(Rough Draft for Discussion)

Waseda University, Japan

US-China-Japan Trilateral Forum

November 11th, 1997

Increasing Importance of Foreign Direct Investment in the World Economy

World foreign direct investment (FDI) has grown rapidly since the early 1980s. Indeed, the rate of increase of world FDI was higher, compared with world trade from the early 1980s through the mid-1990s. As a result of these new developments, FDI has become one of the most important means of integrating the world economy. The role of FDI in the world economy would be significantly greater, if the impact of FDI on various economic activities is considered. FDI enables investing firms to utilize their firm-specific assets such as technologies and managerial know-how efficiently, while FDI recipients can obtain not only the funds for investment but also efficient technologies and know-how. Furthermore, FDI recipients can enjoy the benefits by gaining an access to various networks such as sales and procurement networks being developed by investing firms.

Changing Locations of Foreign Direct Investment in Asia: FDI Diversion in Asia

Asia, in particular East Asia, has been successful in attracting FDI. The magnitude of FDI destined to Asia increased ten-fold in nine years from $5 billion in 1985 to $50 billion in 1994. The share of Asia in all developing countries concerning FDI inflow increased from 39 percent to 57 percent over the 1985-94 period. A similar pattern of increasing importance of Asia (particularly East Asia) can be observed for Japanese FDI outflow. In terms of value, Japanese FDI in Asia in total Japanese FDI increased from 12 percent in 1985 to 24 percent in 1994. One notable development regarding FDI inflow to Asia is the high share of electric and electronics industry. For Japanese FDI in Asia, the share of electric and electronics industry in total manufacturing increased from 11 percent in 1985 to 26 percent in 1994.

The rapid expansion of FDI inflow in Asia has been accompanied by dramatic shifts in the composition of recipient countries from the mid-1980s to the mid-1990s.(Tables 1-3) Roughly speaking, the Asian NIEs (Hong Kong, Korea, Singapore, and Taiwan) were major recipients of FDI through the end of the 1980s, capturing approximately 30-40 percent of FDI in Asia. Around 1988, the ASEAN4 countries began attracting FDI. The share of ASEAN4 in total FDI in Asia increased from approximately 20 percent in the mid-1980s to 30-40 percent in the end of the 1980s and in the early 1990s. Entering the 1990s, China became a very attractive destination for FDI. In terms of value, FDI in China increased about ten-fold in five years, from $3.4 billion in 1989 to $34 billion in 1994.

The above finding of rapid and significant changes in the composition of FDI recipient countries in Asia indicates the experience of FDI diversion in Asia. Some causes of FDI diversion in Asia will be discussed in the next section.

Factors Affecting the Location of FDI

In analyzing the factors affecting the location of FDI, it may be useful to divide FDI into three different groups or types, natural resource-securing type, market-securing type, and cost-saving type. The factors determining the location of FDI are different for these three types of FDI. For FDI of the natural resource-type, availability of natural resources is undoubtedly the most important determinant of FDI location. Resource-securing type FDI was actively undertaken by Japanese firms in the 1960s. Some such examples are iron ore mining in Australia and oil exploration in Indonesia.

A major determinant of market-securing type FDI is the presence of sizable market, which is reflected in large population size and/or population with high income. Tariff-jumping FDI, which is induced by import protection through tariff or non-tariff measures, can be categorized under market-securing type FDI. Foreign direct investment in Asia before the 1980s was dominated by tariff-jumping FDI. Because of the prevalence of import protection in Asia, FDI was the only way to sell in the local market. In recent years, market-securing FDI, which is motivated by the rapid increase in purchasing power of the Asian population, is increasing.

Cost-saving FDI is undertaken by export-oriented foreign firms. To maintain international price competitiveness, export-oriented firms need to set up a production base where production can be performed at low cost. More specifically, low wages, low inflation, undervalued exchange rates, and well-developed and well-functioning infrastructure such as telecommunications and transportation systems are important determinants of cost-saving FDI. Indeed, much of FDI in Asia since the mid-1980s has been of cost-saving type. Cost-saving FDI has been particularly noticeable in electric and electronics industry. Indeed, cost-saving type FDI has been a major factor leading to FDI diversion in Asia, since cost-saving FDI is very sensitive to the economic conditions of the recipient countries.

Let me discuss the case of Japanese electronics firms, for example. Faced with losing price competitiveness of their products because of the drastic yen appreciation in the mid-1980s, many Japanese electronics firms set up their production base in the NIEs such as Korea and Taiwan, in order to maintain their price competitiveness. In the latter part of the 1980s, Korea and Taiwan lost advantages of low cost production, as their exchange rates appreciated because of accumulated current account surplus and their wages increased because of rapid economic growth and influential labor unions. To deal with the situation, Japanese firms shifted their FDI to ASEAN countries, where low-cost labor was abundantly available . In particular, Thailand and Malaysia were major recipients of Japanese FDI pursued by electronics firms. By the early 1990s these ASEAN countries lost some of the attractiveness for cost-saving FDI. Wages increased and shortage of infrastructure emerged. Japanese firms under competitive pressure shifted their FDI destination to China, where low-wage labor was available. Furthermore, a potentially large market also was a key element that led to Japanese FDI in China. Very recently China seems to have lost some attractiveness to foreign firms, as Chinese government abolished pro-FDI measures such as preferential fiscal measures, which enabled foreign firms to gain cost advantage.

So far, I have discussed the determinants of FDI by different types. In the discussion different factors are identified as important determinants for different types of FDI. In addition to these factors, there are some factors that may be important for all types of FDI. A well-functioning legal system is crucial as it provides protection of assets owned by foreign investors. Without security of assets, no foreign investors would undertake FDI. Closely related to the point just noted is protection of intellectual property rights, as intellectual property is a source of competitive edge for most foreign direct investors. These points may be summarized as the capability of providing credible commitment on the part of host government, or governance for short. One of the reasons that foreign investors seem to have lost an interest in China is that it could not offer stable business environment, due to a lack of governance.