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2. Literature Review

2.1 Factors Affecting Investment

FDI is not only one means of affecting service trade, but it is also important in the production of goods. Under appropriate conditions, FDI can generate employment directly and indirectly, promote competition, improve the efficiency of host country workers, and transfer technology from one country to another (Goldin and Reinert 2007). FDI is usually associated with new job opportunities and enhancement of technology transfer, and it boosts overall economic growth in host countries (Chowdhury and Mavrotas 2006).

The theoretical foundation of FDI is rather fragmented, comprising bits and pieces from different fields of economics to elucidate the location pattern of firms (Sun 2002). Several theories have been put forward to explain FDI. Hymer (1960) views multinational corporations (MNCs) as oligopolist. FDI is considered to be the outcome of broad corporate strategies and investment decisions of profit-maximizing firms facing worldwide competition. Dunning (1977) and Rugman (1981) invoke transaction costs to explain firms’ internationalization, putting emphasis on the intangible assets that firms have acquired. Bhagwati and Srinavasan (1983) and Grossman and Helpman (1991) use the international trade theory to explain the allocative aspects of FDI. Dunning (1996) identifies four types of MNC activity: resource-seeking, market-seeking, efficiency-seeking, and strategic asset or capability-seeking.

In the early 1980s, no large FDI inflows to the PRC occurred because of poor infrastructure (OECD 2000); while during 1983–1991, a steady growth and relatively large inflows could be seen as the SEZs expanded from 4 to 14 cities, and FDI incentives were introduced in 1986 (Ali and Guo 2005). FDI began to pour in the PRC after 1992, and annual flows have been over $50 billion since 2002 (Yin 2008). A study by the World Bank (Broadman and Sun 1997) indicates market size and preferential policy as the two most important determinants of the location of FDI in the PRC (Hu and Wang 1999). Some other studies give more specific determinants, such as preferential tax status to foreign investors, lower tariffs, better infrastructure, more flexible labor markets, and less bureaucratic control (Panagariya 1993).

Sun (2002) identifies eight potentially important determinants of FDI distribution across provinces in the PRC. These are (i) market demand and market size; (ii) agglomeration, which refers to the concentration and co-location of economic activities that give rise to economies of scale and positive externalities; (iii) labor quality; (iv) labor cost; (v) level of scientific research; (vi) degree of openness; (vii) political risk; and (viii) FDI substitutes. Swain and Wang (1995), Liu et al (1997), Zhang (2000), Wei and Liu (2001), Zhang (2002), and others argue that the determinants of FDI inflows into the PRC, as identified by FDI theories, can be classified into three categories: micro, macro, and strategic determinants. Micro factors concern firm-ownership specific advantages, such as product differentiation and the size of the firm. Macro determinants of FDI emphasize the market size and the growth of the host country, which is measured by gross domestic product (GDP) and GDP per capita, since rapid economic growth may create large domestic markets and business opportunities. Other macro factors include taxes, political risk, and exchange rates. Strategic determinants refer to long-term factors, such as to defend existing foreign markets, to diversify firms’ activities, to gain or maintain a foothold in the host country, and to complement another type of investment.

Incentive policies are an important factor to consider, especially in developing countries (Sun et al 2002). FDI incentives include tax and other fiscal inducements, financial subsidies, and derogations from regulations offered to foreign-owned enterprises with the purpose of making them invest. More completely, the incentives may include duty-free privileges; concessionary tax rates, breaks, and exemptions; preferential fees for land or facility use; favorable arrangements on project duration, size, sector invested in, location, and type of ownership; flexible treatments regarding business management, employment, and wage schemes; and so on. The aim of policies for attracting FDI must necessarily be to provide investors with an environment in which they can conduct their business profitably and without incurring unnecessary risks. Experience shows that some of the most important factors considered by investors, as they decide on investment location, are (OECD 2003):

i. a predictable and non-discriminatory regulatory environment and the absence of undue administrative impediments to business more generally;

ii. a stable macroeconomic environment, including access to engaging in international trade; and

iii. sufficient and accessible resources, including the presence of relevant infrastructure and human capital.

There are various methodologies to estimate the determinants of FDI. Discussing the potential interdependence of FDI decisions, Head et al (1995) and Head and Mayer (2004) use a discrete choice model which imposes significant restrictions on the data. Ledyaeva and Linden (2006) use the gravity model to determine the sources of uneven distribution of FDI, such as the agglomeration effect, natural resources abundance, skilled labor abundance, capital city advantages, dummy variable for cultural closeness, and common language. Xu (2004) discusses the determinants of entry model of inward FDI to the PRC using logit models, and the result shows that location, resource, project operating period, and investment scale all influence the entry mode significantly.

