Influence of Institutional Factors on Inward and Outward FDI - Essay Example

? Part The Essay Critically Evaluate the Extent to Which al Factors Influence Inward and Outward FDI (Foreign Direct Management) Instructor: Course: Date: Critically Evaluate the Extent to Which Institutional Factors Influence Inward and Outward FDI (Foreign Direct Management) The quality of institutions affects the inflow and outflow of foreign domestic investment, particularly for the developing countries. Good institutions tend to be associated with economic growth which is thought to spur FDI inflows and outflows. On the other hand, poor institutions are associated with corruption which may increase the cost of investment and lead to reduced revenues. Other factors like political instability increases uncertainty, drives away investors thus leading to lower FDI inflows. However, it is difficult to measure the various institutional factors and therefore the extent to which it influences inward and outward FDI is a subjective issue. The issue of “institutional distance” has been found to have an influence on both the inward and the outward FDI. Institutional distance is the difference in the quality of institutions between two or more countries. Quere et al. (2007) studied the determinants of FDI and concluded that “raising the quality of institutions and making them converge towards those of source countries may help developing countries to receive more FDI, hence help them to catch up, independently of the indirect impact of higher GDP per capita”. It is widely known that good quality institutions have a positive impact on the inflow and outflow of FDI. Some scholars suggest that institutional differences may be a source of comparative advantages, some sectors being more ‘institution-intensive’ than others, and that this could be a source of more trade flows. To the extent that trade and FDI are complements, this could raise FDI too. Good governance is one of the institutional qualities which are thought to positively affect the flow of FDI. Globerman and Shapiro (2002) studied the impact of the main components of the governance indicators on both inflows and outflows of a country’s FDI. They concluded that good governance encouraged both FDI inflows and outflows; although the impact of good governance on the outflow of FDI only applies to relatively large and developed countries. However, measuring governance is a subjective task which varies from one research to another. Some studies concentrates on one country yet trade flow involves at least two countries. Since FDI flows can move on either direction, governance of all the countries involved should be scrutinized in order to determine the actual impact of governance on both in-flows and out-flows of FDI. The tax system of a host country is another determinant of FDI. If a tax system of a country is set in a manner that the products and services of foreign firms are more taxed than those of the local firms, the inward flow of FDI is likely to be reduced. This is because the foreign firms would have a challenge in setting the prices of their goods and services; in order to make profits, they might be forced to set their prices above those of the local firms thus leading to lower than expected sales. On the other hand, imposing heavy taxes on the products and services of the local firms may hamper their growth. For this reason, the local firms may not grow to become MNEs and thus affecting the outward FDI. However, heavy taxes on the local firms may lead to investment in other countries where the tax rates of taxation is relatively lower. This will lead to increased out-flow of FDI. Corruption is also another institutional factor which is known to determine the flow of FDI. Many researchers have found that corruption increases the cost of investment and lead to reduced expected revenues. Taking corruption to mean “paying certain individuals in order to get an investment opportunity in the host country”, it would negatively affect the inward flow of FDI. In addition, the misuse of public funds and resources by few individuals in the host country may result in poor economic growth which would discourage investors. It may also lead to the weakening of the country’s currencies since poor economic growth is associated with inflation. According to Aliber’s Theorem, growth of the host country’s economy should be considered before investing in them. The theory suggests that there should be Shift from countries with strong currencies to weak ones to take advantage of purchasing power. This means that the weakened currency of the home country would attract inward flow of FDI. The “easiness of creating a company” is an institutional factor which affects the establishment of companies in other countries. In countries where the process of creating a company is long and difficult, there is low inward FDI. The host country could also be highly protective of its local ownership such that they require ownership of part of the investment made by MNEs. Alber’s theory requires investors to consider the protectiveness of the home economy. If the home economy is highly protective, then the inward FDI is likely to be reduced. Protectiveness can also be the control of price setting of the prices of the MNE’s products and services in order to protect the local products. This has been known to discourage the in-coming FDI. Furthermore, some countries restrict in-coming MNEs because of their exploitative techniques. Hymer’s theory argued that FDI activities may not be to the advantage of the domestic economy. This argument is based on the fact that MNEs are monopolistic firms investing in foreign markets to eliminate competition. They have “ownership specific advantages” which may overcome the “local specific advantages” of the domestic firms. Though it reduces the in-flow of FDI, this theory may justify the protective nature of some countries. The political environment is also a key factor considered by MNEs when expanding their investments to other nations. Political uncertainty and violence (commonly seen developing countries) discourages the inward flow of FDI. Such instabilities may result in loss of property and low returns on the investments made. On the other hand, a stable political environment is known to encourage the in-flow of FDI investments. This is because there are less uncertainties