factors affecting direct investments

8/8/2019 factors affecting direct investments

http://slidepdf.com/reader/full/factors-affecting-direct-investments 1/11

Strategic factors affecting foreign direct investment decisionsby multi-national enterprises in Latin America

Len J. Trevinoa,*, Franklin G. Mixon Jr.b

a Department of Management and Decision Sciences, Washington State University, Pullman, WA 99164-4736, USAb Department of International Business and Economics, Box 5072, The University of

Southern Mississippi, Hattiesburg, MS 39406-5072, USA

Abstract

Cross-country differences in macroeconomic and institutional environments are used to explain MNE behavior, as proxied by

foreign direct investments (FDIs) inflows to seven Latin American countries, namely Argentina, Brazil, Chile, Columbia,

Mexico, Peru and Venezuela for the period 1988–1999. Results indicate that the institutional approach is dominant, thus

supporting recent FDI research that has included statistical measures of institutional reform in their models. Since MNEs must

conform to the institutional environment prevailing in the host country, managers should undertake FDI where there is minimal

institutional distance between the home and the host country environments. In addition, government officials should place

increased emphasis on institutional reform if their objective is to increase inward FDI in their countries. Finally, any assistance

provided by non-governmental organizations, such as the IMF and the World Bank, should also emphasize institutional reform.

# 2004 Elsevier Inc. All rights reserved.

1. Introduction

The opening of markets in developing countries in

recent years has brought with it burgeoning foreign

direct investment (FDI) flows. In the 1990s, FDI

became the largest single source of external finance

for developing countries. By 1997, FDI accounted

for about half of all private capital and 40% of total

capital flows into developing countries. In the past,governments in many developing countries often saw

multinational enterprises (MNEs) as part of the devel-

opment problem, due to assertions of exploitation of

the environment and of the labor force. At present,

MNEs are seen as part of the development solution for

several reasons. First, governments in developing

countries acknowledge that they need outside capital

to achieve their development objectives, partly because

industrial nations have stabilized foreign aid and devel-

opment loans. Second, export-oriented FDI brings

relief from rampant foreign exchange shortages. Third,

recognizing that reversal of portfolio investment is less

costly, a fact that exacerbated recent financial crises in

a number of developing countries, governments now

prefers FDI (UNCTAD, 1999). Fourth, host-countrygovernments recognize that MNEs have access to

resources other than capital, that can assist with their

development (such as technology, management and

access to foreign markets). Recognizing the long-term

costs of failure to integrate their economies into the

global environment, developing countries have opened

up their markets in order to attract more FDI.

There are numerous theories that have been

advanced to explain this phenomenon. The macroe-

conomic approach (Aliber, 1970; Froot & Stein, 1991;

Journal of World Business 39 (2004) 233–243

* Corresponding author. Tel.: þ1-509-335-7850;

fax: þ1-509-335-7736.

E-mail address: [email protected] (L.J. Trevino).

1090-9516/$ – see front matter # 2004 Elsevier Inc. All rights reserved.doi:10.1016/j.jwb.2004.04.003



Grosse & Trevino, 1996) emphasizes why net invest-

ment among pairs or groups of nations tends to flow in

certain patterns. This theory attempts to explain FDI

behavior with macroeconomic variables, such as infla-tion, national income and exchange rate behavior.

With developing countries undertaking market

reforms and becoming more receptive to FDI,

researchers have begun to apply institutional theory

from the strategic management literature (Kennedy &

Sandler, 1997; Trevino, 1999; Trevino, Daniels, &

Arbelaez, 2002) to understand this phenomenon. Insti-

tutional theory emphasizes the influences of systems

surrounding organizations that shape organizational

behavior and decision making (Scott, 1995). As such,

it attempts to explain the organization–environment

interface. According to Hoskisson, Eden, Lau, and

Wright (2000), the role of institutions in an economy is

to reduce transaction and information costs by redu-

cing uncertainty and by establishing a stable structure

that facilitates interactions. Empirical research using

an institutional theoretical approach has emphasized

the study of political risk, bilateral investment treaties,

foreign investment and trade regulations, and capital

markets liberalization in an attempt to explain FDI.

Although both of these approaches have been

employed separately (Grosse & Trevino, 1996; Meyer,

2001) and together (Trevino et al., 2002), no effort hasbeen made to determine the individual importance

relative to each. This paper fills that void by presenting

hypotheses concerning these two approaches. The

empirical results support the superiority of the institu-

tional construct, thus lending credence to recent stu-

dies that have employed institutional theory to explain

FDI into developing and transitional economies (Tre-

vino et al., 2002).

Latin America is a useful region for our study

because Latin American and Caribbean countries

receive a significant portion of FDI inflows going todeveloping countries (UNCTAD, 1999). In addition,

debt crises in this region resulted in reduced FDI

inflows during the first half of the 1980s, after which

they began a steady increase, partially resulting from

macroeconomic and institutional liberalization poli-

cies. Although institutional reform has taken place in

almost all countries of the region, Latin American

countries’ liberalization policies, market reforms and

inflows of FDI have varied cross-sectionally and over

time. The seven countries examined in the current

study were Argentina, Brazil, Chile, Colombia, Mex-

ico, Peru, and Venezuela. Combined, they account for

over 85% of FDI in Latin America.

