Foreign direct investment and macroeconomic risk
Yothin JinjaraDivision of Economics, Nanyang Technological University (NTU), S3-B2A-06, Singapore 639798
Received 16 January 2007; revised 10 May 2007
澳洲留學生dissertationAvailable online 23 May 2007
Jinjarak, Yothin—Foreign direct investment and macroeconomic risk
Motivated by the macroeconomic fluctuations and policy regime switches frequently observed in developingcountries, this paper provides cross country-industry evidence on the links between a host country’smacro risks and foreign direct investment (FDI) activities. For each industry I measure vertical FDI share asa ratio of exports to a parent country relative to local sales by foreign affiliates. Using a panel sample from1989 to 1999, I find that FDI activities of US multinationals in industries with higher share of vertical FDIrespond disproportionately more to negative effects of macro-level demand, supply, and sovereign risks.However, when institutional quality and total FDI share of the host country are sufficiently low, the meritsof cross-industry vertical versus horizontal FDI in response to macro risks disappear. Journal of Comparative
Economics 35 (3) (2007) 509–519. Division of Economics, Nanyang Technological University (NTU),
S3-B2A-06, Singapore 639798.
© 2007 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights reserved.
JEL classification: E32; F21; F23; F40; L16; P51
Keywords: Horizontal and vertical FDI; Institutions; Macroeconomic volatility; Multinationals
1. Overview
What is the main driving force of foreign direct investment (FDI)? This paper adds to a series
of literatures studying the association between institutions, macroeconomic risks, and FDI.1
* Fax: +65 67946303.
E-mail address: [email protected].
1 Another strand of literature focuses on static conditions under which vertical FDI is more efficient than horizontaFDI. There, vertical FDI arises when a multinational firm fragments its production process internationally, locating eachstage of the production in the host country where it can be done at the least cost. Hummels et al. (2001) and Yi (2003)0147-5967/$ – see front matter © 2007 Association for Comparative Economic Studies. Published by Elsevier Inc. All
rights reserved.doi:10.1016/j.jce.2007.05.002Y. Jinjarak / Journal of Comparative Economics 35 (2007) 509–519 511
vertical FDI is applicable to all affiliates operating abroad for each industry.3 The dissimilarityacross industries is apparent: a ratio of exports back to US relative to local sales by foreignaffiliates of industries below the 25th percentile (Utilities, Information, Food, Services) is, onaverage, 44 percent smaller than that of industries above the 75th percentile (Mining, IndustrialMachinery, Transportation Equipment, and Computer Products). In the next section, I investigate#p#分頁標題#e#
empirically the implication of this dissimilarity by projecting cross country-industry patterns ofFDI activity onto a vector of macro risks.\

2. Estimation
To quantify the differential impact of macro risks on vertical versus horizontal FDI activities,
I estimate the following equation:
FDI Activity of Industry j in Host Country k= Constant+β1...m · Country Indicators+ βm+1...n · Industry Indicators+βn+1 · (Host Country k’s Share of Total Sales in industry j in 1989)+βn+2 · [Vertical FDI of Industry j ×Macro Risk in Host Country k] + εj,kwhere β’s are coefficient estimates. I use dummy variables to control for country and industrytime-invariant unobserved characteristics. For this econometric specification, a negative and statisticallysignificant βn+2 indicates that FDI activities of industries with higher share of verticalFDI respond more adversely to macro risks in a host country. The advantage of this setting is thatit makes predictions about within-country differences between industries based on the interactionbetween country and industry characteristics. It should also be less subjected to omitted variablebias and model misspecification.4
I use the 1989, 1994, and 1999 benchmark surveys on US multinational activities compiled
by the US Bureau of Economic Analysis. Table 2 provides a list of countries, together with
their share and level of vertical FDI. Countries in the top half of the table witness, on average,
more than 25 billion USD (in 1995$) of total sales generated by affiliates of US multinationals. In
contrast, the bottom half of Table 2 shares just a little below 10 percent of total sales.5 This feature
of the sample is useful for guiding the robustness check. Although there is a presumption that
horizontal FDI should dominate in large destinations, high-income, industrial countries, I find in
this sample set that the average share of vertical FDI is 19 percent for both large and small hosts
(excluding Barbados, Bermuda, Netherlands Antilles, Nigeria, and UAE as outliers).
