# **1. INTRODUCTION**

Foreign direct investment (FDI) has been the largest source of external finance for many developing countries—greater than remittances, private debt and portfolio equity, and official development assistance (UNCTAD, 2019).<sup>1</sup> Higher FDI inflows can ease capital constraints, contribute to gross output (Borensztein, De Gregorio, and Lee 1998; Choe 2003; Hansen and Rand 2006), drive employment growth (Craigwell, 2006; Fu and Balasubramanyam, 2005; Harding & Javorcik, 2011), and increase aggregate productivity through positive productivity spillovers and technology transfers (Das, 1987; Fosfuri, Motta, & Ronde, 2001; Javorcik, 2004; Saurav and Kuo 2020; Wang & Blomstrom, 1992). FDI also deepens trade linkages (Freund & Pierola, 2012; Moran, 2014; Swenson, 2008): inter- and intrafirm trade conducted by foreign affiliates accounts for about three-fourths of global exports (UNCTAD 2013). Thus, the presence of foreign affiliates and FDI can be a significant driver of economic growth.

However, FDI inflows to developing countries have been decreasing since the global financial crisis in 2008–09. From a pre-crisis average of 3 percent of GDP per year, FDI inflows have contracted to less than 2 percent of GDP in recent years.<sup>2</sup> This trend reflects a mix of economic factors, including declining rates of return on FDI, changes in U.S. tax policy, increasingly asset-light forms of international production, and rising trade and investment policy uncertainty. On top of these preexisting trends, the COVID-19 pandemic will further decrease FDI flows.

To drive economic growth and resilience, developing countries are prioritizing efforts to strengthen investment competitiveness to better attract and retain FDI. To that end, policy makers need to identify the drivers of FDI and specific market entry and operational constraints that may deter foreign investors. Via a new survey covering over 2,400 foreign investors across 10 major middle-income countries (MICs), this paper responds to this need by assessing the importance of various policy factors—including FDIrelated regulations, political risk, and investment promotion—as well as studying heterogeneity across different types of MNE affiliates.

The remainder of the paper is structured as follows: Section 2 reviews the literature on policy factors that affect FDI. Section 3 describes the survey data and presents descriptive analysis of variables. Section 4 presents the descriptive statistics. Section 5 details the analytical methodology. Section 6 discusses the results. Finally, Section 7 concludes and discusses policy implications.

# **2. LITERATURE REVIEW: THE ROLE OF POLICY IN DRIVING FDI**

> 1 Recent projections show remittances exceeding FDI for low- and middle-income countries in 2019, although they are not projected to do so for the 10 surveyed MICs given their relatively higher FDI compared to remittances (Global Knowledge Partnership on Migration and Development [KNOMAD] database: https://www.knomad.org/data/remittances). Foreign bank lending is also a significant source of private external finance and represents about half of all external liabilities of emerging-market countries (Bräuning and Ivashina 2019).

> 2 Although FDI inflows as a share of GDP have declined in most of the surveyed MICs, experiences have varied. For example, from 2008 to 2018, FDI inflows to China fell sharply (from 3.7 percent to 1.5 percent) but increased in Brazil (from 3.0 percent to 4.7 percent). As discussed in the Overview, a mix of economic factors are plausibly shaping global FDI trends, including declining rates of return on FDI, changes in U.S. tax policy, increasingly assetlight forms of international production on the backs of digital technologies, and rising policy uncertainty.

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