2. Foreign direct investment in Latin America:

a brief history

Foreign direct investment in Latin America has a

long history, often dating back to the 19th century.

Early FDI was primarily export-oriented and/or driven

by MNEs seeking natural resource supplies. Import

substitution industrialization in the post-WWII era led

to a shift in FDI toward manufacturing for domestic

consumption. Lacking foreign exchange in the 1980s,

many governments in Latin America began to open up

their markets in a return to export-oriented FDI.

Foreign direct investment in Argentina was preva-

lent from the late 19th century until the beginning of

WWII. It was initially sought to improve the trans-

portation infrastructure. However, the post-WWII era

produced nationalist economies throughout most of

Latin America and, in the case of Argentina, the closed

nationalistic economy continued until the late 1980s,

culminating in macroeconomic dislocation. This eco-

nomic and institutional landscape led to capital flight

and ultimately to market reform, characterized bytrade openness, deregulation and privatization. These

reforms led to increased FDI flows. The foundation of

Argentina’s economic transformation was the Con-

vertibility Law, a currency board implemented in

1991. Other important elements included trade liberal-

ization, privatization, tax reform, and deregulation

(Petrocella & Lousteau, 2001). In the beginning of

the 1990s, the vast majority of FDI flows came in the

form of privatizations. After 1993, FDI flows increas-

ingly took place in the private sector.

The role that FDI plays in the modern Brazilianeconomy is different than that which it played in

previous eras. Prior to WWII, FDI was concentrated

in public utilities, including transportation, in the

primary goods export economy, and in banking, with

a small percentage in the manufacturing sector. Simi-

lar to Argentina, post-WWII FDI flows shifted to

manufacturing as part of an import substitution indus-

trialization strategy. In the 1990s, the role that FDI

played changed considerably. Brazil adopted institu-

tional and macroeconomic reforms, partially designed

234 L.J. Trevin o, F.G. Mixon Jr./ Journal of World Business 39 (2004) 233–243



to stimulate FDI. Elements of these reforms included

establishment of the real plan, privatization of state-

owned enterprises, and implementation of the Merco-

sur free trade area. It has been estimated that of theworld’s 500 largest corporations, 400 have invest-

ments in Brazil (Baer & Rangel, 2001), making Brazil

a major source of investment for MNEs and empha-

sizing the importance of Brazil to the strategy of major

MNEs.

Chile’s history of FDI is similar to that of other

Latin American countries, having shifted from invest-

ment in infrastructure development and primary

products to a post-WWII import substitution indus-

trialization policy and, more recently, to manufactur-

ing. Although Mexico is known for being one of the

earliest countries in Latin America to undertake

macroeconomic and institutional reforms, primarily

because of the publicity surrounding NAFTA, Chile

was the first Latin American country to liberalize its

foreign investment regulations. Decree Law 600 was

promulgated in 1974 and it liberalized tax codes,

repatriation restrictions, and the foreign exchange

market. The country’s market reform policies appear

to have been effective because Chile received over $7

billion in FDI inflows between 1987 and 1994

(Ramirez, 2001). Continuing with institutional

reform, the June 6, 2003 signing of a Chile–U.S.free-trade agreement established clear and transparent

rules for foreign investors, including an open system

for dispute settlement.

Although Colombia’s history of FDI parallels that

of other Latin American countries, liberalization did

not take place as a reaction to an economic or foreign

exchange crisis, or at the beginning of a political

administration. Nevertheless, radical reforms were

implemented between 1990 and 1994. These included

dramatic tariff reductions, liberalization of trade and

foreign exchange transactions, and financial and capi-tal markets reform. Although Colombia had fewer

state-owned enterprises than other Latin American

countries, in the early 1990s, some of the banks the

government had absorbed in the financial crisis of the

early 1980s were reprivatized, and the government’s

stake in the automobile manufacturing sector was sold

(Birch & Halton, 2001).

Mexico, along with Chile, was one of the first

countries to abandon import substitution industriali-

zation in favor of an open, market-oriented model that

culminated with the passage of NAFTA. Although

Mexico’s FDI history is similar to that of other Latin

American countries, its recent past differs substan-

tially in that FDI has flowed primarily to newly createdfirms in the maquiladora sector along the U.S. border.

In other countries, FDI funds have been primarily

channeled to traditional sectors, such as mining and

energy. The impetus to change Mexico’s FDI policy

can be traced to the country’s desperate need for

foreign exchange following the 1982 debt crisis. Ele-

ments of market reform included opening of markets

previously closed to foreigners, privatization, dereg-

ulation, national treatment and, of course, NAFTA

(Ramirez, 2001).

Peru began to open its doors to external capital in

the early 1990s, somewhat later than other Latin

American countries. In an economy fraught with

populist regimes, foreign debt crises, and political

and economic instability, Peru had been effectively

closed to FDI. However, since 1991, macroeconomic

and institutional changes included the introduction of

a free market policy, the deregulation of prices, the

adoption of monetary and fiscal control measures

(designed to reduce inflation), and privatization

(Rojas, 2001). All of these elements sent clear signals

that Peru wanted to become a member of the global

marketplace. Like other countries in the region, pri-vatization has led to increased FDI flows in Peru.

