Foreign Direct Investment

Foreign Direct Investment: Analysis of Aggregate Flows

Assaf Razin
Efraim Sadka
Copyright Date: 2007
Pages: 158
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  • Book Info
    Foreign Direct Investment
    Book Description:

    The 1990s saw global flows of foreign direct investment increase some sevenfold, spurring economists to explore FDI from a micro- or trade-based perspective.Foreign Direct Investmentis one of the first books to analyze the macroeconomics of FDI, treating FDI as a unique form of international capital flow between specific pairs of countries.

    By examining the determinants of the aggregate flows of FDI at the bilateral, source-host-country level, Assaf Razin and Efraim Sadka present the first systematic global analysis of the singular features of FDI flows. Drawing on a wealth of fresh data, they provide new theoretical models and empirical techniques that illuminate the vital country-pair characteristics that drive these flows. Uniquely,Foreign Direct Investmentexamines FDI between developed and developing countries, and not just between developed countries. Among many other insights, the book shows that tax competition vis-à-vis FDI need not lead to a "race to the bottom."Foreign Direct Investmentis an essential resource for graduate students, academics, and policy professionals.

    eISBN: 978-1-4008-2924-8
    Subjects: Economics

Table of Contents

  1. (pp. 1-12)

    Economists tend to favor the free flow of capital across national borders, because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several advantages, as noted by Feldstein (2000). First, international flows reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting standards, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies.

    Capital can flow across countries...

  2. Part I. Foreign Direct Investors and Liquidity Shocks
    • (pp. 15-33)

      International equity flows take two major forms: Foreign Direct Investments (FDI) and Foreign Portfolio Investments (FPI). Despite the empirical interest in foreign equity flows, very little work has been done on jointly explaining FDI and FPI in a rigorous analytical framework. In this chapter, we propose such a framework, and provide a model of a trade-off between FDI and FPI which is consistent with the empirical regularity that FDI flows are generally less volatile than FPI flows. For instance, Table 5 in Lipsey (2000) shows that the ratios of standard deviations to means are 1.008 for FDI flows to Europe...

    • (pp. 34-40)

      The preceding chapter provided an analysis of the allocation of foreign equity investors between FPI and FDI investors. A key macro-level implication of this model is that source country-wide financial shocks, which generate different liquidity needs across various liquidity-constrained foreign investors, raise the share of FPI, relative to FDI, in the total export of foreign capital. The theory in chapter 2 is indeed geared toward explaining the allocation of the shock of foreign capital between portfolio and direct foreign investors. In this chapter we confront this hypothesis with the data. The latter consist of stocks of FPI and FDI in...

  3. Part II. Foreign Direct Investment with Threshold Barriers:: Theory
    • (pp. 43-52)

      In Part I we attempted to explain the allocation of foreign investors between FDI and FPI. We highlighted a key difference between the two types of investments. In the case of FDI, both ownership and control of a firm are acquired, whereas in the case of FPI control is not achieved. The acquisition of control entails FDI investors an efficiency gain, but at a fixed cost of becoming FDI investors and a variable information-based cost associated with liquidity needs. A balance between the benefits and costs of FDI generates an equilibrium assignment of investors to foreign direct investments and foreign...

    • (pp. 53-62)

      So far we have focused on the host country as a recipient of FDI and other flows in a partial equilibrium context in which domestic input prices are fixed. Specifically, labor inputs and wages were fixed and therefore ignored. Naturally, the flows of FDI affect the domestic stock of capital. Therefore, even though the return to capital may be tied through capital mobility to the world rate of interest, wages may still vary. This chapter addresses the general-equilibrium interaction between wages and FDI. We cast this interaction in a bilateral source–host country setup.

      Consider a pair of countries, “host”...

    • (pp. 63-70)

      So far our setup allowed heterogeneity across firms, and our analysis has gone to the details of the firm level. Thus, an empirical investigation based on this analysis would have required firm-level data. Firm-level data are typically available only for a small subset of countries and on a cross-section basis. On the other hand, there is a fairly rich dataset on aggregate bilateral flows. These data enable us to study how cross-country differences in institutions, macropolicies, productivities, and so on affect bilateral FDI flows. But these aggregate data do not allow us to infer whether a reduction in aggregate FDI...

  4. Part III. Foreign Direct Investment with Threshold Barriers:: Empirics
    • (pp. 73-78)

      In this chapter we present some basic elements of the econometric approach adopted in the empirical investigation of the theoretical implications of our analysis of the bilateral FDI flows in the preceding part. Recall that a crucial feature of the formation of FDI that we emphasized in the first part is the twofold nature of FDI decisions. There is a decision to make concerning the question whether to invest at all—captured by a “threshold” selection equation, and concerning how much to invest—captured by the flow or gravity equation.

      The twofold nature of FDI decisions gives rise to many...

    • (pp. 79-88)

      In this chapter we employ data on bilateral FDI flows in a sample of 24 OECD countries over the period from 1981 to 1998 in order to illustrate the application of the Heckman selection and the Tobit and OLS methods. This application provides a benchmark empirical study of the determinants of FDI. In the next two chapters we extend this benchmark study to include some major variables which constitute the focus of the theoretical investigation in Part II.

      Data are drawn from OECD reports (OECD, various years) on a sample of 24 OECD countries, over the period from 1981 to...

    • (pp. 89-98)

      Foreign direct investment has become a key channel of international capital flows. In chapter 6 we explained that cross-country productivity differences can generate FDI flows. In particular, country-specific productivity shocks within a source-host country pair affect FDI in a variety of possibly conflicting ways. A positive productivity shock in the source country is expected to have a negative effect the selection equation. A positive productivity shock in the host country may also have somewhat surprisingly a negative effect in the selection equation, but a positive effect on the flows of FDI.

      The twofold (selection and flow) FDI decision is generated...

    • (pp. 99-108)

      In this chapter we focus the empirical analysis of the determinants of bilateral FDI flows on the effects of taxation. In the era of increased globalization, cross-country differences in taxation may play a major role in the international allocation of investment:

      European countries have been steadily slashing corporate-tax rates as they vie for foreign investment, potentially adding to pressure on the U.S. for similar cuts as it weighs a tax overhaul. Following the lead of Ireland, which dropped its rates to 12.5% from 24% between 2000 and 2003, one nation after another has moved toward flatter, lower corporate rates with...

  5. Part IV. Policy in a Globalized Economy
    • (pp. 111-123)

      In the globalized economy the issues of tax competition and coordination are becoming increasingly pressing for policy makers. It is especially relevant for the taxation of income from internationally mobile factors, such as the income generated by FDI. As theEconomist(1997, 17–18) succinctly puts it,

      Globalization is a tax problem. . . First, firms have more freedom over where to locate . . . This will make it harder for a country to tax [a business] more heavily than its competitors . . . Second, globalization makes it harder to decide where a company should pay tax, regardless...

  6. (pp. 124-126)

    Capital flows of all types have increased significantly over the past few decades, and most recently some of the biggest increases have occurred in foreign direct investment. This is especially true of rich countries, but is increasingly true of developing nations too.

    These flows in the form of FDI are also important because it is believed that FDI has special benefits over other forms of capital flows. First, these flows are thought to be more stable, and do not leave the host country exposed to financial crises. Second, FDI is often supposed to be associated with technology transfer, which may...