3 If the production technology determining vertical FDI does not carry over to all foreign affiliates and changes frequently
over time, the choice of export versus FDI becomes an important consideration. For studies on export versus
FDI, see for example Brainard (1997), Grossman and Helpman (2004), and Helpman et al. (2004). On the insensitivity
of production technology to host-country conditions, see for example Morley and Smith (1977).
4 Rajan and Zingales (1998) use similar empirical approach to study whether industrial sectors that are relatively more
in need of external finance develop disproportionately faster in countries with more-developed financial markets.
5 Using the total sales numbers is admittedly a crude approximation. The immediate concern is transfer pricing.
Swenson (2001) finds an association between foreign corporate tax rates and the reported transaction prices between#p#分頁標題#e#
parent firms and foreign affiliates. Because of data availability, it is difficult to measure cross industry-country differences
in transfer-pricing manipulation over time. I treat this distortion as a random component.Y. Jinjarak / Journal of Comparative Economics 35 (2007) 509–519 515
disregard close to a third of the observations. With such limitations in mind, I report in panels II
and III of Table 4 the regression results using the 25 billion USD cutoff. We can see that the
vertical-versus-horizontal differential impact of macro risks is not applicable to those smallershare
destinations. The merits of cross-industry vertical versus horizontal FDI in response to
macro-level risks apply only to a subset of medium and large host-country destinations.
To a degree, the results are in line with theory and country-level evidence in Aizenman and
Marion (2004): at industry-level, we also see in a subset of FDI destinations that supply and sovereign
risks have more deleterious impact on vertical FDI, whereas demand risk discourages both
vertical and horizontal production modes. The estimation also performs quite well, explaining
67–86 percent of variation in the data. One method in which we can quantify economic significance
of the coefficient estimates is as follows. Industries above the 75th percentile of vertical
FDI share (average = 0.47) include Mining, Industrial Machinery, Transportation Equipment,
and Computer Products. Industries below the 25th percentile (average = 0.03) are Utilities, Information,
Food, and Services. A one standard deviation change of sovereign risk is 1.7 score
on host-country’s investment profile. If we set the host country’s initial share of total sales at its
overall mean, the coefficient estimate on sovereign risk then predicts that total assets of the higher
vertical-FDI share group (the 75th percentile) should adversely respond 0.52 percent more than
the lower share group. Summing together the negative effects of supply, demand, and sovereign
risks on the total assets, a differential of 1.24 percent is found. In comparison, the size of total
assets for the top half of Table 2 is, on average, 88 billion USD. Therefore, a differential of 1.24
percent is significant. Fig. 1 provides a summary of the vertical-versus-horizontal differential
response of FDI activity to macro risks.
3. Discussion
Interaction between contractual incompleteness and uncertainty plays a central role in the
evaluation of the relative costs of governance through market-based bilateral contracts versus
governance through internal organizations (Joskow, 2005). Assuming there is industry-specific
uncertainty that drives vertical FDI, the results reported here can then be interpreted as increases
in macroeconomic risks having stronger effects when the industry-specific uncertainty
is small. In a longer sample, the estimation may also be exposed to multicollinearity as productivity#p#分頁標題#e#
shocks tend to account for the long-run movements in real exchange rate fluctuations by
Balassa–Samuelson’s (Alexius, 2005). Another reservation on the regression results is that the
flow and stock of US FDI data can provide rough approximations to country distributions of FDI
sources and destinations, but are poor approximations to industry distributions of FDI and to
changes over time in country and industry distributions (Lipsey, 2007).