Oil has defined Venezuela and its FDI regime for

over a century. In 1991 and 1992, after a number of

technological and financial failures, the state oil com-

pany, Petroleos de Venezuela, signed 11 letters of

intent with transnational oil companies interested in

pumping crude. Recently, the combination of severe

economic crisis, coupled with foreign currency

restrictions, has pushed Venezuela farther from

reforms. The country’s desperate need for foreign

capital continues to conflict with its historical desireto exercise sovereignty over its natural resources.

3. Literature review of macroeconomic

variables

For developing countries to compete for FDI

inflows, they must implement macroeconomic poli-

cies designed to reduce inflation, stabilize the

exchange rate and increase the GDP of the host

L.J. Trevin o, F.G. Mixon Jr. / Journal of World Business 39 (2004) 233 – 243 235



country. With market-oriented economies in Latin

America effectively in operation for little more than

a decade, instability of prices, employment and output

would be expected. A high rate of inflation is a sign of internal economic instability and of a host govern-

ment’s inability to maintain expedient monetary pol-

icy. From the MNE’s viewpoint, high inflation creates

uncertainty regarding the net present value of a costly,

long-term investment. For these reasons, companies

may avoid making investments in countries with high

inflation. Studies published before Latin American

countries made significant reforms (Schneider & Frey,

1985) as well as those published after reforms were

enacted (Trevino et al., 2002) confirmed that compa-

nies invested less in developing countries with high

inflation rates.

The value of a country’s currency may be under-

mined by monetary policy or by economic upheaval.

Currency devaluation may result from such policy

changes, and foreign investors must incur costs to

prevent transaction and translation losses when host

country currencies depreciate. Thus, ceteris paribus, a

constant real exchange rate is preferred by MNEs in

order to reduce the exchange rate risk inherent with

investment in a foreign country. Another perspective

suggests that currency under (over)valuation is an

example of market disequilibrium. A currency maybe defined as undervalued when, at the prevailing rate

of exchange, production costs for tradable goods are,

on average, lower than in other countries. In this case,

MNEs would be inclined to locate production of

internationally traded goods in countries with under-

valued currencies and to purchase foreign production

capacity with overvalued foreign exchange (Froot &

Stein, 1991; Grosse & Trevino, 1996; Klein &

Rosengren, 1994). From an additional perspective,

the apparent under(over) valued exchange rate based

on a firm’s production costs (i.e., wages for a labor-abundant country) denotes that the country has a

comparative advantage in producing the product

and MNEs would be inclined to locate a plant within

that host country.

The demand-side of FDI theory argues that invest-

ment will go primarily to markets large enough to

support the scale economies needed for production.

This reasoning helps to explain why most FDI goes

to developed countries rather than to developing

countries (Grosse & Trevino, 1996), given that most

investment historically has been market seeking.

Investment in developing countries has been in

response to import substitution policies. Although

Tuman and Emmert (1999) used GDP as a surrogatefor market size and found it to be insignificant in

explaining FDI among Latin American countries,

more recently Trevino et al. (2002) found that GDP

was a significant and positive indicator of FDI flows in

Latin America. Further, UNCTAD (1994) concluded

that market size was the primary determinant of FDI.

4. Literature review of institutional variables

Institutional theory in the strategic management

literature suggests that institutions provide the rules

of the game that structure interactions in societies and

posits that organizational action is bound by these

rules (North, 1990). Within this realm lies political

risk, which may be defined as the risk that a host

country government will unexpectedly change the

institutional environment within which businesses

operate (Butler & Joaquin, 1998). From a financial

perspective, political risk may alter operating cash

flows via discriminatory policies and regulations.

MNEs may deal with political risk by avoiding the

risk altogether, by buying insurance, or by negotiatingwith the governing body prior to investment. Although

previous studies reached mixed conclusions about the

effect of political risk on FDI (Grosse & Trevino,

1996; Kobrin, 1979; Tallman, 1988), we expect a

country with high political risk to be less appealing

to foreign investors.

Capital markets are responsible for mobilizing and

allocating capital and for apportioning risk. It is

beneficial when a host country ensures that capital

flows to its most optimal use and is allocated for

economic, rather than for political reasons. In orderfor developing countries to attract FDI, they must

attempt to enforce a capital allocation system with

strict and transparent rules and regulations. At the

same time, they should not exert excessive control

over capital account transactions, such as via

exchange-rate controls and/or repatriation or foreign

ownership restrictions. In an effort to spur internal

development, many Latin American countries have

enacted capital market reform. If governments main-

tain strict control over capital transactions, such as via

236 L.J. Trevin o, F.G. Mixon Jr. / Journal of World Business 39 (2004) 233 – 243



foreign exchange controls and restrictions on FDI,

then MNEs may be reluctant to invest due to fears

about restrictions on new capital formation, divest-

ment and repatriation.Latin American countries, like their counterparts in

other regions of the world, have been privatizing

government-owned companies. The primary reason

is that many of these companies operated inef ficiently

under government ownership. These governments

believe they can reduce their fiscal expenditures

because they will no longer need to subsidize

money-losing operations. In addition to signaling a

more favorable investment climate, governments can

receive tax revenue from them if they become profit-

able. From the MNE’s perspective, the potential for

cost savings by transferring technology and manage-

ment capabilities to the privatized firm is often present

because most of these companies operated inef fi-

ciently under government ownership. Recent studies

of privatization in Latin America (Devlin & Comi-

netti, 1994; Hartenek, 1995; Trevino et al., 2002)

concluded that privatization has helped to attract

FDI to the region.