2.2 Incentive Policies

Jensen (2003) thinks investment incentives take a variety of forms. There are the positive financial incentives that developed countries generally offer, such as payments for each job created, access to cheap finance, loan guarantees, and subsidized utilities. Among these kinds of incentives, tax breaks are the most common form. Many countries offer duty-free access to imports of inputs, and tax holidays or reduced rates of corporation tax to investors, often confined to a distinct geographic area known as an export processing zone. There may also be exemptions from different kinds of local taxes as provided for in the investment policy of local governments. Another type of incentive is lowering labor and environmental standards, which looks like a cheap way to attract investment in the short run. But there is no evidence to suggest that lowering standards is an effective way to attract investment. On the contrary, developed countries, which on the whole maintain more rigorous standards, receive more investment than developing countries. The incentive may become relevant as a bargaining chip to be used by investors who have already decided on their investment location.

Regarding the success of incentive policies, in contrast to Jensen’s idea that tax incentives should be emphasized, Chen (2007) argues that tax incentives neither make up for serious deficiencies in a country’s investment environment nor generate the desired externalities. But when other factors, such as infrastructure, transport costs, and political and economic stability, are more or less equal, the taxes in one location may have a significant effect on investors’ choices. With an increasing number of governments competing to attract MNCs, fiscal incentives have become a global trend that has grown considerably since the 1990s.

The PRC is likely to maintain its economic growth policy and investment promotion (OECD 2000). It has provided foreign investors with special favorable policies on taxation, land use, and foreign currency exchange in coastal regions, particularly in 4 special economic zones and 14 open cities. Preferential FDI policies might be one important factor in the country’s overwhelming performance of attracting FDI so far (Zhang 2002). Respondents from a number of manufacturing sectors, such as automotive, electronics, and telecommunications, also strongly agree that incentive policies encouraged their investment. The Government of the PRC has already played a nimble game to attract FDI into the country, being the largest host country for FDI among developing countries; and it supports the success of its incentive policies.

2.3 Developing Cross-Border Economic Zones in the Greater Mekong Subregion

The GMS countries welcome FDI, and have done so for a number of years. FDI inflows are seen as one method of boosting economic development and growth, and assisting in the transition process— consisting of both economic reforms and business liberalization measures—underway in these countries. As such, GMS governments are strongly pursuing FDI by undertaking reforms in the legal and regulatory environments, and implementing competitive and market-oriented investment policies and incentives. While adopting different approaches to the reform process, GMS governments’ reform agendas are commonly focused on improving physical infrastructure, reducing the cost of doing business, and promoting political stability and credibility, as well as transparency and predictability of the legal and regulatory frameworks. These relate to the macroeconomic conditions of the countries, such as current and future inflation rates, expected GDP growth rates, degrees of foreign indebtedness, and exchange rate risks (ADB 2005).

A lot of scholars believe that developing CBEZs and transport networks may improve mutual understanding and cooperation among GMS countries. This could also help to develop regional integration, which would reduce the cost of transport and trade, and therefore increase the volume of trade, improve economic growth, and reduce poverty. As a result, the reduction of business costs and the increase in trade would help to attract more FDI (Bi 2008). To implement the goal, the GMS countries have adopted an economic corridor approach. But, as Zhang (2009) points out, nodal points within economic corridors, particularly key border cities or towns, have strategic importance as centers for economic activity, including business development, trade expansion, and investment. However, the development of most border crossing points is still hampered by both physical infrastructure and the policy environment. If the constraints are not addressed, the economic corridors will not realize their full potential. At the present situation, private sector participation in the cross-border zones is still limited because of a number of factors, especially

i. lack of information for the private sector on related initiatives;

ii. inadequate investment in cross-border trade logistics facilities and services;

iii. poor access to financing, particularly for cross-border investments; and

iv. the absence of a forum for dialogue between the public and private sector stakeholders.

Zhang (2009) argues that these factors must be addressed to improve the environment for cross-border trade and business development.

Ishida (2009) notes that economic corridors have been developed under the GMS Economic Cooperation Program, where the Cross-Border Transport Agreement is a measure for cross-border economic cooperation. He thinks the types of SEZs in the GMS can be classified as metropolitan areas, ports and harbors, border areas, and junctions or crossroads, based on the experiences of the first ASEAN member states and the PRC, and the possibilities provided by GMS economic corridors.