The Impact of Regional Economic Integration on FDI Attraction

2.1.2.2. Impact of regional economic integration on FDI attraction

a. The impact mechanism of regional economic linkages on FDI attraction

Regional economic integration can promote or redirect investment activities through mechanisms that expand investment areas and adjust policies for investors of other member countries in the same association. Integration promotes FDI through trade liberalization and market integration, efforts to harmonize common policy frameworks of participating countries - including investment (protection and liberalization) and direct investment cooperation for regional investment projects (See Table 2.1).

Table 2.1: Impact mechanism of regional economic integration on FDI attraction

Mechanism

Impact on FDI flows in the associated region	Impact on FDI flows outside the associated region
Liberalize and/or protect investments through the provisions of investment treaties	Allow/encourage increased flows from investors within the region, including third country investors from outside the associated region	Encourage third country investors outside the investment association area to take advantage of incentives and avoid investment protection
Trade and market integration provisions in economic association agreements	Allows for the reorganization of production activities – including investment and divestment – at countries participating in regional economic integration	Attracting new investment from third countries to access more open markets and global value chains
Harmonizing policies to implement economic integration commitments	Encourage investment by reducing transaction costs and risks	Facilitate/encourage increased FDI inflows if policy harmonization includes investment regulations applicable to investors from third countries outside the economic integration area
Larger region-wide investment projects (e.g. infrastructure or research and development) are implemented through agreements. zoning	Increase investment opportunities	Increase investment opportunities

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(Source: UNCTAD, 1996)

Integration can increase FDI by liberalizing and removing investment restrictions or reducing transaction costs through the removal of trade barriers and policy convergence among member countries. FDI attraction outside the associated region can also increase due to the attractiveness of an expanded market – this is especially important for the smaller group of economies in the economic association. In addition, integration

Regional economic integration increases trade barriers with countries outside the association, thereby increasing import-substituting FDI flows. Investment outside the association may also increase as a result of concerted efforts to promote investment within the economic association (Basil et al., 2003; Clark, 2000).

International economic integration also affects FDI flows as a result of the rationalization of production facilities of MNEs in the region to gain location economies. This process can lead to increased FDI flows or investment diversion within the economic integration area, especially when integration reduces trade barriers allowing enterprises to take advantage of economies of scale, producing and serving larger regional markets (Kokko & Patrik, 2004).

b. Factors affecting the impact of regional economic linkages on FDI attraction

The impact of regional economic integration – ranging from free trade areas to economic unions – on FDI attraction depends on many factors. The most prominent factors include (i) the scope and depth of the agreements in the association ; (ii) the credibility of the commitments ; (iii) the existing economic-investment relations between member countries ; and (iv) the advantages of one host country over another member country in the same association (UNCTAD, 1996). In addition, this impact also depends on the characteristics of the enterprises involved and the time frame of analysis.

First, the scope and depth of integration commitments. The scope and depth of economic commitments will determine the degree of policy harmonization of each linkage. Shallow linkages that do not commit to tariff reductions among member countries and determine the level of external tariffs with non-member countries will affect FDI activities through economic growth of member countries in the regional economic linkage (dynamic impact) or through trade activities between member countries or strategies with competitors (static impact). Deeper regional economic linkages that allow free movement of capital (including FDI) will have a greater impact on investment determinants of MNEs other than trade and growth. In general, the deeper the level of economic linkages, the more channels the linkages’ influence on FDI determinants is exerted. In addition, as FDI regulations become more harmonized due to the impact of economic integration, FDI attraction factors related to regional economic location advantages and business facilitation incentives play an increasingly important role.

Second, the reliability of commitments in economic association. The reliability of economic association is shown through the level of commitment terms in economic association.

international economic integration is implemented – this is another factor that determines the impact of international economic integration on FDI determinants. The failure of members to fully implement their commitments in regional integration makes the impact of the integration provisions on FDI determinants not be promoted. In the 1960s and 1970s, many economic integrations were not fully implemented, leading to these regional-level economic integrations not having any obvious impact on FDI flows. International economic integrations such as the EU, NAFTA and MERCOSUR have created a greater impact on FDI determinants, especially those related to policies and economic conditions, thanks to the strict implementation of commitments compared to economic integrations in the previous period. The choice of members to maintain conditional investment portfolios and restrict market access for foreign investors in certain sectors can have an impact on the scale of FDI attraction (even if the restricted portfolios are only temporary). Foreign investors may doubt the compliance with economic commitments of member countries. Along with that, the speed of implementing commitments in economic integration such as the speed of improving the investment environment and eliminating tariff barriers also has a direct impact on the business efficiency of investors and thereby affects the attraction of FDI to member countries.