5. Modeling FDI within the macroeconomic and

institutional frameworks

Eq. (1) presents a test of the macroeconomic

and institutional theories:

FDI ¼ b1RERT þ b2CPIPC þ b3GDPC þ b4CALI

þ b5PRIV þ b6PRSK þ e: (1)

In Eq. (1) FDI represents inward FDI for the seven

Latin American countries under study for the period

1988–1999. RERT is the real exchange rate of Latin

American currencies at year-end, per U.S. dollar.

CPIPC represents the annual percentage change inconsumer prices in the host country’s currency. GDPC

is the host country’s per-capita gross domestic pro-

duct, in U.S. dollars. CALI is the degree of the host

country’s control over capital account transactions on

an annual basis. PRIV is the value of domestic priva-

tizations (less FDI) in each country. Lastly, PRSK is

each host country’s political risk rating. See the ‘‘Data

Sources and Descriptions’’ at the end of this study for

data sources and a more detailed description of the

variables.

Based on the discussion in the previous two sec-

tions, we expect that:1

b1¼

?

b2 < 0

b3 > 0

b4 > 0

b5 > 0

b6 > 0

Table 1 presents the findings of an OLS estimation

of Eq. (1).2 The six regressors are jointly significant in

explaining FDI across countries/time. They produce a

sizable R-square for panel data. In four of five cases,

our expectations are borne out regarding the signs of

the variables. In the case of CPIPC (i.e., the unex-

pected sign), the parameter estimate is not significant

at any conventional level. Parameter estimates for

RERT, GDPC, and PRSK all are significant at the

0.05 level. These results support recent findings by

Trevino et al. (2002). Lastly, Eq. (1) passes a speci-

fication error F test (RESET)—failing to reject the

null hypothesis of ‘‘no specification error’’—at the

0.10 level.3

1 This study uses the political risk measure published by

Institutional Investor (various issues), where a higher number

indicates more political stability. Although we expect a negative

relationship between political risk and FDI, this would show up as a

positive coefficient in the equation. Data sources for the other

variables in Eq. (1) are provided below in a separate section.2 As Table 1 notes, we used 56 observations in our regressions.

For some variables (years), we had missing data. Specifically,

observations on CALI and PRSK cover the period 1988–1995,

those on GDPC and CPIPC cover the periods 1988–1997 and

1988–1998, respectively, while those on RERT and PRIV cover the

period 1988–1999. We selected all the observations at our disposal

where there were no missing data for any of our variable series.

This selection process facilitated the tests of non-nested hypotheseswe detail below.3 We use the standard RESET procedure from Ramsey (1969).

First, predicted values for FDI are obtained from the OLS model.

These predicted values are squared and cubed, and enter equation

one as additional regressors (Gujurati, 1988). A RESET F statistic

of 1.651 (2, 48 df) is produced regarding the joint significance of

these two additional regressors. The insignificance of the F statistic

fails to reject the hypothesis of ‘‘no specification error’’ in the base

regression model. Ramsey’s RESET is a useful test for detecting

many types of specification error, such as omitted variables,

irrelevant variables, nonlinearity, and errors in measurement

(Gujurati, 1988; Kmenta, 1986).




Because heterogeneity or country effects are very

common in panel data, we also employ fixed effects,

least squares dummy variable (LSDV) approach to

modeling Eq. (1). This approach tests for a common

constant intercept term by including a dummy variable

series for our seven Latin American countries. In our

specification, Argentina serves as the omitted country.

Results from the LSDV model also are presented in

Table 1. The LSDV results mirror those of the OLS

version in terms of the signs for CALI and PRSK.

CPIPC retains its expected sign in the LSDV model,though not in the OLS specification. However, GDPC

and PRIV retain anomalous signs in the LSDV spe-

cification, though neither is better than marginally

significant in the LSDV column. PRSK is statistically

different from zero, as are most of the country dummy

coef ficients. In fact, a joint F test on the significance of

the set of country dummies produces a test statistic of

9.305 ([6, 44] df), suggesting that the LSDV model be

used instead of the OLS to determine the relative

importance of each FDI theory.

6. Macroeconomic and institutional theories of

FDI: is either dominant?

In order to discern the relative importance of themacroeconomic and institutional theories of FDI,

additional empirical testing is necessary. Following

Maddala (1992: 514–518), we re-specify the two

empirical approaches to FDI as Eqs. (2) and (3):

H0 : FDI ¼ b X M þ u0; (2)

H1 : FDI ¼ d Z IR þ u1: (3)

Again, FDI represents inward FDI for the seven Latin

American countries under study for the period 1988–

1999, X M is the vector of the three macroeconomic

determinants (along with the country dummies) of FDI, and Z IR is the vector of the three institutional

variables (along with the country dummies) under

consideration. The separate hypotheses in Eqs. (2)

and (3) above are said to be non-nested given that

neither Eq. (2) nor Eq. (3) can be obtained from the

other by imposing a restriction (Kennedy, 1998). That

is, each equation has variables not included in the

other (Davidson & MacKinnon, 1993; Kmenta, 1986;

Ramanathan, 1998). It is often the case that there are

competing theories that attempt to explain the same

dependent variable, and the explanatory variables in

the different theories are non-overlapping. Maddala

(1992) suggests the use of various joint test ( J tests)

procedures for testing the ‘‘competing’’ theories, but

notes that one ‘‘limitation of [these] test[s] is that

[they] sometimes . . . reject both H0 and H1 or accept

[both] H0 and H1’’ (Maddala, 1992: 516). For the

purposes of this study, Maddala’s concerns are not

relevant. We follow the novel use of J tests in Mixon

and Gibson (2001), where ‘‘complementarity’’ of

theories was tested, rather than ‘‘competitiveness,’’

and their J test finding that both H0 and H1 were

accepted supported that contention. We also note thatthe models in Eqs. (2) and (3) are not necessarily

competing theories, however they are non-nested and

the tests suggested by Maddala (1992) may discover

the dominant source of FDI.

