A comparison of fdi determinants in asean3 and asean5 countries new evidence from financial integretion factor analysis doctoral thesis major finance

Doctoral Thesis

A comparison of FDI determinants in ASEAN3 and
ASEAN5 countries: New evidence from financial
integration factor analysis
Srovnání determinant PZI v zemích ASEAN3 a ASEAN5: Nové
důkazy z analýzy faktoru finanční integrace

Author:

Ho Thanh Tri

Degree programme:

P6202 Economic Policy and Administration

Degree course:

6202V010 Finance

Supervisor:

prof. Ing. Juraj Sipko, PhD. MBA

Zlín, January, 2020


© Ho Thanh Tri

The publication was issued in the year 2020.

Key words in Czech: hrubý domácí produkt (HDP), infrastruktura, otevřenost
obchodu, mzdové náklady, úroková sazba, index vnímání korupce, směnný kurz

Key words in English: Foreign Direct Investment (FDI), Gross Domestic Product
(GDP), Infrastructure, Trade Openness, Labor cost, Interest Rate, Corruption
Perception Index, Exchange Rate

Full text of the Doctoral thesis is available in the Library of TBU in Zlín.

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ACKNOWLEDGEMENTS
I am deeply grateful to my Supervisor – Professor Juraj Sipko for his invaluable
advice, guidance, and kindness supported in conducting this study.
I would like to thank Tomas Bata University in Zlín for awarding the scholarship
that allowed me to concentrate on my research. It is pleasant to express my gratitude
to the Faculty of Management and Economics as well as Pavla Bartošová and
Martina Drábková for supporting me in the administrative procedures during my
study at the University.
I would like to especially thank Professor Drahomíra Pavelková, Boris Popesko and
Dr. Lubor Homolka, who gave me much advice for my dissertation.
I am also very grateful to my family: my mother and brothers. Without their support,
I could not have completed my study. My deepest gratitude goes to my mother, Lê
Thị Minh Nhu for her immeasurable love and encouragement.
And there are also many friends that I would like to say thank you to them for their
help, support and encouragement during the time I study abroad.
I dedicate this achievement to all.

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ABSTRACT
Foreign direct investment (FDI) contributes greatly to the economic development of
the receiving country by providing an important source of finance for development
and acting as a channel for the transfer of capital and new technology. On the one
hand, FDI adds to the stock of domestic capital and increases the productivity of
production factors such as raw materials and labor. On the other hand, FDI also
contributes to diversifying the economy by adding new economic actors and
promoting competition to produce better products at lower prices in the host country.
The literature has indicated that FDI inflows are determined by the market size, the
degree of openness, the role of institutional factors and degree of economic
integration. Besides, other factors such as labor costs, infrastructure, domestic tax
rates, and institutional environment are correlated significantly with FDI inflows.
Many studies about the factors were influenced by foreign direct investment inflows
in developing countries as well as developed countries. However, none of the
research articles compare FDI determinants in ASEAN3 and ASEAN5 with the new
issue of the financial integration factor measured by the KAOPEN index to see
whether or not it has an impact, along with other factors, on attracting FDI inflows
in ASEAN3 and ASEAN5 member countries. Therefore, in this study, the author
conducts a "a comparison of FDI determinants in ASEAN3 and ASEAN5," focusing
on the new issue of the financial integration measure by KAOPEN index and a reexamination of the impact of other factors such as gross domestic product,
infrastructure facility, trade openness, labor costs, interest rate, institutional stability,
and exchange rate to FDI inflows. The author uses the quantitative research
strategies by the panel ordinary least square estimation with the method of first
differencing to address the critical research question and research hypotheses of this
study. There are three stages of this study. In the first stage, the author identifies
factors influencing FDI inflows in ASEAN countries. In the second stage, the author
uses econometric models to give concrete empirical evidence. And in the third stage,
the author draws a conclusion based on findings from the econometric models. The

author also includes an interview conducted with experts on the impact of these
factors on attracting FDI in ASEAN member countries, which can help policymakers
improve the FDI attraction of ASEAN member countries as well the FDI attraction
of Vietnam. This study collected data from eight ASEAN member countries during
two financial crises from 1996 to 2016. The author divides ASEAN member
countries into two groups, ASEAN3 and ASEAN5, based on their level of economic
development. The findings indicate that the coefficient of financial integration is
positive and statistically significant at a 1% level of significance on FDI capital
inflows. The empirical results also support the hypothesis that foreign direct
investment in ASEAN3 and ASEAN5 is positively correlated to market size and
4


infrastructure facilities, and negatively correlated to labor costs as well as trade
openness in ASEAN3.

