While there are several strategic reasons why multinational companies (MNCs) decide to invest abroad, some are more key than others. Ultimately, the most important point for them is whether it is possible to make a profit by establishing a presence in a new foreign market.
Broadly speaking, there are three main types of FDI operations:
• Market-seeking – where a company looks to invest in a location due to its market size and growth potential. There is a high correlation of foreign direct investment (FDI) trends and gross domestic product growth.
• Efficiency-seeking – where a company looks to invest in a location due to lower costs, better production processes and so on in the host country.
• Resource-seeking – where a company looks to invest in a location due to its natural resources. This type of FDI is particularly prevalent in energy, mining and agrifood industries.
Karl Sauvant, resident senior fellow at the Columbia Center on Sustainable Investment, says FDI drivers should be grouped under three categories:
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• Economic determinants
• Regulatory determinants
• Investment promotion.
Economic factors, he says, are the ones connected to the possibility of MNCs making a profit. A good regulatory framework is an enabler and good investment promotion, which includes investment facilities and incentives, is the icing on the cake.
At Investment Monitor, we have put together the following list of what are the most important drivers MNCs should focus on when selecting their next FDI destination.
Key drivers of FDI
FDI drivers are not univocal and will to a degree vary according to the type of MNC and, in particular, to the type of operations they are trying to set up. Drivers differ between companies – what sector they are in and where they are looking to invest. For example, a US-based company looking to establish an automotive manufacturing operation in Asia will have a different set of priorities or drivers to a European financial services company looking to set up an office in North America.
However, the selection of a new FDI destination is a sensitive process for MNCs as it generally involves significant capital expenditure and commitment of senior staff time and other resources.
The decision can also have significant impact on the company’s profits, productivity, share price and international reputation.
Most companies pick a location based on a combination of cost and quality factors.
Cost is an essential component of the FDI site selection decision-making process. Normally driven by demand, there are many different types of costs involved in setting up an FDI operation. To begin with, labour cost. MNCs often invest abroad to outsource labour-intensive production to countries with lower wages. However, while for a financial services operation labour costs might constitute 90% of overall costs, for heavy manufacturing industries the cost of raw materials, energy and distribution is more relevant. Property cost is another type of cost that MNCs need to look at when they are considering establishing a presence in a new market.
“Although costs are certainly a key driver, FDI trends suggest that these are not necessarily as important as other factors; for example, labour quality and availability and market size,” explains Investment Monitor chief economist Glenn Barklie. “In most countries, capital cities and/or key business cities will typically receive the lion’s share of FDI, even though these cities are likely to be the most expensive. Companies typically weigh the costs against the quality offered when assessing a location. Most will encounter some form of a cost/quality trade-off to find their optimal location.”
These factors include:
• Business environment – this can be broken down into two sub-categories: regulation and tax regime. If a country has an enabling FDI regulatory regime, it is obviously a preferable and accessible destination compared with one that has higher barriers to entry or, for instance, an FDI blacklist for certain sectors that it deems strategic and intends to protect from foreign ownership and influence. From a tax perspective, large multinationals have often sought to invest in countries that apply lower corporate tax rates. Ireland, for instance, has been successful in attracting Google and Microsoft for this reason.
• Political stability – this is another important factor in establishing the quality of a prospective FDI destination. As FDI involves a level of risk, political instability is a strong deterrent for an MNC selecting a country for an investment. Often related to political instability is the level of corruption and trust of institutions.
• Labour – this is an important FDI driver not only because of its cost. Availability and quality of labour are arguably even more important. Some MNCs decide to invest abroad as they require higher skilled labour, especially in industries such as pharmaceuticals, electronics and telecommunications. When associated with low cost, higher-skilled labour makes certain countries particularly attractive to MNCs in specific sectors. The quality of labour is fast becoming one of the most – if not the most – critical drivers of FDI.
• Education – partly linked to labour, the presence of good universities might also be an enabling driver for an MNC looking for higher-skilled workers. A country that invests in high-level education is more likely to produce a quality workforce compared with one that is not, and suggests that overall, its economy is targeted at enhancing talent.
“FDI companies not only avail of the talent of students at universities in terms of offering employment, but in some sectors, such as life science and R&D, companies will look to establish a presence close to a university to partner with, tap into networks and/or access research,” says Barklie.
• Industry clusters – the presence of competition in a prospective market is often a positive marker. Foreign firms looking to establish a presence in a new country can achieve economies of scale if somebody has opened that path for them already. Investing in areas with a good track record is also easier to achieve and is perceived to carry less risk. While it is generally perceived as a positive driver for FDI, a too-crowded market is not a good destination for an MNC looking to make a profit. There is typically a domino effect in FDI of one company going into a new market, being successful and then several other companies following to get their piece of the pie. Therefore, when a smaller location is looking to attract an anchor MNC they will speak of ‘first-mover advantage’.
• Infrastructure – the presence and quality of infrastructure across the board is a key FDI driver for most MNCs seeking to invest in a new country. The state of physical infrastructure, including road connectivity, airport connections and ports, as well as its cost is crucial in assessing how easy it is going to be to reach destinations as well ship goods and products to the global market. Countries with access to the sea might also be preferable destinations as the costs of moving goods are lower. The importance of technology infrastructure has also been growing in recent years and seems set to skyrocket as Covid-19 causes more people to work from home. Internet connectivity, good broadband and Wi-Fi and, more recently, the roll-out of fibre optics and the establishment of data centres are all positive markers.
“We will likely see in the coming months and years how the importance of infrastructure on FDI is likely to change,” says Barklie. “Good road, rail and air connectivity were often seen as essential; however, with a likely rise in people working from home, these factors will be less important for many workers and therefore businesses in several [service-based] sectors. Companies may also begin to rethink being located in highly clustered areas due to staff concerns and also to explore cost savings of out-of-town locations.”
• Size of domestic market – MNCs might be looking for a country not just to invest in, but also to sell to. In this instance, the size of the domestic market is important. In particular, the size of the population and scope for economic growth are important for attracting investment. Therefore, countries with large populations and a growing middle class are ideal targets. Examples include Poland in Eastern Europe and China, India and Indonesia in South East Asia. A large proportion of FDI is market-seeking.
• Incentives – these usually come as part of an investment promotion agency’s plan to attract FDI to its country. This is generally considered a good sign. However, Sauvant notes that an incentive scheme should be “the icing on the cake” rather than a main driver as an FDI destination that has potential should not need too many incentives to attract capital.
• Living environment – more recently, MNCs have become more sensitive to the quality of the living environment of the countries they are assessing for investments. The cost of living and the presence of factors that guarantee a good work-life balance are taken into consideration by companies that are looking to relocate some of their managers there to set up new operations. The living environment is seen as an important driver for creative industries and tech sectors in order to attract talent.
Far from being a fixed recipe, this list aims to provide an overview of what drivers are taken into account by an MNC looking for a new FDI location. The priority that each of these drivers takes will vary according to the type of FDI operation each MNC is looking to set up.
This article is part of a series on FDI drivers. The full list comprises:
- Business environment
- Political stability
- Domestic market size
- Quality of life