The procedure for testing H0 (the maintained

hypothesis) against H1 is as follows: Eq. (3) is esti-

mated by LSDV and the predicted values of FDI are

obtained (predFDIIR). Eq. (4) below is then estimated:

FDI ¼ b X M þ aðpredFDIIRÞ þ v: (4)

Table 1

Summary of OLS and LSDV regression results dependent variable:

FDI

OLS LSDV

Constant À2.365.02Ã (À1.67) 8.737.99 (1.39)

RERT À28.63ÃÃ (À2.01) 5.62 (0.39)

CPIPC 0.07 (0.25) À0.15 (À0.77)

GDPC 0.50ÃÃ (2.10) À2.32Ã (À1.67)

CALI 4.114.34ÃÃ (2.36) 785.18 (0.40)

PRIV 0.30Ã (1.78) À0.23 (À1.59)

PRSK 83.29ÃÃÃ (2.95) 208.80ÃÃÃ (3.43)

Country dummies

Brazil À5.997.70Ã

Chile À10.990ÃÃ

Columbia À13.723ÃÃ

Mexico À4.846

Peru À7.669.54Ã

Venezuela À9.265.72ÃÃÃ

No. of observations 56 56

F statistic 5.01ÃÃÃ 9.53ÃÃÃ

Adjusted R2 0.304 0.651

Notes. The numbers in parentheses above are t values. For the

country dummies, t values are not presented to conserve space,

though significance levels are included.Ã Denotes significance at the 0.10 level.ÃÃ Denotes significance at the 0.05 level.ÃÃÃ Denotes significance at the 0.01 level.




The hypothesis that a ¼ 0 is tested. If this hypothesis

is not rejected, then H0 is not rejected by H1. If the

hypothesis is rejected, then H0 is rejected by H1. A test

of H1 (as the maintained hypothesis) against H0 isbased on analogous steps, and examines the statistical

significance of l (where l is the counterpart to a). The

results are presented in Table 1 as the ‘‘Davidson–

MacKinnon J tests’’ (Davidson & MacKinnon, 1981;

MacKinnon, 1983). The results indicate that the insti-

tutional model significantly ‘‘adds to’’ the macroeco-

nomic model in explaining inward FDI in Latin

American countries. This result supports the conten-

tion that recent empirical considerations of various

measures of institution building have been beneficial

and that empirical use of these broad concepts has

added to our understanding of the determinants of

FDI. On the other hand, the J test for H1 vs. H0 fails to

indicate that the macroeconomic model significantly

‘‘adds to’’ the institutional model. In fact, the coef fi-

cient for l is negative (i.e., À0.402).

Maddala (1992) explains that J tests are, in small

sample cases, sometimes less rigorous than traditional

F tests. He concludes, what ‘‘. . . all this suggests is

that in testing non-nested hypotheses, one should use

the J test with higher significance levels and supple-

ment it with the F test on the comprehensive model

. . .’’ (Maddala, 1992: 518).F tests are performed by comparing an unrestricted

model with all six regressors and the country dummies

to the two models in Eqs. (2) and (3), each of which is

restricted to three regressors and the country dummies.

Unlike the one-degree-of-freedom J tests, the F tests

reported in Table 2 are based on the error sum of

squares (ESS) from LSDV estimation and represent [3,

44] degrees of freedom. Our F tests, as did the J tests

above, employ the same data panel as the OLS and

LSDV regressions reported in Table 1.

The F statistics in Table 2 support the conclusion of

the J tests. That is, while institutional theory adds tomacroeconomic theory in explaining FDI, macroeco-

nomic theory fails to statistically extend institutional

theory in this regard. This finding lends support to

newer studies that have examined the relationship

between institutional reform and FDI (see Hoskisson

et al., 2000; Trevino et al., 2002).

7. FDI decisions by MNEs in Latin America in

response to institutional reform

The relationship between capital markets liberal-

ization in Latin America and the expansion strategies

of international banks into the region is one example

of FDI decisions made by MNEs in response to

institutional reform. Although policies introduced in

Latin America over the last two decades have differed

from country to country, internal reforms can be

segmented into two phases. In the first phase, interest

rates were allowed to be determined by market forces,

instead of by fiat, and financial resources were allo-

cated on the basis of supply and demand. During the

first phase of reforms, banks were invited to operate inmarkets in which they did not have prior access. These

included areas such as leasing and factoring, broker-

age underwriting and pension fund management. With

economies of scale and scope becoming an increas-

ingly important factor to foreign banks, the ability to

operate in these areas was seen as increasingly impor-

tant to their plans to globalize operations. In the

second phase, banks were required to maintain more

conservative capital to asset ratios, to impose more

stringent requirements on loans, and to provide more

uniform and transparent information to governingbodies. The financial reforms enacted during the

