metadata: authors: 0: author: Albuquerque,Rui Andre Pinto De
1: author: Loayza,Norman V.
2: author: Serven,Luis
count: Caribbean,World,Latin America
docna: 0: docna: World market integration through the lens of
            foreign direct investors
docty: Policy Research Working Paper
subtopic: Investment and Investment Climate,International Trade and Trade Rules,Capital Flows,Capital Markets and Capital Flows,Public Sector Administrative and Civil
            Service Reform,Economics and Finance of Public
            Institution Development,Democratic Government,Public Sector Administrative & Civil
            Service Reform,State Owned Enterprise Reform,Energy Privatization,De Facto Governments,Privatization,Macroeconomic Management
teratopic: International Economics and Trade,Finance and Financial Sector Development,Macroeconomics and Economic Growth,Public Sector Development,Energy,Governance,Private Sector Development
abstracts: cdata!: The authors analyze the unparalleled
            increase in foreign direct investment to emerging market
            economies in the past 25 years. Using a large cross-country
            time-series data set, the authors evaluate the dependence of
            foreign direct investment on global factors or worldwide
            sources of risk (that is, factors that drive foreign direct
            investment across several countries). They construct a
            globalization measure that equals the share of explained
            variation in direct investment attributable to global
            factors. The authors show that the globalization measure has
            increased steadily for industrial and developing countries.
            For the full sample of countries, the globalization measure
            rose eightfold from 1985 to 1999. Furthermore, in recent
            years developing countries' exposure to global factors
            has approached that of industrial countries, particularly
            for Latin America. Finally, the globalization measure
            correlates strongly with measures of capital market
            liberalization. Overall the authors find strong support for
            the hypothesis of increased market integration which implies
            a greater role for worldwide sources of risk. They discuss
            the implications of the results for public policies
            regarding capital market liberalization and policies
            directed at attracting foreign investment.
repnme: repnme: World market integration through the lens
            of foreign direct investors
display_title: World market integration through the
            lens of foreign direct investors
listing_relative_url: /research/2003/05/2388824/world-market-integration-through-lens-foreign-direct-investors
topicv3: Trade m1326924 698,Balance of Payments m1326965 441,Capital Markets m1326967 332,Privatization m1327236 1283,Investment Entry m1504647 2544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade,Finance and Financial Sector Development,Macroeconomics and Economic Growth,Public Sector Development,Energy,Governance,Private Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 60
author_keys: 0: author_key: 606413
1: author_key: 97109
2: author_key: 93728
model_extractions: > **POLICY RESEARCH WORKING PAPER 3060**

# Abstract

Albuquerque, Loayza, and Serv6n analyze the unparalleled increase in foreign direct investment to emerging market economies in the past **_25_** years. Using a large cross-country timeseries data set, the authors evaluate the dependence of foreign direct investment on global factors or worldwide sources of risk (that is, factors that drive foreign direct investment across several countries). They construct a globalization measure that equals the share of explained variation in direct investment attributable to global factors. The authors show that the globalization measure has increased steadily for industrial and developing countries. For the full sample of countries, the globalization measure rose eightfold from **1985** to **1999.** Furthermore, in recent years developing countries' exposure to global factors has approached that of industrial countries, particularly for Latin America. Finally, the globalization measure correlates strongly with measures of capital market liberalization. Overall the authors find strong support for the hypothesis of increased market integration which implies a greater role for worldwide sources of risk. They discuss the implications of the results for public policies regarding capital market liberalization and policies directed at attracting foreign investment.

This paper-a product of Macroeconomics and Growth, Development Research Group-is part of a larger effort in the group to understand international capital flows. Copies of the paper are available free from the World Bank, **1818** H Street NW, Washington, **DC** 20433. Please contact Tourya Tourougui, room **MC3-301,** telephone 202-458-7431, fax **202-5223518,** email address ttourougui@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at albuquerque@simon.rochester.edu, nloayza@worldbank.org, or Iserven@worldbank.org. May **2003.** **_(51_** pages)

> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

Produced **by** Partnerships, Capacity Building, and Outreach
# **World Market Integration Through the Lens of Foreign Direct Investors***

Rui Albuquerque Norman Loayza Luis Serv6n

**JEL** Classification: F21, **F23, F36, G15, G18, G28.**

Keywords: Capital market integration, emerging economies, global factors, foreign direct investment.

*We thank Philip Joos for help in gathering information on Johnson and Johnson, and the comments of Eduardo Fern6ndez-Arias, Greg Bauer and Klaus Schmidt-Hebbel, and participants<sup>atacon-</sup> ference organized **by** the Inter-American Development Bank and the World Bank. We thank Geert Bekaert, Campbell Harvey and Christian Lundblad for providing us their liberalization<sup>variables.Pa-</sup> tricia Macchi provided excellent research assistance. Albuquerque thanks the World<sup>Bankforfinancial</sup> support. Albuquerque is affiliated with the William **E.** Simon Graduate School<sup>ofBusinessAdmin-</sup> istration. Address: Carol Simon Hall, University of Rochester, Rochester, NY<sup>14627;email:albu-</sup> querque@simon.rochester.edu; phone: **(585) 275-3956;** fax: **(585) 461-3309.** Loayza and Serv6n are both affiliated with the World Bank. Address: **1818** H Street, NW, Washington, **DC**<sup>20433;emails:</sup> nloayza@worldbank.org, Lserven@worldbank.org; phone (202) 473-7451; fax<sup>(202)</sup><sup>**522-2119.**</sup>
1 a 4
**1 Introduction**

Recently, there has been<sup>a strongmovetowards greaterintegrationof emergingmarket</sup> economies into world<sup>capitalmarkets.The processof integration starts with the removal</sup> of capital market restrictions,<sup>mostnotably the liberalizationof foreigninvestors'partic-</sup> ipation in domestic<sup>stockmarkets,thelisting of domesticfirmsin foreignmarkets, and</sup> the privatization<sup>ofstate-owned companies.'Among themaingoalsof these reformsare</sup> a reduction in the domestic<sup>costof capitalandanincrease inforeign capitalinflows.2</sup> There is **by** now a substantial<sup>bodyof empirical evidenceonhowthecostof capital</sup> responds to a financial<sup>liberalization program.The consensus view from that literatureis</sup> that the cost of capital<sup>declines in the post liberalizationera.However,this decline is not</sup> as large as theory would<sup>havepredicted,sometimesnot even economicallyor statistically</sup> significant.

This paper analyzes the<sup>dynamicsof foreigncapitalflowsinresponsetoincreased</sup> integration of capital<sup>markets.</sup> Our focus on flows<sup>rather thanpriceshastwo main</sup> objectives. First and<sup>foremost,thesuccessandcontinuityof theliberalizationreforms</sup> depend on the benefits<sup>ofsuchprograms,whichon thebasis of the currentevidenceon</sup> prices might be viewed<sup>asmeager</sup><sup>**by**reformopponents.</sup><sup>**Of**course,itispossiblethat</sup> the noted small price<sup>impactalso reflects thereforms'imperfectcredibility. Ift hatis the</sup> case, one would expect<sup>flows to behave in a fashion similar to prices, otherwiseone would</sup> expect flows to increase<sup>significantly.Lookingat thebehaviorof flowsthusmayprove</sup> important to distinguish<sup>between theoriesthatattempttoexplainthesmall observed</sup> price changes after the<sup>liberalization.Second,notmuchis knownabout thedynamicsof</sup> international capital<sup>flowsinconnectionwith therecent periodof globalcapitalmarket</sup>

> 'See for example<sup>Bekaert,HarveyandLumsdaine(2001),Marston</sup><sup>**(1995),**andStulz(1999a). Beim</sup> and Calomiris (2001)<sup>reportofficialdatesof financialliberalizationmeasuresandotherreforms across</sup> several countries.

> 2 For example, Errunza and Losq **(1985)** and Bacchetta and van Wincoop (2000) give theoretical arguments for these<sup>effects tooccur.</sup>

> 3See Bekaert and Harvey (2000), Henry (2000), Chari and Henry (2002), and Stulz **(1999b).**

1~
# integration.<sup>4</sup>

We choose to analyze the behavior of direct investment flows as opposed to portfolio equity flows, or total capital flows. This is done for several reasons. First, foreign direct investment is the fastest growing form of international capital **flows** and the most important form of private international financing for emerging market economies.<sup>5</sup> To the extent that multinationals are vehicles for improving risk sharing across countries (e.g. Errunza, Hogan and Hung<sup>**1999,**and Rowlandand Tesar2000),they may be partly</sup> responsible for the small price response of domestically listed firms after stock market liberalizations.

Second, low portfolio equity inflows may be a reflection of the weak development of the domestic capital markets as opposed to a lack of interest in pursuing greater diversification **by** foreign investors. In fact, many local companies in liberalizing countries have chosen to list elsewhere in order to reach foreign investors directly in their home market. In contrast, while in many ways foreign direct investment behaves as equity, it does not rely exclusively on the existence of developed domestic stock markets. Third, many foreign investors might choose to invest in emerging economies' equity **by** trading on country funds or ADRs listed in the New York or London markets. While the existence of these assets allows for the desired risk sharing (see Errunza, Hogan and Hung **1999),** it also makes it difficult to track portfolio capital flows across countries. This criticism is particularly relevant for the vastly used **US** Treasury International Capital dataset.