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ABSTRAKT
Přímé zahraniční investice (PZI, Foreign direct investment - FDI) významně
přispívají k hospodářskému rozvoji hostitelské země tím, že poskytují důležitý zdroj
financí pro rozvoj, převod kapitálu a nové technologie. Na jedné straně PZI navyšují
zásoby domácího kapitálu a zvyšují produktivitu výrobních faktorů, jakými jsou
suroviny a práce. Na druhé straně PZI také přispívají k diverzifikaci ekonomiky tím,
že vytváří nové hospodářské subjekty a podporují konkurenceschopnost s cílem
vyrábět v hostitelské zemi lepší produkty za nižší ceny.
Literatura naznačuje, že příliv PZI je určován velikostí trhu, stupněm otevřenosti,
rolí institucionálních faktorů a stupněm ekonomické integrace. Další faktory, jakými
jsou mzdové náklady, infrastruktura, daňová sazba dané země a institucionální

prostředí, pak s přílivem PZI vysoce korelují. Mnoho studií zaměřených na tyto
faktory bylo ovlivněno přílivem přímých zahraničních investic jak v rozvojových
zemích, tak v rozvinutých zemích. Žádný z výzkumných článků však nesrovnává
determinanty PZI v ASEAN3 a ASEAN5 s novou problematikou faktoru finanční
integrace měřenou indexem KAOPEN, aby se zjistilo, zda má nebo nemá dopad,
spolu s dalšími faktory, na příliv PZI do ASEAN3 a členských zemí ASEAN5.
Z toho důvodu provedl autor této práce „srovnání determinant PZI v ASEAN3 a
ASEAN5“ zaměřující se na novou problematiku faktoru finanční integrace měřenou
indexem KAOPEN a na následné přezkoumání dopadu dalších faktorů, jakými jsou
hrubý domácí produkt, infrastruktura, otevřenost trhu, mzdové náklady, úroková
sazba, institucionální stabilita a směnný kurz, na příliv PZI.
K řešení zásadní výzkumné otázky a výzkumných hypotéz použil autor této práce
kvantitativní výzkumné strategie s využitím metody nejmenších čtverců aproximací
s metodou první diferenciace. Tato práce má tři fáze. V první fázi autor identifikuje
faktory ovlivňující příliv PZI v zemích ASEAN. Ve druhé fázi autor využívá
ekonometrických modelů k zajištění konkrétních empirických důkazů. Ve třetí části
pak autor, na základě výsledků z ekonometrických modelů, vyvodí závěr. Autor také
poskytuje rozhovor s odborníky o dopadu těchto faktorů na atraktivitu PZI v
členských zemích ASEAN, což může politikům pomoci zlepšit atraktivitu PZI jak v
členských zemích ASEAN, tak i ve Vietnamu. Tato práce shromáždila data z osmi
členských zemí ASEAN v průběhu dvou finančních krizí v letech 1996 až 2016.
Autor rozděluje členské země ASEAN do dvou skupin, ASEAN3 a ASEAN5, na
základě úrovně jejich ekonomického rozvoje. Výsledky naznačují, že koeficient
finanční integrace je pozitivní a statisticky významný pro příliv kapitálu PZI, při
statistické hladině významnosti 1%. Empirické výsledky také podporují hypotézu,
že přímé zahraniční investice do ASEAN3 a ASEAN5 pozitivně korelují s velikostí
trhu a vybaveností infrastruktury a negativně korelují se mzdovými náklady a
otevřeností trhu v ASEAN3
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TABLE OF CONTENTS
ABSTRACT ..................................................................................................................4
ABSTRAKT ..................................................................................................................6
LIST OF FIGURES AND TABLES...........................................................................10
LIST OF ABBREVIATIONS AND ACRONYMS ...................................................12
1.INTRODUCTION ...................................................................................................14
1.1 Research background and motivation ................................................................14
1.2 Research questions and objectives .....................................................................18
2.LITERATURE REVIEW ........................................................................................20
2.1 Theories of FDI .................................................................................................20
2.2 Previous empirical studies of FDI determinants ...............................................23
2.3 Financial integration ..........................................................................................27
2.3.1 Financial integration concept .......................................................................27
2.3.2 Benefits and risks of financial integration ...................................................28
2.3.3 Financial integration in ASEAN countries ..................................................30
2.4 Financial integration index of Chinn-Ito ...........................................................38
3.RESEARCH METHODOLOGY .............................................................................48
3.1 Stages of research process .................................................................................48
3.2 Definition of variable ........................................................................................49
3.2.1 Foreign direct investment .............................................................................49
3.2.2 Financial integration .....................................................................................49
3.2.3 Market size ...................................................................................................52
3.2.4 Exchange rate ...............................................................................................53
3.2.5 Labor cost .....................................................................................................53
3.2.6 Infrastructure facility ....................................................................................53
3.2.7 Institutional stability .....................................................................................54
3.2.8 Interest rate ...................................................................................................54
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3.2.9 Trade openness .............................................................................................55
3.3 Sampling and data collection.............................................................................56
3.4 Statistical method ..............................................................................................57
4.RESULT FROM QUANTITATIVE ANALYSIS ..................................................59
4.1 Descriptive statistics ..........................................................................................59
4.2 Correlation between the variables......................................................................60
4.3 Result from regression analysis .........................................................................62
5.RECOMMENDATIONS .........................................................................................73
5.1 Financial integration ..........................................................................................73
5.2 Market size ........................................................................................................76
5.3 Monetary policy .................................................................................................77
5.4 Trade openness ..................................................................................................78
5.5 Institutional stability ..........................................................................................78
6.CONTRIBUTION TO SCIENTIFIC AND PRACTICAL KNOWLEDGE ...........81
6.1 Contribution to scientific knowledge ................................................................81
6.1.1 Developing and introducing models, indicators for FDI determinants in
ASEAN ..................................................................................................................81
6.1.2 Providing approaches, findings, and suggestions from previous relevant
studies ....................................................................................................................81
6.1.3 Acquiring a deeper understanding of FDI determinants in ASEAN ...........81
6.1.4 Adding theoretical contribution to studies of FDI determinants..................82
6.2 Contribution to practice knowledge ...................................................................82
6.2.1 Providing critical evaluation of FDI in ASEAN ..........................................82
6.2.2 Practicality of this study’s approach ............................................................82
6.3 Contribution to education ..................................................................................83
7. CONCLUSION AND SUGGESTIONS .................................................................84
7.1 Conclusion .........................................................................................................84
7.2 Suggestions for future research..........................................................................84
8