1990s openly encouraged the entry of foreign banks

into Latin America. The second phase of reforms

created a regulatory environment similar to that of

international banks’ home country environments, in

the process creating a more certain investment climate

and opening the door for foreign banks to operate in

the local market. Capital markets liberalization, thus,

helped to create an environment with appropriate

institutions and removed the entry barriers for foreign

Table 2

Tests of non-nested hypotheses (H0 ¼ macroeconomic model;H1 ¼ institutional model)

Davidson–MacKinnon

J tests F tests

Test of H0 over H1 1.249ÃÃÃ (4.50) 7.222ÃÃÃ

Test of H1 over H0 À0.402 (À0.89) 1.098

Notes. The numbers in parentheses above are t values for the J tests

regression parameters. The F statistics above reflect tests with [3,

44] df.ÃÃÃ Denotes significance at the 0.01 level.




banks, enabling them to expand into Latin America

and to gain an increasingly large market share in the

region (ECLAC, 2003).

One example of a multinational bank that has madesignificant inroads into Latin America in the post-

reform era is Citigroup, one of the world’s largest

financial institutions. In fact, it is the largest bank in

Latin America, based on share of regional lending

(ECLAC, 2003). Although Citigroup has had a pre-

sence in Latin American for well over a century, its

presence was largely limited to corporate and private

banking services. This strategy was due in large part to

its awareness of institutional weaknesses in Latin

America that led to the debt crises of the 1980s and

1990s, and ultimately to institutional reform. The

bank ’s strategy shifted abruptly in 2001, when it moved

full force into consumer banking with the well-pub-

licized $12.5 billion acquisition of Mexico’s Banamex-

Accival financial group. This was the single largest FDI

transaction in Latin America to date. Citibank ’s bold

shift in strategy allowed it to gain control of over 25%

of consumer and corporate banking in Mexico. Citi-

bank ’s FDI decision making in Latin America is

directly related to the liberalization and deregulation

of international financial markets in the region.

Although Citigroup has made significant inroads

into Latin America, two Spanish banks’, Banco San-tender Central Hispano (SCH) and Banco Bilbao

Vizcaya Argentaria (BBVA), expansion strategies in

the region have been even more aggressive. Their

initial strategy was to become a force in consumer

banking, which had shed itself of most institutional

controls and that was seen as having the greatest

growth potential. Both of these Spanish banks went

on a buying spree in Latin America during the time

when first and second generation reforms were imple-

mented. Between 1997 and 2002, SCH made 26

acquisitions valued at over $13 billion in all of thecountries that we studied, in addition to Bolivia and

Paraguay. During the same timeframe, BBVA made 12

acquisitions valued at over $6 billion in six of the

seven countries that were the focus of this study in

addition to an investment in Uruguay. Spanish banks’

acquisition strategies in Latin America can be traced

to liberalization policies within the European Union

because these internal liberalization policies pushed

European banks into expansionist modes to gain

economies of scale. Coupling the need to globalize

operations resulting from liberalization policies within

the European Union with institutional reform in Latin

America, SCH’s and BBVA’s international expansion

in Latin America was a natural outcome.Institutional reform was initiated in the early 1990s

in much of Latin America in response to shortcomings

in many sectors, including a lack of public funds for

investment and gaps in technology. During this time-

frame, governments introduced reforms designed to

attract foreign private capital. Although reforms took

place in many sectors, nowhere is this policy more

evident than in the telecommunications sector. In the

early years of reform, many Latin American countries

privatized their public telecommunications companies

and allowed unprecedented foreign participation,

attracting large investments and substantial improve-

ments in the telecommunications infrastructure.

It was not long before the impact of privatization

programs in Latin America was realized, with Tele-

fonica of Spain making its presence felt in the region

early on. In 1991, it became part of a consortium led

by GTE Corporation (now Verizon Communications)

that became majority owner of Telefonos de Vene-

zuela, with a nearly $2 billion investment. Shortly

thereafter, Telefonica of Spain expanded its Latin

American operations, investing another $2 billion to

acquire a 40% stake in two Peruvian companies,Empresa Nacional de telecommunicaciones, a domes-

tic and international long distance monopoly, and

Compania Peruana de Telefonos, the local telephone

company of Lima, the country’s capital. The two

companies subsequently merged to form Telefonica

de Peru, and in 2000 Telefonica of Spain gained

complete control of this company with an investment

of over $3 billion. Telefonica of Spain is a prime

example of a MNE that has responded to privatization

reform and it has consolidated its position as a leading

provider of fixed and mobile telephony in both Vene-zuela and Peru. In Peru, it has retained its dominant

position, but in the larger market of Venezuela, it has

faced considerable competition due to liberalization of

the mobile market combined with the expansionist

strategy of Bell South.

