University of Economics International Institution of Social Studies Ho Chi Minh City, Vietnam Eramus University of Rotterdam, The Netherlands VIETNAM – THE NETHERLANDS PROGRAMME FOR MASTER OF ART IN DEVELOPMENT ECONOMICS LOCATION SPECIFIC DETERMINANTS OF JAPANESE FOREIGN DIRECT INVESTMENT IN SELECTED ASIAN COUNTRIES BY HUYNH THAO THUY VI A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Development Economics Under the supervision of Dr Le Cong Tru HO CHI MINH CITY, 2014 DECLARATION This is to certify that the thesis entitled “Location-specific determinants of Japanese foreign direct investment in selected Asian countries”, is submitted by me in fulfillment of the requirement for the degree of Master of Art in Development Economics to Vietnam – Netherlands Programme This thesis comprises only my original work and due supervision and acknowledgement have been made in the text to all other material used Huynh Thao Thuy Vi ACKNOWLEDGEMENT I would not be possible to finish this thesis without the support of people surrounding me Firstly, I am really grateful to my supervisor, Dr Le Cong Tru, for his guidance, comments and supervisions Secondly, I would like to express my gratitude to Dr Truong Dang Thuy for his econometric guidance Thirdly, I want to acknowledge all lecturers of Vietnam-Netherlands Programme for the wide knowledge they provided me during the time I studied here Next, I would like to express my gratitude to my parents for all of their sacrifice, encouragement and support for me Last but not least, I would like to thank my friends and people, who supported for my thesis but were not above-mentioned ABBREVIATIONS FE Fixed Effect FDI Foreign Direct Investment GDP Gross Domestic Product JBIC Japan Bank for International Cooperation JFDI Japanese Foreign Direct Investment JETRO Japan External Trade Organization MNE Multinational Enterprises RE Random Effect ABSTRACT This thesis contributes to examine the location-specific determinants influencing on Japanese foreign direct investment This research uses fixed effect method and panel data of ten selected Asian countries in the period from 1995 to 2012 The determinants are classified into three groups: policy factor, business facilitation and economic factor In this study, except for the variables which belong to policy factor and business facilitation, the others of economic factor are categorized in accordance with three main motives for Japanese enterprises investing abroad Those motives are market-seeking, resource-seeking and efficiency-seeking The study finds that market size, natural resource, inflation rate, exchange rate volatility, political risk and infrastructure development are the significant factors Moreover, among ten selected Asian countries, there are the differences between intercept coefficients of Vietnam and other countries who are Thailand, Indonesia, Vietnam– Philippines and China In other words, except for the determinants in the regression model, there would be other factors making those countries to be more dominant than Vietnam Finally, recognizing the need of Japanese foreign direct investment, the policy makers in host countries should apply the relevant policies to improve the business environment for becoming promising destinations and attract more Japanese foreign direct investment Key words: Japanese foreign direct investment, panel data, location-specific, Asian countries, fixed effect TABLE OF CONTENT DECLARATION ACKNOWLEDGEMENT ABBREVIATIONS ABSTRACT TABLE OF CONTENT LIST OF FIGURES LIST OF TABLES CHAPTER INTRODUCTION 1.1 1.2 1.3 1.4 PROBLEM STATEMENT RESEARCH OBJECTIVES 10 RESEARCH QUESTION 10 THESIS STRUCTURE 11 CHAPTER LITERATURE REVIEW 12 2.1 THEORETICAL LITERATURE 12 2.1.1 Early concepts & studies of determinants of FDI 12 2.1.2 Neoclassical Trade Theory (Heckscher-Ohlin model & MacDougall-Kemp model) 13 2.1.3 Hymer – Kindleberger Paradigm 13 2.1.4 Internalization theory 14 2.1.5 The OLI paradigm - Eclectic theory 15 2.2 EMPIRICAL STUDIES 17 2.3 CONCEPTUAL FRAMEWORK 22 CHAPTER RESEARCH METHODOLOGY 25 3.1 VARIABLE DEFINITION AND TESTING HYPOTHESES 25 3.1.1 Market size 25 3.1.2 Natural resource 25 3.1.3 Inflation rate 25 3.1.4 Exchange rate volatility 26 3.1.5 Trade openness 26 3.1.6 Political risk 27 3.1.7 Infrastructure development 27 3.1.8 Labor cost 28 3.2 DATA AND MODEL SPECIFICATION 28 3.3 RESEARCH METHODOLOGY 31 3.3.1 Descriptive Analysis 31 3.3.2 Regression Analysis 32 CHAPTER DATA ANALYSIS 37 4.1 THE OVERVIEW OF JAPANESE FDI IN ASIAN COUNTRIES 37 4.1.1 Before the crisis in 1997 37 4.1.2 After the crisis in 1997 43 4.1.3 Several remarkable characteristics of recent Japanese FDI in Asia 45 4.2 EMPIRICAL RESULTS 47 4.2.1 Descriptive analysis and some general tests 47 4.2.2 Econometric results 52 CHAPTER 