The Determinants of Foreign Direct Investment in Latin America*

Numerous studies on the determinants of foreign direct investment fl ows in Latin America underscore the importance of riskand cost-mitigating institutions that support good governance, political and economic freedom, and demonstrate a credible commitment to economic reform by regional governments. This study tests these variables against market size, macroeconomic policy, and factor controls to assess which combinations of variables explain the distribution of foreign infl ows. Using a time-series cross-sectional data set of fi fteen Latin American economies from 1985 to 2003, the study concludes that past performance on the current account provides suffi cient commitment by regional governments and that regime, good governance, and reform variables are, by comparison, inconsistent predictors of foreign direct investment. Foreign direct investment (FDI) has played a critical role in the modernization of Latin American economies, yet the factors explaining why global fi rms enter the region remain the subject of debate.1 There is little doubt that during the most recent period of economic reform, which has been dominated by market-oriented policies, FDI has gained a preeminent role as a provider of foreign capital, technology, and employment (Cuadros, Orts, and Alguacil 2004). There is not a single Latin American country, including Cuba, that is not actively wooing foreign fi rms to open new subsidiaries or to expand existing operations in their economies. Scholars, however, differ on the determinants of FDI infl ows. Some credit the renewed emphasis on deregulation and liberalization of markets. Others claim that cost-sensitive fi rms shift their operations to expand their margins in highly competitive global markets and that Latin America has relatively low factor costs. The promise of exploiting lucrative opportunities leads fi rms to invest in the region, which business analysts have regarded * I thank the three anonymous reviewers for their comments on a previous version of this article. Special thanks to Sam Whittemore for his valuable research assistance. All errors that remain are the author’s responsibility. 1. FDI is defi ned as private capital fl ows in the form of multinational fi rms purchasing or opening of new subsidiaries outside the home economy. The commonly accepted threshold for FDI is if the parent fi rm gains 10 percent or more of a controlling interest in a going concern in a host economy. By its very nature, FDI is nonspeculative and long term. Latin American Research Review, Vol. 43, No. 1. © 2008 by the Latin American Studies Association. P4552.indb 55 1/11/08 12:17:21 PM 56 Latin American Research Review for the past decade as an emerging area, second only to East Asia and India. Analysts of government bureaucracies and political institutions claim that foreign fi rms are well aware of the different levels of good governance across the region and favor those states that have a proven track record of protecting property rights. In short, FDI responds to different dimensions of cost, risk, and opportunity. But what combination of factors best explains FDI fl ows to Latin America in the past two decades? The three analytical dimensions of cost, risk, and opportunity converge on the particular qualities of states and markets that shape the expectations of foreign fi rms. Markets that are unstable and impose excessive start-up costs or that fail to provide adequate factors of production at a competitive price are less likely to attract FDI in a globalized “fl at world” where profi t margins are squeezed if fi rms are not swift and states are not shrewd (Strange 1992; Friedman 1999, 2005). Missed opportunities impose another layer of cost. In the rapidly changing world of global competition, not investing at the right time can prove as costly over the long term as moving into a market with initially uncompetitive conditions (Schoenberger 1994). Of course, risk is the other side of opportunity. Firms that invest without guarantees against future expropriation and that face host governments that are highly corrupt and lack transparency may lose their competitive position even if market conditions are propitious (Globerman and Shapiro 2002). States that embrace market-oriented reforms make the most credible commitments to foreign investors that they will be welcomed for the long haul (Gastanaga, Nugent, and Pashamova 1998). Macroeconomic reform and deregulation will reduce risks as well as costs, whereas reforms that create new market opportunities, such as privatization, may enable FDI where it was previously limited or forbidden. Since the 1980s, Latin America has been one of the more challenging markets for managers of multinational corporations (MNCs) as they calculate costs, risks, and opportunities. To a great extent, the view of the region from abroad has been colored by Latin America’s periods of intense macroeconomic crisis. Even in economies such as