Master programme in Economic History

Determinants of Location in Outward U.S. Foreign Direct Investment

Frank Ix

Abstract: The flow of capital across borders through foreign direct investment has become a major driver in the world economy and continues to gain prominence due to the rise of Asia and other emerging markets. The United States, as the largest economy in the world for over half a century, has played a crucial role in this capital flow. Everyday, millions of private U.S. dollars pour across borders towards direct investments in foreign companies and development of international subsidiaries and joint ventures. This thesis uses panel regression data to assess what factors determine which markets receive U.S. investment and why. Out of a sample of fifteen initial independent variables, six are proven to be significant, most notably exports, exchange rates, population size, CPI, and CO2 emissions. Because of the possible limitations of a panel regression, further research is also recommended for many variables.

Keywords: foreign direct investment, FDI, American investment, cross-border M&A, international economics

EKHR21

Master thesis (15 credits ECTS)

June 2011

Supervisor: Håkan Lobell

Examiner: Lars-Olof Olander

Table of Contents

Page
1. / Introduction / 03
1.1 / Research Problem / 04
1.2 / Aim and Scope / 04
1.3 / Outline of the Thesis / 05
1.4 / Defining FDI / 05
1.5 / Types of FDI / 06
1.6 / The American Case / 07
2.0 / Literature Review/Theory Background / 09
2.1 / Introduction of Variables / 19
2.2 / Hypotheses / 30
3. / Data and Methodology / 32
3.1 / Data / 32
3.2 / Model / 32
4. / Empirical Analysis / 35
4.1 / Results / 35
4.2 / Discussion / 40
5. / Concluding Remarks / 44
6. / References / 47
7. / Appendices / 49

Acknowledgements

Special thanks to my supervisor Dr. Håkan Lobell and Dr. Jonas Helgertz from the Department of Economic History at Lund University, as well as Chris Culvern and Michelle Snow, whose suggestions and advice helped significantly towards the completion of this thesis.

1. Introduction

With the integration of world markets over the last three decades, the role of foreign direct investment (FDI) has deservedly garnered increased academic attention. The movement of capital across borders in private transactions unlocks economic growth potential not only in the FDI recipient country, but in the investing country, as well. While individual cases may result in differing conclusions on the impact of FDI on both firm and economic growth, the growing role of cross-border investment in global finance is readily apparent. For the United States, outward FDI reached an all-time high in 2008, with $3.1 trillion invested on foreign soil and investment income totaling $346B (U.S. Bureau of Economic Analysis, or BEA). Although most countries in the world receive FDI from the United States in one form or another, the recipients of most of this investment are those that hold the most promise of delivering returns, as deemed by individual investors. However, the political and economic environments that promote these returns differ greatly between countries. Also, the dynamics within individual firms are different from industry to industry. Therefore, the most attractive combination of environments for a firm and recipient country vary greatly over time and space.

Over the last decade, countries that once received a large portion of American investment have decreased-while other emerging markets have increased- their share. Obvious explanations for this would point to the diverse landscape of political, economic, and financial stabilities between countries, while other explanations could include wage levels, natural resource wealth, and exchange rate volatility. At the same time, countries that once received investment due to cheap labor resources now receive investment for access to unique technologies. In other words, the makeup of outward FDI determinants appears to have changing importance over time and space. In many cases, neighboring countries will promote certain domestic characteristics to attempt to attract FDI, so that a small country (like Singapore) might offer tax breaks, while a larger country (like China) with more natural resources might not need to focus on tax incentives because FDI will be attracted regardless.

Whether participating in cross-border mergers and acquisitions (M&A), joint equity ventures, or overseas expansion, American investors must weigh many factors when deciding among future investment locations. While delivering on shareholder returns is usually the goal, these investments and returns come in many forms, with each one having unique impacts on an investor’s portfolio. Some companies may be going abroad to avoid domestic tax rates or restrictive trade barriers, to attract unique technologies and talent, or to keep up with the competition. More often, perhaps, companies invest in other countries to diversify risk, take advantage of growth opportunities in high growth markets, or to tap into a new group of previously unreachable consumers. In order to understand why some countries have developed a certain talent for attracting FDI, and why some companies have become adept at deciding which markets to invest in, it is crucial first to understand the possible answers to these questions as determinants. Furthermore, which of these determinants carries the most weight in investment decisions, and do these decisions change over time? This paper will analyze the factors that may affect the share of U.S. outward FDI a country receives over the period of 1982-2008.

1.1 Research Problem

The topic of research is how national political and economic environments affect the amount of foreign investment that that country receives and how this may change over time. Although the United States provides a great example because of the enormity of its outward FDI and diversity of recipient countries, the hope with this study is that the factors that attract FDI should be transferable across cases. In this sense, the results from this study are aimed at contributing to the field of FDI determinants rather than the specific case of the United States and its relationship with FDI. Because there have been few recent studies using the United States in this type of experiment, this study should contribute to the depth of research into FDI determinants, with particular benefit of timing given that the dynamics of the global economy have changed greatly since 2008.

1.2 Aim and Scope

Toward the pursuit of determining the right economic and political atmosphere for attracting FDI, this paper will use a panel regression to study 51 recipient countries of US FDI over a 26-year period (1982-2008) to gain insight into why American firms invest in some foreign countries more than others. Therefore the aim of this paper is to tackle this topic and provide evidence for multiple determinants. As stated, this paper will hopefully contribute to the FDI determinants literature, which to date has yet to find a general consensus. This paper does not aim to provide grounds for a general consensus, but instead to simply add one large, important case study to the growing quantity of research done previously in the hope that it will respond to some areas of debate.