BIBLIOGRAPHY .......................................................................................................86
LIST OF THE PUBLICATIONS BY THE AUTHOR ..............................................98
AUTHOR’S PROFESSIONAL CURRICULUM VITAE .......................................100

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LIST OF FIGURES AND TABLES
Figure 2.1: Gross domestic product: Annual average growth rate, 1995 -2015.....32
Figure 2.2: Gross domestic product: Annual average growth rate in selected Asian
countries, 1995 -2015..............................................................................................33
Figure 2.3: Exports and imports of goods and services, annual, 2005-2016 (US
Dollars at current prices in millions) ......................................................................35
Figure 2.4: FDI inflows and financial integration in ASEAN 1996-2015 .............36
Figure 2.5: Foreign direct investment in ASEAN 1996-2016 ................................37
Figure 2.6: Financial integration measured by the KAOPEN index of ASEAN ..47
Figure 3.1: The stages of the research ....................................................................48
Figure 3.2: FDI inflows into Asean from 1990 to 2016 .........................................51
Figure 3.3: The theoretical framework ...................................................................56
Figure 3.4: The observed and unobserved effects influencing to FDI ...................58
Figure 5.1: ASEAN 2025 Vision ............................................................................74
Table.1.1: FDI policies of ASEAN .........................................................................14
Table 1.2: FDI inflows in ASEAN3 and ASEAN5 countries (millions of USD) ..16
Table 2.1: ASEAN Countries: Economic Indicators ..............................................34
Table 2.2: Summary of the features of exchange arrangements and regulatory
frameworks for current and capital transactions in IMF member countries. Examples
are taken from Vietnam...........................................................................................39
Table 2.3: Regulations on cross-border portfolio investments in selected ASEAN

countries ..................................................................................................................40
Table 2.4: Comparison of financial integration measures ......................................43
Table 3.1: Top 5 according to the total FDI inflows between 1990 and 1996 .......50
Table 3.2: FDI inflows into ASEAN from 1990 to 2016 .......................................50
Table 3.3: Summary of the factors influencing FDI in ASEAN ............................56
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Table.4.1: Descriptive statistics ..............................................................................59
Table 4.2: The correlation matrix of ASEAN3.......................................................60
Table 4.3: The correlation matrix of ASEAN5.......................................................61
Table 4.4: Variance inflation factor (VIF) of ASEAN3 and ASEAN5 ..................61
Table 4.5: The parameter estimates of ASEAN3 ...................................................62
Table 4.6: The parameter estimates of ASEAN5 ...................................................63
Table 4.7: Total external debt in ASEAN5 (1996-2002) - (in millions $) .............65
Table 4.8: Imports of goods and services in ASEAN5 (1996-2002) - (in millions $)
.................................................................................................................................65
Table 4. 9: Trade of goods and services in ASEAN3 and other economic countries
(% GDP) ..................................................................................................................67
Table 4. 10: The global competitiveness index 2016-2017 rankings .....................68
Table 4.11: Summary of empirical findings result in ASEAN3.............................70
Table 4.12: Summary of empirical findings result in ASEAN5.............................71
Table 5.1: Some recommendations towards achieving regional financial integration
goals by 2025 ..........................................................................................................75
Table 5.2: The focus targets of the ASEAN Community .......................................77
Table 5.3: Four key areas and several suggested recommendations in addressing
anti-corruption challenges .......................................................................................79

