The impact of foreign direct investment on economic growth a case study of vietnam

The Impact of Foreign Direct Investment on Economic Growth: A case study of Vietnam Name: Luong Hai Dinh Student ID: 22080922... The FDI, economic growth, job creation, impoverishment, a

Dissertation submitted in partial fulfillment of the

Requirement for the MSc in Finance

Supervisor: Prof Dr Do Thi Van Trang

September 2023

The Impact of Foreign Direct Investment on Economic Growth: A case study of Vietnam

Name: Luong Hai Dinh Student ID: 22080922

Executive summary

Economic growth is considered one of the important factors to evaluate the development of a country For developing countries, it is much more important for emerging countries to enhance economic growth as a means of maintaining social stability Despite its remarkable progress after the end of the war in 1975, Vietnam is still a developing nation with low domestic revenue and private sector capital Due to this, throughout the past ten years, foreign direct investment (FDI) has been a significant source of funding for Vietnam (UNCTAD, 2023)

Theoretically, FDI brings about many positive effects on the host country In particular, FDI leads to the creation of entrepreneurship in the host nation As new foreign enterprises enter the market, sectoral output rises, and local prices fall Foreign and domestic businesses operate more effectively as productivity increases competition in the host country as local firms expand capacity through education and training In addition, foreign companies offer resources to the host nation in the form of technological innovation, which has a multiplier impact on domestic businesses' ability to produce goods and raise GD Not to mention, FDI serves as a bridge for foreign exchange, giving local businesses great opportunities for foreign capital infusion, and investments are expanding rapidly in the long run Innovative marketing and distribution channels are also opened by foreign businesses, improving access to international markets On the other hand, Moran (1998) identified four main negative consequences of FDI First, FDI reduces domestic savings and investment by extracting rent and siphoning money through local capital markets and local foreign exchange supply Second, MNEs displace domestic producers, reducing the output of domestic inputs Thirdly, domestic suppliers in the host nations are anticipated to benefit from FDI's backward connections However, developing countries do not grant their citizens similar advantages Fourth, the majority of businesses break the laws governing safety, health, and the environment in the nations where they do business

Hence, the main objective of this study is to examine how FDI affects employment and economic growth in Vietnam The FDI, economic growth, job creation, impoverishment, and human capital variables used in this analysis are all annual time series for Vietnam The main data sources for this study, which spans the years 2000 to 2021, were the Vietnam Bureau of Statistics and the World Bank Development Indicators (WDI) databases The IMF, Bank of Vietnam, and the database of the United Nations Conference on Trade and Development (UNCTAD) were other sources of data

Hypotheses of the study are as follows:

 H1 (+): An increase in FDI inflows will boost economic growth

 H2 (+): An increase in domestic investment will boost economic growth

 H3 (+): An increase in trade openess will boost economic growth

 H4 (+): An increase in human capital inflows will boost economic growth

 H5 (-): An increase in inflation rate will hinder economic growth

The findings show that FDI has a positive impact on economic growth This finding agrees with some FDI-led growth hypodissertation' proponents (Borensztein et al., 1998; Lean & Tan, 2011; Insah, 2013; Iqbal & Abbas, 2015) The establishment of numerous industrial sectors in Vietnam with high demands for technology and added-value products, such as machinery manufacture, energy, computers, and telecommunications, has been directly supported by FDI, which has been

a crucial driver of economic growth

In addition, economic growth is also positively impacted by domestic investment, trade openness, and human capital, but negatively impacted by inflation rates These results are in line with some earlier research (Bahname, 2012; Yaseen, 2014; Adamu et al., 2015) The study also highlights

the importance of human capital in sustaining economic growth A higher degree of human capital tends to encourage economic growth by pushing aggregate output growth, preventing marginal product decline, enhancing cross-sector knowledge transfer, and facilitating reverse engineering

As FDI has a great contribution to Vietnam’s economic growth, there should be more policies being implemented relating to fiscal and monetary aspects so that Vietnam can reap more benefits from foreign investments The government should also adopt openness as a key international trade philosophy to promote FDI and exports At the same time, it is important for the government to maintain macroeconomic stability by controlling inflation as this monetary policy is proven to have a negative impact on domestic economic growth

Acknowledgement

All those who contributed to the successful completion of this dissertation have my most sincere gratitude Without the continuous support and encouragement of these people, my study journey, which was both tough and fulfilling, would not have been done