Our analysis relates the driving factors of foreign direct investment to the observed increased integration of capital markets. To motivate this connection we argue that **'A** recent study **by** Bekaert, Harvey and Lumsdaine (2002) finds that after a liberalization equity flows increase **by** an annualized rate of 1.4% of market capitalization, but drop **3** years after **by 0.55%. 5 As** a fraction of world gross domestic product, total private capital inflows to emerging markets grew from a steady annual average of **1.3** percent in the period from **1976** to **1989** to an annual average of 2.0 percent in the period from **1990** to 2000, representing a **56** percent increase. In this process foreign direct investment flows increased significantly more than portfolio equity or bond flows. The average annualized growth rate of foreign direct invetment was **17** percent in the period from 1976t o 2000 whereas the corresponding figure for all private non-direct investment flows was **7.6** percent (authors' computations using data from the World Bank World Development Indicators 2002 for low and middle income countries).

2
increased integration brings the world<sup>economyclosertoanequilibrium with perfectrisk</sup> sharing. In the polar case of perfect risk sharing only aggregate or global risk matters, because risk from local factors can be diversified<sup>away.This meansthat domesticreturns,</sup> wage and interest rates, and consumption<sup>alldependonlyonglobalfactors.Inthe</sup> opposite extreme polar case of fully<sup>segmentedcapitalmarkets,investorscanonlyhold</sup> their own country's assets and must<sup>bear allt he risk fromlocalfactors. Thus, doinestic</sup> prices and quantities depend only on<sup>localfactors,and trivially,inthispolar casethere</sup> are no international capital flows.<sup>Inthemorerealisticintermediatecaseofpartially</sup> segmented capital markets, local and<sup>globalriskfactorsimpact domesticpricesand</sup> quantities as well as the decisions<sup>offoreign(anddomestic)investors.</sup> We build an empirical model of foreign direct investment<sup>thatnests severaltheories</sup> and estimate it using a large cross<sup>sectionandtimeseriesdatasetofdevelopingand</sup> developed countries. Particular<sup>careisputinidentifying andmotivatingtheroleof</sup> global and local factors as drivers<sup>ofdirectinvestment.Globalfactorscauseforeign</sup> direct investment to change across<sup>severalcountries,whereaslocalfactorsarecountry-</sup> specific and have no direct or indirect<sup>impactonforeigndirectinvestmentintoother</sup> countries.<sup>6</sup> To the best of our knowledge<sup>this is thefirstpaper thatstudies therelevance</sup> of global factors as determinants<sup>offoreigndirectinvestment.</sup> We proceed **by** estimating the exposure<sup>ofcountries,andthelevelof directinvest-</sup> ment, to global factors. To do this<sup>weconstruct a measureoft heexplainedvariancein</sup> foreign direct investment that is due<sup>to variationinthe global factors.This wecallthe</sup> globalization measure. To construct<sup>theglobalization measurewemaketheidentifying</sup> assumption that each country is small<sup>relative totheworld economy,whichimpliesthat</sup> local factors may have a global component<sup>themselves,butthereverseisnottrue,i.e.,</sup> there.is no feedback from local<sup>factorstoglobalfactors.Ourempirical approachuses</sup>

> 61n related literature Calvo, Leiderman, and Reinhart **(1993),** Fernandez-Arias **(1996),** and Calvo and Reinhart **(1996)** analyze pull versus<sup>push factorsin totalcapitalflowsemphasizingtheroleof</sup><sup>**US**short</sup> term interest rates. Griffin, Nardari<sup>andStulz(2001)analyze pull versus pushfactorsin portfolio equity</sup> flows. The definitions of pull<sup>and pushfactorsare usuallytied to the geographiclocationof thefactors.</sup> This is not the case in our analysis<sup>so wechoosenottousethesameconcepts for clarity.</sup>

**3**
both the time series and cross sectional dimension of the data. We re-estimate the investment model over moving windows of **16** years of data and use the re-estimated model to compute the globalization measure. This approach accommodates the difficult problem of identifying structural breaks, and possibly multiple breaks, in a large cross section of countries and with many variables.

Consistent with the hypothesis of increased world capital market integration, the analysis reveals that global factors have increased in importance in explaining the **dy-** namics of the cross section of foreign direct investment and the level of aggregate foreign investment over time for developing and developed countries. For the full sample of countries in **1999,** the globalization measure was **62** percent, which represents an **8** fold increase since **1985.** Fhrthermore, developing countries' exposure to global factors has increased faster than that of developed countries and the gap is narrower at the end of the 1990s, particularly so for Latin America. Interestingly, we find a significant decline in global factors as drivers of direct investment around the time of the debt crisis of the 1980s for developing and developed countries alike, but no noticeable change due to the recent Mexican, Russian, or East Asian crises. Finally, using the liberalization variables in Bekaert, Harvey and Lundblad (2002), we show that our globalization measure is explained to a significant extent **by** the level offi nancial liberalization.

The increased exposure to global factors that we find is associated with increased flows of direct investment into emerging market economies. While these findings constitute evidence of greater worldwide market integration, we also find that growth in local productivity, trade openness, financial depth, low government burden, and macroeconomic stability are important domestic drivers.

The sequence oft he paper is as follows. Section 2 briefly presents severalt heories of foreign direct investment. This section appeals to appendix **A** for three case studies (Enron International, Intel International, and Johnson and Johnson) intended at providing explicit examples of global factors at work as drivers of foreign direct investment and to 'See for example Bekaert and Harvey **(1995),** and Bekaert, Harvey and Lumsdaine (2002) for alternative approaches.

4
appendix B for a simple empirical model<sup>of foreigninvestment. Section</sup><sup>**3**presentsthe</sup> results from our analysis. Finally, section<sup>4concludeswithadiscussion of thepublic</sup> policy implications of our findings.

# **2 Modeling Foreign Direct Investment**

We discuss several theories of foreign direct<sup>investmentplacingparticularemphasison</sup> recent work on capital market issues. These<sup>theorieswillbe subsequentlyembeddedin</sup> an empirical framework.

## **_A._** _Taxes, Wage Rates, and Taiffs_

Countries that want to attract a foreign direct<sup>investorusually haveto compete with</sup> other countries, which represent feasible<sup>alternativestotheinvestor,</sup><sup>**by**offeringgener-</sup> ous benefit packages (usually this includes<sup>thecountryoforiginof themultinational).</sup> These packages include, among other things,<sup>taxholidays,guaranteesof astable labor</sup> market generally with low or fixed nominal<sup>wagerates, and the provisionof high quality</sup> transportation or co imunications infrastructures.

**A** multinational company might also<sup>beinterested in producingina countrybecause</sup> of the location ofi ts product market. For<sup>example,high domesticimporttariffsmakeit</sup> too costly for the multinational to export<sup>itsproductsfroma foreigncountry.Alterna-</sup> tively, the multinational can produce domestically<sup>forthe local market(see,forexample</sup> Kindleberger **1966** and Horst **1973).**

## _B. Eapropriation Risk and Inalienable Assets_

> 8The reader is referred to Caves **(1996)** for<sup>a comprehensivereview of theoriesandempiricaltests on</sup> direct investment. Outside of the scope<sup>of ourempiricalmodelingis the role of asymmetricinformation</sup> in promoting foreign direct investment<sup>(e.g.Razin, Sadka,andYuen</sup><sup>**1999**andTesarandHull2000).</sup> Another issue not pursued here is the use<sup>of</sup> transfer<sup>pricing</sup><sup>**by**multinationalsto reduce incometaxation</sup> at the parent level (e.g. Casson **1979).** Moreover,<sup>due to theiruseof differentfinancialinstrumentsin</sup> funding investments (i.e., debt and equity<sup>at home and abroad),multinationals mightbe better equipped</sup> to do tax arbitrage across countries and<sup>assets(e.g.Hodderand Senbet</sup><sup>**1990,**andMillsand Newberry</sup> 2002).

**5**
Participation in international capital markets has obvious risks to investors, most notably the risk ofd irect or indirect expropriation.<sup>9</sup> Countries not only expropriate foreign direct investors, but also international debt creditors and portfolio equity investors. The risk of expropriation naturally gives rise to financing constraints because international investors perceive the increase in the likelihood of expropriation as more capital is funneled in. Importantly, foreign direct investment is harder to expropriate, because it is usually attached to intangible assets which are themselves hard to expropriate (Eaton and Gersovitz 1984 and Albuquerque 2002).10 In Albuquerque (2002), this leads to a default premium that is smaller for foreign direct investment, to relatively greater inflows of foreign direct investment and to direct investment being less volatile than other flows.

## **_C._** _Wealth Effects_

> Changes in the real exchange rate affect the relative wealth levels of foreign and domestic investors and may further lead to changes in investors' actual relative purchasing

> power. Froot and Stein **(1991)** showed that in order for changes in exchange rates to

> change the relative purchasing power of domestic and foreign investors, these investors must be subject to binding financing constraints. If not, additional money could be

> borrowed that re-establishes their original purchasing power. In their setting, a real appreciation of the foreign currency increases the purchasing power of foreign investors

> and leads to more direct investment.

# **2.1 An Econometric Model of Foreign Direct Investment**

The upshot of the preceding discussion and of the simple model developed in appendix B is the following equation for aggregate optimal foreign direct investment flows into a

> 9Examples of indirect expropriation include the levying of high unexpected profit taxes, the imposition

> of restrictions on capital outflows, or the real devaluation of the local currency.

