Most of the theoretical literature about the impact of FDI on developing countries agrees that foreign firms tend to create positive externalities when there is insufficient local investment or technology, as long as the country has locational and labour advantages. In this context, FDI not only represents increasing capital inflows but also a source of knowledge, technological transfer, managerial skills, new production processes and other qualitative resources that create spillovers to the domestic economy.
There are many elements that influence the success of some developing countries in attracting a specific sort of foreign investment. Generally speaking, FDI depends on the state of economic development of the host country and the existence of minimum conditions to operate efficiently, like human capital, physical infrastructure, macroeconomic stability and an economy relatively open to international trade (i.e. low or zero tariffs). These conditions seem to facilitate efficient operations by foreign plants and therefore are quicker at creating positive effects on output growth. Contrary to the traditional belief that abundant cheap labour was enough to guarantee high levels of FDI flows, such consideration does not seem to be a significant determinant for foreign corporations. Nowadays, positive externalities created in the economy by a firm that requires relatively skilled labour are higher than those created by firms that employ unskilled cheap labour.
The promotion of FDI (as well as exports) does not imply automatic and positive effects on the domestic economy. Some studies suggest that there must be favourable
economic conditions to create positive externalities. FDI also requires the existence of certain conditions in the host country to operate and therefore affect the economy positively. In this sense, in the literature we also see an increasing interest to investigate and analyse the determinants of FDI in developing countries. These empirical studies provide valuable information that can be used to design economic policies that stimulate certain areas that are likely to improve FDI inflows. Some studies have found that minimum conditions are required to attract foreign capitals, for example economic stability, physical infrastructure, human capital, and favourable economic policies among the most important. For example, Borensztein et al. (1998) found, in a sample of 69 developing countries, that foreign firms contributed more to output growth -than domestic firms- in those countries that had a minimum stock of human capital. This is so because most multinational corporations concentrate in manufacturing industries, in intensive in capital sector and which production is usually for the international market. These characteristics are more likely to demand higher levels of skilled labour. Therefore, some FDI requires the existence of a labour force with minimum adaptation conditions and learning capability.
Spillovers from FDI in host countries can vary across countries and industries, but Bromstrom and Kokko (1996) maintain that the evidence suggests that positive technological effects of multinational corporations are likely to improve in the presence of competition and local capability. This suggests that multinational corporations react strongly (and therefore increase technological transfers) in the presence of domestic competition that forces them to maintain the leading the position. In a same fashion, Bromstrom et al. (1994) in the specific case of Mexico found that skilled labour, local competition and growth in the manufacturing industries were positive determinants of technology transfers by foreign plants. While Love and Lage-Hidalgo (2000) found that FDI from the US was positively determined by domestic
demand and the differences in relative wages, this finding regarding relative wages supports the contention that cheap labour is still an important incentive to invest in Mexico.
The formation of a trade agreement area has been considered as conducing to improve foreign capital flows to developing countries. The empirical evidence suggests that there is an important link between FDI and trade liberalisation (Bende-Nabende, 1999). A country that belongs to a free trade area seems to offer more potential to increased profitability, since international integration lowers trade costs and increases market size. In this regard, foreign firms will tend to favour countries that belong to international trade areas because it reduces the risks associated with operating from a host country, it also offers higher rates of return and the certainty that trade tariffs will not increase. In a study of five Southeast Asian countries with different levels of development, Bende-Nabende et el. (2001) found that the formation of a preferential trade agreement had a positive lagged influence on FDI flows to the more developed countries and a negative influence on the flows to the less developed countries.
In the case of Mexico, trade agreements and FDI inflows seem to be closely related, especially since Mexico joined GATT in 1986 and NAFTA in 1994. For example, Blomstrom and Kokko (1997) assert that the Mexican accession to NAFTA in 1994 had a strong impact on FDI inflows because it provided the environment to produce and export from Mexico due to locational advantages, the provision of cheap labour and the creation of commercial opportunities among the most important (especially for foreign investors outside NAFTA).
These findings suggest the relevance of considering different channels and microeconomic aspects through which trade liberalisation and FDI may occur. Only in this way it will be possible to understand the context in which FDI can affect the host economy.
3.4 Conclusions
The history of studies related to the measurement and analysis of the effects of trade liberalisation has shown some interesting aspects that should be considered in future investigations. The main characteristic of multi-country studies was the intensive use of cross section data and the overgeneralization of the results to a large number of countries. In most cases, the overgeneralization led to obtain positive results that supported the assertion that trade liberalisation was indeed a growth engine in most developing countries, when in fact most of the results depended on the methodological techniques and the influence of large countries in the sample. One of the most important disadvantages of these studies was the assumption that regression coefficients were constant across countries. So, the positive effects of openness was rather apparent than real.
On the other hand, recent economic research is focused on the analysis of specific cases of countries that have experienced trade reforms. Most of them apply causality tests in order to determine first the direction of the causality effect and include a large number of variables on the right hand side of the equation. This approach recognises the existence of different channels by which liberalisation might impact output growth and also recognises the interdependency between the variables (GDP, exports and FDI for example), therefore the popularity of simultaneous equation models and VARs in country case studies.
However, in both sorts of studies a problem persists with the definition of variables and data sets that affect the results. In short, the cross country regressions and the case studies have shown that the approach applied does matter in this regard.