I would like to show my sincere deep gratitude to Prof ten giao vien, my dear Supervisor My perspective on economic issues changed while she was in charge This sharpened my analytical perspective and study focus She has provided me with a tremendous deal of insight and information, as well as constant criticism of my work and demands that I perform better Your dedication and enthusiasm motivated me to put in a lot of effort, which improved the quality of

my dissertation and strengthened my research abilities Her unwavering assistance cannot be returned

I also want to thank my family from the bottom of my heart for never losing faith in my abilties and for always supporting me Your kindness and encouragement have been my inspiration

I want to thank you to my friends and classmates for being an inspiration and for being a solid shoulder for me to lean on when I met any difficulties in life

I would also like to express my gratitude to the library staff and anyone else who helped with this study in whatever manner

This dissertation is proof of the combined efforts of everyone who has always loved and helped

me I appreciate you taking part in this significant milestone in my life

Contents

Executive summary 3

Acknowledgement 6

List of Abbreviations 9

CHAPTER 1: INTRODUCTION 10

1.1 Background 10

1.2 Research problem 11

1.3 Research objectives 12

1.4 Data and Methodology 12

1.5 Dissertation Outline 13

CHAPTER 2: Vietnam – a developing economy 14

2.1 Overview of Vietnam 14

2.2 Economic reforms 14

2.3 Government expenditure reforms 15

2.4 Vietnam’s openness policy 16

2.5 Economic growth after the adoption of Economic Reforms 17

CHAPTER 3: FDI and Investment regulations in Vietnam 20

3.1 FDI Inflows into Vietnam 20

3.2 Investment regulations in Vietnam 21

CHAPTER 4: FDI Theories and its economic importance 26

4.1 Definitions 26

4.2 FDI Theories 27

4.3 The Economic Importance of FDI 30

CHAPTER 5: Methodology and data 33

5.1 Modelling Economic Growth 33

5.2 Measuring Economic Growth 35

5.3 Methodologies and data 36

CHAPTER 6: Results and Discussions 40

6.1 Regression analysis 40

6.2 Diagnostic tests 44

CHAPTER 7 Conclusion and Recommendations 45

References 47

Appendices 53

List of Abbreviations

CPI Consumer Price Index

DI Domestic Investment

GDP: Gross Domestic Product

GDPGR: Gross Domestic Product Growth Rate

GOV: Government of Vietnam

GSOV: General Statistics Office of Vietnam

IMF: International Monetary Fund

IR: Inflation Rate

OECD: Organisation of Economic Cooperation and Development

SMEs: Small and Medium Enterprises

MNEs: Multinational Enterprises

SOE: State Owned Enterprise

TOT: Terms of Trade

TO: Trade Openess

UNCTAD: United Nations Conference on Trade and Development

VAT: Value Added Tax

WOEs: Wholly Owned Enterprises

WTO: World Trade Organisation

CHAPTER 1: INTRODUCTION

1.1 Background

Economic growth is considered one of the important factors to evaluate the development of a country For developing countries, it is much more important for emerging countries to enhance economic growth as a means of maintaining social stability The governments of these countries have been working to reduce unemployment and poverty Despite its remarkable progress after the end of the war in 1975, Vietnam is still a developing nation with low domestic revenue and private sector capital Due to this, throughout the past ten years, foreign direct investment (FDI) has been a significant source of funding for the nation (UNCTAD, 2023)

The table below shows the growth of FDI inflows in Vietnam:

Figure 1.1 FDI in Vietnam 1986 – 2022 (USD billions)

Vietnam has implemented a wide range of investment-favoured policies to draw FDI, which will speed up economic growth and lower unemployment Since attaining independence in 1975, the Government of Vietnam (GOV) has made economic change a top priority The GOV

implemented a number of economic changes with the goal of drawing FDI from multiple nations

in Europe and America in order to raise the standard of life in Vietnam FDI in Vietnam has expanded since the reforms, rising from USD 30 million in 1985 to USD 4,146.13 million in

2022

There is no denying that FDI has considerably boosted Vietnam's economic growth and standard

of living The effect of FDI on this country's economic growth has been the subject of some research However, there are still some restrictions with the methodology used and the reference period, which has to be updated

