Today, multinational firms are undoubtedly key players and their investment decisions are a big factor behind the changing economic landscape of the world. But what factors drive their investment decisions? October's RIETI Report features the Non-Technical Summary of a Discussion Paper delving into this question, a rare attempt to identify the determinants of, and interaction between, fixed capital investment decisions by multinational firms at the micro level.
The original Discussion Paper was co-authored by René BELDERBOS (Katholieke Universiteit Leuven / Maastricht University / UNU-MERIT), FUKAO Kyoji (Faculty Fellow, RIETI), ITO Keiko (Senshu University) and Wilko LETTERIE (Maastricht University).
This Non-Technical Summary does not constitute part of the above-captioned Discussion Paper but has been prepared for the purpose of providing a bold outline of the paper, based on findings from the analysis for the paper and focusing primarily on their implications for policy. For details of the analysis, read the captioned Discussion Paper. Views expressed in this Non-Technical Summary are solely those of the individual author(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).
Problem in Perspective and Hypothesis
While a number of studies have been conducted on the activities of multinational firms, very few have examined how those firms make decisions on fixed capital investments in their home and host countries. For instance, there are many studies that have focused on firms' choice of locations for launching overseas operations, examining what factors or conditions make a country or region an attractive location for fixed capital investments by multinational firms. However, firms' behavior in subsequent investment decisions - i.e. the choice of a location for subsequent fixed capital investments from among the multiple locations in which they operate - has yet to be fully explained or verified. A limited number of empirical studies found a complementary relationship between multinational firms' fixed capital investments in their home country and their investments in foreign countries, suggesting the possibility that an increase in investments overseas may have a positive impact on investments in the home country. However, those firms face financial as well as technical constraints associated with the types of goods that they produce in a way to ensure competitive advantage. Thus, in order to expand investments in a certain location, a firm may have to reduce investments in other locations. In other words, there may be substitution effects across multiple locations in multinational firms' fixed capital investment decisions.
In this paper, we examine what factors are important determinants when multinational firms, in the face of various constraints, decide the level of fixed capital investments in each of their existing locations around the world. We developed a model of simultaneous fixed capital investment decisions by multinational firms in their home and host countries and applied the model to Japanese multinational firms to examine their investment decision behavior. Our theoretical model assumes that multinational firms - each of which produces multiple, sufficiently differentiated products - choose optimal locations and production volumes for each of their unique products. It is considered that a firm's decision on the level of investments in a specific location is based on the country and industry attributes of that location as well as on the country and industry attributes of other locations in which the firm operates.
Main points of the findings
Using data collected in the Survey of Overseas Business Activities and the Basic Survey on Japanese Business Structure and Activities conducted in 1996 and 1997, we empirically analyzed fixed capital investment decisions made by Japanese manufacturers and their manufacturing affiliates overseas for a total of 1,707 locations. Our analysis found that growth in a firm's fixed tangible assets in each location (including the headquarters) is determined not only by factors affecting the return on investment in the location itself (i.e. effective demand, wages, etc.) but also by relative wage levels in all the other locations in which the firm operates. This means not only that a firm's investments in a specific location are kept at a low level when the average wage rate is high for the relevant industry in the country to which the location belongs, but also that the level of investments in a specific location tends to be higher when the corresponding wage levels are higher in other countries in which the firm operates. It is thus suggested that multinational firms determine investment allocations across multiple locations in a substitutive manner in accordance with the relative wage level of each location. It was also found that firms facing liquidity constraints globally have lower growth in tangible fixed assets. This suggests that multinational firms face the challenge of making simultaneous decisions, not only about where to produce their products but also about where to spend their limited financial resources.
Our research findings suggest that Japanese multinational firms have been responsive to changes in the relative costs across their production bases and thus diverted investments in fixed capital from high-wage countries to low-wage countries. This indicates that the features of multinationality itself are another source of high competitiveness, enabling them to minimize production costs through the optimal allocation of investments across multiple locations around the world. Meanwhile, when a country's economy deteriorates due to some sort of economic shock or wage levels rise relative to those in other countries, multinational firms may reduce investments in the country more sharply than in other countries. Such behavior of multinational firms may exacerbate the negative effects of wage hikes or deepen recession in the country. Greater liquidity constraints in the home country may also prompt multinational firms to reduce investment in overseas locations. Many Japanese multinationals operate globally, making greater investments in overseas locations than in Japan. As derived from our analysis, multinational firms' fixed capital investment behavior in a country is determined not only by factors in the country but also by those in other countries in which they operate. This indicates that in formulating policies, a government needs to consider economic growth and other indicators of national economy not only in absolute terms but also in relative terms, that is, in comparison with other countries.