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LIST OF ABBREVIATIONS AND ACRONYMS
ACAs

Anti-Corruption Authorities

AEC

ASEAN Economic Community

ADB

Asian Development Bank

AFFTA

American Fly Fishing Trade Association

APAC

Asia Pacific Accreditation Cooperation

AIC

ASEAN Integrity Community

AREAER Annual Report on Exchange Arrangements and Exchange Restrictions
ASEAN

Association of Southeast Asian Nations

CSP

Cyber Security Program

FD

First Differencing

FDI

Foreign Direct Investment

FII

Foreign Institutional Investor

GDP

Gross Domestic Product

ICT

Information & Communication Technology

IMF

International Monetary Fund

ISO

International Organization for Standardization

MNCs

Multinational Corporations

MNEs

Multinational Enterprises

NAFTA

North American Free Trade Agreement

OECD

Organisation for Economic Co-operation and Development

POLS

Panel ordinary least square
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RIA

Regional integration agreements

TWMNCs Third World MNCs

UNCTAD United Nations Conference on Trade and Development

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1. INTRODUCTION
1.1 Research background and motivation
Foreign direct investment (FDI) contributes greatly to the economic development
of the host country by promoting the factors of economic growth of a country, i.e.
transfer of capital and new technologies. As a result, the attraction of foreign direct
investments is getting more and more attention from economists and policymakers.
On the one hand, FDI adds to the stock of domestic capital and increases the
efficiency of production factors such as raw materials and labor as input. Moreover,
FDI contributes to diversify the economy by adding new economic actors and
promotes the competition to produce better products at lower prices in the host
country. Consequently, the ability to produce goods and services in the host country
is improved.
FDI has played an essential role in the economic development of many developing
countries. According to Khachoo and Khan (2012), claimed the developing countries
do not have enough national savings in order to finance their investments, and thus,
they need foreign capital in form of both direct and indirect investments. Thangavelu
and Narjoko (2014) proved that FDI made an essential contribution to the
development of the ASEAN-5 (Indonesia, Malaysia, Philippines, Singapore, and
Thailand) economies. Hence, many developing countries, such as the ASEAN
economies, want to achieve their growth targets, in order to increasingly competing
and attracting more FDI sources through various policies, which are summarized in
Table 1.1.
Table 1.1: FDI policies of ASEAN. Source: Adopted from the research of
Xaypanya et al. (2015)

Singapore

Reduces business expenses as part of a cost reduction package
amounting to S$ 10 billion in savings and extends 30% corporate
investment tax allowance to industrial projects and to several
selected service industries like manufacturing, engineering, and
technical services and computer-related services

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Thailand

Malaysia

Indonesia

Philippines

Cambodia

Laos

Vietnam

Allows 100% foreign equity ownership for manufacturing
investment projects regardless of locations

Offer 100 % foreign-equity ownership in the manufacturing sector
without imposing export conditions on new investments,

expansions and diversifications. With limited exceptions,
foreigners have direct ownership of land and property in Malaysia
Offers wholesale and retail trade up to 100% foreign equity
ownership to qualified investors, in addition to 100% foreign
equity in the manufacturing sector, and reduces the processing
time for approval of investments less than US$100 million, to 10
working days. Banks are open for 100% foreign equity ownership
Opens its retail and distribution sectors to foreign equity, and its
private construction in the domestic market to foreign companies

• In March 2011, the country issued Prakas No. 288 on
authorization to use tax removal/ reduction programs of
Cambodia under the Agreement on ASEAN Merchandise Trade
• Tax incentive in securities exchange: (i) 10% of tax on profit for
securities companies; and (ii) 50% reduction of withholding
taxes on interest and dividend distribution for public investors
Allows duty exemption on imported capital goods required by the
promoted investment projects
• Offers duty exemptions for imported capital goods for all
projects, on the importation of raw materials for production in
encouraged investments and for projects located in mountainous
or remote regions during the first five years of operation
• The period required for the issuance of investment licenses for
several types of the project has been reduced to 15 days from the
receipt of the required documentation Investment licensing for
projects under the US $5million in Viet Nam has been
decentralized to provincial and city levels
15

