19. október, 2005 Helga Kristjánsdóttir The Role of Threshold Costs in Foreign Direct Investment (Bein erlend fjárfesting og fastur kostnaður) 19. október, 2005 Helga Kristjánsdóttir

Background Following World War II, the production capacity of industrialized countries increased substantially In 1960s large Japanese car manufacturers had to choose between exporting and investing in United States Multinational entity (MNE), or a Multinational, is a firm with multinational activities

Background In 1980s, general-equilibrium and partial-equilibrium trade theories were combined in New Trade Theory 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)

Background Most FDI among developed countries, i.e., East and West, rather than North and South Small open economies particularly dependent on exports and FDI Export ratio (goods and services) of Iceland is comparatively small, or 35% of GDP in 2003 Scandinavian countries’ export ratios ranged from 37-44% Japan and US had export ratios below 12%

Research Objective Extend existing knowledge in the field Emphasize criteria used for selecting certain theories for application to Icelandic data Gravity, as in physics, and knowledge Interpret implications of empirical results for Iceland in an international perspective

Data Used in this Research The data used in the research is unique: Data on Foreign Direct Investment in Iceland on the 24 countries having OECD membership throughout the period estimated (1989-2001) FDI: Foreign ownership of controlling stock in a particular firm (generally 10% or more) Central Bank of Iceland 24 OECD countries, 4 sectors,13 years

Earlier Research 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

Earlier Research FDI sector shares and levels Brainard (1997) 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

Model Setup Bergstrand 1985 specification: Yi is GDP of exporting country Yj is GDP of recipient country Dij is distance between economic centers of source and host countries Aij reflects factors that aid or restrict trade between country i and j  log-normally distributed error term,E(lnij) = 0

Model Setup The specifications applied here include Sector and trade bloc fixed effects, both individually and simultaneously Marine, Manufacturing, Power, Other Waldkirch (2003)

Model Setup Combination of Gravity Model and Knowledge-Captial (KK) Model Knowledge-Capital model by Carr, Markusen and Maskus (CMM, 2001) Endowment inclusion in gravity model obtained from the KK literature Generally the KK model with incorporation of endowments – skilled / unskilled labor

Model Setup Typical KK model with skilled and unskilled labor may not be right endowment approach for Iceland Proxy knowledge in several ways ILO occupation, first and second occupation levels Education, 2nd School Education Per capita wealth Additions here include important factors of endowments - hydro energy supply, oil prices

Model Setup 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

Some Regression Results OLS / TOBIT 1ST STEP 2ND STEP Yj (+) (+) (+) (+* / --) Yi (--) (--)*** (+/--*) (--) Yj per N (+) (+)*** (+)*** (+/--) Yi per N (--) (--) (+) (--) ---------------------------------------------------------------------------------------------------------- Y = economic size Y / N = economic wealth

Conclusions Distance is found to be a barrier to exports As in Krugman (1991) Find support for the intuition behind KK model, i.e. that endowments matter Use more endowment proxies than merely the knowledge-endowment proxies, crucial to Icelandic economy Find GM and KK model combination useful for explaining fixed FDI costs

Conclusions Taken together, we find FDI to be decreasing in wealth of the source country, however increasing in the wealth of Iceland, and the same holds for the economic sizes of Iceland and the source country. Also, we find indication of more FDI following more skilled labor in source, and less so in host. Estimates indicate negative effects of distance increase on FDI, and rather so in the first step. Moreover, results indicate that current FDI is positively affected by source country per capita hydro power supply when overcoming fixed costs , as well as previous year manufacturing pollution allowance. Finally, previous year world oil prices are found to positively affect marginal change in FDI in the Heckman second step. Overall, the Heckman procedure allows us to receive results in two steps. Our estimates indicate that variables are found to be more significant in the first step of the Heckman procedure, rather than in the Heckman second step. This can be interpreted such that FDI is more highly affected by fixed changes than marginal, and therefore fixed costs rather than marginal.