5.1 CONCLUSION AND POLICY IMPLICATION 57 CONCLUSION 57 5.2 5.3 POLICY IMPLICATION 58 LIMITATION AND SUGGESTION OF FURTHER RESEARCH 59 APPENDIX A: RESULT OF HAUSMAN TEST 60 APPENDIX B: RESULTS OF HETEROSKEDASTICITY & 61 SERIAL CORRELATION TEST 61 Table B-1: Heteroskedasticity test 61 Table B-2: Serial Correlation test 61 APPENDIX C: REGRESSION RESULTS 62 REFERENCES 63 LIST OF FIGURES Figure 2.1: Conceptual Framework 23 Figure 4.1: Japanese FDI by region (billion Yen) 38 Figure 4.2: Japanese FDI in 10 selected Asian countries (billion Yen) 40 Figure 4.3: Japanese FDI in NIEs (billion Yen) 41 Figure 4.4: Japanese FDI in ASEAN4 (billion Yen) 42 Figure 4.5: The correlation between Political Risk (pol) and Trade Openness (TO1) 49 Figure 4.6: The correlation between trade and GDP 50 Figure 4.7: The response of Japanese enterprises considering Vietnam, Thailand, Indonesia, Philippines and China as the promising countries 56 LIST OF TABLES Table 2.1: The summaries of some typical theories of FDI 16 Table 3.1: Summary of testing hypotheses 28 Table 3.2: Summary of expected signs of variables 30 Table 4.1: Regional distribution of FDI by Japanese firms 39 Table 4.2: Promising countries for overseas business operation over the medium-term in term of Japanese enterprises 45 Table 4.3: Summary of variables in the study 48 Table 4.4: Correlation coefficients of variables in the study 48 Table 4.5: The VIF and TOL factors before excluding trade openness (TO1) 49 Table 4.6: The VIF and TOL factors after excluding trade openness (TO1) 51 Table 4.7: Summary of Estimation Results 52 CHAPTER 1.1 INTRODUCTION PROBLEM STATEMENT For the time being, because of the immobility and long run profitability, foreign direct investment (FDI) is one of the important factors contributing to the economic growth of countries in the world (Nakamura & Oyama, 1998) Through FDI, the financial resources are transferred to the host countries to set up and expand the production conditions in those countries Furthermore, the technological achievements and managerial knowledge are also transferred from the investing countries to the host countries Those factors would contribute to the economic development of the recipients Moreover, the host countries may also take advantage of the networks through the sales and distribution networks of foreign investors As to the destination of FDI, with the available and potential advantages, Asia has been still the leading region in attracting FDI with 3,740 projects tracked in 2012, which increases its global market share to 31.72% Many countries in Asia have achieved the dominant economic growth through FDI into many specific industries, such as, business and financial services, ICT, chemicals, plastics and rubber, etc As to the source country or home country of FDI, Japan is still the dominant one all over the world, especially in Asia In spite of the decreased number of outward FDI projects from Japan, the ratio of Japanese FDI in Asia still went up from 34.57% in 2011 to 37.37% in 2012 (Fingar, 2013) According to the survey conducted by Japan External Trade Organization (JETRO) on 3,397 JETRO member firms and 6,403 enterprises using JETRO services in 2013, 64.9% of firms intend to expand overseas operation by conducting new investments going with existing operation bases whereas 91.7% set up locations in Asia Pacific It would be indicated that because of natural disasters and difficult domestic business environment in Japan, for example, labor costs, tax burden, domestic regulations, etc, Japan firms are concentrating on widening their overseas investments (JETRO, 2014) Moreover, as to the conception of Japanese firms, the countries in Asia have been possessing advantages, which would promote them to be promising destinations for JFDI Those advantages can be listed as current size of local market, inexpensive source of labor, social and political stability, etc Despite many motives for Japanese firms to invest in Asia, there are many issues in this region, which raised concerns for Japanese enterprises As indicated in the report of Japan Bank 4.2.2 Econometric results Based on the summary of estimation results in Table 4.7, this study aims to reach the research objectives through analyzing the research hypotheses After excluding the variable of trade openness, there are seven hypotheses, which are mentioned in the previous chapter and stands for seven determinants influencing on FDI inflows theoretically The Table 4.7 indicates the summary of regression results of these seven determinants Furthermore, because the REM is rejected by Hausman test, there are only the results from FEM reported and analyzed Table 4.7: Summary of Estimation Results Explanatory variables FEM Coefficients 0.0002 0.1351 0.0472 -0.8400 