What is FDI?

Foreign Direct Investment (FDI) occurs when an investor in one economy establishes a lasting interest in another and gains a significant degree of ownership over a business in that second country. FDI inflows come with many benefits. It can bring new access to markets, improve the skills of the host labor force, introduce new technology into the host economy, and promote competition and efficiency. The role of FDI in Belize is apparent when one looks at how areas such as San Pedro or Placencia have developed from small fishing villages to tourism hubs over the last two decades. The question then arises, what drives FDI? While it’s common to say that FDI is driven by factors such as a healthy business environment, political stability, and labor costs, there are other factors that play a role in FDI decision making. This article looks at the role of language, distance, and labor costs in FDI decision making. In particular, we’ll look at how the effect of factors like wages is a bit unclear.

The Traditional Story of FDI

In introductory economics courses like ECON 101, students are often taught about the theory of capital flow from rich to poor countries until returns are equalized. This theory suggests that capital will move from countries with high capital and low returns to countries with low capital and high returns, eventually reaching a point where returns are balanced between the two.

However, the reality is more nuanced. Barriers such as asymmetrical information between foreign investors and a host country, differences in institutional quality, and the state of infrastructure can impede these capital flows. In a more detailed look at UNCTAD data ranging from 1990 to 2022, we see that while FDI flows to developing countries (excluding China) have been increasing over the last decade, developed economies still receive the majority.

This is notable because when measured as a percentage of GDP, the importance of FDI in developing countries’ economies has been increasing while it has stayed relatively stagnant for developed countries.

The importance of inward FDI flows in Belize has also been increasing since 1990 when measured as a percentage of GDP, as shown in the figure above. Considering the importance of FDI in developing economies, along with Belize’s, the following section will look at some of the determinants of FDI.

What Drives FDI?

Is it Wages and Taxes?

A 2017 study conducted by Nielsen, Asmussen, and Weatherall reviewed 153 quantitative studies across various disciplines to find empirical evidence for drivers of FDI. The figure below shows the results of their analysis. Many of the results were expected, such as good physical infrastructure, human capital, proper governance and institutions, and high demand for a good or service correlating positively with FDI. Of note, the authors looked at the hypotheses that high tax rates and wages were negatively correlated with FDI flows. They found mixed support for those hypotheses. For the tax hypothesis, the articles were split 50/50 in terms of support for the hypothesis. When looking at the wage question, 49% of articles found a negative relationship between wages and FDI, while 34% found no relation and 17% found a positive relationship.

The above results are surprising and may seem counterintuitive. The authors suggest that a possible explanation for these results may be that the high wage locations that were looked at in the studies also had other positive attributes such as strong institutions and developed infrastructure, thus not properly controlling for the effects of wages. Another issue with the papers that were looked at is that different methodologies may have been used, thus making standardizing results more difficult.

Another possible explanation for the surprising wage result may be that there is a tradeoff between labor quality and wage levels. In 2021, Hou, Li, Wang, and Yang took another approach to look at FDI inflows. Using province-level data from China, they found that the effect of wages on FDI decisions decreases as labor quality increases. This suggests that FDI deciding firms may prefer higher quality labor with higher wages if the alternative is low wages plus low labor quality.

Is it Language and Distance?

In 2018, Ly, Esperanca, and Davcik studied the effects of language, distance, information flows, and technological similarity in FDI decisions. While the effects of language, distance, and technological similarity have been studied quite extensively, the authors note that the role of information asymmetry, countries having different levels of information about each other, has not been studied comprehensively. The authors found that language similarity and information flows between countries had a positive association with FDI. It was also found that geographical distance and high technological differences between countries had a negative effect on FDI decisions. The latter was found to have different impacts on recipient countries depending on their level of development. High levels of technological difference among high-income countries had a negative effect on FDI flows, while it had a positive effect on low-income countries.

The results of this study have interesting policy implications. The authors found that FDI patterns were different depending on the source country’s income level. For example, multinational corporations (MNCs) from high-income countries were more likely to be conservative when making FDI decisions such as preferring shorter distances, similar languages, and a similar level of technological development. In contrast, MNCs from lower-income countries were more likely to be less stringent about the environments they invest in. The results also suggest that negative factors such as distance may be mitigated if other positive factors are found in a host country.

What can Policymakers Learn from This?

The determinants of FDI remain a complex issue, but there are some highlights that can be gathered from a brief look at the literature.

• Targeted Incentives: Policymakers can tailor incentives to attract FDI based on the nuanced understanding of how MNCs from different countries behave. For instance, offering incentives that support higher labor quality might be more effective than solely focusing on reducing wages.
• Enhancing Information Flows: Recognizing the positive impact of information flows, efforts to improve transparency and accessibility of information can be beneficial. This can build trust and confidence among potential investors. This can include marketing efforts but can also take the form of making economic data more accessible and comprehensive. This is particularly notable for Belize, where there are large data gaps that may hinder decision-making.
• Strategic Partnerships: Given the impact of language similarity, fostering strategic partnerships with countries sharing linguistic and technological similarities may amplify FDI prospects.
• Mitigating Distance Barriers: While distance may pose challenges, the study suggests that negative effects can be mitigated by other positive factors. Policymakers can focus on highlighting these positives to offset distance-related concerns.

In conclusion, the topic of FDI drivers is complicated. Wages, taxes, language, distance, and information asymmetry all influence investment decisions. By embracing this complexity and crafting targeted policies, policymakers can navigate this landscape to attract the foreign investment needed for economic growth and development.