FDI inflows are not only simply a transfer of capital but are associated with advanced technology. These forms of capital flow are distinctly different from OFCF (Ito and Krueger, 2000: p.3) Thus, it is necessary to treat FDI separately from OFCF in analyzing its determinants and impact.
Traditionally, an explanation of the direction, motivation and impact of capital inflows is based on the neo-classical theory of international capital investment, namely the interest arbitrage theory (for example MacDougali, 1960). Capital funds will flow from a country where the expected rate of return is low to one which provides a higher return. However, as described above, the motivation for establishing MNE affiliates is far more complicated than the difference in the nominal rate of return, as postulated by the arbitrage theory. This is first pointed out by Hymer (1960), based on the US experience during the 1950s. The US experienced simultaneously net FDI outflows and net inflows of OFCF. Based on the interest arbitrage theory, the US should have experienced either net outflows or net inflows in both FDI and OFCF. Net OFCF inflows imply that the US interest rate must be higher than somewhere else. Thus, if the movement of FDI flows were fully explained by the interest arbitrage theory, the US would experience net FDI inflows. Hymer’s breakthrough became a starting point for other researchers to seek and develop new theories to explain FDI determinants, such as Vernon’s product-cycle theory (1966), Dunning’s eclectic theory (1977), and Rugman’s internalization theory (1980).
There are four major differences between FDI and OFCF. (1) Investors and Conduits to Transfer Capital Funds
MNEs are the world’s major direct investors. In 2002, foreign assets of the 100 largest MNEs (less than two per cent of the total number of MNEs worldwide) accounted for around 12 per cent of the world’s total stock of FDI (UNCTAD, 2004). Many studies
use MNEs and FDI in an interchangeable manner. More importantly, over four-fifths of the stock of FDI originates from half a dozen countries — the US, United Kingdom, Japan, Germany, Switzerland, and the Netherlands — which are also the major producers of the most advanced technology (Blomström et al, 2000). On the other hand, OFCF investors are far broader in scope, ranging from individuals to institutional investors and banks. In addition, the main conduit for FDI to inject capital funds is through a subsidiary. In contrast, capital funds from OFCF can either go directly to the recipient or to financial brokers.
(2) Investment Motivation
Inflows of FDI and OFCF are motivated by different factors. As mentioned earlier, FDI inflows are the result of a firm’s decision to transplant across countries so they are mainly motivated by business opportunity, competitive advantage, and global strategy, all related to long-term underlying economic fundamentals. In contrast, OFCF is a capital fund allocation across countries to benefit from differences in financial rates of return, e.g. interest rates, exchange rates, etc. These financial returns are related to short-term fluctuations in key macroeconomic indicators such as interest rates, exchange rates, and stock prices. Even though there are some common factors and/or external shocks that can have considerable impact on the returns from FDI and OFCF, such as overall economic performance, political stability, and policy uncertainty, it is still far from conclusive to group both kinds of international capital flows together. The observed evidence during the recent economic crisis in East Asian economies that started in mid 1997, provides a strong case for treatment of these two different capital flows. During the onset of the crisis, OFCF in the five-crisis hit countries experienced huge net outflows while there were still FDI inflows into these same countries, cushioning the large shift of capital flows (Athukorala, 2003a).
(3) Volatility
By their nature, OFCF seem more volatile than FDI (Frankel and Rose, 1996; Radelet and Sachs, 1998; Kim and Hwang, 2000; Lipsey, 2001b; Athukorala, 2003a). OFCF are attracted by financial return and are highly sensitive to any external shock. In
addition, a rapid movement of OFCF from one country to another could generate a considerable amount of profit for investors. With its higher volatility, Frankel and Rose (1996) point out that a country with a high ratio of OFCF to total capital flows is more likely to experience a currency crisis. In contrast, FDI is likely to exhibit a greater sunk cost of investment, i.e. once the investment has been made none of it can be recovered (Rivoli and Salorio, 1996). Thus, the FDI decision on entry/exit takes longer, compared with OFCF. Quick movement (entry-exit) is unlikely to generate a net return to direct investors.
(4) Impact on Economic Development in Host Countries
FDI and OFCF generate different impacts on a host country. Apart from providing additional capital funds, FDI is likely to influence the economic structure as well as the conduct and performance of locally owned firms in the host country. Since FDI means there are new entrants in industries, this can affect industry concentration (Caves, 1996: p.87-8). Their entry can increase domestic market competition and eventually influence the behaviour and performance of incumbent firms. More importantly, the entry of MNEs with their extensive involvement with world R&D activities can provide opportunities for local firms to access advanced technology. Such opportunity is not limited to a subsidiary but other local firms can also gain these benefits. Nevertheless, the net impact of FDI is not necessarily always positive but is conditioned by several economic factors in host countries, as discussed in Section 2.3. In contrast, OFCF obviously provides additional capital funds to the host country and allow the market mechanism to allocate them. The efficiency of the market mechanism in allocating funds depends on the stage of development in the capital and financial markets as well as policy-induced incentives (e.g. tariff protection) in host countries.
Table A. 1.1 provides a summary of key distinct characteristics between FDI and OFCF. While it seems clear the common contribution of FDI and OFCF to host countries is to achieve investment levels beyond their own domestic saving, there are strong reasons to believe FDI inflows are considerably different from OFCF as mentioned
above. Hence, it is necessary to treat FDI differently from OFCF to evaluate its impact on host countries’ economies.
Table A.1.1
Distinct Characteristics between FDI and OFCF
Feature FDI OFCF
Investors MNEs Individuals, institutional
investors, etc.
Conduit to transfer Establish affiliates Contact recipient directly or indirectly through financial intermediates
Investment Motivations Underlying economic fundamentals
Short terms fluctuations of several macroeconomic variables such as exchange rates, interest rates, share prices
Volatility More stable More volatile
Impact on host countries’ economies - Capital funds - Opportunity to access advanced technology - Structure-conduct- performance (S-C-P) of incumbent firms
- Capital funds only - Funds are allocated according to market mechanisms.