1.2839 0.2397 8.23e-07 (omitted) 1.9958 1.4559 0.2736 1.4079 -0.9545 0.4630 -0.5193 0.0280 1.5484 Standard error 0.0001** 0.0455*** 0.0122*** 0.4304* 0.7050* 0.1013** 2.16e-06 GDP NRE IFL LN_EXCV POL INFRA2 ARWAG Country_1 Country_2 0.7787** Country_3 0.7189** Country_4 1.0402 Country_5 0.6570** Country_6 1.6663 Country_7 1.1439 Country_8 1.7809 Country_9 0.6946 Country_10 0.7296** Adjusted R2 57.38% Source: Author’s calculation *, **, and *** denote for the level of significance of 10%, 5%, and 1%, respectively The first and the second hypotheses can be supported by the estimation results at significant level of 5% and 1%, respectively, as expected In details, an increase of billion US dollar in GDP of a host country, the value of JFDI inflow into that country will go up by 0.02% Similarly, JFDI will increase 13.51% if there is a 1% increase in the ratio of ore and metal exports of merchandize exports of host country, which is proxy for natural resource endowment These findings are in line with many studies emphasizing the importance of market-seeking and resource-seeking factors 52 Next, the coefficient, showing a positive and significant impact of inflation rate on JFDI inflow, indicates that a 1% increase in the variable is associated with a 4.72% increase in JFDI It is contrary to the expectation of the third hypothesis Similar finding has been obtained by Buckley et al (2007) As argued by those authors, the foreign firms might be attracted by the host countries with moderate demand inflation It would be reasonable that moderate inflation rate goes with the economic growth It may support the view that with respect to the economic conditions of host country, Japanese firms would not strictly consider a less stable economy with moderate demand inflation to be a serious issue preventing host country from receiving JFDI Moreover, in the study of JBIC (2013), even though inflation has been common in most host countries, the survey showed that as to the Japanese firms, inflation was not mentioned as a remarkable problem The fourth hypothesis, which indicates the negative relationship between exchange rate volatility and JFDI, is supported by the statistically significant estimation result The result shows that when the exchange rate volatility between Japanese Yen and host countries’ currency changes 1%, JFDI into those countries decreases by 0.84% Similarly, Urata and Kawai (2000) also found that the large fluctuations of the exchange rate decrease JFDI inflow because it implies the uncertainty in economic environment of host country As to the sixth hypothesis, Table 4.7 indicates the coefficient of 1.2839 of the political risk variable As to the data of this variable, as mentioned in Chapter 3, the higher value of political risk index demonstrates the higher political stability and leads to the more JFDI theoretically Based on the estimation result, it can be concluded that when the political risk index increases by one unit implying the political stability, JFDI into host country also goes up by 128.39% The estimation result is significant at 10% level This result is similar with the findings of other researches According to the empirical and theoretical conceptions, political risk has been proved to be a remarkably significant factor affecting to the volume of JFDI into one specific country They are studies of Urata and Kawai (2000), Buckley et al (2007), Kinoshita et al (2004), etc Moreover, as mentioned in the survey of Japan Bank for International Cooperation (2013), host country’s political risk including regulatory quality, government effectiveness, etc has been always the concern of Japanese firms As to the seventh hypothesis, infrastructure development is proved to be important factor affecting to JFDI into host countries At the level of significance of 5%, when the Infrastructure 53 Development Index increases by 1% which means of 1% increase in the level of electricity generation per person, the telephone lines and the energy use, JFDI inflow will go up by 23.97% The last estimation result shows the unexpected positive relation between JFDI and average real annual wage, which is the proxy of labor cost However, as we can see in the Table 4.7, this result is also not statistically significant In reality, labor cost is one of the decisive factors influencing on JFDI inflow As analyzed in the overview of JFDI in Asian countries, Japanese firms have been always considering the rise of labor cost in host countries to be the vital issue Urata and Kawai (2000) also mentioned in their study that wages going with material and services cost are supposed to be production cost which has been playing an important role for host countries in attracting JFDI or not Moreover, as mentioned in the survey of JETRO (2014), one of the reasons leading to the expansion of overseas operation of Japanese enterprises is the rising labor cost in Japan Consequently, Japanese companies have to find out the other cheaper sources of labor which would be expected to be abundant in other Asian countries On the one hand, in this thesis, data of labor cost is drawn from International Labor Organization which was also used in the study of Urata and Kawai (2000) and other studies However, there was not enough data thorough out the years provided by this source These two authors studied on the large samples including 117 countries in the world to fix the omittance of data whereas in this thesis, there are only 10 countries to be chosen for the purpose of researching JFDI in specific Asian countries This would be the reason for the unexpected positive relationship between JFDI and labor cost On the other hand, to some extents, an increase in wage would go with the company’s expectation of higher labor productivity (Vladová, 2006) Similarly, Thomas J.A et al (2000) referred productivity as an effort bargain, which are get in return for wage by the employers Moreover, Thomas J.A et al (2000) also emphasized the positive effects of wage increase with specific levels which are matched with each employee’s level of skills, education, etc At that time, the increase in wage would be distributed suitably for the most labor productivity Furthermore, the rise in employees’ income would lead to the higher purchasing power and consumer spending, which would partly push up the economy For the time being, being afraid of low growth and deflation, Bank of Japan has been raising the warning of the need for wage increase in Japanese economy (McLannahan, 2013) While many companies have realized the positive effect of reasonable rise in wage and paid more for the employees, there is still the fall in base salaries in many other Japanese companies As to investment in host 54 countries, this is one of the concerns of Japanese enterprises who want to concentrate on marketseeking, which means that Japanese firms’ production will be sold for the host country’s market By this, the reasonable rise of labor cost would lead to more JFDI inflow in the case that those Japanese firms are motivated by the market-seeking strategy Moreover, as presented in the chapter of methodology, nine dummies variables are created to demonstrate for ten Asian countries which are chosen to be the subjects in this thesis Country_1 to country_10 stands for Vietnam, Thailand, Indonesia, Malaysia, Philippines, Hong Kong, Korea, Singapore, India and China, respectively Vietnam is treated as the reference category and nine dummies will present the differential intercept dummy coefficients, which show the difference between intercept coefficient of each country and Vietnam As we can see, there are differences between intercept coefficients of Vietnam and other countries’ They are the pairs of Vietnam – Thailand, Vietnam – Indonesia, Vietnam – Philippines and Vietnam – China As to Japanese firms, when variables in the regression model are fixed, at the significance of 5%, Japanese FDI will flow into Thailand, Indonesia, Philippines and China more than Vietnam owing to the other factors which were mentioned in the regression This finding would emphasize the study of Vuong and Yokoyama (2011), which is presented in the above part of empirical studies Those authors indicated that Vietnam is just more advantageous than Thailand and China in production cost and labor-related issues On the other hand, Thailand and China are more advantageous in development supporting industry According to the survey of JBIC (2013), there were 18.9% of Japanese firms confirming the underdeveloped local supporting industry in Vietnam whereas this issue in Thailand and China was just 4.5% It can be concluded that supporting industry is the weakest point of Vietnam in attracting JFDI (JETRO, 2013) Moreover, as we can see in the Figure 4.7 demonstrating the absolute figures in Table 4.2 into the relative trend line, by the view of Japanese firms, the voting ratio for Thailand to be the promising country is larger than for Vietnam and this figure has been going up from 2009 to 2013 Obviously, the rank of Thailand to be the promising country for overseas business operation has been higher than Vietnam during the recent three years 55 Figure 4.7: The response of Japanese enterprises considering Vietnam, Thailand, Indonesia, Philippines and China as the promising countries Source: Japan Bank for International Cooperation (JBIC, 2013) As to the comparison between Vietnam and Indonesia in attracting JFDI, when looking at the Table 4.2 about promising countries for overseas business operation over the medium-term in term of