1.2 Research problem

Since 1985, FDI has positive effects on Vietnamese economy by accelerating economic growth, generating employment and reducing poverty in the long run However, some empirical findings suggest contrasting findings about the contribution of FDI to host economies, especially in developing countries The main reasons for contrasting results include total factor productivity, explained by the Solow-Swan Model and other factors explained by the Malign Model, such as the absorptive capacity of the host nation, crowding out local firms, especially in regard to market-seeking FDI While some countries have experienced a positive contribution of FDI to their economies, in some instances a negative relationship has been noted Mucuk and Demirsel’s (2013) study on the effects of FDI on employment in 7 developing countries revealed differnt results While FDI decreased unemployment in Thailand, it raised unemployment in Turkey and

Argentina The main issue this study seeks to address is: What is the impact of FDI on economic

growth in Vietnam? As previously mentioned, there is a dearth of knowledge regarding this topic

Many people believe that newly industrialized nations like Hong Kong, Singapore, and Korea have been successful in achieving high rates of economic growth via drawing FDI Through FDI,

these nations grew quickly, providing Vietnam with a useful lesson The results of this study will

be important to Vietnamese policymakers, investors, communities, and academics If FDI increases economic growth and employment, policymakers should be pushed to create relevant and practical regulations to draw FDI into key sectors that benefit regional economies and provide employment opportunities for the unemployed Through the findings of this study, Vietnam will be given the opportunity to adopt pro-investment policies that will make it a more attractive location for FDI and, as a result, provide it with more growth prospects Long-term growth in income and welfare will make it possible for communities, particularly the rural and urban poor, to escape poverty

1.3 Research objectives

The main objective of this study is to examine how FDI affects employment and economic growth in Vietnam The impacts include:

 to provide an analysis of economic growth in Vietnam in recent decades

 to provide in-depth understanding of FDI, including its worldwide trend, advantages, and disadvantages

 to assess the extent to which FDI has influenced employment in Vietnam;

 to assess the impact of other economic factors (human capital, inflation, trade openness and domestic investment) contributed to Vietnam’s economic growth

1.4 Data and Methodology

The FDI, economic growth, job creation, impoverishment, and human capital variables used in this analysis are all annual time series for Vietnam The main data sources for this study, which spans the years 2000 to 2021, were the Vietnam Bureau of Statistics and the World Bank Development Indicators (WDI) databases The IMF, Bank of Vietnam, and the database of the

United Nations Conference on Trade and Development (UNCTAD) were other sources of data

1.5 Dissertation Outline

There are 7 chapters in this dissertation

In Chapter 1, a background of the research topic will be provided, including research objectives and research problems

In Chapter 2, the political, governmental and economic history of Vietnam is given an overview

It examines the transition of Vietnamese economy since independence

In Chapter 3, the historical context of foreign investment in Vietnam is analysed along with the legal framework that creates an enabling environment for investment

In Chapter 4, theories about FDI will be discussed as well as its importance to an economy

Chapter 5 presents the theoretical framework and defines the variables and data collection process An explanation of the hypotheses proposed in the research is also provided

In Chapter 6, the effects of FDI as well as some other factors on economic growth in Vietnam will be discussed in depth

In Chapter 7, the study is summarised, along with its conclusions, limitations, and some recommendations for future research topics

CHAPTER 2: Vietnam – a developing economy

2.1 Overview of Vietnam

Vietnam is blessed with an abundance of natural resources, including mineral deposits, freshwater fish, good land, and a tropical climate with consistent rainfall Over 70% of the workforce is employed in agriculture, making it the most significant sector of the economy (GSOV, 2021) Vietnam had a robust, young, diverse economy at the time of its independence in

1975, and this was due to the country's enormous natural resources

2.2 Economic reforms

After attaining independence from the USA, the GOV implemented major and ongoing economic reforms in an effort to boost economic growth and decrease poverty The World Bank and IMF provided assistance in putting these into action The Poverty Eradication Action Plan (PEAP),

which had five elements, was introduced by the GOV in 1997 to implement the ERP Pillar 1:

Managing the economy; Pillar 2: Improving output, competitiveness, and income; Pillar 3: Disaster management; Pillar 4: Good governance; and Pillar 5: Human development

Through strong economic growth and employment, PEAP has sought to mitigate poverty First, it seeks to promote human capital development and streamline fiscal policy reforms Second, inflation is controlled through monetary and financial reforms Third, trade strategies have been implemented to promote private investment while promoting global trade, communication and tourism

