What drives foreign direct investment: The role of language, geographical distance, information flows and technological similarity
Introduction
Neoclassical theory predicts that capital will flow from rich to poor countries, and this will hold true until the returns from investments are equaled (Lucas, 1990). In fact, the bulk of foreign direct investment (FDI) take place in developed countries (UNCTAD, 1998), even though the highest returns can be obtained in developing countries (Pigato, 2000). Various and sometime competing explanations are offered in the debate about this phenomenon. Typically, the focus is on host countries' formal barriers, such as political risk, capital restrictions, taxes, legal and regulatory regime. Although it is intuitive that these factors affect FDI, the barriers to international investments have diminished considerably over the past few decades (Ahearne, Griever, & Warnock, 2004; Huberman, 2001). The sharp decline in transaction costs associated with FDI (e.g., similar legal background – UNCTAD, 1998), and diminished corporate tax rates (Devereux, Lockwood, & Redoano, 2008; Slemrod, 2004) have not diminished the skewed pattern of FDI toward developed countries. One possible explanation for this phenomenon is information asymmetry, because it is most acute in the international market (Doherty, 1999) and can hinder FDI. Information asymmetry can arise due to geographical distance (Coval & Moskowitz, 1999), or different legal and regulatory regime, or business practice between home and host countries (Ahearne et al., 2004). These differences are critical for FDI, because the high market entry costs are mainly costs of acquiring information regarding ways to conduct business in the host countries (Mata & Portugal, 2002). This situation is more severe in developing and emerging countries due to limited availability of public information (Kinoshita & Mody, 2001). Given that information is costly (Grossman & Stiglitz, 1980) and leads firms to equate unknown markets with high risks (Coval & Moskowitz, 1999), we expect it would skew investment preference toward countries that are familiar for investing firms. Access to information is made difficult by geographical distance between countries (Ivković & Weisbenner, 2005), thus leading to increased information asymmetry. Consequently, information costs are expected to increase in tandem with distance.
Therefore, we have identified factors which can impact distance and by extension minimize information asymmetry, namely, language, level of technological development and information flows. Theoretically, distance can be an incentive for FDI (Hirsch, 1976) or disincentive (Helpman, 1984), depending on the nature and purpose of the FDI. Language barriers contribute to information asymmetry among multinational corporations (MNCs), because they affect communication processes negatively (Kang & Kim, 2010). In addition, language differences between home and host countries means increased difficulty for MNCs in identifying business opportunities and negotiating agreements (Rauch & Trindade, 2002). Technology, particularly, information and communication technology (ICT), allows firms to circumvent barriers created by distance, enabling remote access to costumers and resources (Nachum & Zaheer, 2005), and reduces the costs of communications and coordination of operations (Mosakowski & Zaheer, 1999).
This research addresses the impact of information asymmetry on FDI in conjunction with the factors identified above. With the exceptions of Kinoshita and Mody (2001) and Loungani, Mody, and Razin (2002), the majority of studies on information's effect on FDI are conceptual in nature (e.g., Goldstein & Razin, 2006). We sought to fill in this gap in the literature by using a dataset covering most of the world's economies and applying a different research methodology than that of previous studies. We used the Poisson Pseudo Maximum Likelihood (PPML) approach suggested by Silva and Tenreyro (2006), instead of the traditional ordinary least squares (OLS). Furthermore, we applied rarely used patent data as proxy for the level of technological development and tourism flow as proxy for information flow.
The present research further relied on the gravity model proposed by Pöyhönen (1963) and Tinbergen (1962). We used UNCTAD's outward bilateral FDI stock data and the Centre d' Études Prospectives et d'Informations Internationales's (CEPII) database for most of the gravity variables. We tested our hypotheses on panel data extending over 13 years (2000−2012).
The results have provided strong and positive evidence for the language effect on FDI, especially for high-income countries. The effects of geographic distance are strongly negative, for both high and low-income countries. We found that technological difference from high-income countries has a negative effect on FDI and a positive effect on FDI from low-income countries. Informational flow is positively associated with the level of FDI stock, even after accounting for possible tourism flow endogeneity. This result is not sensitive to source countries' income level or methodology applied.
This paper is organized as follows. In section two, we review the recent developments of studies on FDI determinants and describe the research hypotheses. In section three, we describe the data used, and present the empirical model in section four. The results and robustness analysis are presented in sections five and six, respectively. Finally, section seven provides a summary and conclusions.
