive high GDP growth and accelerating process of urbanization in future. It is reported that the FDI from US, EU and Japan to developing countries is aiming at market potential growth rather than traditional low labor cost consideration (Xu, et al, 2008). Empirical study done by Casson and Zheng (1991) shows MNEs from US, EU and Japan invested in China are expected to pursue the large market size of China and its future strong successive growth performance.

1.2 Labor cost

Location advantage contained in Dunning’s OLI Eclectic Paradigm also refers to low local labor cost in many circumstances. Stephan (1998) reports based on a survey on 173 Japanese manufacturing investors, he concludes that the low cost of labour plays a key role in attracting FDI. Lim (2001) also shows a positive relationship between cheap labor force and inward FDI, he points that lower labor cost directly encourages cost-minimizing FDI. Moreover, Tseng and Zebregs (2002) find cheap labor force is an influential factor on export-oriented FDI.

China is known as a country with low labor cost. Ceglowski and Golub(2007) state that Chinese labor cost, especially in manufacturing industry is only 25% to 40% of the cost in US, this is due to the surplus labor force, idle production capacity and limited domestic demand, which together drive exported-oriented FDI in China to grow rapidly. The expanding export market will attract more and more investors to increase investment in China. Take Hong Kong and Taiwan for example, Sun, Tong and Yu (2002) illustrate that because of higher and higher labor cost in these regions, investors begin to transfer their business to mainland China in order to gain more profit. Moreover, Sokchea (2006) also reports during the last 12 years, because the average real earnings of China’s urban employees are doubled, many foreign labor-incentive manufactures have reduced their investment in China. More specifically, he finds when labor cost increases by 10 U.S. dollar, the possibility of foreign investment will be reduced by 30%. All of the above arguments support the positive relationship between cheap labor force and inward FDI.

Section 2: Political factor

2.1 International FDI policy

As for international FDI policy, it will focus on the discussion of the Bilateral Investment Treaties (BITs). Sokchea (2006) defines BITs as “an agreement between two signatory countries providing investors with fair and equitable treatment and legal protection”. In the 1990s, BITs developed so quickly that heavily influenced the performance of FDI in China. Broadman and Sun (1997) show the growth of BITs between 1992-2007 which rose from 675 to 3393. They also find China holds the first position in terms of cumulative BITs signed. One of the reasons for the impact on FDI by BITs is that BITs signal to investors the information that government is making effort to provide favorable investment climate, which serves as a significant role in attracting foreign investment. In BITs, investors could find contents about how investment are protected, including provisions on the scope and definition of foreign investment, admission of investment, fair and equitable treatment, as well as dispute settlement, etc. Moreover, additional new provisions about transparency of national laws, performance requirements could be found by investors recently, which improve the current investment situation to a large extent. According to Lemoine (2003), BITs are believed as the most important treaties in protecting international foreign investment, though for different parties, the content of each BIT may be different because of various demands and supply.

However, in some literature, the findings are not consistent with the above arguments. Hallward (2003) reports that BITs only works when the quality of institutions is high and the property rights are strong, so he concludes that the relationship between BITs and FDI is not that obvious. Neumayer and Spess (2005) disagree with Hallward (2003)’s results, asserting that BITs are more influential when the institutional quality is lower, and BITs helps developing countries in attracting FDI rather than developed countries. As for China, Wu (2003) supports that FDI inflows are affected by BITs, but he also finds in developed countries this effect is more apparent. Furthermore, Erskine (2004) shows that even an additional BIT ratified could increase 2.1% of FDI in China. Therefore, the fact that BITs do help promote FDI in China could not be rejected.

2.2 Tax incentives

Before foreign investors decide to invest into the host country, most of them would exam the fiscal policy, especially the taxation policies first. Foreign-invested companies in China are expected to pay 33% corporate tax, however, due to the existence of favorable tax policies, they indeed pay much less than they should. There are mainly three tax concession policies designed for them. The first one is that manufacturing companies are allowed to be fully exempted from tax in the first two years, followed by a 50% tax concession in three years thereafter. The second one is known as the location-based concession, which indicates that besides the tax exemption policy, manufacturing companies that located in the Special Economic Zones (such as ShenZhen, Shanghai PuDong) are given access to another 15% tax reduction. Thirdly, if the companies construct port, airport or rail in China, they will be free from tax payment for the first five years, and then a tax reduction as much as 50% in the next five years (Ernst and Young, 2006). From the above analysis, it could be found that because of the obvious tax benefits provided by government policies, foreign investors are more likely to put their money into China than other places.