With the implementation of these reforms, the GDP went up from more than USD 6.29 billion in

1989 to USD 408.80 billion in 2022 In the meantime, GDPGR has experienced an overall

increasing trend over the period, and it is consistently higher than a 6% level Economic and social indices show that Vietnam's economy has generally grown between 1986 and 2022 This accomplishment can be credited to the GOV's adoption of numerous macroeconomic reforms

2.3 Government expenditure reforms

Through the Medium-Term Economic Framework, the GOV enacted changes to fiscal policy in the administration of governmental expenditures (Fan & Zhang 2008) The changes intended to increase management and accountability, decrease impoverishment, and increase economy as well as efficient use of public resources By establishing public projects funded by domestic tax income and grants, fiscal changes were intended to increase openness in the national budget process Because of this, government spending has dramatically expanded since 1990, reaching almost 785,000 billion VND (USD 32.63 billion) in 2022

Figure 2.4: Total government spending in billion VND from 1990 – 2022

The sectoral composition of government spending reflects the GOV's priorities The

government's primary interests are public administration, defense, and education

2.4 Vietnam’s openness policy

The openness of a country is reflected in its outward-looking domestic and international trade policies, as well as FDI investment Through access to global markets, openness enables a country to innovate and spread technology as well as knowledge (Ramanayake & Lee, 2015) For a developing nation like Vietnam, openness can open up access to niche markets for exported goods and to affordable advanced technology for product manufacturing The nation's standard of living can enhance thanks to openness since it can obtain cheaper items and improve domestic output The government established openness to encourage trade as well as investment as a way

to boost growth in the economy, job creation, and poverty reduction The Export-Led Growth Strategy (ELGS) initiative was devised

The role of openness in a country like Vietnam can be demonstrated in the factors, such as capital accumulation and productivity, which have contributed to the growth of GDP per capita (Babula

& Andersen 2008) International flows from industrialised nations to developing nations can be more easily transferred when there is greater openness Vietnamese-made products and services can reach markets outside of Vietnam through international trade The ability to acquire technology transfer, such as information communication technology (ICT), is made possible by imports for businesses established in Vietnam Skills acquired through training abroad and in Vietnam can be easily transferred through the movement of people Vietnam could grow even more as a tourist destination Additionally, FDI can promote capital accumulation, which raises output and productivity Four essential factors—contribution to the current account, tax income, production, and productivity—can be used to quantify the benefits of trade for Vietnam

2.5 Economic growth after the adoption of Economic Reforms

Early in the 1980s, Vietnam began to implement economic reforms, which contributed to tremendous economic growth GDP in 2005 constant market price climbed from USD 2,708 million in 2000 to USD 16,406 million in 2022 The capital stock expanded from approximately USD 12,900 million to USD 81,500 million, reflecting an annual capital accumulation of USD 35,300 million and expanding at a rate of 6.6% per year At the same time, yearly headline rates

of inflation declined from 158% to 4.3%, showing that Vietnam has worked to achieve macroeconomic stability

Vietnam's economy has seen a significant shift after the reforms, as shown by the GDP growth rates from 2003 to 2022 In particular, it grew steadily and favourably during this time Vietnam maintained good growth even throughout the 2008–2009 global financial crisis, which can be attributed to its adaptability and broad economic basis As can be seen from the graph below, growth rates are consistently higher than a 6% level It is obvious that economic reforms, trade liberalisation, and appropriate policies to promote foreign investment have had a great contribution to Vietnam becoming a manufacturing and export centre, boosting the whole economy

From 2000 to 2005, Vietnam's GDP grew by 6.9% annually on average Vietnam become the third-largest GDP growth in 2005 with 7.5%, followed by China's (14.2%) and India's (7.9%) The two following periods, 2006–2010 and 2011–2015, saw a drop in average GDP growth to 6.3% and 5.9%, respectively The 2007–2008 financial crisis resulted in a 5.6% decline in GDP growth in 2008 and sluggish development from 2011 to 2013 After that Vietnam's GDP increased by 6.4% in 2010 before falling to 6.2% in 2011 and 5.3% in 2012 The average GDP for the years 2016 through 2019 was 6.8%, exceeding the 5-year plan's aim of average growth of

6.5% to 7% It is worth noting that the global economy suffered significantly in 2020 due to the COVID-19 pandemic and Vietnam is not an exception e economy expanded by about 3% despite the Covid-19 outbreak, making it one of the few nations in the area and the world to have positive growth (World Bank, 2023)