1.3 Outline of thesis

The paper will proceed as such: in order to be able to speak fluently about the determinants of FDI, it will be first necessary to fully define FDI and describe the historical reasons that have driven FDI in the most basic sense. This description will be followed by a review of similar research, focusing mostly on case studies on the determinants of FDI around the world, as well as specific studies on the dynamics of U.S. FDI. These two sections will lay the foundation for the rest of the paper: introducing the variables to be used, a description of the data, methodology and framework of this sample, followed by regression analysis, the results, and further concluding remarks.

1.4 Definition of FDI

Foreign direct investment is a term economists have used for decades to describe investments in physical assets in international markets. Initially, this definition was limited to a company purchasing or building a physical facility in another country, most typically used as a production factory. As the nature of international markets has become more complex and more entangled over the last few decades, this definition has expanded to incorporate three other types of direct investment: 1. direct acquisition of a foreign company or facility (further referred to as cross-border M&A); 2. joint venture with a foreign company in their local market; or 3. strategic alliance with a foreign company in their local market. This is opposed to an indirect (or portfolio) investment: an investment in real estate or a corporate entity through stocks, bonds, or an investment fund. The important distinction between the two is that the company making a direct investment has a direct influence on the returns on their investments, whereas an indirect investor simply provides capital for another entity to provide these returns. This study will focus solely on direct investment transactions. The dependent variable will be the U.S. FDI position in each country, which measures “the value of U.S. direct investors' equity in, and net outstanding loans to, their foreign affiliates. The position may be viewed as the U.S. direct investors' net financial claims on their foreign affiliates, whether in the form of equity (including reinvested earnings) or debt (BEA).”

1.5 Types of FDI

Another important component of defining FDI is the historical reasons that companies have been compelled to invest in other markets. The most straightforward breakdown of these reasons came from Chryssochoidis, Millar & Clegg’s 1997 book, in which they provide the following five types of incentives for a company to commit resources to FDI:

1. To gain access to currently unavailable factors of production. These could be natural resources, technical skill, or patents owned by a company in the recipient country

2. To gain access to low-cost factors of production, such as labor or natural resources

3. International competitors creating a partnership across borders to gain access to the other's product lines and client lists

4. To gain access to new consumers in the recipient country’s market

5. To avoid tariffs or other trade barriers

(Chryssochoidis, Millar, Clegg, 1997)

Which of these incentives drives FDI often varies depending on the home market from which the investment derives, such that a company based in a low labor cost economy would not invest abroad for low-cost labor, and a company based in a large market would not prioritize investing in small foreign markets to gain more market access. These priorities can also shift within a group of investors over time. Because this thesis focuses on the U.S. as its home market, it will be important to analyze which of these five factors has influenced FDI determination for Americans and which will be important moving forward, as these factors ultimately determine the location of investment. This study will use multiple variables representing each of these five categories to determine which have the most influence on U.S. FDI.

1.6 American Case

For United States outward FDI, investment position and direct investment income have grown steadily over the last three decades and reached an all time high in 2008 (BEA). As stated, this investment is spread to all corners of the world, albeit unevenly (as shown in Graph 1.). The European Union, for example, receives roughly half of U.S. investment, coming in at $1.6 trillion, while China and India combined only received $62 billion. Despite this large gap, China and India have both had a huge boost in investment over the last decade. In 2000, they received only a combined $13 billion, thus doubling their US FDI income twice in the last eight years (BEA). The countries that receive the most FDI are from Western Europe, such as the Netherlands ($426 billion) and the UK ($449 billion), who top the list each taking about a 15% share of American FDI. Canada and Mexico benefit from their proximity to the U.S., with the former receiving $239 billion while the latter receives $89 billion. In contrast, lesser recipients include South American countries such as Brazil ($44.5 billion) and Peru ($4.7 billion), Africa countries like Nigeria ($3.2 billion) and Egypt ($8.3 billion), and the Middle Eastern countries Saudi Arabia ($5.1 billion) and United Arab Emirates ($3.4 billion).

Within those countries that receive large amounts of U.S. FDI, the types of transactions can vary across many industries for many different purposes. For example, about half of investments in the Netherlands are directed at holding companies, with the remaining investment spread around to industries such as IT, finance, and manufacturing. In the UK, the lion’s share goes towards the banking industry, with the service and manufacturing industries receiving most of the remainder. Between Canada and Europe, the U.S. invests more heavily in the Canadian mining and manufacturing industries than the same industries in Europe. But when it comes to finance and holding companies, the

U.S. invests far more in Europe than in Canada. Perhaps to an even greater degree,

Mexico shares the manufacturing pull with Canada. African and Middle Eastern investment tends to be directed at the natural resources and the service industries. China receives over half of its U.S. FDI for manufacturing, while India’s investment has focused on information and service industries (BEA).

From these breakdowns, we’re able to see that certain industries tend to receive more investment than others, and that certain countries have competitive advantages in certain industries. For example, because of advanced financial markets, Europe is more prone and prepared to give returns on U.S. FDI directed at the banking industry. The Middle East has advantages in natural resources, and therefore receives investments towards natural resource extraction (oil, mining, etc.). India has a well-developed IT sector, and therefore receives funding for information services. However, despite the fact that it is relatively easy to see which industries within countries receive the most U.S. FDI, it does not answer why countries with similar industries receive different amounts. Also, it is conceivable that some countries have developed these industries with the express purpose of attracting U.S. FDI—so what makes some countries more successful at this than others?