Fragmentation: Foreign Direct Investment
Production networks withdeveloping economies typically requireup-front capital formation, financed at least in part by inflows of foreign direct investment (FDI) and technology from advanced countries. Foreign investors erect production facilities and install infrastructure, bring in skilledworkers, and transfer technology at levels of sophistication beyond those available in the country. While such activities violate several assumptions of the H-O model, that model is nevertheless useful in predicting the pattern of FDI flows.
The investment involved is vertical (VFDI), intended to support vertical or intraproduct specialization. In a world of cross-border production fragmentation, the H-O model predicts that VFDI will tend to flow fromcapital- and skill-abundant, laborscarce countries to labor-abundant economies. The Ricardian model predicts that such flows will move from technologically advanced to technologically emerging economies.
As already noted, factor endowments are only one type of location advantage, and therefore cannot fully explain movements of FDI. Once again, the gravity model offers a way of accounting for additional location- specific considerations including distance, country size, border effects, and various institutional and policy-related factors. The bulk of the existing empirical literature on FDI, however, covers periods dominated by horizontal foreign direct investment (HFDI), which prevails among advanced countries and which continues to be the dominant form of FDI.
According to this evidence, FDI responds positively to distance.The explanation lies in the fact that in horizontal specialization FDI is a substitute for exports. As distance and its costs increase, exports are replaced by on-site production for the local market and hence FDI flows rise. Vertical FDI, on the other hand, moves to support production sharing. Hence, when distance raises the costs associated with servicing a network, production sharing becomes unprofitable and FDI declines.