While there is much at stake in eliminating macro risks, to understand the means to the end
poses quite a challenge. Consider, for example, the supply risk. A negative association between
the risk of labor strikes and FDI activity casts doubt on the welfare implication of centralized
versus decentralized wage setting regimes (Leahy and Montagna, 2000). As for demand risk
generated by the volatility of real exchange rates, a risk considered relatively easy to fix, choosing
an exchange rate regime as a policy prescription to eliminate it may actually miss the target
and is likely to be of second order importance to the development of good fiscal, financial, and
monetary institutions (Calvo and Mishkin, 2003). At a broader level, we can consider the findings
in this paper as a first attempt at understanding the role of policy coordination as countries try
to attract new investments and extract benefits from market potential (Barrell and Pain, 1999;Y. Jinjarak / Journal of Comparative Economics 35 (2007) 509–519 517
For developing countries, consumer potentials, abundant natural resources, and labor cost
advantages are all attractive for FDI (Hanson et al., 2002). On the other hand, developing countries
are characterized by larger macroeconomic fluctuations and more frequent policy regime
switches than industrial countries (Aguiar and Gopinath, 2007). That these stylized facts of macro
risks across countries is a driving factor to the sensitivity of vertical versus horizontal FDI activity
corroborates the institutional consideration of international allocation of resources. Much
progress has been made on linking institutional analysis to international trade; Anderson and
Marcouiller (2002), Berkowitz et al. (2006), Blomberg and Hess (2006), Greif (1992), Levchenko
(in press), Marin and Schnitzer (2002), Nunn (2007), Rauch (1999), Rodrik et al. (2004), and
Svaleryd and Vlachos (2005). As a corollary to cross-border trading in goods in the presence of
institutional risks, multinationals likewise face a risk that their investment will be expropriated
for the simple reason that international contracts are practically impossible to enforce (Thomas
and Worral, 1993). Greaney (2003) proposes that the observed trade frictions between countries,
such as the occasional US versus Japan row, are a result of asymmetric trade and investment
flows that may stem from differences in the strength of business and social networks in international#p#分頁標題#e#
trade and FDI. On the empirical front, Aizenman and Spiegel (2006) find that institutional
efficiency is positively associated with the ratio of subsequent foreign direct investment flows to
both gross fixed capital formation and to private investment. As the theoretical and empirics of
multinational firms are not as well developed as other areas of international economics, a combination
of lessons drawn from international trade with comparative institutional analysis applying
to FDI is a promising direction for future research.
Acknowledgments
I am grateful to an anonymous referee, Joshua Aizenman, Swisa Ariyapruchya, and the editor
Daniel Berkowitz for useful comments and suggestions. All remaining errors are my own.
Appendix A
FDI Activity: survey data over five-year interval (1989, 1994, and 1999) compiled by
the BEA’s US Direct Investment Abroad (from http://www.bea.gov/international/index.htm#
omc). Nominal values are deflated by the US GDP deflator (base year = 1995; US GDP deflator
is the implicit price deflator for Gross Domestic Product from the National Income and Product
Accounts at the BEA, http://www.bea.doc.gov/bea/dn/nipaweb/). Three measures of FDI
activity share by foreign affiliates are: Total assets [BEA Table III.B5], Compensation of employees
[BEA Table III.H5], and Net property, plant, and equipment [BEA Table III.B7]. BEA
changed industry classification in 1999. Some of the industries that the survey started reporting
in 1999 are closely related to some pre-1999 industries. These include “Industrial machinery
and equipment” (pre-1999), “Machinery” (post-1999), and “Computer and electronic products”
(post-1999); “Electronic and other electric equipment” (pre-1999) and “Electrical equipment,
appliances, components” (post-1999).
澳洲dissertation網Vertical FDI Share: ratio of foreign affiliates’ exports back to US relative to local sales for
each industry, averaged over the period 1989–1999. Exports are sales by foreign affiliates to the
US [BEA Table III.F4]. Local sales are sales by foreign affiliates to the local market in host
country [BEA Table III.F7].