A highlighted point, the ASEAN region is not really homogeneous, which leads
to the impact of economic factors on FDI inflows would be significant different in
each region in the area (Xaypanya et al., 2015). They found that the differences
between ASEAN3 (Vietnam, Laos, Cambodia) and ASEAN5 (Indonesia, Malaysia,
Philippines, Thailand, Singapore) raised interesting questions for both academics
and policymakers regarding why the two groups of countries performed differently
in attracting FDI inflows. According to the recent data from the United Nation
Conference on Trade and Development (UNCTAD) (2019) in Table 1.2, compared
to other ASEAN nations, Singapore is the largest source of FDI. Thailand, Malaysia,
Indonesia and the Philippines also continue to attract FDI inflows into their
countries. Another report of UNCTAD (2018) indicated foreign investor around the
world have considered the least developed countries in ASEAN such as Cambodia,
Laos, and Vietnam their ideal investment destinations after the trade war between
China and America broke out. Adopting this approach, this study divides the
ASEAN member countries into two groups based on their level of economic
development: ASEAN3 (Cambodia, Laos, and Vietnam) and ASEAN5 (Indonesia,
Malaysia, Philippines, Thailand, Singapore). Moreover, Brunei and Myanmar are
removed from this study due to data limitations.
Table 1.2: FDI inflows in ASEAN3 and ASEAN5 countries (millions of USD).
Source: UNCTAD statistics online (accessed September 2019)
ASEAN3

ASEAN5

Year Vietnam Laos Cambodia Singapore Thailand Malaysia Indonesia Philippines
2005 1954

28

381

17784

7975

4065

8336

1851

2006 2400

187

483

37480

8182

6060

4914

2929

2007 6981

324

867

42609

9195

8595

6928

2824

2008 9579

228

877

11810

8054

7172

9318

1544

2009 7600

190

985

18532

5362

1453

4878

1990

2010 8000

279

1404

57460

14555

9060

13771

1298

16


2011 7519

301

1539

39890

1370

12198

19241

2043

2012 8368

294

2004

60103

9135

9239

19138

2449

2013 8900

427

2068

56672

15493

12115

18817

2280

2014 9200

721

1853

73287

4809

10877

21811

5285

2015 11800

1119 1823

59700

5624

10082

16641

4447

2016 12600

997

2476

73863

1815

11336

3921

6915

2017 14100

1599 2788

75723

6478

9399

20579

8704

2018 15500

1320 3103

77646

10493

8091

21980

6456

The topic of FDI determinants has been widely used and tested in empirical
studies for many developing and developed countries (Asiedu, 2002; Cuyvers et al.,
2011; Hussain & Kimuli, 2012; Khan & Khachoo, 2012; Kolstad & Villanger, 2008;
Nunnenkamp, 2002; Tintin, 2013; Tomio et al., 2010). The analyses carried out by
Ang (2008), Bhatt (2008), Hoang and Goujon (2014), Ismail (2009), Tsen (2005),
Zebua (2016) and Thangavelu and Narjoko (2014), Xaypanya et al. (2015) are used
to study the factors that influence FDI inflow in ASEAN. Based on the eclectic
paradigm theory of Dunning (1988), the factors affecting FDI inflows can be
separated into observable and unobservable effects. This theory is based on the OLI
conditions (OLI stands for Ownership, Location, and Internalization): Ownership
specific advantages (‘Why’ operate in a foreign country?), Location advantages
(‘Where’ do firms produce in a particular host country?), and Internalization
advantages ('How' do they compete in the domestic market of the host country?). In
this study, the author defined the location-specific advantages as the observable
effects, and two advantages of the ownership-specific and internalization as
unobservable effects, which can be time-variant or time-invariant. According to OLI
conditions of Dunning (1988), the observable effects are composed of
macroeconomic stability (measured by the exchange rate, interest rate, institutional
stability), market size (measured by GDP), infrastructure facility (measured by the
fixed telephone subscriptions), level of openness (measured by the trade openness),
low cost of labor (measured by labor cost). The unobservable effects, which can be
time-variant or time-invariant namely government policies, licensing, law and
17