Researchers are also interested in to what extent the taxation influences investors’ decisions of FDI. According to Buettner and Ruf (2005), if the tax rate is increased by 10%, the foreign direct investment will be approximately reduced by 20%. Furthermore, they report that a 1% increase in the tax rate will bring in a reduction in FDI by almost 3.7%. Moreover, OECD (2008) illustrates that due to the increasing mobility of capital, recently, FDI has become more and more sensitive to the tax rate. In spite of this, it may find some OECD countries which have relatively high taxation rate but still have succeeded in attracting FDI, from which it could be concluded that the significance of taxation as a determinant of FDI should not be overstated. And only when the low tax rate combines with other superior local-specific attributes, can it influence the investors’ choice of FDI.

2.3 Intellectual property

Intellectual Property (IP) refers to the creations of the mind: inventions, literary, artistic work, symbols, names, images, and designs which all are used in commerce (China Association of Enterprises with Foreign Investment, 2008). According to CAEFI, during the period 2001 to 2007, the cases related to IP and FDI had increased by 58% (CAEFI, 2008). This number well explains the reason that why many multinational enterprises treat IP issue with more cautions than before, and why they think the most challenging problem they meet in China is IP. Therefore, the country’s legislations against protecting IP will influence foreign investors’ decision on FDI. It is reported that an improved legislation and increased quality and quantity of IP protection, especially in the industries where innovations are the most important feature, will increase the total amount of FDI in China. Considering the benefits brought by a stronger IP protection system, Chinese government has proposed new policies to improve the existing regulations and laws, which aims to be consistent with the international standards, for instance, the new Patent Law that amended in 2000 makes the patent system in China be harmonious with the patent systems in other WTO member countries.

However, in some literature, arguments about the negative effect caused by IP could be found. they question the probable results origin from the temporary monopoly led by IP. Notwithstanding, we still believe that IP will become more and more vital in attracting FDI to China.

Section 3: Cultural factor

Dunning (1998) finds that besides the host country’s economic, institutional and regulatory conditions, it should take the importance of cultural characteristics into account, because it will also affect investors’ location choice. Zhang (2005) illustrates that due to the reasons of linguistic, cultural and geographical proximity, most of the FDI in China comes from investors who are Chinese origin. According to the results conducted by State Statistical Bureau of China (2001), during the time period 1979 and 2001, China’s FDI inflow from Hong Kong and Taiwan is 56.5% on average. Moreover, Zhang (2005) further shows Hong Kong, Taiwan and Singapore’s share of outward FDI to China are 89.5%, 76.8% and 91.8% respectively, while only 2% come from the developed economies, such as EU, US, Canada and Japan.

Recently, another two factors that influence the inward FDI has been reported by some literature, which is the foreign firms’ knowledge transfer and performance that are both affected by culture. China is deemed as a country with a low level of uncertainty avoidance and a high level of trust, while uncertainty avoidance refers to the perception of threats from uncertain situation. Foreign investment always prefers these two properties, especially the high trust, which is claimed to help enhance the relationships interpersonal and inter-organisational. Yao and Wei (2007) find that trust always means “spontaneous sociability, greater speed in relationship formation, expectations of reduced opportunism, and perceptions of lower monitoring costs”, which could help attract more FDI into the host countries. Inversely, high level of uncertainty avoidance may negatively affect investors.

Competitive disadvantages to local companies, discrimination by government are two well known aspects that may drive the foreign investors into a costly way when they are doing business in host countries. Japan is one of the typical examples. It is known as a serious ethnocentrism country. FDI is considered as uncertainty and external competition by many Japanese, traditional customs and the negative attitude by the society discourage the foreign investment. Moreover, some studies disclose that people in a higher trust environment are likely to fight for the common purposes in group and organizations. Furthermore, foreign firms tend to increase the investment when they achieve their former goals and perform well in previous years. Meanwhile, this will give rise to a signal effect which may attract other foreign investors to come to follow them, because most of the firms would like to imitate the processes of other firms that they consider as successful, so due to the herd effect, FDI location decisions have been found to be influenced by the behavior of other foreign firms (Fisman and Khanna, 1999). In China, the Yangtze Delta Regions and the Zhujiang Delta Regions are the areas where foreign investments mainly engage.

Conclusion

To conclude, the economic, political and cultural factors detailed with market-size, labor cost, BITs, tax-incentive policy, IP protection and local culture characteristics all could influence foreign investors’ decision on FDI. Through the comparisons, it can be figured out that the first two are the most important ones considered by investors. Recently, as economy grows in China at a high speed, and income has been increased to a higher level, market-size is becoming more influential than before. BITs convey information to investors that the government is making effort to improve the investment environment, which could help attract FDI to China. The fiscal policy, especially the tax-incentive policy also may affect the location choice of FDI, and due to main three tax concession policies, foreign investors prefer to investing in China rather than other countries. Finally, from the literature it could be found that both the improved IP protection system and special culture and tradition in China have contributed to inflow FDI.