Worldwide foreign direct investment (FDI) inflows continued their upward climb in 1997 for the seventh consecutive year. Seemingly unaffected by the Asian financial crisis, they increased by 19 per cent to a new record level of $400 billion, while outflows reached $424 billion (table 1). The capital base of international production in 1997, including capital for direct investment purposes drawn from sources other than transnational corporations (TNCs), is estimated to have increased by $1.6 trillion in 1997.

The world’s 100 largest TNCs (see table 2 for the top 25 of those firms) show a high degree of transnationality as measured by the shares of foreign assets, foreign sales and foreign employment in their total assets, sales and employment. The top 50 TNCs headquartered in developing countries (see table 3 for the top 25 of those firms) are catching up rapidly. The composite index that combines all three shares bears this out: the top 50 TNCs headquartered in developing countries have built up their foreign assets almost seven times faster than the world’s top 100 TNCs between 1993 and 1996 in their efforts to transnationalize. The transnationality index of the former was 35 per cent in 1996, while that of the latter was 55 per cent. While the value of the index for the top 100 TNCs is higher, it did not change significantly between 1990 and 1995. In contrast, the value of the index for the top 50 developing country TNCs has been increasing steadily throughout the 1990s. Naturally, there are significant differences by type of industry, with telecommunications, transport, construction and trading being the most transnational in the case of the top 50 developing country TNCs, while food and beverages, chemicals and pharmaceuticals, and electronics and electrical equipment were the most transnational among the world’s top 100. The ranking of TNCs by the different transnationality indexes also differs: although General Electric tops the list of the largest 100 TNCs ranked by the size of foreign assets, Seagram ranks first in the composite index of transnationality. Likewise, Daewoo Corporation topped the list of the 50 largest developing country TNCs by foreign assets, but Orient Overseas International ranked first in the composite index of transnationality. Not surprisingly, firms at the top of the composite transnationality index are from countries with small domestic markets.

The impressive numbers documenting the growth of international production disguise considerable variation across and within regions. There is no doubt that the developed countries, with more than two-thirds of the world inward FDI stock and 90 per cent of the outward stock, dominate the global picture, but their dominance is being eroded (table 4). Developing countries accounted for nearly a third of the global inward FDI stock in 1997, increasing from one-fifth in 1990. It is in flows of inward FDI that developing countries have made the biggest gains over the 1990s, with their values as well as shares of global inflows increasing markedly: from $34 billion in 1990 (17 per cent of global inflows) to $149 billion in 1997 (37 per cent of global inflows) (table 5).

Continued strong economic growth in the United States, improved economic performance in many Western European countries, and the mergers-and-acquisitions (M&As) boom are the principal reasons for the acceleration of inflows to developed countries in 1997 (an increase of almost a fifth over 1996, to $233 billion). The United States received $91 billion in inflows, accounting for more than one-fifth of global inflows, and invested $115 billion abroad during the year. Among the countries of the European Union, the United Kingdom received $37 billion (just under a tenth per cent of global inflows) in 1997; in contrast, for the second successive year, Germany registered net FDI withdrawals. Outflows from the European Union were $180 billion in 1997, and a renewed interest in European integration prompted by the expected advent of the Euro in 1999 led to a spurt in the share of investment directed to member countries. Japan received $3 billion in 1997, a record figure, though still low compared to other developed economies, and invested $26 billion abroad.

During 1997, 151 changes in FDI regulatory regimes were made by 76 countries, 89 per cent of them in the direction of creating a more favourable environment for FDI (table 6). New liberalization measures were particularly evident in industries like telecommunications, broadcasting and energy that used to be closed to foreign investors. New promotional measures included streamlining approval procedures and developing special trade and investment zones (adding to the many such zones already in existence). During 1997 alone, 36 countries introduced new investment incentives, or strengthened existing ones. The network of bilateral investment treaties (BITs) is expanding as well, totalling 1,513 at the end of 1997 (figure 3). In that year one BIT was concluded, on the average, every two-and-a-half days. The number of double taxation treaties also increased, numbering 1,794 at the end of 1997, with 108 concluded in 1997 alone (figure 3). The common thread that runs through the proliferation of both types of treaties is that they reflect the growing role of FDI in the world economy and the desire of countries to facilitate it. Discussions of regional initiatives are taking place in most regions in the context of new or existing agreements. On the American continent, negotiations on the Free Trade Agreement of the Americas (FTAA), intended to incorporate a comprehensive framework of rights and obligations with respect to investment, have been launched. If successful, the FTAA will consolidate and integrate the various free trade and investment areas already present in the region. In Asia, the ASEAN Investment Area is scheduled to be established later this year. However, the approach of the ASEAN Investment Area is different from that of other regional initiatives in that it emphasizes policy flexibility, cooperative endeavours and strategic alliances and avoids, at least for now, legally binding commitments. In Africa, there are preliminary discussions on new regional initiatives on investment in the context of the Southern African Development Community (SADC) and the Organization of African States.