In a nutshell, the size of the economy has greatly increased, and the well-being and living standard of Vietnamese citizens have been immensely enhanced, assisting Vietnam to move from being a poor and underdeveloped country to one of the world's middle-income countries since

2008 GDP increased by 18 times from the first year of the economic reform to about 262 billion USD in 2019 (World Bank, 2023)

Figure 2.5 – GPD growth rate in Vietnam from 2003 – 2022 (World Bank, 2023)

The percentage of the population living in poverty has decreased, going from roughly 66% in

1985 to just around 20% in 2022 Over the same period, GDP per capita climbed from 185 to 434 USD Despite the economy's strong growth, roughly 43% of the population—over 15 million

people—were classed as insecure non-poor in 2022 (GSOV, 2022) In contrast, the Gini coefficient shows that there was an increase in income inequality from 0.36 in 1992 to 0.40 in

2014 The administration continues to prioritise eliminating poverty

CHAPTER 3: FDI and Investment regulations in Vietnam

3.1 FDI Inflows into Vietnam

After gaining independence, the newly formed government had two key responsibilities in an endeavour to completely restructure the entire economy Its primary goal was to help diversify the economy and provide prosperity to the country Since the US was no longer in control of the country, the second purpose was to wield both economic and political influence Communities needed to be given more control, and the economy needed to be indigenous The Vietnam Industrial Act was passed by the government in 1978 in order to accomplish this This encouraged international investors to extend their involvement in the economy while encouraging local investors to take part in industrial growth

Vietnam has maintained its status as a top location for foreign companies to invest thanks to economic statistics indicating continuing growth pace According to information from the Ministry of Planning, the nation's various provinces received more than $27.5 billion in FDI in

2022 In 2021, there were totally 108 countries and territories pouring investments into Vietnam Among these countries, Singapore ranked the first, injecting approximately $6.5 billion in capital, accounting for roughly 25% of the total FDI received this year Singapore has been also Vietnam’s leading source of foreign investment for many recent years Ranking second is South Korea, with approximately $5 billion registered in 2022 This country is the home base of tech giants LG and Samsung, 2 of Vietnam’s most significant foreign investors Since the first day of entry into Vietnam 30 years ago, South Korea has cumulatively undertaken more than $80 billion worth of investment, with about 10,000 projects Following these two countries, Japan, China, and Hong Kong are the 3rd, 4th, and 5th largest FDI sources for Vietnam in 2022 in East Asia

Denmark, which made a $1 billion investment in Vietnam to construct its Lego factory in Binh Duong, came in 6th (Alpuerto, 2022)

Following the modifications, the sectoral distribution of registered foreign investments shows a shift away from investment in agriculture and toward other sectors The industry of manufacturing, which includes import-substitution consumer goods for instance sugar, tea, bread, and soap, has drawn the greatest amount of foreign investment Additionally, new industries have developed, including those in real estate, hospitality, and catering as well as in community social services like educational institutions and hospitals Vietnam has been believed to be a best choice for investment as a result of donors encouraging Vietnam to adopt rules for an investment-friendly environment

3.2 Investment regulations in Vietnam

Vietnam is a signatory to bilateral agreements, regional trade agreements (RTAs), and investment treaties It is also a member of the United Nations and its related organizations International and regional duties pertaining to equality, transparency, resolution of conflicts, property rights, financial standards, and taxation restrictions are reflected in Vietnam's FDI regulations

3.2.1 Most Favoured Nation regulations

The MFN clause mandates that nations refrain from making discrimination between their trading and investment partners under the terms of the WTO agreements MFN is enshrined in Vietnam’s border regulations regarding entry and the establishment of business in Vietnam Investment as well as trade partners with Vietnam are treated equally According to the principle

of reciprocity, all visitors from other countries, including tourists, are required to shell out entry visa fees of around USD $50 for a single-entry visa

Company registration Investment license Obtain other licenses

Since Vietnam's economy is liberalized across the board, international investors are empowered

to create businesses in any industry they are interested in Vietnam has welcomed FDI projects from about 108 countries out of 164 WTO members, with considerable ease To establish projects, all UIA registered businesses follow a step-by-step procedure