Institutional reform and privatization in the region

has attracted other international investors into Peru

and Venezuela, such as Bell South of the United

States. Bell South responded to Latin America’s desire

for increased FDI in telecommunications and, as such,




it has become the leading provider of mobile tele-

phone services in Venezuela and Colombia and num-

ber two in Peru. In fact, Bell South’s Venezuelan

subsidiary has captured nearly 60% of the marketand plans to invest an additional $1.5 billion by

2005 (ECLAC, 2003). More recent acquisitions made

by Bell South in response to concessions made by the

Colombian government include a $300 million stake

in Celumovil, a mobile telecommunications company

operating in 6 of Colombia’s 10 largest cities. This

investment, coupled with the acquisition of Compania

Celular de Colombia, for which it paid over $400

million, gave Bell South the largest share of the

Colombian mobile telecommunications market

(ECLAC, 2003). In Peru, where privatization of the

telecommunications sector has been more liberal than

in Colombia, Bell South bought Tele 2000, a multi-

service telecommunications company, initiated its

own fiber optics network in the country and introduced

the Bell South brand. The Bell South example high-

lights MNEs’ FDI strategic decision making in Latin

America in response to host governments’ privatiza-

tion strategies designed to attract FDI.

Institutional reforms introduced in Latin American

countries in the early 1990s were swift and decisive

and the MNE strategic response was predictable. As a

result of institutional reform in the region, the Per-uvian government estimates that it has received over

$4 billion in private investment in the telecommunica-

tions industry between 1997 and 2001 and that addi-

tional agreements have been signed with Telefonica of

Spain and with AT&T of the United States worth

another $5 billion. Similarly, over $5 billion in private

capital flowed into the telecommunications industry in

Venezuela between 1997 and 2001.

8. Managerial implications

Most agree that the economies of developing coun-

tries are inextricably tied to MNEs and private invest-

ment. In addition, it has been shown that MNEs can

enhance their own bottom line by investing even in the

poorest economies of the world (Prahalad & Ham-

mond, 2002). While earlier explanations of FDI were

dominated by economic theories, more recently insti-

tutional theory and institutional distance (i.e., the

extent of similarity between the regulatory, cognitive

and normative institutions of two countries) provide

alternate and complementary explanations for MNE

behavior (see Kostova & Zaheer, 1999; Trevino et al.,

2002; Xu & Shenkar, 2002). In this paper, we usecross-country differences in macroeconomic and insti-

tutional environments to explain MNE behavior, prox-

ied by FDI inflows to seven Latin American countries.

Because it is well established that in order to survive,

MNEs must conform to the institutional environment

prevailing in the host country (DiMaggio & Powell,

1991), firms should understand the level of macro-

economic and institutional reform that has taken place

in proposed host countries, such as those in Latin

America. To assist in this understanding, managers of

MNEs could develop and/or apply separate statistical

indices comprising macroeconomic and institutional

information for proposed host countries. Empirical

results presented here suggest that managers should

take particular care to examine host country institu-

tional environments (reforms), and a longitudinal data

base (of indices for individual countries) could be

useful to managers in formulating FDI strategies.

These indices could go well beyond those institutional

factors examined here. For instance, aspects of labor

market law—an important consideration in Brazil—

could be indexed to supplement information on poli-

tical risk and other institutional factors.Our results may also prove useful to public admin-

istrators in proposed host countries, as well as to

administrators and decision-making boards of interna-

tional development agencies around the world. Given

the statistical dominance of institutional theory in our

model, government of ficials and politicians should

place greater (lesser) emphasis on institutional reform

(macroeconomic conditions) in order to attract greater

levels of inward FDI. This refocusing of effort would

likely exhibit a higher marginal productivity given the

greater scope for political/public influence on a coun-try’s institutional framework rather than its macroeco-

nomic environment (Barro, 1997, 1999). Additionally,

our results also indicate that administrators and advi-

sory boards of public agencies that are involved with

international development efforts, such as UNCTAD,

the International Monetary Fund and The World Bank,

should also consider a similar refocusing of effort.

Many of these agencies often are preoccupied with

assisting LDCs in producing macroeconomic policies

that are helpful with economic development. Our




results suggest that any assistance provided by either

the IMF or the WB should, perhaps, be geared toward

institutional reform. Not only does institutional theory

appear to dominate macroeconomic theories concern-ing MNE’s decision to locate outward FDI, these public

lending enterprises have a vested interest in assuring

that the marginal productivity of their own assistance

efforts is increased.

Acknowledgments

The authors thank two anonymous referees of this

journal, Frank Hoy, and Kamal Upadhyaya for helpful

comments.

References

Aliber, R. Z. (1970). A theory of foreign direct investment. In C. P.

Kindleberger (Ed.), The international corporation. Cambridge,

MA: The MIT Press.

Baer, W., & Rangel, G. B. (2001). Foreign investment in the age of

globalization: The case of Brazil. Latin American Business

Review, 2(1/2): 83–99.

Barro, R. J. (1997). Getting it right: Markets and choices in a free

society. Cambridge, MA: The MIT Press.

Barro, R. J. (1999). Determinants of economic growth: A cross-country empirical study. Cambridge, MA: The MIT Press.

Birch, M. H., & Halton, G. (2001). Foreign direct investment in Latin

America in the 1990s: Old patterns, new trends, and emerging

issues. Latin American Business Review, 2(1/2): 13–31.

Butler, K. C., & Joaquin, D. C. (1998). A note on political risk and

the required return on foreign direct investment. Journal of

International Business Studies, 29(3): 599–608.

Davidson, R., & MacKinnon, J. G. (1981). Several tests for model

specification in the presence of alternative hypotheses.

Econometrica, 49(5): 781–793.

Davidson, R., & MacKinnon, J. G. (1993). Estimation and

inference in econometrics. Oxford: Oxford University Press.