Supply Risks: (i) volatility of value added of host country, measured by lagged three years
coefficient of variation of annual gross value added indices; (ii) variation in the number of labor518 Y. Jinjarak / Journal of Comparative Economics 35 (2007) 509–519
market strikes and lockouts in host countries, measured by coefficient of variation over the current
and past five years. The types of strikes and lockouts covered are constitutional or official,
unofficial, political or protest, sympathetic and general or widespread strikes and lockouts, and
any other forms of action due to labor disputes, e.g. sit-ins, working to rule, go-slows and overtime#p#分頁標題#e#
bans. Source: International Labor Organization’s LABORSTA (from http://laborsta.ilo.org/).
Demand Risk: volatility of real effective exchange rates, measured by coefficient of variation
of monthly values. Source: JP Morgan’s real broad effective exchange rate indices from DataStream.
Sovereign Risk: investment profile, measured by a numerical assessment on three factors relating
to investment risks in host country: (1) viability of contracts/expropriation; (2) profits
repatriation; (3) payments delays. Countries are ranked monthly on a 0–12 scale, with a higher
value indicating lower risk. The reported scores have been rescaled by subtracting from 12 so
that a higher value indicates a greater sovereign risk. Source: International Country Risk Guide,
Political Risk Services Group (from http://www.prsgroup.com/).
References
Aguiar, M., Gopinath, G., 2007. Emerging market business cycles: The cycle is the trend. Journal of Political Economy
115, 69–102.
Aizenman, J., 2003. Volatility, employment and the patterns of FDI in emerging markets. Journal of Development Economics
72, 585–601.
Aizenman, J., Marion, N., 2004. The merits of horizontal versus vertical FDI in the presence of uncertainty. Journal of
International Economics 62, 125–148.
Aizenman, J., Spiegel, M.M., 2006. Institutional efficiency monitoring costs and the investment share of FDI. Review of
International Economics 14, 683–697.
Alexius, A., 2005. Productivity shocks and real exchange rates. Journal of Monetary Economics 52, 555–566.
Anderson, J.E., Marcouiller, D., 2002. Insecurity and the pattern of trade: An empirical investigation. Review of Economics
and Statistics 84, 342–352.
Barrell, R., Pain, N., 1999. Domestic institutions, agglomerations and foreign direct investment in Europe. European
Economic Review 43, 925–934.
Berkowitz, D., Moenius, J., Pistor, K., 2006. Trade, law, and product complexity. Review of Economics and Statistics 88,
363–373.
Blomberg, S.B., Hess, G.D., 2006. How much does violence tax trade? Review of Economics and Statistics 88, 599–612.
Blonigen, B.A., 1997. Firm-specific assets and the link between exchange rates and foreign direct investment. American
Economic Review 87, 447–465.
Braconier, H., Norbäck, P.-J., Urban, D., 2005. Reconciling the evidence on the knowledge–capital model. Review of
International Economics 13, 770–786.
Brainard, L.S., 1997. An empirical assessment of the proximity-concentration tradeoff between multinational sales and
trade. American Economic Review 87, 520–544.
Calvo, G.A., Mishkin, F.S., 2003. The mirage of exchange rate regimes for emerging market countries. Journal of Economic
Perspectives 17, 99–118.
Carr, D.L., Markusen, J.R., Maskus, K.E., 2001. Estimating the knowledge–capital model of the multinational enterprise.#p#分頁標題#e#
American Economic Review 91, 693–708.
Davies, R.B., 2003. Hunting high and low for vertical FDI. Working paper. Department of Economics, University of
Oregon.
Ekholm, K., Forslid, R., Markusen, J., 2003. Export-platform foreign direct investment. Working paper 9517. National
Bureau of Economic Research, Cambridge, MA.
Froot, K.A., Stein, J.C., 1991. Exchange rates and foreign direct investment: An imperfect capital markets approach.
Quarterly Journal of Economics 106, 1191–1217.
http://www.ttc-switch.com/dissertation_writing/Greaney, T.M., 2003. Reverse importing and asymmetric trade and FDI: A networks explanation. Journal of International
Economics 61, 453–465.
Greif, A., 1992. Institutions and international trade: Lessons from the commercial revolution. American Economic Review
82, 128–133.