Section snippets
Literature review
The impact of information asymmetry on capital flow has received considerable attention from both academics and policymakers (e.g., Portes & Rey, 2005; Portes, Rey, & Oh, 2001; Tenzer, Terjesen, & Harzing, 2017). Most studies (e.g., Goldstein & Razin, 2006; Horstmann & Markusen, 1987) are conceptual or qualitative in nature, focusing on how information asymmetry can lead to one form of capital investment instead of another (e.g., FDI versus portfolio flow, and FDI versus licensing). The
Data
We use panel data covering 13 years (2000–2012) for 224 countries and/or jurisdictions. The dataset consisted of 71,309 bilateral FDI stock observations of 649,376 country pairs. We use stock instead of flows, because flows are volatile and can significantly influence the results and question the interpretations (Bénassy-Quéré et al., 2007; Júlio, Pinheiro-Alves, & Tavares, 2013). We deflated FDI stock data using US price deflator base year 2011, to obtain the “real” stock. Approximately 89% of
Model
We use the gravity model suggested by Pöyhönen (1963) and Tinbergen (1962). The model proposes that objects (countries/economies) attract each other according to their mass/size (e.g., population, GDP), and the distance between countries reduces their attraction. This approach has been successfully used to explain bilateral FDI (e.g., Bevan & Estrin, 2004; Kleinert & Toubal, 2010; Petroulas, 2007).
We followed Silva and Tenreyro's (2006) nonlinear specification of the gravity model (PPML),
Results and discussion
The estimation results, using PPML, are presented in Table 2. We also split the samples of FDI into high and low-income countries using the World Bank's GNI per capita criteria—as described in Section 3 and shown in Table 3, Table 4.
All the variables present the expected signs, and are economically and statistically significant. The market size variables, GDPs of both home and host countries are positive and economically significant across all samples.
As to the variables of interest, the
Robustness check
We adopted other proxy measures to cross-check the results in Table 2. We used different proxy measure for information flow (e.g., existence of stock exchange, IMF loan, Multilateral Investment Guarantee Agency), and level of technological level (e.g., fixed broadband internet subscriber). The new estimations confirmed the results in Table 2 (results are available upon request). Additionally, we also tested for the endogeneity of tourism flow by instrumenting the intensity of fixed telephone
Theoretical contribution
This study sheds new light on the link between information asymmetry and FDI (i) providing empirical evidence in a debate that has been mostly conceptual or qualitative in nature and (ii) applying a different methodological approach (a gravity model using PPML) that provides better and more robust estimates than classical OLS techniques. Distance is a significant obstacle to FDI, as it makes communication and interactions between countries difficult. However, we found that high-income
Acknowledgment
We are grateful to J.F. Hennart for his comments on previous versions of the manuscript and Jacinta Garcia from the World Tourism Organization (UNWTO) for providing the data on worldwide tourism flows. We are in debt for the detailed, constructive and valuable comments provided by the two anonymous referees and associate editor Piyush Sharma. This research was partially supported by Fundação para a Ciência e a Tecnologia, grant UID/GES/00315/2013. Amadú Ly would like to acknowledge the
Amadú Ly is a Ph.D. candidate and BRU Research Fellow at ISCTE-IUL, Lisbon, Portugal. His research interests are related to broad topics of international business and finance.
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Amadú Ly is a Ph.D. candidate and BRU Research Fellow at ISCTE-IUL, Lisbon, Portugal. His research interests are related to broad topics of international business and finance.
José Esperança is the dean of ISCTE Business School (IBS). He is a full professor of finance and a former pro-rector for International Relations and Entrepreneurship at ISCTE-IUL, Portugal. He earned a Ph.D. in economics from the European University Institute, Florence, with the title The Investment Decision by Service Multinationals. His research interests include entrepreneurship and small business financing, corporate governance and the impact of language commonality in international business.
Nebojsa S. Davcik is BRU Research Fellow at ISCTE-IUL. He received his Ph.D. in Economics & Management from University of Padua, Department of Economic Sciences “Marco Fanno” in 2010. Dr. Davcik published in academic journals such as the Journal of Business Research, European Journal of Marketing, Journal of Product and Brand Management, among others. He also serves as a member of the Editorial Advisory Board of the Journal of Business Research and Journal of Product and Brand Management as well as an ad hoc reviewer of the Journal of the Academy of Marketing Science, International Marketing Review, European Journal of Marketing, among others.