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Foreign Direct Investment and factors affecting it

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Pakistan Economic and Social Review
Volume XLI, No. 1&2 (2003), pp. 59-75

Abstract. This study has analyzed the volume and determinants of Foreign Direct Investment (FDI) in developing countries of the world. The analysis was based on a sample of 15 developing countries with 5 each from upper middle, lower middle and lower income countries. In general, the flow of FDI to developing countries has followed an uneven path and its volume was modest in the beginning of 1980s but has tended to rise in subsequent years.

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Following panel data model, we applied three approaches, namely common intercept model, random effects and fixed effects model, to clearly identify the factors affecting FDI in developing countries with different levels of income.

The analysis showed that urbanization, GDP per capita, standard of living, inflation, current account and wages are affecting FDI significantly in low income, urbanization, labour force, domestic investment, trade openness, standard of living, current account, external debt and wages in lower middle income and urbanization, labour force, GDP per capita, domestic investment, trade openness and external debt in the sample upper middle income countries.

Similarly, country specific dummies have attributed large variations in FDI to institutional and structural differences among the countries analyzed.

I. INTRODUCTION
Foreign Direct Investment (FDI) has historically contributed to the development of many host countries by way of improving their infrastructure, technical skills, entrepreneur abilities and financial resources in terms of government revenue and foreign exchange. Since FDI is expected *The authors are Lecturer in Economics and a graduate student at Fatima Jinnah Women University, Rawalpindi (Pakistan), and Professor of Economics, respectively.

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as such to expand opportunities of development, its demand has increased rapidly, especially over the last two decades. The growing shortage of official loans from the international financial institutions and aid from the developing countries has further increased the demand for FDI in Less Developed Countries (LDCs) of the world. Although the volume of FDI in developing countries has increased significantly over time, its distribution has been characterized by large variations between and within different regions of the world. Until mid-1980s, Latin America and the Caribbean were the largest recipients of FDI. However, the situation since late 1980s has reversed and the Asian and Pacific countries have became its recipients.

These two developing regions are jointly receiving approximately 85% of FDI flows to developing countries. Individually, in 1998 Africa received 4.5%, Asia 2%, Pacific 46.3%, Latin America and Caribbean 39% and Central and Eastern Europe 10.2% of FDI (UNCTAD, 1999).1 Although the diversity in the magnitude and density of FDI in developing countries has variously been examined, there is still need of systematically analyzing factors affecting it in countries by level of income, which has a direct bearing on the prerequisites of FDI. As such this study has empirically analyzed factors likely to have affected historically the flow of FDI in countries with different levels of income.

Many different factors have affected the volume and distribution of FDI in developing countries of the world. The main beneficiaries of the major FDI inflows have been the countries with political stability (Ghurra and Goodwin, 2000; Root and Ahmed, 1979; De Mello, 1995; Cheng and Kwan, 1999; Schneider and Frey, 1985; Wang and Swain, 1995), favourable policies of tax and subsidies (De Mello, 1999), existence of good business environment, better administrative policies and low level of corruption (Loot, 2000; Ghurra and Goodwin, 2000).

Moreover, macro variables such as size of market, physical infrastructure, skilled labour force, trade openness, inflation, labour cost, productivity and interest rate are also reported as other important factors affecting FDI in developing countries of the world (Kravis and Lipsey, 1982; Wheeler and Moody, 1992; De Mello, 1997; Lucas, 1993; Wang and Swain, 1995).

Historically, the flow of FDI to developing countries has followed an uneven path being modest at the beginning of 1980s and tending to rise in subsequent periods. Specifically, the flow has increased considerably from

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Cf. Loots (2000).

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TABLE 1
Estimates of Random Effects Model

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YASMIN et al.: Analysis of Factors Affecting FDI in Developing Countries

TABLE 2
Estimates of Common Intercept Model

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The year dummies in Table 2 carry significant values indicating that FDI has tended to increase over time in the upper middle-income countries under consideration. All the values for the year prior to 1997 as the base year, means that FDI in these countries was less in those years. For example, FDI flows for Argentina during the year 1997 was US $ 88.673 millions compared to 62.834 in 1996 and even less in the previous years. Similarly, Brazil received FDI of US $ 61.41 millions in 1997, whereas it amounted to 30.43 in 1996. Similar is the case for all the other countries of this group.

V. COMPARING THE ESTIMATES
OF INCOME GROUPS
A comparison of results shows that the lower income countries in general received comparatively less FDI than the higher income groups because of their low levels of GDP and domestic investment and internal imbalances. In contrast, the upper middle income countries received higher amounts of FDI due to their better economic conditions and also because the intensity of their external debt and current account deficit are not as severe as in the lower income countries.

The year dummies for the lower income countries have not shown significant results during the 1970s and 1980s, although the flows increased after that. Although the flows for upper middle income were low in years from 1970 to 1996 but still the concentration was far higher there than in lower income countries. During 1997, the upper middle-income countries have received huge amounts of FDI. For example, like Brazil received almost double the amounts of FDI during the year.

The country dummies for the lower income group show that Pakistan, Sri Lanka and Kenya do not have structural differences as compared to India, whereas Zambia has such structural changes. Due to these structural differences, Zambia has received comparatively higher FDI than other countries. The annual average FDI inflows for Zambia over the year 1990 to 1997 is US $ 246.36 millions compared to 161.53, 43.04 and 34 for Pakistan, Sri Lanka and Kenya, respectively.

Thus, we can see that even within the same groups, countries have received different volumes of FDI mainly because of differences in structural and institutional factors. Similarly, the countries belonging to the other two groups considered for analysis have different volumes of FDI, again due principally to their structural differences.

Finally, it may be argued that FDI is affected more by structural differences of the countries than their other factors. The flow has also been

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affected over time. Although FDI has increased in all the three groups over time, the flow was higher in upper middle-income countries than in the other two groups included in the analysis.

VI. SUMMARY AND CONCLUSION
The main objective of this paper was to find the volume and determinants of FDI in developing countries. The analysis showed domestic investment, labour force, external debt and trade openness as the significant determinants of the flow of FDI among the upper and lower middle-income countries and urbanization, market size, standard of living, inflation, current account balance and wages for the lower income countries.

In fact, the upper middleincome group of the sample countries has received higher flow of FDI than other groups by virtue of its comparatively better internal and external balances, high level of CGDP, DI, trade openness and large market size. In contrast, the countries belonging to the lower income group received the lower FDI inflows than other groups during the selected period mainly because of large deficit in current account, lower wages, low level of GDP and standard of living.

The message of the analysis is that the countries interested in attracting increasing flow of FDI on a sustained basis must adopt suitable policies. The government in these countries should provide incentives and undertake efforts for greater trade openness, higher domestic investment and low debt. Further, effective steps should also be taken to reduce the internal as well as external imbalances. Last but not the least, there seems to be no substitute for improved political environment to attract FDI.

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REFERENCES

YASMIN et al.: Analysis of Factors Affecting FDI in Developing Countries

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Foreign Direct Investment and factors affecting it. (2016, Apr 28). Retrieved from https://graduateway.com/foreign-direct-investment-and-factors-affecting-it/

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