and realistically high expected returns. It could also be argued that stable political environments in the home country enhances emergence of MNEs. This would result in out-ward flow of FDI. In addition, political uncertainties in the home country may make the local companies to invest heavily in other countries where there is stability in politics. According the Uppsala model, physic distance which include differences in political systems and other factors, limits the flow of information between firms and markets. This theory suggests that a firm should learn the markets first and to enter physically close markets. However, many MNEs have successfully invested in countries where there is a difference in the factors such as political systems suggested in the Uppsala model. The rule of law in the host countries could be another factor that influence the in-flow and out-flow of FDI. Some laws may enable the host county’s government to repudiate their contracts and to disrespect the shareholder’s rights. This is likely to discourage new MNEs and even drive away the existing ones thus reducing the inward flow of FDI. In addition, such laws may restrict exportation and importation of various products and raw materials. The MNEs which brings in FDI would not operate effectively with such restrictions. The product cycle theory stated that the production process concerning new products should be started in the home country. The main reason behind this argument is that the product is supposed to be standardized, to gain demand, and attract skilled labor and competition in the home country first. This will also make the products attractive in the host country. So, if there are restrictions of imports and exports in the host country, this will discourage such firms from investing in those countries. In conclusion, institutional factors such as corruption, tax systems, rule of law, political environment, among others, have an impact on both the inflow and the outflow of FDI. The negative impact of factors is mostly felt in developing countries where FDI is needed most. The developed countries are generally the major sources of FDI since many MNE’s originate from there. However, measurements of the impact of the institutional factors such governance are still a challenge. For instance, a governance issue like corruption is hard to measure. Some researchers have measured it in relation to GDP per capita and economic growth while others have related corruption to productivity and economic policies. Because of the difference nature of institutions and situations affecting them, it is might not be possible to come up with a list of universal institutional factors that affect the flow of FDI among various countries. But the general institutional factors could be analysed with a specific focus on countries that have similar or related systems. The Report State Controlled Entities (SCEs)/State Wealth Funds (SWFs) Executive Summary This report examines the global trends of foreign direct investment with a key focus on State-Controlled Entities (SCEs). Foreign direct investment by multinational enterprises (MNEs), serves both the government and the participating firms. However, the interests of the government are different from those of the firms. These conflicts of interest led to the increase in the legislations and policies that are less welcoming to the MNEs. Because of this reason, SCEs were conceived. These SCEs have been considered to be more of threat as compared to other types of FDI investments. This report therefore analyses various case studies in order to determine the trends of these SCEs/SWFs, and identify the reasons why they are perceived in such a manner. Among the reasons identified are political interests, associated with SCEs, which threaten the national security of the home country. In addition, it is suggested that these SCEs should be controlled by enacting new legislation or amending the existing ones in order to enable various countries to have a wider control over them. The report also looks in the theoretical models that explain the growth of SCEs/SWFs. The model described in this report states that SCEs/SWFs grow rapidly because they invest in large and profitable firms that are stable. Finally, the conclusion of the report incorporates a summary of key findings and suggestions for further analysis and future research. Background Information Governments and firms seeks to attract foreign direct investment (FDI) undertaken by multinational enterprises (MNEs) for various varying reasons. Governments benefit by experiencing growth of their economies contributed by the MNEs; they seek to maximize their benefits of this investment in the context of their national economies. Furthermore, firms undertake FDI with a specific end goal to grow their right to gain entrance of business sectors and assets, henceforth expanding their worldwide intensity; their major target is to amplify the profits of this backing in the setting of their worldwide corporate arrangements. This distinction in targets and skeletons gives ascent to tensions that play themselves out in the methodology. Administrations take in national FDI arrangements and respective transaction treaties (BITs). Throughout the late 1960s and the 1970s, the overwhelming methodology was to control MNEs. During the 1990s, it was liberalization, and the approach is again changing. Throughout the 1990s, most parts of the national FDI arrangement updates worldwide made the transaction atmosphere more welcoming for MNEs. Replacement of the national FDI screening agencies by investment promotion agencies (IPAs) is an example of such policy changes which were favorable to the MNEs. There was also a rise in the number of BITs, meant to protect foreign investors to attract more FDI, by more than triple. In short, FDI was considered as one of the key drivers of economic development. Almost all governments revised their FDI regulations, established IPAs and signed BITs. However, after the 1990’s there has been a rise in FDI policy changes that are less welcoming to MNEs. Some countries (especially developed ones) have increased policies governing the approval of new Mergers and Acquisitions (M&As). They have additionally given careful consideration the distinctive sorts of gurus by singling out state-regulated elements (SCEs). Case in point, the number of