Third, the degree of interdependence of member countries before the establishment of regional linkages. The degree of pre-existing interdependence of member countries or the established linkages between countries is also an important factor affecting FDI. For countries that have already established significant economic linkages, the main impact of regional economic linkages on FDI attraction will depend on the extent to which countries adjust their domestic policies. For example, the 1989 US-Canada Free Trade Agreement had little impact on FDI flows to Canada – this is because bilateral trade between the two countries had been significantly liberalized before the agreement came into effect through several rounds of multilateral tariff reduction negotiations or sectoral agreements. Under such conditions, a free trade agreement has very little impact on FDI since countries are not required to cross-penetrate markets through FDI (Blomstrom & Kokko, 1997).

However, multinational companies and corporations interested in investing in a region will still need to choose a specific investment location among the countries in the economic association. Investors will consider regional factors as well as the characteristics and comparative advantages of each country. The locations that attract the most FDI will be those that provide the best opportunities for investors to exploit the specific advantages of each country and region.

2.2. Basic theories on services and FDI in service industries

2.2.1. Services

2.2.1.1. Concept

The concept of service is quite broad. Service is an independent economic sector that meets individual needs and serves production industries. Service provision activities can now appear in any area of life - the service sector also accounts for a large proportion of the national economy and is constantly increasing (OECD, 2016).

OECD (2001) defines services as “products produced to order and inseparable from the process of providing the service. Services are not entities that can establish separate ownership. They cannot be exchanged separately from their production. Services are heterogeneous products produced to order and often modified by the producer based on the requirements of the consumer. Once production is complete, the service must be provided to the consumer ” (OECD, 2001). The OECD approach has clarified the characteristics of services and has many similarities with the definition of services from a marketing perspective of Kotler and Keller (2009), according to which a service is defined as “ any activity that one person can offer to another that is essentially intangible and does not result in any ownership. The production of services may or may not be tied to a physical product ”.

However, with this definition, the classification of sectors and sub-sectors that can be classified into the service group is unclear and not completely consistent among countries in the world. Therefore, for convenience in operation, the General Agreement on Trade in Services (GATS) did not introduce the concept of services but listed services into 12 major sectors (See Table 2.2.). The 12 service sectors are divided into 155 sub-sectors, with 4 main modes of service provision, including: (i) cross-border supply, (ii) consumption of services outside the territory, (iii) commercial presence and (iv) presence of natural persons (WTO, 2020).

Table 2.2: Classification of service sectors according to GATS

12 service sub-sectors under GATS

1. Entertainment, cultural and sports services	5. Construction and engineering services	9. Health and social services
2. Information services	6. Environmental services	10. Tourism and related services
3. Training services	7. Financial services	11. Business Services
4. Business services	8. Transportation services	12. Other Services

(Source: WTO, 2020)

In addition, in the modern concept, the national economic structure is divided into three main sectors, including agriculture, industry and services. According to the National Accounting System (SNA), the Vietnamese economy has 20 primary sectors, of which agriculture has 2 sectors, industry has 4 sectors and services have up to 14 primary sectors (Ho Van Tinh, 2009) (See Table 2.3).

Table 2.3: Classification of service industries according to SNA

14 service industries according to SNA

1. Wholesale and retail, repair of automobiles, motorcycles, motorbikes and other motor vehicles	6. Transportation and warehousing	11. Accommodation and catering services
2. Professional activities, science and technology	7. Information and communication	12. Financial activities, banking and insurance
3. Real estate business activities	8. Health and social assistance activities	13. Administrative activities and support services
4. Arts, entertainment and recreation mind	9. Education and training	14. Service activities other
5. Activities of the Communist Party, socio-political organizations, State management, national defense and security; compulsory social security	10. Activities of hiring out household work, producing material products and services for household self-consumption

(Source: Ho Van Tinh, 2009)

The two classifications of GATS and SNA basically have many similarities in the division of main sectors. The thesis uses both classifications of the above service sectors: When assessing the levels of implementation of Vietnam's commitments related to investment in the service sector, the classification of service sectors according to GATS is used because the agreements in the AEC also use this classification. In addition, due to the characteristics of FDI data collected by the Foreign Investment Agency (2021), the thesis will combine the use of the classification of service sectors according to SNA when studying the current status of FDI attraction from ASEAN to Vietnam's service sectors.

