The Determinants of Foreign Direct Investment: A Review and Re‐Analysis of Evidence from Australia

• Published date: 01 March 2022
• Author: Zac Rafidi,George Verikios
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/1467-8462.12443

The Australian Economic Review, vol. 55, no. 1, pp. 71–90 DOI: 10.1111/1467-8462.12443

The Determinants of Foreign Direct Investment: A Review and

Re‐Analysis of Evidence from Australia

Zac Rafidi and George Verikios*

Abstract

Foreign direct investment (FDI) is founda-

tional to economic growth. Despite this, the

Australian empirical literature is limited.

Therefore we examine the empirical determi-

nants of Australia's inflow of FDI to under-

stand the factors that motivate FDI. Using

autoregressive distributed lag models, the

study also highlights how these determinants

change across time. While inward FDI can be

explained by various theories it is most

effectively understood by Dunning's

Ownership, Locational and Internalisation

framework. Therefore, the factors most im-

portant in Australia to attracting FDI are

monetary policy, productivity, a competitive

tax structure, labour market flexibility and

costs of trade and investment.

JEL CLASSIFICATION

F15; F21

1. Introduction

Over the past century the world economy has

undergone enormous structural and institu-

tional change. The creation of global institu-

tions in the 1940s (for example, the United

Nations, International Monetary Fund (IMF)

and GATT (World Trade Organisation)) and

the large‐scale reduction of trade barriers has

liberalised the global flow of trade and capital

(Sharma and Bandara 2010). However, com-

pared to studies of international trade, there

have been fewer studies of international capital

flows. Prior to 1960, analysis of international

capital flows took place under the guise of

portfolio investment. Studies by Hymer(1960),

Vernon (1966) a nd Kindleberge r (1969) later

made more explicit distinctions between port-

folio and other types of investment that then

developed into a new stream of literature on

foreign direct investment (FDI) and the

multinational enterprise (MNE).

MNEs are defined as large companies with

global operations controlled by a parent

organisation (Faeth 2009). Their rise coin-

cided with increasing global economic inte-

gration and an appetite for profit beyond

domestic borders. To exploit opportunities in

foreign markets MNEs engaged in FDI or

investment that reflects a long‐term or con-

trolling interest of a foreign asset.

1

Unlike

portfolio investment, FDI contends with

obstacles of distance, culture and government

regulation. Theories of FDI are therefore

concerned with how organisations compete

in international jurisdictions.

*Rafidi: KPMG Economics; Verikios: KPMG

Economics and Griffith University, Sydney, NSW,

Australia. Corresponding author: Rafidi, KPMG

Economics, Sydney, NSW 2000, Australia; email:

<zacrafidi@gmail.com>. This article is based on Zac

Rafidi's honours thesis. Thanks are due to his thesis

supervisors, Anthony Makin and Shyama Ratnasiri.

© 2021 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics

Published by John Wiley & Sons Australia, Ltd

Although contested by some, the presence of

MNEs and FDI generates higher productivity

through the transfer of technology and

expertise—stimulating imitative behaviour and

improving market competition (Borensztein, De

Gregorio and Lee 1998). The benefits of FDI

also occur at the macroeconomic level. When

financing the gap between investment and

savings (that is, net capital inflow), the cost of

servicing the inflow is outweighed by higher

rates of productivity. As such, multinational

investment acts to accelerate the growth of

national income and facilitate improvements to

a country's living standards (Makin and

Chai 2018).

But, if not correctly managed FDI can have

destabilising effects. The inflow of foreign firms

has the potential to displace local investment,

give rise to national security concerns, and

hamper employment and wage growth as a result

of firms’capital‐intensive activities and the

substitution of capital for labour (Faeth 2005).

There is also evidence suggesting that while FDI

has a positive long‐term impact on domestic

entrepreneurship it may come at the expense of

domestic entrepreneurship in the short‐run

(De Backer 2003).

In 2017, Australia was host to USD$49

billion of FDI, the eighth largest in the world

(UNCTAD 2018). While Australia's FDI has

had a growing contribution to the domestic

economy, its share among developed econo-

mies has been in steady decline since the

1980s (see Figure 1). An explanation for this

may be that large emerging economies such as

China and India have redirected a significant

share of the world's economic activity.

Nevertheless, Australia's fall in international

competitiveness or its ability to attract invest-

ment is potentially just as consequential.

Since the introduction of application fees in

2015 by Australia's Foreign Investment

Review Board (FIRB), the flow of approved

direct investment proposals has slumped from

41,445 in 2015–2016 to a low of 8,724 in

2018–2019 (FIRB 2019). Geopolitical risks

with China have grown, banking sector

disputes have surfaced and restrictive taxation

procedures and labour market regulations

have persisted. Over this period the World

Economic Forum (WEF) (2017) has made

several downgrades to Australia's position in

the Global Competitiveness Index. Despite the

Bogor Declaration's call for equal promotion

of FDI and trade in 1994, in reality Australia

and the broader Asia‐Pacific Economic

Cooperation (APEC) region have achieved

the opposite, favouring trade as the principal

external source of growth (see Figure 2).

The link between increasing competitive-

ness and the contribution FDI has to GDP,

though, may not be so straightforward. The

current literature on direct investment in

Australia is limited. This is important as the

nation's characteristics are a unique—large in

its physical dimensions, highly endowed with

natural resources and geographically isolated

from the majority of its trading partners

(Guttmann and Richards 2006). This may be

the cause of two concerns: one, the FIRB's

current foreign investment policy restricts its

ability to benefit from FDI—suppressing total

welfare; two, Australia's growing reliance on

trade as a source of growth increases fragility

and sensitivity to global trade shocks. Failing

to improve the understanding of how to attract

direct investment and diversify external

sources of growth, Australia may continue to

forego productive long‐term opportunities

generated by FDI for more convenient but

potentially less sustainable ones.

The primary aim of this work is to examine

the empirical determinants of Australia's

inflow of direct investment through the lens

of various theories. As MNES’motivations

are to some degree heterogeneous across

countries, the value of this work is its

contribution to the understanding of which

factors attract and deter FDI in Australia.

Using autoregressive distributed lag (ARDL)

models, we also highlight how these determi-

nants change over the short‐and long‐run

in an attempt to guide policymakers in the

future.

2. Theories of FDI

The initial theoretical framework explaining

foreign investment originated from the

Heckscher–Ohlin model. This two‐good,

72 The Australian Economic Review March 2022

© 2021 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics