Ice Breaking FDI Ministry of Commerce December 20th 2007 Dr. Helga Kristjánsdóttir

Introduction Multinational entity (MNE), or a multinational, is a firm with multinational activities Flows / Stocks of FDI, 10% rule, potentially negative Most FDI among developed countries, i.e., East and West, rather than North and South Vertical FDI – Production located to gain access to abundant factors (Helpman, 1984) Horizontal FDI – Production located to overcome trade costs and gain market access (Markusen, 1984)

Introduction

Overview Data Sources 1) Seðlabanki Íslands, countries or years, not both. 2) OECD: Bilateral inbound FDI stocks. Parent or host country belongs to OECD. 3) World Bank, WDI: Total inbound and total outbound FDI flows. 4) BEA, Bureau of Economic Analysis: Bilateral US inbound and outbound, combined, stocks, affiliate sales. 5) IMD, WCY World Competitiveness Yearbook.

Overview 1) Determinants of Foreign Direct Investment in Iceland CAM Working Paper Series, University of Copenhagen. September No Determinants of Foreign Direct Investment in Iceland 2) The Knowledge-Capital Model and Small Countries EPRU Working Paper Series, University of Copenhagen. September No , ISSN The Knowledge-Capital Model and Small Countries 3) What Drives Sector Allocation of Foreign Direct Investment in Iceland EPRU Working Paper Series, University of Copenhagen. September No , ISSN What Drives Sector Allocation of Foreign Direct Investment in Iceland 4) Estimating the Impact of Time-Invariant Variables on FDI with Fixed Effects with Ronald Davies and Delia Ionascu. University of Oregon Economics Department Working Papers. May No. UO Estimating the Impact of Time-Invariant Variables on FDI with Fixed Effects 5) Talking Trade or Talking Aid? Does Investment Substitute for Aid in the Developing Countries? IoES Working Paper Series, University of Iceland. May No. W07:02. ISSN Talking Trade or Talking Aid? Does Investment Substitute for Aid in the Developing Countries? 6) Geysir Víking Land: Saga IBR Working Paper Series, University of Iceland. May No. W07:03. ISSN Geysir Víking Land: Saga 7) Substitution Between Inward and Outward Foreign Direct Investment IoES Working Paper Series, University of Iceland. December No. W06:12, ISSN Substitution Between Inward and Outward Foreign Direct Investment 8) Fixed Costs, Foreign Direct Investment, and Gravity with Zeros with Ronald Davies. University of Oregon Economics Department Working Papers, University of Oregon. June No. UO Fixed Costs, Foreign Direct Investment, and Gravity with Zeros

Data Availability Typical data availability could be as follows: Data on Foreign Direct Investment in Iceland Central Bank of Iceland Panel data, with the data dimension being: 17 countries, 4 sectors and 11 years Trade blocs EFTA, EU, NAFTA and NON-bloc

Paper 1: Determinants of FDI Trade literature: Foreign direct investment (FDI) viewed as form of trade Trade in financial capital FDI: Foreign ownership of controlling stock in a particular firm (generally 10% or more) Inward FDI sectors in Iceland Power, Com & Fin, Tel & Trans, Other Study if FDI in Iceland can be explained by location, market size, and several other factors

Paper 1.: Determinants of FDI Trade literature: Gravity models increasingly popular for estimating FDI Brainard (1997); Mody, Razin and Sadka (2003) Fixed country and sector effects Jeon and Stone (1999) and di Mauro (2000) used countries and sectors Here also trade bloc effects

Paper 1: Determinants of FDI Bergstrand 1985 specification: Y i is GDP of exporting country in USD Y j is GDP of recipient country in USD D ij is distance between economic centers of source and host countries A ij reflects factors that aid or restrict trade between country i and j  log-normally distributed error term,E(ln  ij ) = 0

Paper 1.: Determinants of FDI Gravity model useful in predicting FDI levels Consistent with previous literature Unlike earlier findings, wealth more important than market size Effects of market size variables (GDP, POP) often close to being equal and opposite in sign Distance negatively affects FDI, and FDI appears to be driven more by wealth effects than by market size effects

Paper 2.: Knowledge-Capital Model Trade and investment relations of Iceland viewed in global perspective, incorporating factor endowments Knowledge-Capital (KK) model by Carr, Markusen and Maskus (CMM 2001) applied to small country case, using Icelandic data KK model incorporates both horizontal and vertical incentives for FDI