The ongoing negotiations on a Multilateral Agreement on Investment at the OECD reached a critical point in 1998 after two years of negotiations, when pressures grew to make them more transparent and to initiate a broad-based public debate on FDI issues. Partly reflecting this situation, a pause for reflection until October 1998 was agreed to by the OECD ministers. Wide-ranging discussions at the multilateral level have, meanwhile, been taking place mainly in the WTO and UNCTAD. The work of the WTO Working Group on the Relationship between Trade and Investment is focusing on the economic relationship between trade and investment; the implications of the relationship for development and economic growth; existing international arrangements and initiatives on trade and investment; and issues relevant to assessing the need for possible future initiatives. UNCTAD, on the other hand, is seeking to help developing countries participate effectively in international discussions and negotiations on FDI, be it at the bilateral, regional or multilateral level. In pursuing this objective, UNCTAD is paying special attention to identifying the interests of developing countries and ensuring that the development dimension is understood and adequately addressed in international investment agreements.

Although smaller than those of developed countries, the increases in 1997 in FDI flows into developing countries are noteworthy because they took place in an environment that presented a complex mix of adverse changes. Unlike other net resource flows such as official development assistance or some other types of private capital, such as portfolio equity investment, FDI inflows increased in 1997, with no developing region experiencing a decline in the level of inflows figure 4).

A new record level of $45 billion in FDI flows received by China contributed to the 9 per cent increase in total FDI flows to Asia and the Pacific in 1997. With $87 billion in 1997, Asia and the Pacific accounts for nearly three-fifths of the FDI inflows received by all developing countries, and for over a half of the developing-country FDI stock. East and South-East Asia, the subregion most affected by the financial crisis in Asia during the second half of the year, also saw a small increase of 6 per cent to $82.4 billion in 1997 but this trend is unlikely to continue in 1998. The five Asian economies most affected by the crisis saw their combined FDI inflows remain at a level almost unchanged from that in 1996. With inflows totalling $2.6 billion in 1997, largely concentrated in oil-producing Kazakhstan and Azerbaijan, Central Asia has become a more important destination for FDI than West Asia, which received $1.9 billion in 1997.

For Asia, and especially the five Asian countries — Indonesia, Malaysia, Philippines, Thailand and the Republic of Korea — stricken by the financial crisis in the second half of 1997, the most important question relating to foreign investment is how the crisis and its economic consequences will affect inward FDI in the short and medium term. FDI plays an important role in the region and could thus assist the countries in the process of their economic recovery. FDI flows to the region have been quite resilient in the face of the crisis, remaining positive and continuing to add to the capital stock of the affected countries while other capital flows, including bank lending and portfolio equity investment, fell sharply and even turned negative in 1997 as a whole (figure 5). This is not surprising given that FDI is investment made with a long-term interest in production in host countries, in order to enhance the competitive positions of TNCs. Nevertheless, neither FDI flows nor the activities of foreign affiliates in the region, in particular in the five most affected countries, can remain impervious to the changes that the crisis has set in motion.

Indeed, the crisis and its aftermath have changed a number of factors that influence FDI and TNC operations in the affected countries, at least in the short and medium term. Some of the changes are actually conducive to increasing FDI flows to the affected countries. One is the decrease for foreign investors in the costs of acquiring assets whose prices have fallen. In addition, the availability of firms seeking capital and the liberalization of policy with respect to M&As makes the entry of foreign investors through the acquisition of assets easier than before. All this makes it easier for TNCs to enter or expand their operations at the present time, if they can afford to take a long-term view of the market prospects in the region or if they produce for export rather than domestic or regional markets.