examinations by the Committee for Foreign Investment in the United States rose from 1 in 2000 to 35 in 2010. As a result, the climate for FDIs is increasingly becoming less welcoming. Concerns over State Controlled Entities (SCEs) or State Wealth Funds (SWFs) State controlled entities SCEs or State wealth funds (SWFs), unlike other types of FDI, are not only focused on economic benefits but also political gains which threaten the national security of the host country. Jost (2012) noted that SWFs and SCEs have accelerated concerns that SCEs might antagonize national security by emulating political instead of minor business objectives as far as foreign direct investment (FDI) is concerned. He argued that though developed nations do not consider the rise of SCEs to cause new barriers to FDI, many of them have revised their legislation to increase government control over FDI flows. This shows that these FDI investments need controlling in order to avoid their political threats and other threats to national security. However, the legislation must not serve to deter those FDI investments but should make it favorable more welcoming. The amendments of the German investment law, for example, led to significant increases in the SCEs and SWFs in Germany (Jost, 2012). Apart from threat to national security posed by politics associated with SCEs and SWFs, there are also several other threats that are perceived by most countries when considering such FDI investments. “Opportunity or threat” analysis is done nowadays before approving any FDI, especially SCEs and SWFs. Moran (2012) did a study on “Chinese Foreign Direct Investment in Canada: Threat or Opportunity?” The aim of the study was to ascertain two issues: the impact of Chinese FDI on the structure of natural resource industries around the globe, and the point in which Chinese FDI, through acquisition of an existing firm, is considered a threat to national security of that firm’s host country. He used a “three threat” framework to analyze the impact of those threats on various issues (Moran, 2012). This framework groups threats into three: denial or delay in the provision of goods or services that are vital to the operations of the home country, leakage of sensitive technology, and “infiltration, espionage, disruption” of the provision of goods or services crucial for the functioning of the host country. The study revealed even though there were significant benefits of the Chinese FDI investments in Canada, those acquisitions may pose various threats to the national security of Canada (Moran, 2012). These types of FDI investments (SWEs or SWFs) needs to be controlled in order to benefit from them and avoid threats associated with them as well. Both the opportunities and threats of those FDI investments should be evaluated by bearing in mind the interests of the home country, especially national security, (Moran, 2012). The existing legislations should therefore be amended to take into consideration both the benefits and threats of these types of FDI investments. Theoretical Models Explaining the Growth of SCEs/SWFs Many theoretical models, explaining the growth of SCEs/SWFs, have been put forward by various researchers. In this case, focus is drawn on the study done by Nuno (2009) which focused on the rise of SWFs. A large data set (“data from 2002 through 2007 that includes SWF holdings in 8,000 firms in 58 countries”) was used. This study revealed that firms with higher SWF ownership had higher valuations and better operating performance. He argued that SWFs invests in “large and profitable firms that enjoy better external visibility and that they avoid high tech industries or those operating in environments that require extensive research and development”. In conclusion, firms under SWFs perform better and are valued highly in the market, (Nuno, 2009). This explains the rapid growth of SWFs/SCEs in most economies around the world in the recent past and the present. Conclusion The fact that many countries consider state-controlled entities (SCEs) or Sovereign Wealth Funds (SWFs) more of threat than other types of FDI is justified based on the perceived threat of such investments to their national security. Political interests are more pronounced than financial interests, in the SCEs/SWFs FDI investments. This brings about a threat to the national security of the home country since politics are accompanied by corruption and other vices which spark conflicts and divisions among leaders. Other reasons include the perceived disruption of the provision of goods or services which are vital in the normal functioning of the country, and leakage of technological information which is detrimental privacy of the home country. These threats are experienced when dealing with other types of FDIs. All countries should control SCEs/SWFs FDI investments in order to avoid the perceived threats associated with them. This can be done by amending existing legislations or even enacting new ones in order to gain wide coverage of the issues associated with SCEs/SWFs. They should also make use of the international law governing FDI investments. On the least, they should avoid such investments if it adversely affects their national security. Besides the threats of SCEs/SWFs, the growth of these investments has needs further research since there are so many controversial issues surrounding it. A major controversy is noted the relationship between politics and the growth of SWFs/SCEs. However, in this report it was found that politics may not be associated in the growth of these FDI investments (Gaukrodger, 2010). References Gaukrodger, D., 2010. “Foreign State Immunity and Foreign Government Controlled Investors.” OECD Working Papers on International Investment. Globerman, S., & Shapiro, D., 2002. Global Foreign Direct Investment Flows: The Role of Governance Infrastructure. World Development, 30 (11), pp. 1899-1919. Jost, T., 2012. Much ado about nothing? State-controlled entities and the change in German investment Law. Retrieved from www.vcc.columbia.edu Moran, H. T., 2012. Chinese Foreign Direct Investment in Canada. London: Sage. Nuno, F., 2009. Sovereign Wealth Funds: Investment Choices and Implications around the World. Toronto: IMD International. Quere, A. B., Coupet, M., and Mayer, T., 2007. Institutional Determinants of Foreign Direct Investment. The World Economy. Read More