management skills, etc. However, the outcome and conclusions in previous studies
failed to address the issue of being biased, unrobust, and ungeneralized. Moreover,
financial integration is a new factor in the topic of FDI determinants. Many studies
mentioned the effect of financial liberalization policies on economic performance,
however, unable to properly measure financial integration (Chinn et al., 2009). They
introduced the scale of ‘Impossible Trinity’ theory and developed a set of “trilemma
indexes.” namely monetary independence, exchange rate stability, and financial
openness. Financial integration is one of the aspects of the 'Impossible Trinity'
theory. This theory was developed in the field of international economics and it was
formulated by Robert Mundell and Marcus Fleming in the 1960s. Financial
integration allows more capital flows to enter the economy. It helps citizens of the
host country to diversify their assets through offshore investing and it also
encourages foreign investors to bring resources, experience and technology in the
receiving countries. To measure financial integration, there are three broad
categories: de jure, de facto, and hybrid indicators. KAOPEN index is a new
approach, which also has been neglected in previous studies (Quinn et al., 2011).
This study has used the data of financial integration measured by KAOPEN index
of Chinn et al. (2009) for research purposes.
This study aims to investigate the comparison of FDI determinants in ASEAN3
and ASEAN5. Firstly, identify FDI determinants in ASEAN3 and ASEAN5 based
on eclectic paradigm theory of Dunning (1988). Secondly, test the new factor of
financial integration based on KAOPEN index. Thirdly, compare the differences in
FDI determinants between ASEAN3 and ASEAN5. The study sheds some light on
what ASEAN3 and ASEAN5 should do to improve aspects of attracting higher FDI
as well as a new trend for scholars in the field of FDI.
The rest of the dissertation is organized as follows. Section 2 discusses the
literature review and financial integration in ASEAN countries. Section 3 presents
the research methodology adopted in this study. The results, recommendations,
contributions and conclusions are in Sections 4, 5, 6 and 7 respectively.

1.2 Research questions and objectives
This study will address the critical issue for FDI attraction in ASEAN3 and
ASEAN5. The main research question is set out as follows:

18


RQ: What is the difference of FDI determinants between ASEAN3 and
ASEAN5?
According to the research question above, the main research objective and three
sub-objectives of this study are as follows:
RO: To identify and compare FDI determinants between ASEAN3 and
ASEAN5
RO1: To identify FDI determinants in ASEAN3 and ASEAN5 based on eclectic
paradigm theory of Dunning (1988).
RO2: To test financial integration defined in terms of KAOPEN index.
RO3: To compare the differences in FDI determinants between ASEAN3 and
ASEAN5.

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2. LITERATURE REVIEW
To be able to understand and answer the research question “What is the difference
of FDI determinants between ASEAN3 and ASEAN5?” this section will describe
the development of FDI in emerging markets and the trend of FDI in ASEAN
countries through FDI's theories. Afterward, financial integration in ASEAN
countries is discussed. Finally, this section will present the findings of FDI
determinants from previous existing studies.

2.1 Theories of FDI
A significant contribution made to the literature on FDI was made by Steven
Hymer (1960) and Charles Kindleburger (1969) when they developed the market
imperfection theory that considered where enterprises developed coherent strategies
for companies to expand their businesses through capitalizing on their clear
advantages over the local firms. Such overseas operations require more care, time
and effort but local advantages enable the enterprises to maximize the financial
returns. Kindleburger (1969) proposed that it was market imperfections in the host
country that provide the opportunities for FDI. Rather than searching for perfect
competition sites, the investor takes advantage of product differentiation, economies
of scale, advanced skill in marketing, high technology access, better management
skills, positive government and their improved access to capital to take advantage of
the host countries imperfections in the market. Although the investor inherits the
problems of operating in a new environment, these are counterbalanced by their
advantages in competing.
In the research of FDI theories, the eclectic theory of Dunning became a common
analytical framework for understanding FDI as it successfully combined the
understanding of determinants of FDI with other theories such as organizational
theory, location theory, and market imperfections approach. The eclectic method is
based on the OLI conditions (OLI stands for Ownership, Location, and
Internalization): Ownership specific advantages (‘Why’ operate in a foreign
country?), Location advantages (‘Where’ do firms produce in a particular host
country?), and International advantages ('How' do they compete in the domestic
market of the host country?). The conglomeration of the effects of these inter-related
pathways is thought to define the patterns and extent of FDI success. The theory
helps to analyze why, where, and how FDI enterprises operate in host countries
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(Dunning, 1988). Investors grab the investment opportunity to exploit their
ownership-specific advantages and to expand abroad by engaging in FDI (Dunning,
1988). The form of intangible assets of the common governance advantages provide
for the overall positive advantages of the FDI enterprises and factors such as
unlicensed secret technology, management knowledge advantages, and access to
foreign markets make the FDI more beneficial than the one of their rivals (Xuemin
and Decker, 2004). The multinational enterprises (MNEs) use their advantages in
the internalization incentives to maximize their specific strengths across borders
while maintaining the positions within their organization. Their preference is to
internalize their benefits rather than take the risks of licensing them. The I factor is
a result of market imperfections and it is mainly concerned with the interrelation
between ownership and internalization advantages. Internalization enables the
enterprise to acquire further ownership advantages such as an increase of its assets
(Dunning, 1988). Location-specific advantages are the primary condition for MNEs
to expand. MNEs combine their ownership-specific advantages with the positive
factors of the host country in those areas, such as more substantial markets,
population growth, etc., combined with infrastructure advantages, political stability
and positive factors, e.g. stable interest rates, beneficial tax and the balance of trade
(Rugman, 1982). Thus, the macro-levels of the economy help to determine the
location, size, and type of FDI.
A growing body of literature has examined the structure of international trade.
Ricardo (1817) and Smith (1776) put forward their approach, suggesting the theory
about explanations of trade flows between nations. Smith developed his method on
the basis of the competitive advantage of each country. Given by Adam Smith, the
theory of absolute advantage stated that international trade would occur if one
country that was more efficient (had an absolute advantage) in the production of one
commodity or technology. An absolute advantage means that one can produce more
of a good or service than its competing entities using less of a given resource.
However, the failure of Smith's theory is the inability to explain the absolute
advantage of one country. Elaborating Smith's theory to more general framework,