On the other hand, some consequences of the crisis will affect FDI adversely in the short and medium term. For firms focused on domestic or regional markets, reduced demand and slower growth can be expected to lead to some cancelling, scaling down or postponement of FDI in the most affected countries. However, the impact on domestically-oriented foreign affiliates varies among industries. Foreign affiliates in the services sector are particularly susceptible to local demand conditions, because of the non-tradability of most services. Affiliates producing goods and services that depend mainly on imported raw materials and intermediate inputs would be more seriously affected than those relying on domestic sources. The automotive industry, in which TNCs figure prominently in the region, is a good example of the impact of the crisis and the range of responses: a number of automotive TNCs have scaled down, postponed or even cancelled investment projects in some of these countries; firms have also adopted various other measures to cope with the crisis, including injecting funds to help their financially distressed affiliates and subcontractors, relocating parts production, boosting exports and increasing domestic sourcing.

The implications of the financial crisis for inward FDI are also likely to extend to other, less seriously affected, developing countries in Asia. For one thing, some countries, especially those with close economic links to the countries most affected by the crisis, are likely to experience lower economic growth; some countries may also lose export competitiveness vis-à-vis the countries that have devalued. These factors could reduce their attractiveness as host countries, at least in the short run.

Furthermore, and most importantly, many Asian developing countries, including China, Viet Nam and the least developed countries of the region, depend heavily on FDI from other developing Asian countries (figure 6) and inward FDI flows to them could decrease because of a decrease in outward FDI from the countries affected by the crisis. In 1997, overall outward FDI from developing Asian economies rose, but flows decreased from all the five crisisaffected countries except Indonesia. The crisis is likely to reduce the financial capacities of Asian TNCs (including TNCs from Japan) to undertake FDI on account of valuation losses, increased debt burdens on foreigncurrency denominated loans, and reduced profitability of operations due to contraction of demand. The impact of these factors is further compounded for some TNCs by a credit crunch at home and difficulties in raising funds abroad.

It is difficult to predict how the various factors set in motion by the crisis will affect, on balance, inward FDI to the crisis-stricken countries and to the region as a whole in the short and medium term. Despite their overall resilience, flows to the affected countries and to the region as a whole may well fall in 1998, but much depends on the extent to which the financial crisis spills over into the real sector. Aside from that, given that the FDI determinants proper — regulatory frameworks, business facilitation and, most importantly, economic determinants of long-term growth — are attractive, and that the changes resulting from the crisis have positive as well as negative implications for FDI, there is room for cautious optimism. However, the extent to which these various factors translate into actual flows will depend on the assessment by TNCs of the long-term prospects of the region in the context of their own strategies for enhancing competitiveness.

The turnaround in FDI flows to Latin America and the Caribbean that occurred in the early 1990s was further strengthened in 1997: the region received $56 billion (figure 4) — an increase of 28 per cent over 1996 — and invested a record $9 billion abroad. The increase in inflows accounted for twothirds of the overall increase in inflows to all developing countries. Apart from sustained economic growth and good macroeconomic performance, key factors in the region’s FDI boom were trade liberalization, wide-ranging privatization, deregulation and regionalization. With more than $16 billion in inflows, Brazil emerged as the region’s champion in 1997, surpassing Mexico with $12 billion and Argentina with $6 billion.

FDI flows to Africa have stabilized at a significantly higher level than at the beginning of the 1990s: an average of $5.2 billion during 1994-1996 compared to an average of $3.2 billion during 1991-1993. In 1997, inflows were $4.7 billion, almost the same as in 1996 (figure 4). Judging by data for United States and Japanese affiliates in Africa, the continent remains a highly profitable investment location as companies receive rates of return on their investments that by far exceed those in other developing regions. In addition, almost threefifths of FDI flows from the major home countries of TNCs in Africa — France, Germany, the United Kingdom and the United States — have gone into manufacturing and services since 1989, suggesting that the widely held assumption that Africa receives FDI only on the basis of natural resources is mistaken.

Central and Eastern European economies broke their stagnating FDI trend in 1997 — the first year the region as a whole registered a positive GDP growth rate in recent years — by receiving record FDI flows of $19 billion, 44 per cent more than in 1996 (figure 4). This turnaround took place after a decline of 10 per cent in 1996. The Russian Federation was the leading recipient, mainly in natural resources and infrastructure development. In the other Central and Eastern European economies, most of the FDI growth occurred in manufacturing and services. The FDI pattern, however, remains uneven, reflecting the diverse experiences of countries in the transition to market-based economies, the strengthening of regulatory and institutional frameworks relevant for TNC operations, and privatization efforts.