Figure 3.10: Necessary steps to start an FDI project in Vietnam

Step One: Company Registration

Investors register their businesses with the Ministry of Justice as corporations when entering the

nation According to the Vietnam Enterprise Law - 68/2014/QH13, businesses must get a

certificate of their Memorandum and Articles of Association, and a Certificate of Incorporation

Step Two: Obtaining Investment Licence

All FDI must meet a minimum investment level of USD 100,000 projected investment as proof before an investment license will be issued After getting a license, investors can subsequently access various services and licenses as an OSC for investments

Step Three: Obtaining Other Licences

The quantity and scope of investments differ based on national priorities and goals like the environment, jobs, and land Although all industries have been liberalised, each industry has its own set of regulations Some investors must therefore acquire secondary licenses

Step Four: Application for Utilities

Electricity and water are essential utilities for investment Utility applications are required in order for investors to access services

Step Five: Obtaining Work Permits

According to the Decree 152/2020/ND-CP (Decree 152), foreign workers must obtain work

permits

Step Six: Tax Registration

Each business must register for tax identification numbers for employees as well as VAT identification numbers for their businesses The most significant of these rules are the Income Tax Regulations and Statutory Instruments, VAT and Statutory Instruments, which are part of the

2012 Domestic Tax Laws

3.2.2 Financial Regulations

In Vietnam, financial regulations have been designed to regulate the operation of financial institutions such as banks, brokers and insurance firms, as well as investment companies These regulations are first intended to create a level playing field for protecting investors, markets and consumers, to create financial stability By establishing minimal requirements for enabling the flow of capital, investment, and the mobilization of savings, financial regulations are also meant

to help an economy perform economically (Herring & Santomero, 2000)

The GOV eliminated all capital-account controls and all restrictions on capital transfers into and out of Vietnam in 1997 as a result of the adoption of liberalisation policies Except in exceptional instances relating to GATS, it imposes no limits on goods being imported or exported, or investment in a liberal economic environment Conversion and transfer regulations, depend on

the Law on State Bank of Vietnam 2010 in order to control and sustain stability All financial

institutions must be monitored, regulated, controlled, and disciplined by the law for the purpose

to ensure monetary stability On 26 June 2019, the SBV also issued Circular 06/2019/TT-NHNN

on foreign exchange control of foreign direct investment (FDI) to ensure financial stability and govern investment activities in Vietnam These include instructions on how to proceed, including how the funds ought to be transferred

FDI enterprises and foreign investors which take part in business cooperation are required to open direct investment accounts at the licensed credit institutions The capital contribution, the transfer of principal capital, profits and other legitimate incomes must be done via these accounts When it comes to indirect investments, non-residential foreign investors are obliged to open indirect investment capital accounts in VND to perform indirect investment in Vietnam Investment capital in foreign currencies must be converted into Vietnam Dong to make investment via those accounts As for overseas indirect investments, residents, which are not credit institutions, are required to open and use bank accounts, to transfer investment capital abroad, to transfer capital, profit and other earnings back to Vietnam in line with the SBV’s regulations

A number of financial regulations have been enacted to address fraud and money laundering

including the Anti-Money Laundering Act 2012 The content of the regulation requires that during

the remittance of finances, senders and financial institutions are required to know customer information Investors from other countries are allowed to transfer and exchange currencies that are appropriate for the specific transaction Although investors are allowed to exchange and transfer money, there are exceptions for specific foreign investments that receive advantages Based to the restrictions, FDI about incentives from the government requires approval from the Vietnamese Authority Investment, and transfers are required consistent with the aim of the intended repatriation

In order to be compliant with Vietnamese sanitary and phytosanitary standards, further

regulations apply to all investments All businesses are required to pay taxes that are collected

both directly and indirectly These taxes are classified as domestic and customs taxes

CHAPTER 4: FDI Theories and its economic importance

Investments in a portfolio could be domestic or foreign International (Foreign) Portfolio Investment (IPI) is cross-border investment in which a foreign investor acquires a stake in another country in the form of stocks, bonds and other assets, with no long-lasting relationship and a managerial role (Alfaro, 2014) There are also other IPIs of which investors will not establish long-term relationships and have no control over management There are two main components of capital flows: financial derivatives and other residual investments

4.1.2 Foreign Direct Investment

FDI can be defined as a lasting interest investment made by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor The long-term interest suggests that the direct investor and the direct investment company have a long-lasting relationship It also demonstrates the substantial influence on business management