Mexico, Brazil, and Argentina, where fundamentals such as the size of the domestic market, labor costs, and a commitment to structural adjustment reform have been more or less consistent throughout the 1990s, periodic fi nancial meltdowns and contagion from the crises of other regions such as Southeast Asia and Russia, have reversed some of the gains made from reform or undermined the comparative advantages of countries in the region. Assessment of the particular determinants of costs, risks, and opportunities for investment is costly, and often MNCs have relied on sustained good macroeconomic performance to gauge the overall readiness of Latin American countries for FDI. P4552.indb 56 1/11/08 12:17:22 PM DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN LATIN AMERICA 57 This study tests various propositions that fl ow from the myriad logics of costs, risks, and opportunities, comparing the explanatory power of these hypotheses to a baseline expectation that good macroeconomic performance predicts FDI infl ows. The analysis fi nds that macroeconomic stability is a key condition of increased FDI, but specifi cally it is the consistent performance of the current account that matters most. That is, the reduction of trade imbalances in particular and the attendant need to fi nance them sends the strongest signal to foreign investors of a more generalized commitment by Latin American governments to sound and sustainable macroeconomic policies. Two mutually reinforcing logics exist to support this conclusion. First, foreign investors understand that the Latin American region in particular has a history of fi nancing current account defi cits in an unsustainable manner. Investors in the region have memories of the yawning current account defi cits of the late import-substitution industrialization (ISI) period that deepened balance of payments crises and led to the explosion of external debt and the collapse of the largest economies in the region during the debt crisis of the 1980s. During the 1990s, current account defi cits led to the dependence on short-term, foreign currency-denominated, and indexed debt that played a key role in major fi nancial collapses such as Mexico’s Tequila Effect crisis in 1994–1995.2 The erosion of current account balances in states with high foreign and private debt commitments creates high ratios of debt to annual exports, a key indicator of an impending fi nancial crisis. For example, the Brazilian currency crisis of January 1999 was preceded by months of growing public debt and eroding current accounts. As the debt-to-export ratio grew, capital fl ight by investors put pressure on the central bank’s managed fl oating exchange-rate system, eventually causing its collapse. To be sure, investors’ anxieties had many causes, not least among them increasingly shaky exchange-rate regimes and overvalued currencies, as well as losses in other regions where emerging markets had their own meltdowns; however, the ever-worsening core indicator of how the macroeconomy was affecting the economic fundamentals of Latin American markets was the performance of the current account. Second, current account performance is an indicator of a Latin American country’s orientation to global trade. During the 1990s, FDI increasingly returned to the region. Much of this new investment involved the placement of manufacturing facilities designed to globally source transnational production (Green 1998; Tuman and Morris 1998). Latin American countries that made a commitment to open markets, particularly by 2. On the role of the current account as a cause of the Mexican peso crisis, see Edwards (1997) and Teichman (2001, 148). P4552.indb 57 1/11/08 12:17:22 PM 58 Latin American Research Review signing regional trade agreements (RTAs), and to facilitating export performance would become the chief benefi ciaries of the global distribution of production. However, RTA cooperation has tended to break down in Latin America when macroeconomic performance weakens (Eichengreen 2004). For example, periodic current account defi cits have caused Brazil and Argentina to reverse their commitments to Mercosur a number of times since 1995 (Carranza 2003). In this sense, the current account is not just an indicator of a commitment to market-oriented reform but also a guarantor of a sustainable orientation to the new international division of labor. The size and level of development of the country, the degree to which the host economy is globalized in terms of trade, and the degree of its overall growth are weaker predictors of FDI fl ows than is the record of the country’s trade balance over time. Although some scholars favor costsensitive and risk-averse behavior as key explanatory variables, this study fi nds that good governance and regulatory and fi scal costs are relatively inconsequential. The FDI fl ows tend toward the politically less transparent (perhaps less democratic) countries in the region, but when progress on economic reform is considered, regime eff