> 'oExamples of intangible assets include blue prints, managerial skills, and marketing networks.

**6**
country: In this equation It is the level<sup>of directinvestmentinflows,</sup><sup>_At_is the domesticproductivity</sup> level, _wt_ is the wage rate, _Rt_<sup>isthedomesticcostofcapital,</sup><sup>**1**</sup><sup>**_-_**</sup><sup>_Pt_is theprobability</sup> of expropriation of foreign investors,<sup>3tisthestochasticdiscountrateused</sup><sup>**by**foreign</sup> investors to discount future<sup>flows,"andxtis therealexchangerate measuredinunits of</sup> foreign currency per unit of domestic<sup>currency.The remaining terms reflectthe possibility</sup> that the drivers of direct investment display<sup>autoregressiveconditionalheteroskedasticity.</sup> According to the model in appendix<sup>B and the theory discussionabove,the coefficient</sup> cl **> 0,** and c2 **-** c5 are all predicted<sup>to bepositiveif the correspondingvariablesdisplay</sup> positive persistence. According to Froot<sup>andStein</sup><sup>**(1991)c6<0.**As intheirsetting,</sup> this is also the case here if the<sup>futurevalueof therealexchangerateisindependentof</sup> today's value. However, if the<sup>rateof changeof therealexchangeratedisplayspositive</sup> persistence, a high value<sup>ofthedomestic currencytodaysignalsanevenhighervalue</sup> tomorrow and high future profits measured in foreign<sup>currency units.Inthis case</sup><sup>**c**</sup> **6**<sup>**_>_0.**</sup> Therefore, the sign on the<sup>changein therealexchangerate istheoreticallyambiguous.</sup> Inspection of **(1)** clarifies<sup>whatare the localand global factorsdrivingforeigndirect</sup> investment. Local factors are captured<sup>**by**thepercentagechangeintherealexchange</sup> rate, the domestic productivity<sup>shocks,andthedomestic realinterestrateandwage</sup> rate. In the estimations below<sup>weallowforalargersetoflocalfactors.Importantly,</sup> these local variables are driven<sup>**by**(or represent)localfactors only to theextent that they</sup> are orthogonal to the global<sup>factors.Infact,in ageneralequilibriumcompletemarkets</sup> model without capital market frictions<sup>therealexchangerate,the wagerate,andother</sup> local variables are only functions<sup>of theglobalfactors(or statevariables).But,to the</sup> extent that the world is partially<sup>segmented theselocal variableswill containimportant</sup>

> "In the Consumption-CAPM<sup>modelthestochasticdiscountfactorequalsthemarginalrateofin-</sup> tertemporal substitution.

**7**
localc omponents as well.1<sup>2</sup> For example, country productivity shocks are known to have significant global components (e.g. Glick and Rogoff **1995,** and Iscan 2000). Thus, we may write InAt **=** _aolnA +aalnAf_ where **_AG_** and **AL** stand for the global and local components of domestic productivity respectively. Below we use these ideas in constructing our globalization measure which captures the size of the global exposure in foreign direct investment.

> Importantly, the stochastic discount rate used **by** foreign investors to discount cash flows from local subsidiaries (,<sup>3</sup> t) is driven **by** global factors. In general, the discount factor varies with state variables or factors that impact the foreign investor's intertemporal rate of substitution. Some of these factors might also be local sources of uncertainty if markets are incomplete. If this country risk cannot be diversified away we may write

What global factors capture the variation in discount rates?T his question is a difficult one to answer as it presumes that we have a fully specified general equilibrium model to identify these factors. Often researchers have chosen to view the global factors as unobservable (e.g. Harvey **1991,** and Campbell and Hamao **1992).** This is also our **first** route. We estimate latent, or unobserved, factors from a set ofg lobal variables **Zt:"** The number of rows in matrix **b** indicates the number of relevant global factors acting through the discount factor. Under the assumption of a representative international investor, estimation of **(1)-(3)** across many countries yields a system'of equations with

> 1<sup>2</sup> This is a natural assumption, because foreign direct invetment is to some extent an outcome of transactions costs and capital market imperfections (see for example Caves **1996).** "The same identification issues apply to local factors, but because there is no good way of imposing restrictions on these we assume they are observed.

> 41n picking these global variables we constrain ourselves to use the instruments that have been shown to explain the cross section of international equity returns.

**8**
cross equation restrictions<sup>comingfrom</sup><sup>**b.**Onewaytoimposetheserestrictionsis to</sup> first estimate the global factor<sup>using principal componentsandthenuseit in the system</sup> of equations described<sup>**by (1)-(3).**</sup> The empirical section<sup>thatfollowsalsopresentsresultsfromamodel whichisesti-</sup> mated under the assumption<sup>thatwe,aseconometricians, observethe global factors.In</sup> this approach we use<sup>thesameglobalvariablesthatwereusedintheprincipalcompo-</sup> nents analysis as the<sup>_defacto_globalfactors.Intherobustnesssectionweestimatethe</sup> latent global factor<sup>with</sup><sup>**GMMby**imposing the cross equation restrictions directlyin the</sup> estimation of the<sup>investment equation</sup><sup>**(1).**</sup>

# **3 Empirical Analysis**

In this section, we implement<sup>andestimatethemodel describedin equations</sup><sup>**(1)-(3)**us-</sup> ing cross-country<sup>andtime-seriesdata.Throughthiscountry-levelexerciseweexamine</sup> the significance of<sup>varioustheorieson thedeterminantsof foreigndirectinvestmentdis-</sup> cussed above. Furthermore,<sup>weusetheestimatedmodel andtheglobalizationmeasure</sup> to ascertain the relative<sup>importanceof localand global factors in explainingthe variation</sup> of foreign direct investment.<sup>**By**examiningthe time seriesbehavior of the globalization</sup> measure and how it<sup>differsacrossindustrialanddevelopingcountries,wederiveconclu-</sup> sions on how the process<sup>of market integrationisaffectingthebehaviorof foreigndirect</sup> investment.

This section is organized<sup>aroundthemajorempiricalobjectivesandcorresponding</sup> exercises outlined above.<sup>First,wepresentthevariablesincludedin our empiricalmodel</sup> of foreign direct investment<sup>andprovidetheirbasicdescriptivestatistics.Second,we</sup> discuss the results of<sup>foreigndirect investmentregressions for various countrysamples and</sup> different restrictions<sup>oncountry-specificparameters.And third,wereportanddiscuss</sup> the variance decomposition<sup>resultsand theglobalizationmeasure.</sup>

**_9_**
# **3.1 Definition of Variables and Descriptive Statistics**

> The empirical specifications that we present below relate foreign direct investment inflows, measured as a percentage of gross domestic product **(GDP),** to global and local factors.'<sup>5</sup> To characterize the global factors we use a set of global variables **ZG** that summarize the array of returns faced **by** international investors. These variables have been used to explain the cross section of both international and **US** expected equity returns (e.g.

> Campbell and Hamao **1992)** and include the **US** T-bill rate, an index of total return in world stock markets, the slope of the **US** yield curve, the **US** credit spread and the rate of growth ofw orld per capita **GDP,** which provides a proxy for global productivity growth. To transform the nominal returns in the T-bill rate and the stock market index into real returns we include the **US** inflation rate among the global variables as a measure

> of inflation expectations. However, because realized inflation provides a noisy measure

> of anticipated inflation, in the regressions we do not restrict it to enter subtracting from the nominal rates of return.

As suggested above, we work both with the entire list of global factors, which assumes that these are observable, and with a synthetic measure of these variables, which assumes that the global factors are unobservable, constructed using a principal components procedure. We build the synthetic measure as a weighted sum oft he principal components of the set of global variables, with the weights given **by** the fraction of the overall variance explained **by** each of the components. We call the resulting variable synthetic global factor. **16** Our selection of variables used to describe the local factors reflects the variety of views on the determinants of foreign direct investment outlined in the previous sections. In our basic specifications we include a totalo fn ine local variables in **Z4.** These are: per capita **GDP** growth, as a measure of domestic productivity growth;o verall tax pressure, proxied

> '<sup>5</sup> Appendix **C** contains a detailed description of our data and its sources.

> "We apologize for the abuse in notation. In terms of our notation in section 2t he first approach assumes **b** is the identity matrix, whereas the second approach assumes that **b** is composed **by** the

> weights described in the text.

**10**
**by** public consumption relative<sup>to</sup><sup>**GDP,**which we would expectto havea negativeimpact</sup> on foreign direct investment; financial<sup>depth, measured</sup><sup>**by**the ratio of creditto the private</sup> sector as a percentage of **GDP,** to<sup>assess the role of the domesticcredit sector in attracting</sup> foreign direct investment; the rate<sup>of change of the real exchangerate, to capturepossible</sup> wealth effects; institutionalq uality, proxied **by** the Reedorn House Civil Liberties index, as a measure of the strength of<sup>propertyrightsandtheabsenceofcorruption,which</sup> should have a positive effect on<sup>foreign direct investmentif it is relatedto the probability</sup> of not expropriating foreign investors;<sup>tradeopenness,reflectingtherecentliterature</sup> on the complementarity of trade<sup>andforeigndirectinvestment(specifically,weusethe</sup> residuals from a regression of the ratio of total trade to **GDP** on the log of population, country area, and an oil exporters<sup>dummy);and,finally,three variableswhich attempt to</sup> measure uncertainty through the volatilities of the growth rates of real per capita **GDP,** the real exchange rate, and the terms<sup>of trade,allof whichshouldbeexpectedtoaffect</sup> foreign direct investment negatively<sup>(recallthattheseuncertainty-relatedvariablesare</sup> implied **by** our model in appendix<sup>Bif thereis conditionalheteroskedasticity).Below we</sup> also allow for other variables such as<sup>thedomesticwagerateforwhichwehavelimited</sup> data.