Devlin, R., & Cominetti, R. (1994). La Crisis de la Empresa Publica,

Las Privatizaciones y la Equidad Social. In Reformas de politica publica: 1–35 (Vol. 26) (LC/L 832). Santiago, Chile: CEPAL.

DiMaggio, P. J., & Powell, W. W. (1991). Introduction. In W. W.

Powell & P. J. DiMaggio (Eds.), The new institutionalism in

organizational analysis: 1–38. Chicago: University of Chicago

Press.

Froot, K. A., & Stein, J. C. (1991). Exchange rates and foreign

direct investment: An imperfect capital markets approach.

Quarterly Journal of Economics, 106 (November): 1191–1217.

Grosse, R., & Trevino, L. J. (1996). Foreign direct investment in

the United States: An analysis by country of origin. Journal of

International Business Studies, 27 (1): 139–155.

Gujurati, D. N. (1988). Basic econometrics. New York: McGraw-

Hill.

Hartenek, G. (1995). Privatization as a catalyst for FDI: The case of

Argentina. In Foreign direct investment: OECD countries and

dynamic economies of Asia and Latin America. Washington,DC: OECD Publications and Information Center.

Hoskisson, R., Eden, L., Lau, C. M., & Wright, M. (2000). Strategy

in emerging economies. Academy of Management Journal,

43(3): 249–267.

Kennedy, P. (1998). A guide to econometrics. Cambridge, MA: The

MIT Press.

Kennedy, R. E., & Sandler, A. (1997). Transition to a market

economy: The components of reform [Case No. 9-797-080,

Mimeo]. Harvard Business School.

Klein, M., & Rosengren, E. (1994). The real exchange rate and

foreign direct investment in the United States: Relative wealth

versus relative wage effects. Journal of International

Economics, 36 (3/4): 373–389.

Kmenta, J. (1986). Elements of econometrics. New York:

Macmillan Publishing Company.

Kobrin, S. J. (1979). Political risk: A review and reconsideration.

Journal of International Business Studies, 10(1): 67–80.

Kostova, T., & Zaheer, S. (1999). Organizational legitimacy

under conditions of complexity: The case of the multi-

national enterprise. Academy of Management Review, 24(1):

64–81.

MacKinnon, J. G. (1983). Model specification tests against non-

nested alternatives. Econometric Reviews, 2(1): 85–158.

Maddala, G. S. (1992). Introduction to econometrics. New York,

NY: Macmillan Publishing Company.

Meyer, K. (2001). Institutions, transaction costs and entry mode

choice in Eastern Europe. Journal of International BusinessStudies, 32(2): 357–367.

Mixon, F.G., Jr., & Gibson, M. T. (2001). The retention of

state level concealed handgun laws: Empirical evidence from

interest group and legislative models. Public Choice, 107 (1/2):

1–20.

North, D. (1990). Institutions, institutional change and economic

performance. Cambridge: Cambridge University Press.

Petrocella, D., & Lousteau, M. (2001). FDI in Argentina during the

1990s. Latin American Business Review, 2(1/2): 33–54.

Prahalad, C. K., & Hammond, A. (2002). Serving the world ’s poor,

profitably. Harvard Business Review, 80(9): 48–57.

Ramanathan, R. (1998). Introductory econometrics with applica-

tions. New York: Harcourt Brace & Company.

Ramirez, M. D. (2001). Foreign direct investment in Mexico andChile: A critical appraisal. Latin American Business Review,

2(1/2): 55–82.

Ramsey, J. B. (1969). Tests for specification error in classical linear

least squares regression analysis. Journal of the Royal

Statistical Society, 31(Series B): 250–271.

Rojas, (2001). The increased role of capital in the Peruvian

financial system: 1990–1998. Latin American Business Review,

2(1/2): 101–118.

Schneider, F., & Frey, B. S. (1985). Economic and political

determinants of foreign direct investment. World Development ,

13(2): 161–175.




Scott, W. R. (1995). Institutions and organizations. Thousand

Oaks, CA: Sage.

Tallman, S. B. (1988). Home country political risk and foreign

direct investment in the United States. Journal of International

Business Studies, 19(2): 219–234.Trevino, L. J. (1999). Market reform and foreign direct investment

in Central and Eastern Europe: A comparative assessment. In

D. K. Despotis & C. Zopounidis (Eds.), Proceedings of

Decision Sciences Institute. Athens: New Technologies Pub-

lications.

Trevino, L. J., Daniels, J. D., & Arbelaez, H. (2002). Market reform

and FDI in Latin America: An empirical investigation.

Transnational Corporations, 11(1): 29–48.

Tuman, J. P., & Emmert, C. F. (1999). Explaining Japanese foreign

direct investment in Latin America, 1979–1992. Social Science

Quarterly, 80(3): 539–541.

United Nations Conference on Trade and Development. (1994).

World Investment Report 1994: Transnational corporations,employment and the workplace. New York and Geneva:

UNCTAD.

United Nations Conference on Trade and Development. (1999).

World Investment Report 1999: Foreign direct investment and

the challenge of development . New York, NY: UNCTAD.

Xu, D., & Shenkar, O. (2002). Institutional distance and the

multinational enterprise. Academy of Management Review,

27 (4): 608–618.


factors affecting direct investments

Documents