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Goods and Foreign Direct Investment

Since the early 1980s, world FDI flows have grown faster than either world trade or world output. Notwithstanding the financial turmoil in east Asia, in 1998, global FDI inflows increased for the seventh consecutive year to reach $430-440 billion (see IMF Survey below), becoming an important source of private external finance for developing countries. What are the factors that determine the inflow of FDI into a country? What policies are most conducive to an inflow of FDI? Does FDI benefit the host country and if so, what are the mechanisms through which such benefits are propagated to the rest of the economy? How does FDI interact with trade flows? Does FDI substitute or complement trade flows? These are some the most important, but by no means comprehensive, issues addressed in the literature.

FDI Determinants

The features that traditionally made a country a desirable destination for FDI include political and economic stability, the market size, availability of natural resources and human capital, growth prospects, the existence of a favorable investment and tax regimes, and so forth. A recent UNCTAD report (see UNCTAD and IMF Survey below) concludes that such traditional features, although still important, they no longer constitute a significant point of differentiation. In a world increasingly characterized by liberalization and globalization, firms look for places to invest that offer specific advantages or "created assets," including good communications infrastructure and intangibles such as attitude to wealth creation and business culture. 

The importance of such non-traditional factors are, for example, aptly highlighted in the context of three Eastern European countries --the Czech Republic, Hungary and Slovenia. Recent research (see Kaminski below) reveals that the choice of the method of privatizing large state-owned enterprises as well as government willingness to open the ‘strategic’ sectors to foreign investors  have had a profound impact on the flow of FDI to these countries as well as on the growth and composition of their exports.

Effects of FDI

There are two approaches to studying these effects the effects of FDI on the host country. One approach, rooted in the standard trade theory, is more concerned with the direct effect of FDI (or portfolio investment) on the host country's factor endowments and rewards. The main prediction of this type of model is that FDI raises the marginal product of labor and reduces the marginal product of capital. The other approach, stemming from the theory of industrial organization, puts more emphasis on the indirect effects or externalities of FDI. The starting point for this approach is to ask why firms undertake investment abroad to produce the same goods they produce at home (for an excellent overview of this approach see Caves, 1996). Several recent research works employing this approach, conclude that FDI can promote economic development of the host country by helping to improve productivity growth and exports, but that the exact relationship between foreign multinational corporations and their host economies varies quite a bit between industries and countries. Blomström, and Kokko (1997a, see below) conclude that the characteristics of the host country and the policy environment are important determinants of the net benefits of the FDI (see also Djankov and Hoekman, 1999 and  Kaminski 1999, see below)
Relation Between FDI and Trade Flows

Many theories of the multinational firms are based on the notion that foreign production and trade are substitutes, several empirical studies of foreign investment and trade uncover a complementary relationship. In a recent  empirical analysis of foreign investment in the U.S. between 1974 and 1994, Swenson (1999, see below) finds that the questions of   substitutability/complementarity between FDI and trade flows is closely related to the aggregation level of data.  Disaggregation reveals that substitution effects are present at the product level, while complementary effects are identified at higher levels of aggregation. 

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