Factors affecting foreign direct investment (FDI)

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Factors affecting foreign direct investment (FDI)

This detailed article aims to explore some of the major factors affecting foreign direct investment (FDI). FDI can have a positive impact on the economy of any country. It stimulates local production, reduces unemployment rate, and caters to the growing demand for goods and services. It also transfers know-how and technology to the host country. However, FDI inflow is not an automated activity. Countries need to take several initiatives to attract foreign investors. This article provides an overview of the key factors that affect FDI in various countries.

 

What is foreign direct investment (FDI)?

According to OECD (2022) FDI is a category of cross-border investment in which an investor resident in one economy establishes a long-term interest in and a substantial degree of control over a company resident in another economy. Such a relationship can be evident from the ownership of 10% more of the voting power in a company.

 

Some countries are very famous for receiving FDI. According to Munoz et al. (2021) USA, Netherlands, Luxembourg, China, UK, Hong Kong, Singapore, Switzerland, Ireland, and German are the top FDI recipients in the world. On the other hand, China, Luxembourg, Japan, Hong Kong, and USA are the top five countries that invest heavily in other countries.

 

List of factors affecting foreign direct investment (FDI)

 

Investment climate

When it comes to FDI, the investment climate of a country plays a crucial role. It includes all the factors that attract investors, like policy, infrastructure, regulatory framework, the nature of competition in the market, and more. The government can improve the investment climate by introducing incentives for investors, removing unnecessary regulations, and improving the transparency of the administration. Certainly, a favourable investment climate can help a country attract substantial FDI and improve its economic outlook.

 

Political and legal factors

The political and legal environment of the host country can have a significant impact on FDI. Investors prefer to invest in countries with stable political systems. They also want a transparent legal system that provides a level playing field for all types of businesses.

 

A stable political system can encourage investors to put their money in a country. It can also ensure that they can operate without any fear of political interference. On the contrary, a weak political and legal environment can hamper the flow of FDI in the country. Investors may shy away from investing in the country and may look for other alternatives.

 

Wages

Wage rate is one of the key factors affecting foreign direct investment. When a company decides to set up a new production unit, it looks at the wage rate of the host country. If the country has a higher wage rate, the company may decide to set up its production facilities in another country which offers lower wage rates. Several developing countries have indeed attracted FDI as they offer abortable labour.

 

Tax rates

The tax structure in the host country plays a crucial role in attracting foreign investors. A lower tax rate can attract investors from other countries, as they can make higher profits from their investment. A higher tax rate may prompt them to shift their focus on other countries.

 

Availability of skilled labour

The availability of skilled labour in the host country is another factor that affects the flow of FDI. Investors usually prefer to invest in countries with a skilled labour force, as they can operate the production facility more efficiently. Skilled employees and workers can help companies adopt new technologies and improve the quality of goods and services. They can also reduce the production costs and improve the profit margin of the companies.

 

According to U.S. News (2022) Japan, South Korea, Germany, China, UK, USA, Canada, Norway, Switzerland, and Denmark are the top countries in the world for most skilled labour force. No wonder why some of them are the world’s top FDI recipients!

 

Infrastructure

Infrastructure is one of the key factors affecting foreign direct investment. Investors prefer to invest in countries with better infrastructure, as it can help them reduce the cost of doing business and increase the productivity.

 

A strong infrastructure system can help businesses handle their logistics efficiently, which can lower their production costs. Conversely, a weak infrastructure can deter investors from investing in the country. They may find it difficult to transport their goods and services to the end customers. This can increase their operation costs and hurt their profitability.

 

Culture

The culture of the host country can also have an impact on FDI. Investors prefer to invest in countries with cultures similar to their own, as it can make it easier for them to operate smoothly without facing any cultural challenges.

 

When a company decides to enter a new market, it must understand the consumer attitudes and behaviors which are highly influenced by their culture. Failure to understand local customs and tastes may lead to big failures. Tesco failed in Japan; eBay failed in China; and Starbucks failed in Australia. One of the reasons for these failures is the lack of cultural understanding.

 

Summary of the factors affecting foreign direct investment (FDI)

There are many factors that can affect foreign direct investment. Investors need to take those factors into account while making an investment decision. Likewise, the government of a host country should take necessary steps to motivate investors to invest in their country.

 

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Last update: 25 August 2022

References:

Munoz, C, Matei, S. & Howell, K. (2021) The world’s top recipients of foreign direct investment, available at: https://blogs.imf.org/2021/12/16/the-worlds-top-recipients-of-foreign-direct-investment/ (accessed 24 August 2022)

OECD (2022) Foreign direct investment (FDI), available at: https://www.oecd-ilibrary.org/finance-and-investment/foreign-direct-investment-fdi/indicator-group/english_9a523b18-en (accessed 23 August 2022)

U.S. News (2022) These countries have the most skilled labor force, available at: https://www.usnews.com/news/best-countries/rankings/skilled-labor-force (accessed 25 August 2022)

Author: M Rahman

M Rahman writes extensively online with an emphasis on business management, marketing, and tourism. He is a lecturer in Management and Marketing. He holds an MSc in Tourism & Hospitality from the University of Sunderland. Also, graduated from Leeds Metropolitan University with a BA in Business & Management Studies and completed a DTLLS (Diploma in Teaching in the Life-Long Learning Sector) from London South Bank University.