Ricardo formulated the theory of comparative advantage. This theory was based on
differences in labor productivity between both countries which provide incentives
for trade. The academicians contended that countries would export products that
utilize their relatively abundant and cheap factors of production and import products
that use the scarce factors (Heckscher 1919, Ohlin 1933). However, these theories
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did not provide an answer to the question concerning overseas production as these
theories were based on the assumption of international immobility of factors of
production. In 1966, Vernon proposed his theory, successfully combining
international trade and international investment.
Vernon’s theory was called “Product Life Cycle Theory” and it provides an
explanation for factors such as the availability of larger and cheaper capital, superior
management, the discovery of new markets, etc. Vernon’s theory was used to
explain certain types of foreign direct investment made by U.S.-based firms in
Western Europe in the manufacturing sector during the period of 1950-1970
following World War II. The U.S. has become an importer of many of the goods that
it had once exported. The product life cycle involves three stages: (1) The invention
and introduction of new product; (2) The process of bringing a product from perfect
to mature; (3) The standardization of the product itself. In the first stage, new
products hitting the market were not able to generate any profit as the costs of the
introduction outweighed the profits. In the following, the products were welcomed
and consumed rapidly by the market. As products matured, a certain degree of
standardization took place. Then there were others imitating those products. There
was competition between firms making the same products and pricing became the
main competitive tools and cost became a more serious issue. As a matter of fact,
production was moved to other countries on the basis of its cost. Products were then
exported to the US by US based firms. In brief, we can see how FDI began to appear
in the second phase of a business cycle. However, the products did not improve.

One of the main limitations of these studies is that they neglected the structure of
vertical and horizontal FDI. Helpman (1984) showed a model of international trade
where firms decide to invest in the domestic market and then export to other
countries. He believed that heterogeneity influenced every industry; thus, the
productivity of firms can vary. As a result, firms are organized based on their
productivity. The least productive firms which cannot generate enough profits will
have their businesses shut down. Meanwhile, low-productivity firms can only
operate only in their local markets. Firms can operate abroad via two ways which
are through FDI and selling commodities by exports. In other words, the reason that
all firms choose to engage in FDI is to avoid transportation expenses. According to
theory of horizontal FDI, this is called "the proximity-concentration trade-off".

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2.2 Previous empirical studies of FDI determinants
The factors that impact the FDI into developing countries have been presented in
numerous research articles. The experimental studies of Hussain and Kimuli (2012),
using data collected from 57 low- and middle-income countries for the period of
2000 – 2009, showed that countries with high a GDP rate, a fast GDP growth and a
favorable business environment can better attract FDI. Many other researchers also
focused on this topic.
Hussain and Kimuli (2012) explored the different factors responsible for variation
into FDI to developing countries. They used a macro panel data of 57 low and lowermiddle-income countries selected from a timespan of ten years (2000-2009). Their
model includes seven independent factors such as market size, inflation rate, tariff
rate on imports, secondary enrollment rate, money supply to GDP ratio and two
dummy variables that are country- and time-specific. The findings revealed that
developing countries could attract FDI by focusing on increasing their market size
and promoting more liberal trade policies. Moreover, improving the quality of the
workforce, developing financial institutions and maintaining low inflation rate can

