FDI determinants: theory and evidence

Theories assuming perfect markets
Differential rates of return

Until the 1960s, FDI was largely assumed to exist as a result of international
differences in rates of return on capital investment, with capital moving
across countries in search of higher rates of return. Although the hypothesis
appeared to be consistent with the pattern of FDI flows recorded in the
1950s (when many US MNEs obtained higher returns from their European
investments), its explanatory power declined a decade later when US investment
in Europe continued to rise in spite of higher rates of return registered
for US domestic investment (Hufbauer, 1975). The implicit assumption of a
single rate of return across industries, and the implication that bilateral FDI
flows between two countries could not occur, also made the hypothesis theoretically

Portfolio diversification

The search for an alternative explanation of FDI soon revolved around the
application of Markowitz and Tobin’s portfolio diversification theory. This
approach contends that in making investment decisions MNEs consider not
only the rate of return but also the risk involved. Since the returns to be earned
in different foreign markets are unlikely to be correlated, the international
diversification of an MNE’s investment portfolio would reduce the overall risk
of the investor. Empirical studies have offered only weak support for this
hypothesis. This is not surprising when one considers the failure of the model
to explain the observed differences between industries’ propensities to invest
overseas, and to account for the fact that many MNEs’ investment portfolios
tend to be clustered in markets with highly correlated expected returns.

Market size

The market size hypothesis, which has its roots in neoclassical investment
theory, focuses on the role of both the absolute size of the host country’s
market and its growth rate. The hypothesis states that the larger the market,
the more efficient the investors’ utilization of resources will be and, consequently,
the greater their potential to lower production costs through the
exploitation of scale economies. In his survey of earlier work on the determinants
of FDI, Agarwal (1980) found the size of the host country’s market
to be one of the most popular factors influencing a country’s propensity to
attract inward investment, and most of the subsequent empirical literature
has provided further support to the market size hypothesis (see, among
others, Tsai, 1994; Billington, 1999; Chakrabarti, 2001).
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