The characteristics that make a country attractive for FDI, the so-called location advantages (LAs), vary in their level of sophistication, from generic (cheap labour and basic infrastructure), to highly advanced (strong research and development capabilities and world-class labour).
Most developing countries have adopted the free market approach to their economic policies, thus making their LAs visible to multinational corporations. Accordingly, the offer of generic LAs, usually located in developing countries, is relatively high while the offer of sophisticated LAs, typically found in advanced economies, are more rare. The potential benefits for FDI are amplified for developing countries, given the urgency that they have for economic development, their limited means and the fierce competition among them in attracting FDI.
From the companies’ perspective, more potential locations for investment mean a more complex evaluation process, plus the bigger risk posed by the lack of historical FDI data for such countries.
It is rational then to present this case along two axes:
- Stock of FDI: LAs determine the amount and sophistication of FDI that a country is able to attract;
- Utilisation of the FDI stock: based on the mechanisms by which the LA of a country benefits from the presence of the FDI stock in the country. Additionally, the manner in which LAs develop over time is critical for companies that have invested in that country for the long-term configuration of their global strategy.
Comparing Mexico and Costa Rica
By adopting free market and FDI-conducive policies, Mexico and Costa Rica have made their LAs visible to companies, thus attracting significant FDI flows since the early 1990s. The internationalisation level of their economies (as measured by the FDI stock as a percentage of GDP) is comparable to that of France (2005 figures: Costa Rica 25.8%, Mexico 27.3%, France 28.5 %). On the other hand, their performance in attracting FDI is different.
According to the latest United Nations Committee on Trade and Development’s World Investment Report, Costa Rica is performing above expected for a country of its size while Mexico is performing below its potential. Moreover, the way the two countries utilised their FDI inflows was different: Costa Rica integrated the FDI sector with the domestic economic sector more fruitfully. The two stages that will be analysed here are the FDI inflow and the FDI utilisation stage.
For Mexico, the most important LAs in the early 1990s were: the proximity of the country to the largest economy in the world (the US); the dedication of the country to the free-market policies confirmed in the North American Free Trade Agreement (NAFTA); and very low-cost labour. These LAs attracted large FDI inflows to the country. Some LAs are fixed (such as geographic LAs), unaffected by the level of global competition; other LAs such as NAFTA are static, while LAs such as cheap labour inevitably erode over time due to increased global competition
If NAFTA was the event that unleashed the FDI potential of Mexico, the milestone for Costa Rica was the $300m semiconductor assembly test plant Intel investment in 1996, because of its relative importance, given the size of the country and the positive effect it had in attracting further FDI projects. The major LAs of Costa Rica at the time were: the political stability of the country; a low-cost but technically well-educated workforce; and a dedication to free market and FDI policies. Nevertheless, Costa Rica was not even short-listed by Intel as a potential host country for its investment in Latin America.
Sophisticated and co-ordinated efforts by the Costa Rican investment promotion agency and the government managed to convince Intel that Costa Rica was the right choice for its investment. They convinced Intel that attracting FDI in the high-tech sector was a high priority for the country; they provided it with highly credible investment incentives; and they stressed the fact that the education system was geared towards the high-tech sector.
Although Mexico attracted large FDI inflows, the knowledge spillovers to the local economy (the most important long-term FDI benefit for a host country) have been limited. These spillovers are based on the linkages of the FDI sector with the local economic sector. However, more than 95% of the inputs that the companies’ subsidiaries use in Mexico are imported rather than sourced from local firms. And Mexico has not upgraded its education system to match its FDI-led development goals, limiting its absorptive capacity for knowledge spillovers.
More countries have entered the competition globally for FDI, offering similar but lower-cost LAs, such as cheap labour. Thus, the competitive position of Mexico in attracting FDI has been eroded because it competes with basically the same LAs in a much harder competitive environment.
Mexico does enjoy fixed LAs and the proximity to the US, and large amounts of FDI still flow into the country but it is largely the same quality as 10 years ago; and still the FDI sector is fairly excluded from the local sector. Both of these factors limit the country’s FDI utilisation capabilities.
Similarly in Costa Rica, major investors such as Intel initially neglected to create strong linkages with the local economy, except in related industries such as packaging. However, the investment of multinational corporations in the Costa Rican education system at all levels (primary, secondary, university) has been a key contribution. The importance of such a linkage has not only helped the companies to reinvigorate their operations in the country over time, but has also helped the already competitive local software industry to upgrade its human resources to become even more competitive.
Intel, for example, has upgraded its initial plant for more value-added electronic products, such as chipsets, and has expanded lately to software development. The local software sector managed to attract high-quality FDI, often in terms of joint ventures with local firms, thus optimising the knowledge spillovers to the local economy. The fact that Microsoft has leading Costa Rican software firm ArtinSoft as its preferred supplier of worldwide upgrade services for customers confirms such a case. Costa Rica is now competing for relatively high-quality FDI not only in the information and communications technology (ICT) sector, but also in other advanced sectors, such as in medical devices, and in shared service centres.
The public policy and corporate strategy implications from these two examples can be summed up as follows:
- FDI works best as an accelerator rather than the sole driver for economic growth in developing economies. This can be achieved through the connection of the FDI sector with the local sector of the economy through linkages and increased absorptive capacity of the local sector, as, for example, the software industry of Costa Rica. This evidence supports the integration of FDI into a wider framework for economic development that would emphasise the increase in the competitiveness of the local sector and the local education system with FDI as an accelerator.
- Location advantages are dynamic and not static. LAs such as cheap labour are bound to erode over time as more countries enter the competition for FDI, often with stronger generic LAs. Even LAs such as participation in regional free trade agreements and proximity to a large economy decrease in importance over time because more countries enter into such agreements, and because dependence in one or a few countries on FDI inflows ignores the fact that the FDI outflows increasingly come from a larger number of countries. This underlines the need of host countries to upgrade their LAs over time to remain in a competitive position.
- A country’s ability to improve its LAs is highly relevant for multinational corporations. FDI usually has a long-term time frame and involves a large financial cost. The selection of a host country should take into account the erosion of the host country’s initial LAs as more countries enter the global economic system. If the initial LAs do not improve, then global competitive pressures inevitably result in the companies operating in a non-optimal location. This decrease in the company’s competitive position may result in significant exit costs incurred by relocation of the investment to another country, together with the reputation cost resulting from such a withdrawal. Hitachi, for example, has recently experienced these costs by deciding to relocate the production of its 4500-job hard-drive plant from Mexico to China, Thailand and Philippines because of competitive pressure.
- Institutions and state capacity are important in both attracting and utilising FDI. A credible structure of investment incentives, an open-to-change education system compatible with the FDI utilisation effort, in addition to a well co-ordinated and credible FDI promotion effort, require a far more sophisticated institutional capacity than merely adopting free market policies to demonstrate the location advantages of a country.