Japanese enterprises, the current rank of Indonesia is higher than Vietnam Furthermore, as we can see in the Figure 4.7, the ratio of responses of Japanese enterprises considering Indonesia as the promising destination has been increasing by the time In addition, according to 18 major and minor factors rated by the Japanese enterprises to be the advantage or the issue of host countries, except for the determinants discussed in the regression model, supply base for assemblers or supporting industry has been considered to be the reason leading to the more advantageous point of Indonesia than Vietnam’s In 2013, more than 25% of Japanese companies voted for Indonesia to be promising destination of JFDI owing to supply base for assemblers whereas this figure for Vietnam was just 11% 56 CHAPTER CONCLUSION AND POLICY IMPLICATION 5.1 CONCLUSION This research attempts to find out the location-specific determinants of Japanese foreign direct investment, in the case of selected Asian countries It is motivated by the expanding investment of Japanese firms in the world, especially in some specific regions in Asia In this study, there are eight hypotheses illustrating the relationship between JFDI and the host country’s factors The regression of the model is conducted by using panel data from 1995 to 2012 in ten Asian countries, which are Vietnam, Thailand, Indonesia, Malaysia, Philippines, Hong Kong, Korea, Singapore, India and China Moreover, by applying Hausman test, fixed effect model is chosen to be more appropriate The empirical results of the location-specific determinants of JFDI show that most of policy factors, business facilitation and economic factors are important determinants Market size is the typical determinant having the significant influence on JFDI inflow It can be said that for Japanese firms investing in Asian countries, local sales is the first motive in attracting them to invest abroad Furthermore, based on the significant estimation results, this research finds that export production is also the other major motive of Japanese firms Therefore, they emphasize the importance of production conditions in host countries Those conditions including good infrastructure, etc are always in Japanese firms’ concern and consideration Low-wage labor is also taken into account in the group of production conditions of host countries Despite the unexpected sign and statistically insignificance, low-wage labor is the important determinant that needs to be considered with sufficient data in the further research Particularly, the estimation result indicating the significance of natural resource endowment is reasonable towards a country with limited natural resource like Japan Moreover, Japanese firms seem to be risk-averse when the estimation result shows that high political risk and high exchange rate volatility standing for high economic risks discourages JFDI inflows into host countries However, the sign of inflation rate in this research is positive It can be explained that when investing in host countries, which are Asian, Japanese firms consider an acceptable level of inflation rate standing for the expanding size of market By applying dummies variables, one more finding of this thesis is the differences between intercept coefficients of the pairs of Vietnam – Thailand, Vietnam – Indonesia, Vietnam 57 – Philippines and Vietnam – China By that, when all the determinants in the regression model are fixed, Thailand, Indonesia, Philippines and China would receive JFDI inflow than Vietnam This finding is similar with the research and survey of other empirical studies and Japanese reliable institutions 5.2 POLICY IMPLICATION This study indicates the positive relationship between JFDI and the determinants of market size, natural resource endowment, inflation rate, trade openness, political risk and infrastructure development Meanwhile, the negative relationship between JFDI and exchange rate volatility is also presented Based on the findings through estimation results, this part aims to discuss about the policy to enhance the investment climate to attract JFDI inflows into Asian countries Japanese firms are interested in expanding their business operation in Asia because of the growing demand in this region (Urata, 2002) Moreover, as mentioned in the study of JBIC (2013), market potential, the first consideration of Japanese firms, needs to be taken into account to be enhanced On the other hand, although the empirical result shows the positive relationship between JFDI and the inflation rate, the authorities in host countries should pay attention to maintain the acceptable inflation rate standing for the economic stability to make sure that it is at the enough reasonable level to attract the investment from Japanese