The sample of countries used in<sup>ouranalysis is dictated</sup><sup>**by**data availabilityonly.We</sup> include in our data set every<sup>countrypossessingatleastthreeobservationsforeachof</sup> the variables listed above within the<sup>periodrangingfrom</sup><sup>**1970**to</sup><sup>**1999.**This yields94</sup> countries with a combined total<sup>of over</sup><sup>**1,900**observations.</sup><sup>**Of**these,close to one-fourth</sup> correspond to 20 industrial<sup>countries,whiletherestcorrespondtothe74developing</sup> countries in the sample.

Table **1** presents descriptive statistics for the overall sample. As the table suggests, the data set contains a few negative<sup>numbersfor theratioof foreigndirect investment</sup> to **GDP** which correspond to<sup>episodesofdisinvestment.</sup> The largest negative values for foreign direct investment<sup>belongtoPanamain</sup><sup>**1987-88.**Therearealsosomelarge</sup> positive values reflecting foreign<sup>direct investmentintosmalleconomies,withthe largest</sup>

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one corresponding to Equatorial Guinea.

# **3.2** Regression Results

To implement **(1)** we introduce a random error and country-specific effects. The countryspecific effects are needed due to the diverse set of countries in our sample. We also perform our regressions using the share of foreign direct investment on domestic **GDP** rather than the logarithm of foreign investment to control for size. As discussed above, we present estimates for two models. In the first model we restrict the coefficients on all global and local variables to be the same across all countries. Letting **Zt** = **[ZG** Z]', the corresponding regression equation is where the indices t and f represent time and country, respectively.

In the second model, we allow both country-specific intercepts and country-specific slope coefficients on the global factor, but restrict the coefficients on local variables to be the same for all countries. In this case, the regression equation becomes, Given that the values of global variables are the same for all countries at a given point in time, the first model may understate the importance of global factors in explaining the variance of foreign direct investment **by** restricting the variability of the global component across countries. The second model allows for heterogeneous responses to the same global conditions, which increases their predictive power on foreign direct investment at the potential cost of reduced estimation efficiency.

## **3.2.1** Model **1:** Homogeneous Slope Coefficients

The results from estimating Model **1** are presented in Thbles 2 and **3.** In the first of these we include each of the six global variables independently in the regression. In the 12
latter one, we replace the global variables<sup>**by**the synthetic global factor, discussedabove.</sup> We work with three samples of countries<sup>-all,industrial,anddevelopingcountries-and</sup> .report their results<sup>ineach columnof both tables.</sup> First, consider the case when the global<sup>variablesareincludedindependentlyin the</sup> regression (Table 2). For the sample<sup>of all countries the overallfit of the regression</sup><sup>_(R2_=</sup> 0.45) is substantial given the large number of observations **(over 1,900).** Not surprisingly, much of that is due. to the country-specific<sup>effects.In fact, the within-country</sup><sup>_R2,_which</sup> measures the ability of the model to<sup>explainthe changesin the dependentvariablewithin</sup> a given country, is **0.13.** There<sup>areinterestingdifferencesbetweentheindustrialand</sup> developing country samples regarding<sup>the fitof theregression.The overall</sup><sup>_R2_is about</sup> 20 percent larger for developingt han<sup>forindustrialcountries.</sup> However, the withincountry _R_<sup>_2_</sup> for industrial countries<sup>ismorethantwiceas largeasthatfordeveloping</sup> countries. Therefore, relative to industrial<sup>countries,the level of foreign direct investment</sup> in developing countries appears to vary<sup>more across countries, and their changesin foreign</sup> direct investment are less predictable.

Let us consider the results on the<sup>global variables.For the three samples under consid-</sup> eration, the results are similar.1<sup>7</sup> Both<sup>the T-Billrate and the slope of the</sup><sup>**US**yield curve</sup> always have negative and significant<sup>coefficients.Thegrowthrateof worldpercapita</sup> **GDP** is negative in all samples and<sup>significantlyso,exceptinthe sampleof industrial</sup> countries. (Its lack of significance in<sup>the developed-countrysamplemaybeduetothe</sup> fact that, given their large size,<sup>developed countries'owngrowth rate is heavily correlated</sup> with the world rate of growth, thus<sup>confusingglobalandlocalfactors.)An increasein</sup> these three variables denotes an improvement<sup>inthe performanceof internationalassets.</sup> The fact that both the T-bill rate and<sup>theslopeof the</sup><sup>**US**yieldcurvecarrynegative</sup> and significant coefficients indicates<sup>that FDIflows respond to both short- and long-term</sup> global investment returns (and not just short-term **US** interest rates as Calvo et al., **1993,** found for total private capital flows<sup>oras Bekaert,Harvey andLunsdaine2002found for</sup> 7 The **U.S.** inflation rate is only used as a control variable, and we do not discuss its related results.

**13**
**US** portfolio equity flows). The **US** credit spread does not carry a statistically significant coefficient, which may be explained **by** considering that an improvement in the return of high-yield assets is likely to be accompanied **by** a correspondingly large increase in their risk. In net, therefore, an increase in the return of high-yield global assets does not distract FDI flowing to local markets. **A** similar explanation applies to the lack of significance of the index of world stock market returns: an increase in the index not only denotes an increase in returns but may also signal an increase in the associated risk. At any rate, the last two results are surprising in light of the evidence in Griffin et al. (2001) for **US** portfolio equity flows who find a significant impact of **US** returns as push factor for **US** equity flows.

Turning to the local variables, the results for the three samples are similar with a few interesting discrepancies. In the three samples of countries, the growth rate ofG DP per capita and the measure of trade openness present positive and significant coefficients, while the size of government consumption carries a negative and significant coefficient. The size of these effects appears to be stronger in industrial than developing countries. Improvements in overall productivity (as reflected in higher economic growth) and larger trade openness serve to attract foreign direct investment into the country. Conversely, a worsening in the burden of government (through higher taxation, for instance) acts as a deterrent for foreign direct investment flows into the country. These findings are largely consistent with other studies (e.g. Singh and Jun **1995** and FernAndez-Arias and Hausmann 2000). In turn, the measure of financial depth carries a positive and significant coefficient in the full and developing country samples, but is not significantly different from zero in the industrial country regression. This suggests that improving financial development from poor levels does encourage foreign direct investment into the country, but this effect disappears as financial markets get **highly** developed.

In the samples of all and developing countries, the volatility of per capita output growth presents a negative and significant coefficient, implying that macroeconomic instability drives away foreign direct investment. The other measures of volatility (of the 14
real exchange rate and the terms of trade) do<sup>nothaveasignificanteffectonforeign</sup> direct investment inflows in any of the<sup>samples.It islikelythattheireffectisalready</sup> captured **by** volatility of economic<sup>growth.</sup> The rate of real exchange rate depreciation<sup>islikewiseinsignificantinallthreere-</sup> gressions. This contrasts with the evidence<sup>inGoldbergandKlein</sup><sup>**(1998)**(whofind</sup> that foreign direct investment **by** both Japan<sup>andtheUnitedStatestotheEastAsian</sup> countries in their sample is significantly affected<sup>**by**bilateralrealexchangerates)and</sup> questions the hypothesis in Froot and Stein<sup>**(1991).**Finally,wefindnoevidence that the</sup> quality of governance, as reflected in the<sup>civillibertiesindex,hasanimpactonforeign</sup> direct investment inflows in any sample.

Table **3** shows the results obtained when the<sup>globalvariablesare replacedwiththe</sup> global factor. We conduct this exercise in order<sup>tofacilitatethecomparisonwiththe</sup> results on the heterogeneous model below.<sup>Asexplainedabove,the syntheticglobalfac-</sup> tor is constructed as a weighted average of the<sup>principal componentsof thesixglobal</sup> variables. In the calculation of the global factor,<sup>all six original variablesenterwith posi-</sup> tive weights. Since the significant global<sup>variablescarrynegativecoefficientsin thebasic</sup> regression (see Table 2), it is not surprising that<sup>the'global'principalcomponentalso</sup> presents a negative and significant coefficient (except<sup>inthe industrial countrysample).</sup> As it is measured here, a decline in the synthetic<sup>globalfactorrepresentslessattractive</sup> conditions for investment in international markets.<sup>Theregressionresultsconfirmthat</sup> this acts as a push force for foreign direct investment<sup>to flow intolocal markets.</sup> It is interesting to note that the size of the coefficient on the<sup>globalfactoristhree</sup> times as big in developing than in industrial countries,<sup>andonlysignificantfor developing</sup> countries. This is to be expected given that<sup>internationalmarket conditionsasproxied</sup> **by** the global factor are to a large extent determined<sup>**by**localconditionsinthericher</sup> economies and, particularly, the **US.** In addition,<sup>thesearealsothemostintegrated</sup> economies.

Judging from the regression fit, the global factor appears<sup>to be a goodsummarymea-</sup>

**15**
sure. In fact the _R_<sup>_2_</sup> _o_ btained with the synthetic global factor is almost the same<sup>as that</sup> found using the **6** global variables independently. Moreover, the estimated coefficients on the local variables obtained with the more parsimonious model are quite similar in terms of sign, size, and significance.