Edgeworth Box O s = Origin for Source Country Unskilled Labor Origin for Host Country = O h Unskilled host country skill(i)-skill(j)>0 Skilled host country skill(i)-skill(j)<0 Small host country Y(i)-Y(j)>0 Location of Iceland RELATIVE ENDOWMENTS RELATIVE SIZE Sdiff=0 Large host country Y(i)-Y(j)<0 Ydiff=0 Skilled Labor

Paper 2.: Knowledge-Capital Model Blonigen, Davies, and Head (2003) Horizontal model cannot be rejected in favor of the KK model Davies (2003) Finds support for KK model Braconier, Norbäck, and Urban (2003) Find support for CMM specification

Paper 2.: Knowledge-Capital Model Basic KK specification and modification Thoroughly analyze knowledge effects Specification restrictions, enlarged sample, outlier omission Blonigen, Davies, and Head (2003) Davies (2003) Also proxy by education and per capita wealth Squared and cubed skill level and subsamples

Paper 2.: Knowledge-Capital Model Driving forces for FDI in Iceland appear to be different from those in large countries Potential data difficulties when there are large differences in GDPs or population Alternatively, omission of important factor endowments such as energy or fish stock

Paper 3.: Sector Allocation of FDI Skilled and unskilled labor may not be right endowment approach for Iceland Inward FDI Sector decomposition, resource endowments Power, Com & Fin., Tel & Transport, Other Waldkirch (2003) Also natural resources, infrastructure, pollution quotas and government stability

Paper 3.: Sector Allocation of FDI FDI sector shares and levels FDI shares reflect relative size of each sector within a particular year of investment Brainard (1997) Inward and outward FDI share proxies separately as share of affiliate sales in total exp Slaughter (2000) FDI proxied by investment share (measured as majority-owned affiliates) in overall MNE investment

Paper 3.: Sector Allocation of FDI FDI theories assume certain threshold costs Generally not dealt with in FDI empirical models Markusen (2002): fixed cost that MNEs need to consider when undertaking FDI Heckman's (1979) two-step model to control for whether sample selection is driving results KK model seems to explain fixed costs but not the level of investment (marginal change) However, gravity model provides information on both

Paper 3.: Sector Allocation of FDI Results different from what was anticipated since KK model still does not perform very well for Iceland Heckman procedure application to gravity rather than KK model, since this gives better indication of how host-country characteristics affect FDI However, endowment inclusion in gravity model can be credited to KK literature

Paper 4.: Impact of Time-Invariant Vars Introduction: First time application of fixed effects procedure to Foreign Direct Investment (FDI). Estimating panel fixed effects with vector decomposition (XTFEVD) in three-stages: 1. Estimates for time-variant variables. 2. Takes out the unexplainable part. 3. Runs again, using the unexplainable part.

Paper 4.: Impact of Time-Invariant Vars Hofstede (2001) 5 cultural distances –1. Power Distance (PD) –2. Individualism (Independence) –3. Masculinity (Masculinity) –4. Uncertainty tolerance (Uncertainty) –5. Long-term orientation (Time)

Paper 4.: Impact of Time-Invariant Vars Model and Data: The model efficiently estimates impact of time-invariant variables - while also controlling for fixed effects. Three commonly used FDI datasets are applied, running from 1980 to 2000: 1) BEA, Bureau of Economic Analysis: Bilateral US inbound and outbound, combined, stocks, affiliate sales. 2) OECD: Bilateral inbound FDI stocks. Parent or host country belongs to OECD. 3) World Bank, WDI: Total inbound and total outbound FDI flows.

Paper 4.: Impact of Time-Invariant Vars Estimation Results: Estimation results indicate that by eliminating estimation biases, the differences across datasets largely disappear. Thus, controversies in the literature that are driven by differences in data sets may be resolved by using this estimation technique. Findings show that omission of fixed effects, when using OLS, significantly biases several of these variables, for example when proxying for culture.

Paper 4.: Impact of Time-Invariant Vars Conclusions: Magnitude, rather than differences are an important predictor of FDI. Results indicate that FDI comes from and goes to countries with high: Masculine values, Long term goals, Power Distance, FDI outflows from countries with high Independence, but less into these.