firms and not create any negative reaction Also, because of the negative relationship between JFDI and exchange rate volatility, it is very important to maintain the stability of host country’ currency to show its economic stability Furthermore, there is no doubt that good infrastructure can boost JFDI inflows The important role of good infrastructure is not only shown in this study’s estimation result, but also in other studies, especially in the study of JBIC (2013), in which underdeveloped infrastructure is always the issue in most host countries In details, according to Japanese firms, the electricity infrastructure needs to be addressed in all regions, especially in Asia because this region has taken the lead in frequent power cuts that create damage for Japanese firms Last but not least, the trade-related policy is also the significant determinant, which can be controlled by the host countries’ government to attract more JFDI Beside the motivation of local sales, Japanese firms also concentrate on the export production when investing in host 58 countries Therefore, flexible and open economy is an advantage towards a country desiring to receive the foreign investment 5.3 LIMITATION AND SUGGESTION OF FURTHER RESEARCH As we can see in the estimation results, the average real wage, which stands for labor cost, was indicated to influence on JFDI positively This result does not match with other empirical studies Moreover, in the recent survey of JBIC (2013), labor cost is the significant issue that Japanese firms always consider when they have intended to invest in any host country However, unlike the OECD countries whose labor cost‘s data are calculated and updated in details, this data in Asian countries is not sufficient In this study, we use the data of average real wage retrieved from International Labor Organization to proxy for labor cost Nevertheless, the figures provided by this source are not sufficient during the years The lack of too much data of one variable might lead to the bias estimation towards this variable By basing on the empirical studies and using the data from ten Asian countries, this study provided the general and important determinants of JFDI On the other hand, the future research can focus on widening the samples and classifying host countries into developed and developing ones to find out whether there is any difference of the location-specific determinants of JFDI between these two groups Furthermore, the main sectors that have the dominant ratio of investment from Japanese firms can be taken into account to indicate the determinants going with those factors In reality, the different sectors would require the different determinants In other words, a determinant, which is important one of JFDI in this sector, can be insignificant towards the other sector Since then, the suitable policies can be suggested for host countries’ authorities to improve the specific sectors and attract more JFDI in those sectors According to the figures from JBIC (2013), automobiles, chemicals, electrical equipment & electronics and general machines are the main sectors that can be considered in the future research 59 APPENDIX A: RESULT OF HAUSMAN TEST 60 APPENDIX B: RESULTS OF HETEROSKEDASTICITY & SERIAL CORRELATION TEST Table B-1: Heteroskedasticity test Table B-2: Serial Correlation test 61 APPENDIX C: REGRESSION RESULTS 62 REFERENCES Baum, Christopher F (2001) Residual diagnostics for cross-section time series regression models The Stata Journal, 1(1), 101-104 Buckley, Peter J, & Casson, Mark C (2009) The internalisation theory of the multinational enterprise: A review of the progress of a research agenda after 30 years Journal of International Business Studies, 40(9), 1563-1580 Buckley, Peter J, Clegg, L Jeremy, Cross, Adam R, Liu, Xin, Voss, Hinrich, & Zheng, Ping (2007) The determinants of Chinese outward foreign direct 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The role of exchange rates China Economic Review, 17(2), 198-209 Yanikkaya, Halit (2003) Trade openness and economic growth: a cross-country empirical investigation Journal of Development economics, 72(1), 57-89 66 ... entitled Location- specific determinants of Japanese foreign direct investment in selected Asian countries , is submitted by me in fulfillment of the requirement for the degree of Master of Art in Development... contributes to examine the location- specific determinants influencing on Japanese foreign direct investment This research uses fixed effect method and panel data of ten selected Asian countries in the period... two types of direct investment to explain for the reasons why the investors would like to seek the control Since then, the theory of direct investment was formed In the direct investment of Type