What role do investment promotion agencies (IPAs) play in promoting outward FDI from Japan and South Korea? Our results suggest that source-country IPAs are more effective in promoting outward FDI into politically risky host countries. However, this depends on whether the firm in the source country is listed or unlisted. More specifically, our research has found that the positive effect made by IPAs on outward FDI in politically risky countries is limited to unlisted local firms, which are widely assumed to be less competitive and productive.
Most countries, particularly developed countries, have governmental or semi-governmental agencies that promote the international business activities of the companies within them, including foreign trade and FDI. Likewise, countries set up bodies to attract foreign investment. In fact, one key aspect of globalisation is fierce international competition for inward FDI, which is widely viewed as beneficial for growth and job creation. This competition has contributed to the explosive growth of global FDI, which now exceeds global trade.
There is a growing recognition that FDI generates benefits not only for host countries but for source countries as well. In particular, there are a number of channels through which outward FDI raises the investor’s productivity at home and contributes to the growth and development of its home country. For example, investing abroad helps maximise the efficient use of capital in source countries. It also exposes the company in question to the world’s best business practices, which are subsequently adopted by firms back home. The acquisition of superior foreign technology through foreign investment benefits the investor firm, which may have positive spill-over effects for the recipient country's economy.
FDI is an inherently risky business activity for firms as it involves large costs, particularly when it comes to acquiring information to overcome the lack of knowledge and familiarity with the local market. Investors’ lack of knowledge about consumer preferences, suppliers and other key features of foreign markets is a serious market failure that deters investment in foreign countries. To mitigate the high risks of foreign investment, some source countries have set up governmental or semi-governmental agencies to help their firms venture abroad. Such IPAs promote outward FDI, even though IPAs have traditionally been a tool for attracting inward FDI.
It is often difficult to evaluate the effectiveness of IPAs in promoting outward FDI. More precisely, it is difficult to establish whether the presence of, say, a South Korean IPA office in Thailand encourages South Korean companies to invest in Thailand. The biggest difficulty is the 'endogeneity' problem. That is, the South Korean government may decide to set up an IPA office in Thailand precisely because many South Korean companies are investing in Thailand. This, in turn, may be due to a good relationship between South Korea and Thailand, or Thailand’s relatively attractive investment climate. Omitting such country pair-specific elements and host country-specific elements creates biases in estimates.
Government and semi-governmental agencies have long been active in promoting international business. In particular, they have attempted to expand exports from their countries and attract FDI inflows into their countries. This is because exports and inward FDI have traditionally been viewed as more beneficial for growth and development than imports and outward FDI.
Mirroring this widespread perception, most observational analyses of governmental promotion of international business activities have largely been limited to the effectiveness of export promotion and inward FDI promotion. The balance of evidence from those studies indicates that export promotion has been effective in boosting exports and inward FDI promotion has been effective in boosting FDI inflows.
There is growing recognition that imports and outward FDI can yield substantial benefits for productivity and growth. For example, imports of capital goods embodying superior technology from advanced economies can help lift the technological capabilities of the importing country’s firms and industries. The acquisition of superior technology through outward FDI can generate similar benefits. Some governments have begun to promote imports and outward FDI in recognition of their benefits.
Impact on outward FDI
Our study is the first to empirically investigate the effect of governmental and semi-governmental agencies on outward FDI. To do so, we looked at the impact of the Japan External Trade Organization (Jetro) and Korea Trade-Investment Promotion Agency (Kotra) on Japanese and South Korean outward FDI, respectively.
Intuitively, the role of governmental agencies in mitigating the large risk associated with venturing into foreign markets should be no less pertinent for outward FDI than it is for exports. The recent emergence of developing countries, especially those in Asia, as globally significant exporters of capital and sources of outward FDI renders our study especially relevant for developing countries. In terms of methodological contribution, we seek to address the endogeneity problem inherent in the effect of governmental institutions or agreements on international business activities by using panel data from two source countries. This allows us to control both country pair time-invariant characteristics and host country time-varying characteristics.
Our empirical results strongly confirm the importance of addressing the endogeneity problem in accurately measuring the impact of IPAs on outward FDI. In the baseline case, which does nothing to mitigate the endogeneity problem, we find a significant positive effect of IPAs on outward FDI. That is, our results suggest that Jetro’s presence in the host country has a positive impact on the investments of Japanese firms in that country and likewise for Kotra’s presence in its host country.
When we address only one source of endogeneity – biases from unobservable host country effects – the results are qualitatively the same as in the baseline case. However, the magnitude of the coefficients for IPA variables is smaller than in the baseline case. When we address both sources of endogeneity – both unobservable host country effects and unobservable country pair effects – all IPA variables become insignificant. Our results underline the importance of addressing endogeneity in the empirical analysis of the effect of government promotion of not only outward FDI, but also exports, imports and inward FDI. Failure to do so will overstate the impact of government agencies on international business activity.
When we divide our sample of host countries according to their level of political risk, which tends to be highly correlated with business risk, we find that IPAs are more effective in politically risky host countries. This implies that IPAs can help firms from their countries invest in countries with difficult political and business environments by providing them with relevant local information.
The presence of IPAs from their home countries can also give a psychological sense of security to investors venturing into risky and uncertain markets. However, this result differs between listed and unlisted firms. The positive effect of source-country IPAs on investment in high-risk countries is limited to unlisted firms, which are typically smaller and less productive than listed firms. This is intuitively plausible as the larger and more productive firms have more internal capacity and resources to navigate the turbulent waters of high-risk markets.
Our findings entail a number of policy implications. At the broadest level, our failure to find a significant positive effect of IPAs on outward FDI once we fully tackle endogeneity problems implies that the presence of source-country IPAs per se does not promote investment from home country firms. That is, setting up an IPA office in a country may or may not be effective in increasing investment into that country. Further analysis indicates that the returns to IPAs are higher for assisting small, less productive firms and for promoting investment in politically risky countries. In this context, it is interesting to note that encouraging small and medium-sized enterprises (SMEs) to venture abroad has recently emerged as one of Jetro’s key policy objectives.
Our evidence lends empirical support to Jetro’s singling out of SMEs as a group that would benefit from its assistance. Our evidence also implies that it is more productive for IPAs to locate their offices in high-risk countries than in low-risk countries. The policy implication for high-risk host countries is that attracting IPAs can lead to more investment from the IPA's home countries. Of course, the more fundamental long-term challenge for such countries is to reduce their political risk level, but in the short run the presence of foreign IPAs can boost FDI inflows.
Kazunobu Hayakawa is with the Institute of Developing Economies, Japan
Hyun-Hoon Lee is with the Kangwon National University, Korea
Donghyun Park is with the Asian Development Bank, Philippines