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Dongpei Huang is a Ph.D. candidate at Columbia University and Sayuri Shirai is an economist in the Research Department. We are deeply indebted to Andrew Caplin who helped us to elaborate our ideas presented in this paper. We thank Jagdish Bhagwati, Eduardo Borensztein, Ronald Findlay, Glenn Hubbard, Philip Jefferson, Mohsin S. Khan, Jian Hai Lin, Frederick Mishkin, Ashoka Mody, Peter Wickham and seminar participants at the International Monetary Fund. The opinions expressed in this paper are those of the authors and do not necessarily reflect those of the IMF. The remaining errors are, of course, our own.
Aharoni (1966) has considered the situation in Israel where the large infusions of FDI, which were anticipated when Israel’s Law for Encouragement of Capital Investments was enacted, did not materialize, Young (1992, p. 24) has emphasized that Singapore’s Pioneer Industries Ordinance introduced in 1959, which provided the most significant tax holiday enjoyed by foreign investors, failed to attract much FDI until after 1968. Since then when the Singaporean government expanded its own financial participation in manufacturing and other sectors, FDI began to increase.
Arni (1987) has provided a detailed description of the sequential process of operations before a joint venture is implemented. The operations include, for example, market surveys, preinvestment studies, searches for joint venture partners, detailed project studies, proposals to host country governments, approvals by them, and project financing. These sequential operations are included in the broad definition of search costs.
The overall investment environment refers to economic and political fundamentals. It includes both the general environment as well as the environment specific to locations and industries. Uncertainty about the general environment is likely to decline faster than for the specific environment since more information about the later is necessary to lower uncertainty.
There are at least four major theories that attempt to explain the pattern of FDI. The Hecksher-Ohlin-Samuelson model suggests that capital flows from capital-abundant countries to labor-abundant countries. The product cycle theory indicates that FDI occurs as firms in the product-maturing market try to capture the remaining rents, by expanding overseas. The portfolio theory regards FDI as a way to reduce the overall investment risk through diversification. The industrial organization theory emphasizes firm-specific advantages, transaction costs and maintenance of oligopolistic power, as forces for FDI. For an extensive survey of the literature, see Agarwal (1980), Eckaus (1986) and Lizondo (1990).
For example, it took a few years for All-Nippon Airways (ANA) until it finally took an joint venture equity in the hotel industry with Xiyuan Hotel, the Bank of China and C. Itoh, one of the leading Japanese trading houses. In early 1984, the Japanese carrier began to investigate investment opportunities in China by sending a study mission to various cities. However, it could not make a firm investment decision for a long time because investment conditions were judged to be difficult. In May 1986, China, which needed to provide parking and other facilities for the 1990 Asian Games, contacted ANA through C, Itoh, which was already involved in other joint projects in China. After the initial approach from the Chinese side and negotiation by the experienced Japanese firm, ANA finally signed a joint venture contract in October 1987.