# **3.2.2** Model 2: Heterogeneous Global Factor Coefficients

So far we have imposed the restriction that the global factors have the same effect in<sup>all</sup> countries. We now relax this constraint and re-estimate the model<sup>allowingfordifferent</sup> effects across countries. Here we limit ourselves to the synthetic global factor<sup>given</sup><sup>**by**the</sup> principal components procedure. As an extension, we will consider below joint estimation of the parameters of the direct investment equation and the latent global factor<sup>while</sup> allowing the impact of the latter to vary across countries.

The results using the synthetic global factor are shown in Table 4. The first column reports the full-sample results. Comparingt he estimates with those obtained under parameter homogeneity, it can be seen that among the local variables the rate of<sup>**GDP**</sup> growth and its volatility, as well as the trade openness variable, remain **highly** significant. The coefficient on government consumption declines somewhat but remains significant at the **10** percent level, while that on financial depth loses all significance. In contrast, the volatility of the terms of trade now carries a significant negative coefficient.

The table alsor eports the mean of the country-specific coefficients<sup>ontheglobal</sup> factor. For the overall sample it equals **-0.0069,** not very different<sup>fromthe coefficient</sup> obtained from the restricted regression **(-0.0053),** and strongly<sup>significant.However,</sup> the individual-country estimates (not reported) are fairly disperse.<sup>**Of**the94individual</sup> estimates, **56** are negative (of which **16** significant at<sup>the</sup><sup>**5**percentlevel)and</sup><sup>**38**positive</sup> **(3** significant).

Columns 2 and 3 in Table 4r eport the estimates<sup>obtained intheindustrialand</sup> developing country subsamples. For industrial countries the results<sup>are again fairly similar</sup> to those obtained from the restricted specification. The main difference<sup>isthat the credit</sup>

**16**
variable now is marginally<sup>significant, whilethevolatilityofthe termsof tradeisnot.</sup> The average across countries of<sup>the impact of the global factor equals</sup><sup>**-0.0018,**very close</sup> to the restricted estimate of **-0.0015.** The individual estimates vary substantially<sup>in</sup> magnitude and significance.<sup>Outof20,12arenegativeand</sup><sup>**8**positive.However,only</sup> one of the former is significant<sup>at the</sup><sup>**5**percentlevel.</sup> In the case of developing countries<sup>(column</sup><sup>**3),**themaindifferencerelativetothe</sup> restricted specification regardingt<sup>helocalvariablesisthatbothfinancialdepthand</sup> government consumption are<sup>nowinsignificant,whilethe volatilityof the terms of trade</sup> becomes marginally significant. The mean of the country-specific<sup>coefficientsonthe</sup> global effect equals **-0.0078,** not<sup>toodifferentfromtherestrictedestimate</sup><sup>**(-0.0061)**</sup> obtained earlier. **Of** the individual<sup>estimates,44arenegative (of which</sup><sup>**15**significant)</sup> and **30** positive (of which<sup>**3**aresignificant).Figure</sup><sup>**1**showsthedistributionsofthe</sup> individual estimates on the<sup>global factorfordevelopedanddevelopingcountries.Both</sup> are concentrated around **-0.01,**<sup>butthedistributionofdevelopingcountriesismore</sup> disperse, with two large values<sup>at the right endofthe distribution.</sup>

# **3.3 A Globalization Measure**

The regressions reported above confirm<sup>that foreign directinvestmentisaffected</sup><sup>**by**both</sup> local and global factors. However,<sup>weare interestedinassessingthe relative importaice</sup> of the twoi n the determination<sup>offoreigndirectinvestmentflows.Furthermore,we</sup> want to know if their contributions<sup>havechangedovertime,andwhethertheydiffer</sup> systematically across different groups<sup>of countries.</sup> How much of the explanatory<sup>powerof our empiricalspecificationsis respectivelydue</sup> to local and global factors? The<sup>answerinvolves a basic identification problem,given that</sup> both sets off actors are not mutually<sup>orthogonal.Assumingthateachcountryissmall</sup> relative to the world economy, it is<sup>reasonableto inferthat globalfactorsare exogenous</sup> with respect to local factors. In other<sup>words,thereisnofeedbackfromlocalfactors</sup> to global factors. This identifying assumption<sup>allowsadecomposition of theexplained</sup>

**17**
variance of the dependent variable into twop arts: one part explained **by** the global factors, either directly or through their impact on local factors, and another explained **by** that component of the local variables which is orthogonal to the global variables. Note that only the latter component is truly local( i.e., not affected **by** global variables).

More formally, to obtain the variation of foreign direct investment explained **by** global factors, we first regress the local variables on the global factors and take the residuals from that regression as the 'true' local factors. Construct The contribution oft he global factor to explained variation in direct investment is which we call globalization measure. **By** construction the globalization measure lies between **0** and **1** with **1** indicating full globalization with no role for local factors. In computing the globalization measure we exclude from the denominator country-specific fixed effects. Strictly speaking they do not represent an 'explanation' of the observed variation in foreign direct investment, but rather a measure of our ignorance concerning _time-invariant_ country-specific ingredients. Thus, the decompositions below refer to the 'within' variation of the data, i.e., after removing the fixed effects.

Toa nalyze how the roles of local and global factors have changed over time, we perform repeatedly the above decomposition **by** re-estimating Model **1,** as specified in Table 2, over a changing time sample. Specifically, we use a moving 16-year window to define the relevant sample for each re-estimation.<sup>18</sup> In each estimation, we use the sample of all countries available in the corresponding time window. Using the estimated parameters, we compute the shares of explained variance **by** global and local factors for

> "sNote that the country sample may change slightly across re-estimations due to the fact that the panel is unbalanced. For this reason, we experimented also with other alternatiKe procedures, such as windows of growing size, i.e., adding years, but not dropping them, for each re-estimation. The results were qualitatively similar. We find the approach in the text preferable since it accounts for potential sample breaks (see Bekaert and Harvey **(1995)** for another approach).

**18**
the samples of all, industrial, and developing<sup>countries.'9Table</sup><sup>**5**andFigure2report</sup> the globalization measure.

There are two very clear results. The<sup>firstisthattheshareof variance explained</sup> **by** global factors or globalization<sup>measure hasincreasednotably inthelast</sup><sup>**15**years,</sup> from less than **10** percent to over **60** percent.<sup>Furthermore,theincreaseisstatistically</sup> significant, as implied **by** the<sup>**95**percentconfidencebandsshowninFigure2a, derived</sup> from a bootstrapping procedure.

The second result is that the globalization<sup>measurehas been largerfor industrial than</sup> for developing countries (Figure **2b).** This<sup>is naturalgiventhattheformerarearguably</sup> more integrated economies. However,<sup>thisdifferencehasshrankovertheyears:fifteen</sup> years ago the share of global factors<sup>wastwiceaslargeinindustrialthandeveloping</sup> countries, but **by** the end oft he 1990's the gap<sup>wasreducedto</sup><sup>**30**percent.Indeed,the</sup> same bootstrapping procedure used<sup>above shows thatin the period</sup><sup>**1989-93**the estimates</sup> of the contribution of the globalf actor<sup>for industrialcountrieslieoutside the</sup><sup>**95**percent</sup> confidence bands (not shown to avoid cluttering<sup>thegraph)constructedfor developing</sup> countries, suggesting that the difference<sup>betweenthe twosetsof countriesregarding the</sup> role of,global forces was significant.<sup>After1994,this ceasestobethecase.</sup> Where does the increased importance<sup>oftheglobalfactorscomefrom?Isitdueto</sup> the direct impact or its indirect impact<sup>via thecorrelationwiththe localfactors?This</sup> is an important question not only because<sup>one would liketo checkthatour identification</sup> procedure is not eluding the contribution<sup>ofglobalfactors,butalsobecauseforthe</sup> reasons argued above, according to<sup>whichwe expectforeign directinvestment to be more</sup> exposed to global factors, we should<sup>alsoexpectlocal variablestoalso bemoreexposed</sup> to them.

We have decomposed the explained variance<sup>**by**the globalfactorintothe component</sup> coming directly from the global factor<sup>(i.e.,</sup><sup>_Var_</sup><sup>**_(i_**</sup> **_)_**<sup>**_'ZG))_**and thatcomingfrom the impact</sup>

> 1<sup>9</sup> That is, for a given estimation window,<sup>weallowthedata butnot theestimated parametersto</sup> vary across the three samples, i.e., all,<sup>industrial,anddevelopingcuntries.Forall samples,weusethe</sup> estimated parameters corresponding<sup>tothesampleofallcountries.Thisallowsusto focuson the effects</sup> of different data on explanatory<sup>variablesacrosssamples.</sup>

**19**
of the global factor on the local variables (i.e., _3var_ **_(i)'ZG))._** For the full sample both sources of variation show a similar pattern, with the indirect role of the global factor increasing from 2 percent to **11** percent of the explained variance. Thus we argue that the direct impact of the global factor is more important, but also that the indirect impact grows as expected.