To explain the differences in FDI performance among countries and to ascertain why firms invest where they do, it is necessary to understand how TNCs choose investment locations. In general, FDI takes place when firms combine their ownership-specific advantages with the location-specific advantages of host countries through internalization, i.e. through intra-firm rather than arm’s-length transactions. Three broad factors determine where TNCs invest: the policies of host countries, the proactive measures countries adopt to promote and facilitate investment, and the characteristics of their economies (table 8). The relative importance of different location-specific FDI determinants depends on the motive and type of investment, the industry in question, and the size and strategy of the investor. Different motives, for example, can translate into different location patterns depending on the investor’s strategy.

The core enabling framework for FDI consists of rules and regulations governing entry and operations of foreign investors, standards of treatment of foreign affiliates and the functioning of markets. Complementing core FDI policies are other policies that affect foreign investors’ locational decisions directly or indirectly, by influencing the effectiveness of FDI policies. These include trade policy and privatization policy. Policies designed to influence the location of FDI constitute the “inner ring” of the policy framework. Policies that affect FDI but have not been designed for that purpose constitute the “outer ring” of the policy framework. The contents of both rings differ from country to country, as well as over time. Core FDI policies are important because FDI will simply not take place where it is forbidden.

It is in the context of a greater similarity of investment policies at all levels that business facilitation measures enter the picture. They include investment promotion, incentives, after-investment services, improvements in amenities and measures that reduce the “hassle costs” of doing business. While these measures are not new, they have proliferated as a means of competing for FDI as FDI policies converge towards greater openness. Furthermore, business facilitation measures have become more sophisticated, increasingly targeting individual investors, even though this involves high human capital and other costs. Among these measures, afterinvestment services can be singled out because of the importance of reinvested earnings in overall investment flows and because satisfied investors are the best advertisement of a country’s business climate. Financial or fiscal incentives are also used to attract investors even though they typically only enter location-decision processes when other principal determinants are in place.

Once an enabling FDI policy framework is in place, economic factors assert themselves as locational determinants. They fall into three clusters, corresponding to the principal motives for investing abroad: resource (or-asset)-seeking, market-seeking and efficiency-seeking. In the past, it was relatively easy to distinguish the type of FDI corresponding to each of these motives. Historically, the availability of natural resources has been the most important FDI determinant for countries lacking the capital, skills, know-how and infrastructure required for their extraction and sale to the rest of the world. The importance of this determinant per se has not declined but the importance of the primary sector in world output has declined. In addition, large indigenous, often state-owned, enterprises have emerged in developing countries with the capital and skills to extract and trade natural resources.

The forces driving globalization are also changing the ways in which TNCs pursue their objectives for investing abroad. Technology and innovation have become critical to competitiveness. Openness to trade, FDI and technology flows, combined with deregulation and privatization, have improved firms’ access to markets for goods and services and to immobile factors of production and have increased competitive pressures in previously protected home markets, forcing firms to seek new markets and resources overseas. At the same time, technological advances have enhanced the ability of firms to coordinate their expanded international production networks in their quest for increased competitiveness.

To attract such competitiveness-enhancing FDI, it is no longer sufficient for host countries to possess a single locational determinant. TNCs undertaking such FDI take for granted the presence of state-of-the-art FDI frameworks that provide them with the freedom to operate internationally, that are complemented by the relevant bilateral and international agreements, and that are further enhanced by a range of business facilitation measures. When it comes to the economic determinants, firms that undertake competitiveness-enhancing FDI seek not only cost reduction and bigger market shares, but also access to technology and innovative capacity. These resources, as distinct from natural resources, are people-made, they are “created assets”. Possessing such assets is critical for firms’ competitiveness in a globalizing economy. Consequently, countries that develop such assets become more attractive to TNCs. It is precisely the rise in the importance of created assets that is the single most important shift among the economic determinants of FDI location in a liberalizing and globalizing world economy. In addition, the new configuration also includes agglomeration economies arising from the clustering of economic activity, infrastructure facilities, access to regional markets and, finally, competitive pricing of relevant resources and facilities. One implication for host countries wishing to attract TNCs undertaking competitiveness-enhancing FDI is that created assets can be developed by host countries and influenced by governments.