help countries to attract FDI. The main limitation of their research was that only 215
observations out of a total of 570 collected in 57 countries in ten years were used. In
addition, 355 observations were missing.
Nunnenkamp (2002) used survey data from the European Round Table of
Industrialists on investment conditions in 28 developing countries since late 1980s.
The model included six independent factors which affected FDI inflows such as
population, GDP per capita, GDP growth, administrative bottlenecks, entry
restrictions and risk factors of host countries. Surprisingly, the study found out that
little had changed so far. Meanwhile, there was a correlation between FDI and nontraditional determinants such as cost factors, complementary factors of production
and openness to trade.
Khachoo and Khan (2012) analyzed determinants of FDI inflows into developing
countries over a long period. The study was based on a sample of 32 developing
countries in order to establish a panel data estimator. The study considered GDP,
foreign exchange reserves, wage cost, infrastructure development and trade
openness to identify the factors that affect FDI inflows. Empirical results showed
that the coefficients of GDP, foreign exchange reserves, wage cost and infrastructure
development were significant whilst trade openness was not meaningful. Therefore,
international investors did not consider the importance of the trade openness of the
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receiving investment when deciding where to set up subsidiaries. This is
contradictory to some of the theories as well as to some empirical studies Garibaldi
et al (2001), Compos et al. (2003), but it is suitable for the tariff jumping hypothesis,
which argues that the nature of FDI into most developing countries is either marketseeking or tariff-jumping in order to avoid trade restrictions. The results of the study
suggested that developing countries should improve the infrastructure system,
accumulate foreign exchange reserves and encourage GDP growth to attract inflows
of FDI.
Tomio et al. (2010) estimated a panel data model to deliver results supporting the
hypothesis that FDI into Latin America is positively correlated to its economic

stability, growth and trade openness, and improvement in the institutional and
political environment. However, a key variable failed to deliver the expected result
- the government effectiveness had a negative relation with the dependent variable.
Meanwhile, researchers found evidence that developing markets can offer MNCs
many incentives to lessen production costs or to gain access to abundant resources.
FDI is an important factor in mots developing countries in South-Eastern Asia.
Cuyvers et al. (2011) highlighted the success of Cambodia in attracting FDI with a
study, namely the Determinant Factors on Foreign Direct Investment in Cambodia.
Based on the Cambodian Investment Statistics of CIB (1994–2004), Cambodia
attracted FDI for about 5,313 million USD in the form of fixed assets during 1994–
2004. There are two main modes of FDI entry in Cambodia: Cambodian-foreign
joint ventures and wholly foreign-owned enterprises. The factors determining FDI
into Cambodia included market size, international trade, labor costs, lending interest
rate/borrowing costs, exchange rates, inflation rate, political risk, regional
integration, and geographic distance. The research paper analyzed panel data sets
between 1995-2005. The results indicated that the determinants of approved and
realized FDI are somehow similar. GDP and exchange rate of the host country had
a positive impact on inward FDI flows into Cambodia. As expected, geographical
distance negatively affected the level of FDI inflows into Cambodia.
Kolstad and Villanger (2008) studied a panel data considering 57 countries for the
period between 1989-2000 to reach the conclusion that the service sector is dominant
in world foreign direct investment flows. The 57 countries included developing,
transition and developed economies. The model consisted of eleven independent and
dependent variables which represent logged FDI inflows per capita in the service
sector as a whole and in each of the major service industries including finance,
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business activities, transport and trade. The results of the study confirmed that
service FDI was market-seeking, and unaffected by trade openness of receiving

countries. The use of lagged variables suggested that the producer services
responded with different lags to FDI in manufacturing, whereas the finance industry
responded faster than the transport one.
Hoang and Goujon (2014) analyzed the factors of FDI inflows in ASEAN
countries during the period from 1991 to 2009, aiming to determine the factors
affecting FDI in ASEAN. This study considered a panel of six ASEAN countries,
including Vietnam, Indonesia, Malaysia, Philippines, Singapore and Thailand. In
their model, the independent factors that were mentioned included market size of the
host country, trade openness, labor cost, human capital, labor productivity, political
stability, e.g. corruption index, inflation rate and interest rate, financial development
such as domestic credit provided by the banking sector and exchange rate. Fixedeffects and random-effects models were applied in the analysis. Results showed that
the REM is more appropriate than the FEM after Hausman test. That study indicated
that market size, trade openness and the quality of the infrastructure have a positive
impact on FDI inflows. When associated with macroeconomic factors, the exchange
rate policy and the real interest rate have a fundamental effect on FDI inflows.
However, the inflation rate and the financial development statistically have no
significant influence on FDI inflows. Lastly, FDI inflows into the region are strongly
influenced by political risks and institutional quality.
ASEAN remains a major global FDI destination. The study - Determination of
Foreign Direct Investment in ASEAN countries: Some Empirical Evidence, which
was developed by Wong (2005) who investigated the determination of FDI in
ASEAN countries in general and in every country of the Association through panel
data. The empirical estimations were carried out by using the fixed and random
effects estimator. The sample period was taken from 1972 to 2002 with data from
the IMF. The study introduced a model consisting of four independent factors:
market size, trade openness, interest rate and government consumption. The study
included two dummy variables related to AFTA (0 for 1972 - 1991 and 1 for 19922002) and the Asian financial crisis (1 for 1997-1998, 0 for the rest). While market
size had a significantly positive effect on FDI, AFTA and the Asian financial crisis
did not have any significant impact on it.
As the ASEAN region has become one of the most attractive investment

destinations in the developing world, Bhatt (2008) made an attempt to understand
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