It is important to note that the ability of the model to explain foreign direct investment inflows _(R_<sup>_2_</sup> _)_ has increased, though modestly, over the last **15** years. This is shown in Table **5** and also in Figure **3.** More remarkable is the rise in the within-R<sup>2</sup> , from about **6** percent to over **16** percent, revealing an improved performance oft he model to explain the _changes_ in foreign direct investment inflows over time. Throughout the last **15** years the ratio of within- to total-R<sup>2</sup> grew gradually from about one-sixth to close to one-third, implying that our explanatory variables gained predictive power on foreign direct investment inflows relative to the (unobserved) country-specific effects. This complements the evidence in favor of the increasing role of global factors to explain foreign direct investment inflows.

Is the impact of global factors different across regions of the developing world? On the one hand many countries around the world and across Latin America and East Asia have liberalized their capital markets through the last 20 years. On the other hand, policy effectiveness and commitment may have differed substantially across countries and in systematic ways, perhaps due to cultural issues or social rigidities. Figure 4 plots our globalization measure across regions of the developing world: Latin America and Asia. It is apparent from the picture that in recent years Latin America has seen greater exposure to global factors than Asia, a difference of nearly 20 percentage points. One possible reading oft his is that the integration process of countries in this region has been more successful.

20
# **3.4 Global Factors and the**<sup>**Levelof ForeignDirectInvestment**</sup>

The analysis of the globalization<sup>measurerevealsanincreased exposureofdirectin-</sup> vestment to global factors.<sup>However,itisnotinformativeabouthowintegrationhas</sup> contributed to the increased<sup>_level_offlowsofdirectinvestment.Thiseffectisshownin</sup> Figure **5.** The<sup>figureplotstheratioofforeigndirectinvestmentto</sup><sup>**GDP,**relativeto</sup> the mean level of direct investment,<sup>thatwouldresultif ithadbeen drivensolely</sup><sup>**by**</sup> the global factor.<sup>To constructthefigureweusetheestimatesfromModel</sup><sup>**1**with the</sup> and<sup>countas theglobalfactor onlyits directimpact(i.e.,we excludethe</sup> synthetic factor impact oft he global<sup>factor on the localvariables).</sup> While foreign direct<sup>investmentwas fairlystableasimpacted</sup><sup>**by**globalfactorsuntil</sup> late 1970s, it declined<sup>substantiallyintheearly1980's.Thisisconsistentwith the</sup> drying up of international<sup>capitalflowssubsequentto theLatinAmericadebtcrisis,as</sup> suggested **by** models<sup>ofsovereigndefault(e.g.EatonandGersovitz</sup><sup>**1981).**Itisalso</sup> the period of great<sup>inflowstowardsthe</sup><sup>**US**economy.The post-1982periodis associated</sup> with increased integration<sup>ofcapital markets(particular soin the 1990's)andourresults</sup> show a substantial<sup>roleof theglobal factor:foreigndirectinvestmentas a share of</sup><sup>**GDP**</sup> increased from roughly<sup>**0.009**below average in</sup><sup>**1982**to 0.004above averagein</sup><sup>**1999.**These</sup> numbers are roughly<sup>consistent with thosein footnote</sup><sup>**5**in the Introductionto this paper</sup> that suggested that<sup>foreign directinvestment as percentage of world</sup><sup>**GDP**increased</sup><sup>**by1**</sup> percentage point<sup>fromthe1980sto the1990s.It should be notedthatthe resultswould</sup> be even stronger had<sup>weincludedtheindirecteffectof theglobalfactoracting through</sup> the local variables.

# **3.5 Global Factors and Liberalization**

In this subsection we correlate<sup>our globalizationmeasurewith measuresof financiallib-</sup> eralization. We use the liberalization<sup>measuresin Bekaert,Harveyand Lundblad(2002),</sup> official liberalization,<sup>firstsignandinvestabilityplus a measureofb alance-of-payments</sup> restrictions. Official<sup>liberalizationisadummy variablethattakes thevalueofoneif</sup> 21
the equity market is liberalized based on the chronology in Bekaert and Harvey (2000). First sign is a broader measure that takes the value of one if there is either an official liberalization or ADR and country fund introduction.<sup>20</sup> Investability is the ratio of capitalization of the IFC 'Investable" to the "global" stocks in a country as in Edison and Warnock (2001). For balance-of-payments restrictions we consider 4 types of restrictions recorded **by** the International Monetary Fund. They are (i) restrictions on payments for capital transactions, (ii) restrictions on repatriation off oreign investment earnings, (iii) presence of multiple exchange rates, and (iv) restrictions on current account transactions. For each of these categories, the IMF records a score of **1** when restrictions apply, and **0** otherwise. Our proxy is the sum of these scores for a given country and year.

Each of these liberalization variables is country specific while our globalization measure applies for groups of countries. To come up with a proxy for the extent of liberalization in a particular group of countries we compute the weighted average liberalization level for each variable where the weights are the countries' gross domestic product divided **by** the sum of outputs across all countries.

In table **6** we report the results of regressing the globalization measure on the 4 different indices of liberalization. As expected, the signs of the coefficients are positive for the first three measures and negative for balance of payments restrictions (a **high** value for balance of payments restrictions indicates low liberalization). Most coefficients are significant at the **1** percent significance level and the R-squares from the regressions are very high (ranging from **.5** to **.7** for developing countries and are about **.16** for industrial countries except when using capital restrictions where the R-square is **.6)** indicating that a substantial portion of the time series variation of our globalization measure is accounted for **by** the rise of world market integration. Interestingly, the increased relevance of global factors is much more related to increased liberalization- in developing countries than in industrialc ountries.

We view the results presented in table **6** as evidence that increased financial and

> 20 For developed countries first sign turns out to be identical to official liberalization.

22
capital market integration worldwide<sup>has contributed to an increasedroleof global factors</sup> in driving direct investment.

# **3.6** Extensions

In this section we do a roll of extensions<sup>androbustnesscheckstoouranalysis.Our</sup> motivation to have this separate analysis<sup>hastodowiththelackof high-qualityand</sup> broad-coverage data on variables representing<sup>otherexplanationsforforeigndirectin-</sup> vestment inflows. We consider, in turn, the<sup>relationshipof foreigndirect investmentwith</sup> the level of local wages, local stock-market<sup>activity,thedegreeof balance-of-payments</sup> restrictions, and the occurrence of privatizations.<sup>Acrossallof thesealternativespecifi-</sup> cations we systematically found that our<sup>previousresultson the roleof theglobal factors</sup> are not qualitatively affected.

The results are presented in Table **7,** where<sup>eachcolumn isdevotedtoadifferent</sup> additional explanatory variable. In the first<sup>extension,we considerthe level of localwage</sup> rates as an additional determinant of<sup>foreigndirectinvestmentinflows.Thisvariableis</sup> measured as average annual wages and<sup>salariesinthe manufacturingsector,expressed</sup> in constant **US** dollars. The number of<sup>observationsis reduced</sup><sup>**by**closeto40percent</sup> with respect to the basic regression. However,<sup>themainresultsarepreservedinthe</sup> new regression. The wage variable enters<sup>theregressionwitha negativeandsignificant</sup> coefficient, indicating that local labor costs<sup>doinfluenceforeigners'decisionto investin</sup> the country.

Next, we consider local stock-market activity, proxied<sup>**by**theratioof stock market</sup> traded value to **GDP.** It carries a positive and<sup>significantcoefficient,whichimpliesthat</sup> local stock-market activity and foreign direct investment<sup>inflowsare positively related.</sup> However, given that foreign direct investment<sup>is likelytoinvolvetransactionson stock-</sup> market listed companies, it is difficult to<sup>establish thedirectionof causalitybetweenthe</sup> two variables. Note that when we include this<sup>variableintheregression,thesample</sup>

> 21Results are available upon request.

**23**
size is reduced to less than half. When stock-market activity is included in the regression, private credit -the proxy for financial depth used in the basic regression- loses its significance (and positive sign).

Column **3** presents the results when the occurrence of privatizations is considered as an additional local variable. This is a dummy variable that takes the value of 1 in a given country/year observation when there are positive revenues from privatization transactions in the corresponding country and year. The main drawback of the data set for this variable is that it starts in **1988.** We assume that prior to this year the privatization dummy takes the value of zero. This is incorrect in a handful of cases (notably the United Kingdom and Chile) but we believe is accurate in the majority of cases given that the strong drive for privatization across the world started in the 1990's. As expected, the occurrence of privatization carries a positive and significant coefficient, which attests to the importance of foreign participation in the privatization processes, particularly of developing countries. It seems that privatization acted as a catalyst that allowed local factors to exert a stronger pull over foreign direct investment flows.

Next, in column 4 we add a qualitative measure of balance-of-payments restrictions mentioned in the previous subsection. The inclusion of this variable reduces the sample size only slightly, and most results from the basic regression are preserved. As expected, this variable carries a negative (and significant) coefficient, implying that measures designed to control the level and volatility of international flows act as deterrents to foreign direct investment.

Finally, we turn to estimation of the coefficients of the latent global factor, allowing the effects of the latter to vary across countries. Unlike the estimations presented so _far,_ this poses a nonlinear problem due to the presence of cross-equation restrictions forcing the relative magnitude of the coefficients on the six global variables to be the same for all countries **-** although their _absolute_ magnitude may differ across countries.

