Low wages don't drive FDI

The key factor that drives foreign direct investment is obviously the potential for returns, which tends to depend significantly on the cost differential between the source and destination locations of the FDI.

For our purposes here, let's define cost differential as the difference in the cost of a typical basket of goods and services. The cost differential then in turn depends substantially on the wage arbitrage between the locations, which can be simply defined as the difference in wages of labour providing those goods and services.

Other than the potential for returns, investments in a location are usually dependent on two other key factors: the risk profile of that location, and the investment policies of the destination location, which dictate the nature and extent of FDI coming into that location.

In theory, a decline in wage arbitrage should adversely affect FDI, while a decrease in destination country risk and relaxation of investment policies should encourage FDI. The key purpose of our analysis is to understand whether management of these factors is enough to ensure the strong inflow of FDI, or whether there are other factors, which need to be considered while making policy decisions to attract FDI.

To analyse the impact of the various factors that affect FDI, let's look at the manufacturing/products sector, which has traditionally driven the bulk of the FDI. One of the great success stories of manufacturing-driven FDI has been the US-China relationship over the last couple of decades. During this period, overall FDI into China has increased nearly 18 times (going from about $3.5 billion in 1990 to over $60 billion in 2005), and the US has been one of significant contributors.

Analysis shows, as expected, that there is a strong positive correlation between FDI and improvements in the regulatory environment during this time period. Surprisingly though, there seems to be no correlation between FDI and change in risk at all.

What is truly surprising though is that there emerges a strong negative correlation between FDI and manufacturing wage arbitrage. Thus, while wage arbitrage has been continuously declining between the US and China, the FDI has been continuously increasing!

When the same analysis is extended to the US and India, the correlation continues to hold for FDI and the regulatory environment, but becomes completely different when compared for wage arbitrage and risk.

The FDI-risk correlation comes out moderately negative, which seems to make sense, since decreasing risk should encourage FDI. The FDI-wage arbitrage correlation in this case actually does come out moderately positive, but still not explicitly enough.

Extended to a host of other source-destination pairs, including the US-Mexico, UK-India/China, Germany-Poland/Czech Republic, and Japan-China, the analysis reveals the following: FDI and wage arbitrage seem to move almost independently, thus implying that FDI can increase when wage arbitrage goes down as well as when it goes up.

Similarly, the FDI-risk analysis reveals that FDI can improve when risks decrease, but can also improve when there is no change in the risk profile of the destination country.

Finally, the FDI-government policy indicates that FDI almost always goes up when the government policies become more conducive to FDI. Of the three results, the last is the only one which seems to make theoretical sense, and even if one were to allow for some ambiguity in risk measurement and hence be somewhat tolerant of the FDI-risk correlation results, the analytical relationship between FDI and wage arbitrage turns out to be completely surprising and defying fundamental principles.

Digging a little deeper into FDI and wage arbitrage numbers, one finds that across the pool of destination countries examined, the FDI has been growing at widely varying rates over the last 15 years, from a 10 per cent range for countries like Poland and Mexico to over 40 per cent for India.

During the same period, however, wage arbitrage between any of these countries and the source countries regularly sending work into these countries has been declining at only a marginal rate (less than 0.5 per cent per annum) in all cases, and has even been increasing nominally in some cases.

This paradox only serves to strengthen the argument that there is much more to attracting FDI than simply the cost benefits that a country can provide.

What does this imply then for the Governments and policy makers of countries looking to attract FDI? Simply put, the key implication of this analysis is that policy makers might have to make significant investments in "softer", non-core factors such as "sales & marketing" efforts and increasing awareness of the attractiveness of their locations to be able to attract FDI, over and above investments in creating and maintaining the basic financial attractiveness of their locations.

The "hard" factors, such as returns, risk, and policy, seem to be either hygiene factors for attracting FDI, or at least somewhat subject to self-correcting mechanisms to ensure that attractiveness is maintained, e.g. the minimal changes in labour arbitrage seem to imply that factors such as foreign exchange and other market forces or policies are kicking in to ensure that labour arbitrage stays relatively flat.

Thus, the hard factors might be a necessary, but are by no means a sufficient condition to ensure the attractiveness of a location. If the Indian Government needs to make FDI work wonders for its growth, then it might do well to invest in "dressing up" India attractively over and above ensuring financial viability.