FDI entails the transfer of equity owned by the investors in the company across international borders and gives investors access to the assets of other businesses and other sources, like borrowing via loans and portfolio investments This make FDI different from investment portfolios which do not grant access to the aforementioned privileges In addition, FDI investors typically have a long-lasting engagement with the company and frequently manage it directly, which makes FDI liquidation become difficult

4.2 FDI Theories

4.2.1 International Trade Theories

The 'theory of absolute advantage' developed by Adam Smith in 1776 and the 'comparative advantage theory' developed by David Ricardo later served as the foundation for modern international trade theories These early theories, like those of the mercantilists, did not take into account FDI's contribution to production On top of this, the Heckscher-Ohlin (H-O), often known as the factor endowment theory, began to demonstrate that a nation's commerce would be based on three aspects (Carbaugh, 2004) First of all, tastes and preferences influence demand conditions Secondly, factor endowment promotes competitiveness by utilising readily accessible and inexpensive factor inputs Finally, the use of technology also helps to facilitate production Although FDI was not pointed out as other prior theories, the H-O theory laid the foundation for later FDI theories like the Portfolio Investment Theory (PIT) as well as later FDI theories

The PIT started as a perfect market-based theory (Gamal, 2008) Building on international trade theories, the PIT was first proposed by (Markowitz, 1952) According to Markowtiz (1952), portfolio selection was based on the law of large numbers, where the actual yield of the portfolio

is almost the same as the expected yield Therefore, investors should diversify and maximise expected returns by investing in securities that provide maximum expected return Later, Tobin (1958) developed the Portfolio Theory of Money according to four assumptions First, all investors are risk averse Second, people hold their wealth in two forms: money and non-money assets Third, the values of the two parameters (interest rate and real wealth) enable investors to rank portfolios, providing maximum utility Fourth, investors’ portfolio decisions are made based

on specific periods

4.2.2 Capital Movements Theory

The influential Capital Movements Theory, which made the first attempt to explain FDI, was created by Mundell (1957) based on the theoretical underpinnings of theories of international commerce As an extension of the H-O Theory and in response to the early PIT, Mundell created

a fundamental model to describe both capital and trade movements Because of tariffs, capital flows from a high-tariff to a low-tariff nation, given the assumption that products and factors of production in these nations are alike (Denisia, 2010) Therefore, trade and capital movements serve as alternatives, and capital flows decrease imports FDI's function as a factor input was not explained by Mundell's model Trade and capital flows are separate things Even with limitations, Mundell's Capital Movements Theory became a valuable tenet of FDI theories

4.2.3 Transaction Cost Theory as a Basis for FDI

Transaction costs which consist of all expenses concerning a company’s operational activities lay

a foundation for FDI flows through cheaper costs, as a way to gain greater profit There are two

reasons why FDI exists by internalisation theory (Buckley & Casson, 1976) The first is that businesses pick low-cost nations to establish themselves The second reason is that businesses may keep localising by cutting expenses up until the advantages of further internalisation exceed the disadvantages Although this theory can explain FDI, it was still considered ambiguous to explain the reason behind internalisation, along with failing to explain FDI in a short term

4.2.4 Kojima’s Japan FDI Model

According to Kojima, FDI coming from Japan is trade-oriented, but FDI coming from the USA is anti-trade Kojima came up with five ideas as the driving forces behind FDI in accordance with the H-O and Rybczynski theory of comparative advantage First, trade-oriented was the classification given to FDI that sought for resources from nature MNEs make investments in products with a comparative advantage in the host nation because of comparative disadvantages

in the home country In order to offset its comparative disadvantage, the home nation boosts imports of basic and manufactured goods, which leads to a growth in vertical specialization Second, it was also thought that FDI that was labour-oriented was trade-oriented As wages increase in industrialised countries, developing countries gain a comparative advantage in labour-based industries This makes it advantageous and sensible for a developed country to locate its conventional labour-intensive businesses in low-wage nations in which labour is inexpensive Investment that is labour-focused is export-oriented, not import-substituting

4.2.5 The Exchange Rates Theory

The FDI Exchange Rates Theory was proposed by Aliber (1970) who believes that businesses in countries with strong currencies, such as the USA and the UK, frequently make investments overseas whereas businesses in countries with weak currencies are unable to do so For instance, Vietnam attracts FDI inflows from strong-currency nations because currency depreciation