> The results of this model are shown in the last column of Table **7.** To make the estimation results more easily comparable with those from previous specifications, we

24
constrained the coefficients on the global variables<sup>toaddupto</sup><sup>**-0.010**whileleaving</sup> unrestricted the country-specific coefficient<sup>on theresultinglinearcombinationof global</sup> variables. For want of a better term, we label<sup>suchcoefficient'global effect'. Tomake</sup> the estimation results easier to understand, note<sup>that the estimatedimpact of any global</sup> variable on FDI flows to a particular country<sup>isgiven</sup><sup>**by**the'globaleffect' of such country</sup> times the coefficient on the global variable in<sup>question.</sup> It can be seen from the table that all of the<sup>global variables,withthe only exception</sup> of the stock market return, carry significantly<sup>negativecoefficients.Inturn,the average</sup> of the global effect across countries<sup>isclosetounityandstronglysignificant. Yetthe</sup> estimates of the global effect display substantial<sup>variation across countries:</sup><sup>**62**are positive</sup> (of which **23** significant at the<sup>**10**percentlevelorbetter)and</sup><sup>**32**negative(ofwhich</sup> 2 significant). As for the local variables,<sup>thesizeandsignificanceoftheircoefficient</sup> estimates are remarkably similar to those<sup>reportedfrom the estimation of Model2in the</sup> first column ofT able 4.

# **4 Final Remarks and Policy Implications**

This paper presents strong evidence that<sup>thelargeincreasesinforeign directinvestment</sup> flows and its distribution across countries<sup>areassociatedwithincreasedimportanceof</sup> global factors among industrial and<sup>developingcountries.Thisincreasedrelevanceof</sup> global factors is associated with an increased integration<sup>of worldcapital marketsfollow-</sup> ing the many reforms and liberalization programs<sup>of the mid1980'sand1990's.</sup> Our results complement those of papers that find increases<sup>in theextentof integra-</sup> tion (mainly) after **1990 by** studying the behavior<sup>of equityreturnsin several emerging</sup> markets. Unique to our paper is the analysis<sup>of the integration</sup><sup>**by**looking at capitalflows</sup> as opposed to prices and **by** describing<sup>theprocessof integrationforemergingaswell</sup> as developed economies. Carrieri, Errunza and<sup>Hogan(2002)show thatinthe</sup><sup>**1990s,**</sup> significantly more of the variation in returns<sup>of 'ineligible'domesticsecuritiescan beex-</sup> plained **by** the world return. Similarly, Bekaert,<sup>Harveyand</sup><sup>**Ng**(2002)findthatequity</sup>

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returns display greater correlation with regional and world market returns after **1990,** and Bekaert and Harvey **(1997)** show that global factors (characterized **by** a similar set of variables as used in this paper) have become more important after liberalizations in explaining stock return volatility in emerging markets.

The paper also makes a contribution to the literature on the determinants of foreign direct investment. We develop theoretical arguments and motivate extensively the presence of global factors as drivers of foreign direct investment. The increased exposure to global factors that we find is associated with increased flows of foreign direct investment into emerging market economies. While these findings constitute evidence of the relevance of global or external factors for foreign direct investment, we also find that growth in local productivity, trade openness, financial depth, low government burden, and macroeconomic stability are important domestic drivers.

The finding that local factors have become less important in accounting for the variation in foreign direct investment should not be seen as an endorsement for an hands-off attitude of local governments towards foreign investment. Much to the contrary. First, our empirical model explains roughly **50** percent of the cross sectional and time series. variation in foreign direct investment. It could be that some of the remaining variance in direct investment is coming from local factors that we are omitting and that are largely uncorrelated with global factors. Though we find this hypothesis unlikely due to the extensive list of variables that we use, we cannot completely rule it out. Second, local factors still account for a sizeable amount of variation in foreign direct investment even after excluding the component that is due to the correlation ofl ocal and global factors. Disregarding their role could turn sour particularly in crisis periods. It is during crisis periods that the characteristics of local factors can be determinant to prevent massive outflows. Third, and related to the points above, the dynamics of foreign capital inflows will almost always involve a cross country comparison leading to a selection that in itself is mainly driven **by** a direct comparison of local factors and possibly also **by** how these local factors relate to the multinational's own global risk factors. Finally, much of

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the integration of capital markets comes from<sup>policyinitiativestakenfromwithineach</sup> country. In many emerging economies, the<sup>defense ofexisting reformsand the pursuitof</sup> further liberalization policies represents a challenge<sup>for localpolicymakersthatcannot</sup> be put off.

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# **A Global and Local Factors in Foreign Direct Investment: Case Studies**

There is considerable evidence that multinationals make investment, financing, and cash management decisions at the parent company level. Tests have found that, controlling for local variables, domestic investment responds to changes in such variables as the parent company's aggregate supply ofl iquidity, aggregate debt to equity ratios, and worldwide cost of capital and hurdle rates.2 For example, Mills and Newberry (2002) show that worldwide tax incentives have led subsidiaries to shift income into the **US** during **19871996 by** changing their subsidiaries' leverage.

In this paper,h owever, we inspect the role of global factors which, being outside the control of the multinational, are the drivers of the parent company's aggregate variables. This section discusses three cases of direct investments of multinationals highlighting the role of global and local factors in the decision making process. We view this presentation as particularly interesting since the foreign direct investment literature has not identified any role for global factors up to now, which is reflected in the way empirical analysis is conducted.

## _Enron International's Dhabol Power Pmject,_<sup>_India2 3_</sup>

The Dhabol Power Project consisted of a2 ,000m egawatt power station located at Dhabol, near Bombay. It amounted to a **$2.8** billion investment from a joint venture formed **by** the **US** energy giant Enron Corporation (with **79.93** percent of equity stake), Bechtel Enterprises Inc. and General Electric's Financial Services (each with equal shares). Construction was expected to start in mid-year **1995** and was expected to be completed **by** December of **1998.** _The global factors:_ **A** country's energy sector is very dependent on the domestic business cycle. Thus, Enron viewed its strategy of foreign expansion as a way to diversify

> 22The interested reader is referred to Caves **(1996, pp** 137-140).

> 23This discussion is based on Eun and Resnick (2001) and in several newspaper articles obtained from the database Lexis-Nexis.

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> risks inherent with fluctuations in the **US** business cycle. At the time Enron was also

> moving into other markets like Bolivia, Brazil, and Italy. **A** second global factor was that Enron was doing very well in the **US** and enjoyed easy access to credit from a booming **US** economy. **A** third global/regional factor was that, while the project came as an invitation

> from the Indian government, it provided a client for Enron's Qatar **$5** billion project to develop natural gas reserves.

_The Local Factors:_ India's proximity to the Qatar project is itself also a local favorable factor. Another local favorable factor for Enron was that India had an energy deficit, which guaranteed demand for the product. The main risks faced **by** Enron were political in nature. First, India revealed itself as a labyrinth of bureaucracy to Enron. Second, after long negotiations with the central Indian government, and shortly after construction began in **1995,** the newly elected provincial government of the state of Maharastra (where Dhabol is located) stopped construction. The provincial government demanded a say in the deal discussing among other things the pricing of electricity, the amount purchased **by** its state, and environmental concerns. The project did go ahead, but renewed disputes about tariffs with the state of Maharastra in 2001 forced its shutting down. **By** this time, Enron had invested **$1** billion and was looking for a buyer.

# _Intel Investment,_ **_C_** _osta Rica24_

In 1996 .Intel announced plans to build an assembly-and-test semiconductor plant worth **$300** million in Costa Rica. In contrast with Enron's case above, Costa Rica was not. viewed as a market itself and all of the output from this factory was to be exported to other countries.

> _Global factors:_ Intel's decision to expand production sites is related to its role as primary supplier and developer of semiconductors worldwide. The pace oft echnological cloning in semiconductors dictates that Intel must have a one or two year advantage

> over its competitors in order to recover the research and development costs in the new

> 24This discussion is based on Spar **(1998).**

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computer chip. Thus,<sup>it iscritical thatIntel can producequicklyenougha large amount</sup> of computer chips. Since upgrading<sup>existingplantsitselftakestime,Intelhashadthe</sup> policy of building new factories<sup>"every ninemonthsor so'(Spar</sup><sup>**1998,pp.**4).Thus,it</sup> is the pace of worldwide growth<sup>andoveralldemandforprocessorsthat dictateIntel's</sup> expansion decisions.

_Local factors:_ Intel favored Costa<sup>Rica out of anoriginal list of12candidatecountries</sup> including Brazil, Mexico, Chile, Thailand,<sup>andIndonesia.First, CostaRicadisplayed</sup> an established and trustworthy<sup>politicalsystem.Second,CostaRicahadanon-union</sup> work environment with a reasonable<sup>supplyof qualifiedworkers." Third,CostaRica</sup> presented itself as a pro-business<sup>environmentandgrantedIntel with a fasttrack permit</sup> process that was critical to<sup>acceptance.Last,butnotleast, (thoughIntel didnotget</sup> any special tax treatment<sup>relativeto otherforeigninvestors,)the</sup><sup>**8**yearexemptionof</sup> corporate taxes and subsequent<sup>4year reductionof the tax ratein</sup><sup>**50**percent represented</sup> significant savings for<sup>Intel.OtherconcessionstoIntelincludedreducedenergyrates</sup> (through changes in the industrial<sup>rate structure) andimprovedaccess to theairportand</sup> airport facilities.

