Along with the rapid process of trade liberalization, developed and developing countries began to put forth a multilateral effort into promoting foreign direct investment (FDI) for the purpose of capital inflows, technology transfer, and job creation. By implementing FDI promotion policies such as providing investment incentives and lowering investment barriers, global FDI inflows have increased constantly over time. In case of Korea, the size of FDI inflows and number of foreign invested companies dramatically increased after the government implemented foreign investment promotion policy to overcome the Asian financial crisis in 1998 and reached its highest peak in 2014. While FDI inflows became an essential part of domestic economy, they are still considered to be marginal when compared to those of developed and also developing countries. Taking into account of the importance of FDI inflows in Korean economy yet marginal FDI performance with respect to its potential, therefore, it is important to acknowledge the determinants that promote and hinder the FDI in Korea. This report analyzes and evaluates the determinants of FDI by investigating prior foreign and domestic trade studies and by performing the empirical analysis. In particular, we estimate for the determinants of FDI by dividing the analysis based on FDI patterns (Greenfield FDI and M&A FDI). In particular, based on the results from analyzing the changes in investment barrier across domestic industries over time, we derive FDI openness index for each industry sector and estimate its effects on different patterns of FDI inflows into domestic industries by using Korean industry-level FDI data.
Investigating for global and domestic FDI trends from the statistical and institutional perspective indicates that while FDI inflows were restricted and strictly regulated at the individual country-level before 1980s, countries began to promote FDI competitively as positive perception on FDI expanded across the globe along with the Uruguay Round Agreement and WTO establishment. Recently, it is observed that countries are amending regulation systems to promote FDI strategically by putting more weights on its quality than quantity. Consistent with institutional trends, the size of global FDI inflows began to increase after 1980s, with having its rapid growth between late 1990s and early 2000s, and had a stable growth after late 2000s. The most distinguishable feature of global FDI trend is the emergence of developing host countries and an increase of M&A FDI share. In particular, FDI inflows into developing countries have constantly increased over time and accounted for 55% of global FDI inflows in 2014, which surpasses that of developed countries. While M&A FDI inflows, on the other hand, is smaller than greenfield FDI in terms of its size and share, it constantly increased over time and recorded an increase of 28% in 2014 compared with the previous year.
Consistent with global FDI trends, Korea was reluctant to implement FDI promotion policies before 1980 and instead, relied heavily on a foreign loan to develop its economy. After the Asian financial crisis in late 1990s, however, the government began to remove all of M&A investment barriers to recover the economy in short time. Recently, the government is implementing FDI promotion policies strategically and selectively that can coincide with its goal of advancing certain domestic industries. In terms of FDI size, Korea experienced a rapid growth in M&A FDI after 1997 and it showed a constant increase over time. Investigating Korean FDI inflows by taking into account of source countries and FDI patterns, we find that while prior FDI inflows were concentrated in greenfield FDI form, mostly from industrialized countries such as European countries and United States, recent FDI inflows are concentrated in M&A form, mostly from Asian countries.
Examining the changes in investment barrier across domestic industry sectors, we find that most of manufacturing sectors were fully liberalized in 1990s and except for few sectors, all manufacturing sectors were liberalized after 2000. Service sectors, on the other hand, showed a lower level of investment liberalization relative to manufacturing sectors. In particular, sectors that include public services and transportation services showed the lowest level of investment liberalization. After analyzing the changes in investment barriers, we computed for the FDI openness index for each industry sector by using the methodology from Hoekman (1995). Taking into account of prior results that examined the determinants of FDI, we performed an empirical analysis on the determinants of different patterns of FDI. In particular, we used country-level and Korean industry-level FDI data to estimate the determinants of greenfield FDI and M&A FDI. Examining the determinants of country-level FDI by decomposing the sample based on the income-level of host countries, the estimation results showed that GDP per capita has significant effects on greenfield FDI, while inflation rates, real exchange rates, and financial market development have significant effects on M&A FDI across developed countries. Across developing countries, on the other hand, GDP growth, inflation rates, and country risk indices had significant effects on greenfield FDI, while real exchange rates, financial market development, country risk indices, and number of investment treaties with other countries had significant effects on M&A FDI.
Examining the determinants of domestic industry-level FDI by dividing the sample on the basis of time periods, we found that greenfield FDI is likely to increase among industry sectors where firms can use high-skilled labor by bearing higher wages and where FDI openness is high during the earlier sample period, while it is likely to increase among industry sectors where FDI openness is small over the recent sample period. M&A FDI, on the other hand, is likely to be associated with R&D investment and FDI openness during the earlier sample period, while it is significantly affected by the number of labor-management dispute cases over the recent sample period. These results imply that while FDI openness previously had a large impact, investment environment is becoming more effective on promoting M&A FDI.
This report provides important policy implications on promoting FDI in Korea. First, the estimation results on FDI openness having a significant effect on both greenfield and M&A FDI imply that investment liberalization policy is effective on promoting FDI and that additional investment liberalization on service sectors that showed the smallest FDI openness would be more effective on promoting FDI in the future. However, it should be noted that Korean government have already adopted and made much improvement on legal systems to promote FDI.
To make more practical progress, therefore, we need to focus on improving business and investment environment, such as “regulation free zone” that is currently being considered for the promotion. Amending numbers of FDI promotion systems that are already being implemented in correspondence to policy objectives would also make practical progress on promoting FDI in the future. Second, the estimation results on country’s financial market development showing significant and positive effects on M&A FDI across developed countries where Korea is included imply that advanced financial market is essential to promote FDI in the future. In particular, implementing policies that can promote more financial companies and produce professional manpower can strengthen the competitiveness of financial systems and can lead to promote more M&A FDI in the future. Furthermore, high-skilled labor and numbers of labor-management dispute cases having significant impact on greenfield FDI indicate that the government should support training programs that can produce professional manpower who can fit into interests of foreign firms and need to put forth additional efforts on improving labor-management relations.