# _Johnson_ **&** _Johnson,_ **_U.S.A._**<sup>**_26_**</sup>

In this last case study we look<sup>intoadisinvestmentdecisionmade</sup><sup>**by**Johnson</sup> Johnson **(J&J)** in **1998.** Accordingt o **J&J** this decision<sup>fundamentallychangedthe</sup> nature of its worldwide manufacturing<sup>operations,reducingthe numberof manufacturing</sup> facilities around the world<sup>**by36**plants, from</sup><sup>**159**tol</sup><sup>**23**plants,withasubsequent</sup> decrease of 4 percent of the<sup>globalworkforce.One thingthatis interesting in this case</sup> study is that nothing<sup>changedat thelocalf actorleveltoalteror initiateJ&J'sdecision.</sup> _Global factors:_ "The most significant<sup>reconfigurationof facilitiesinthe Company's</sup> history," **(J&J 1998** Annual<sup>Report,</sup><sup>**pp.1)**could onlyhavemadesenseinamorein-</sup> "Apparently labor market<sup>conditionsand therecentcurrencycrisiswerethe deciding factorbetween</sup> Mexico and Costa<sup>Rica.</sup>

> 26This presentation is based on the cmpany's **1998** and **1999** annual reports.

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tegrated world. According<sup>to</sup><sup>**J&J,**theworldwidedecreasein transportationcosts and</sup> lowering of trade barriers made<sup>productionin severalcountrieseconomicallyinfeasible.</sup> Therefore, J&J's new strategy<sup>wastomoveproductionfromalocalto aregionalcon-</sup> figuration, taking advantage<sup>ofscaleeconomiesandlowtransportationcosts.Clearly,</sup> the decrease in transportation<sup>costsisdueto worldwidetechnologicalimprovements.As</sup> for the worldwide movement<sup>tolowertariffs,wearguethatittooisdriven</sup><sup>**by**global</sup> factors. Perhaps the most important<sup>ofthese factorsistheincreased belief(resulting</sup> from advances in economic<sup>science)thatloweringtariffsis a necessaryconditiontobol-</sup> ster growth. **Of** course, the<sup>decisionofw hichcountriestoabandonmustneverthelessbe</sup> confronted with local factors<sup>that relateto geography,laborcosts,taxbenefits,andso</sup> on.

# **B A Simple Model of Foreign**<sup>**Direct Investment**</sup>

In this appendix we elaborate<sup>asimplemodelofforeigndirectinvestment.Consider</sup> the investment decision problem<sup>of a domesticsubsidiaryof a multinationalcorporation</sup> (subsidiary for short).<sup>Thesubsidiaryisassumedtobe fullyownedandfinanced</sup><sup>**by**the</sup> parent company. For simplicity<sup>the subsidiarylives for2periods,t andt</sup><sup>**+1.27**Inperiod</sup> t investment It is chosen. In<sup>periodt</sup><sup>**+1,**theproductivityshockAt+lisrealized,labor</sup> _Lt+1_ is chosen and production<sup>takesplace.Pricesaretakenasgiven.Thereis a unique</sup> good produced domestically<sup>andallquantitiesareexpressedinunitsof this good.The</sup> domestic consumption good<sup>differs from theforeigngoodavailablefor consumptionand</sup> investment **by** the foreign investor.

The multinational discounts profits<sup>fromthe domesticsubsidiarylrt+lusingthedis-</sup> count rate **Ot+1-28** This discount rate<sup>ismeasuredinunits of the foreign goodandhence</sup> profits received from the subsidiary<sup>mustbeadjustedto reflectchangesintherelative</sup>

> 2It is straightforward toc onsider<sup>aninfinitelylived firm.Inthiscasewecansolvethefirst order</sup> conditions using a linear approximation.<sup>The resultsfrom this approximationaresimilar toourcurrent</sup> setup, but the details are more<sup>involved.</sup>

> 28The discount rate or stochastic discount factor in the Consumption-CAPM model equals the intertemporal rate of substitution.

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price of the foreign good or real exchange rate **_xt._** The expected discounted profits of the local subsidiary in units of the foreign good are: where 1 **_>_ y +** a which leads to economic profits to pay for fixed intangible assets owned **by** the foreign investors, _Rt_ **_=_ 1+** _rt_ is the gross rate of interest for the multinational measured in local currency units, **_wt+1_** is the real wage rate, Pt+1 is the stochastic probability of no expropriation, and _V_ is the value of the investment at time t.

The maximization problem described above yields the following first order condition for investment (after incorporating the optimality condition for labor): The right hand side of (4) gives the marginal cost of an additional unit of investment in local currency units. This cost is equated to the expected marginal benefit of investing which is accrued through additional output in period t **+ 1.** To solve for optimal investment assume that all variables are log-normally distributed with multivariate autoregressive conditional heteroskedasticity." Let Zt+1 **=** [ln pt+1, In/t+1 In ,InAt+,,Inwt+]'. Then: with L being a diagonal matrix, and Et being a variance-covariance matrix of shocks. Note that through Et shocks to the discount factor can be correlated with shocks to local 2 9Clearly assuming that pt is log-normally distributed is not reasonable since **_Pt >_ 1** is not legitimate for a probability. However, provided the likelihood that **_pt >_ 1** is very small this is ar easonable approximation.

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variables. The solution to<sup>the first orderequationis:</sup> where co is a constant, the _p's_ are the persistent parameters in **g,**<sup>and a</sup><sup>**=[1,1, 1,1/ (1-**a),</sup> _a/ (a_ **1)]'.** Note that because<sup>ofconditionalheteroskedasticityofe,investmentisa</sup> linear function of lagged<sup>variancesof theshocks.We allowforthispossibilityinour</sup> estimations.

This completes the analysis<sup>ofinvestmentdecisionsofa singlesubsidiary.Assume</sup> now that the domestic<sup>economy is composed of manyidentical firms and thatevery period</sup> new firms enter into this<sup>market,overlappingwithfirmsalreadyinplace.Anaggregate</sup> version of **(5)** holds for<sup>theeconomyasawholeprovidedall foreignsubsidiariesface</sup> similar prices, productivity<sup>anddiscountfactors,whichweassume.</sup>

# **C Definition ofV ariables**

Here we provide ad etailed<sup>descriptionofthe data.Unlessnotedweuseanannual</sup> frequency.

Foreign Direct Investment/GDP:<sup>Ratioof GrossFDIinflows(incurrent</sup><sup>**US$)**</sup> toG DP (in current **US$).** IMF Balance of Payments and<sup>TheWorldBankGlobal</sup> Development Finance.

T-Bill: **US** 3-month Treasury<sup>Billrate takenfromBloomberg.Frequency:annual</sup> average (end of month<sup>price).</sup> Stock Market Return:<sup>Percentagechangeof Morgan StanleyWorldCapitalIndex</sup> from Bloomberg. Frequency:<sup>annualaverage(endof monthprice).</sup> Slope: Slope of the **US**<sup>TermStructurefromBloomberg,computedas the</sup><sup>**10**year</sup> Bond rate minus 3-month Treasury<sup>Bill rate.Frequency:annualaverage(end of month</sup> price).

Spread: **US** Credit Spread<sup>fromBloomberg,computedasMoody's</sup><sup>**AAA**bondrate</sup> minus Moody's **BAA** bond<sup>rate.Frequency:annualaverage(end of monthprice).</sup>

**U.S.** inflation rate: Geometric<sup>averageof currentand last-yearinflationrate.IMF</sup> International Financial Statistics.

World Growth: **GDP** weighted<sup>averageof</sup><sup>**GDP**growthrate(sampleof countries</sup> with complete data). World Development<sup>Indicators.</sup>

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**GDP growth:** Growth rate of real per capita **GDP.** Summers and Heston dataset and World Development Indicators.

Trade openness: Residual of a regression of the log of the ratio ofr eal exports plus imports (in **1995 US$)** to real **GDP** (in **1995 US$)** on the logs of area and population, and dummies for oil exporting and for landlocked countries (see Loayza, Fajnzylber, and Calder6n 2002). World Development Indicators.

Financial Depth: Ratio of private credit **by** deposit banks and other financial institutions to **GDP** (Beck, Levine, and Demirgug-Kunt 2000).

Government consumption: Ratio of general government final consumption expenditure to **GDP.** World Development Indicators.

Institutional quality: Civil liberties **(0,1).** Higher scores indicate more liberties. Freedom House: Freedom in the World.

REER growth: Growth rate of real effective exchange rate. IMF International Financial Statistics.

REER volatility: Standard deviation of real effective exchange rate percentage changes. IMF International Financial Statistics.

**GDP** growth volatility: Standard deviation of growth rate of real per capita **GDP.** Summers and Heston dataset and World Development Indicators.

Terms of Trade volatility: Standard deviation of terms of trade percentage changes. World Development Indicators.

Wages: Average annual rate of wages and salaries in the manufacturings ector, expressed in constant **1995 US$.** United Nations: Industrial Development Organization.

Traded Value to **GDP:** Ratio of total shares traded on the stock market exchange to **GDP** (Beck, Levine, and Demirgug-Kunt 2000).

Official liberalization: Dummy variable that takes the value of one if the equity market is liberalized based on the chronology in Bekaert and Harvey (2000).

First sign: Dummy variable that takes the value of one if there is either an official liberalization or ADR and country fund introduction.

Investability: Ratio of capitalization of the IFC "investable" to the "global" stocks in a country as in Edison and Warnock (2001).

Balance of Payments Restrictions: Simple average of **(0,1)** scores for the following categories of balance of payments restrictions: multiple exchange rate practices,c urrentaccount restrictions, capital-account restrictions, and surrender of export proceeds. IMF Exchange Arrangements and Exchange Restrictions.

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