2.2.1.2. Characteristics

Since the 1980s, the four characteristics include (i) Intangibility,

(ii) Inseparability, (iii) Heterogeneity and (iv) Perishability – also known as IHIP characteristics (Edgett and Parkinson, 1993; Zeithaml et al., 1985) are widely recognized as the factors that distinguish services from goods. Specifically:

Intangibility: Services are essentially intangible in nature, they cannot be touched, smelled or seen. In addition to being physically intangible, services are also difficult to grasp with the mind and are therefore mentally intangible (Regan, 1963).

Inseparability : Another characteristic of services is the inseparability of service production and consumption. A service cannot be separated from its source. The production of a service requires the source that produces it – whether a person or a machine.

– must be present. In other words, the production and consumption of services occur simultaneously. This is in contrast to goods – the consumption of a product occurs whether or not its source is present (Kotler, 1994).

Heterogeneity: Services are difficult to standardize. Heterogeneity refers to the high variability in the performance of services. The quality and nature of a service may vary from producer to producer, from customer to customer, and from time to time. Heterogeneity in quality and output is particularly evident in labor-intensive services (Parasuraman et al., 1985).

Perishability: Services are perishable in the sense that they cannot be stored for use at a later time. Therefore, they must be consumed as soon as they are produced. In other words, services cannot be produced before they are required nor can they be stored to meet later demand. If a service is not used when it is available, it is wasted. Due to the inability to store and be flexible to fluctuations in demand, service organizations are more affected by changes in demand for their services (Carson, 1985).

Recently, several scholars have challenged the notion that IHIPs are characteristics that distinguish services from goods (Moeller, 2009). The authors argue that previous studies have mainly considered personal services or low-tech, high-contact services (Bowen, 2002). With the development of new technologies, IHIP characteristics tend to no longer characterize services. The inseparability between production and consumption, as well as the perishability of services, can be overcome by communication, for example, web-based lectures, interactions in distance learning, or minimally invasive surgery that can be performed by doctors remotely (Grove et al., 2003; Rust, 2004; Lovelock and Gummesson, 2004; Vargo and Lusch, 2004). These changes are the basis for facilitating the movement of certain types of services from one country to another and the provision of services remotely.

2.2.2. FDI in service industries

2.2.2.1. Characteristics

UNCTAD (2003) found that the growth of FDI in services reflects two factors: the rise of the service economy in developed countries, which accounts for

on average about two-thirds of total GDP; and openness to FDI in the services sector of all economic groups. Since many services cannot be traded or stored but must be produced where they are consumed, FDI is the primary means of bringing these services to foreign markets. In addition, host country regulations often require foreign firms to establish local facilities to provide services.

Theoretical studies (Deardorff, 1985; Markusen et al., 2005) indicate that FDI in services is more complex than FDI in goods, because services differ from goods due to the intrinsic characteristics of services as mentioned above. The characteristics of services affect the investment patterns and therefore, the motivations for FDI in services may be different from those for FDI in goods. In addition, FDI in services is still more restrictive than FDI in manufacturing because service sectors tend to be subject to investment controls or restrictions by non-tariff measures. For example, sectors such as telecommunications, banking, transportation and electricity supply are often subject to economic regulations or cautious opening because these sectors are considered to be strategically sensitive by host countries (Jensen et al., 2007).

2.2.2.2. Factors affecting FDI attraction in the service industry

Although FDI in services is different in nature from FDI in manufacturing, researchers have demonstrated that there is no need to develop new theories to model the determinants of FDI in services. An overview of theoretical and empirical studies shows that there are many factors affecting FDI inflows into services. Most FDI in services is driven by market-seeking factors such as market size, the growing number of middle-income consumers, economic growth, and benefits of regional integration (Dunning, 2003; Wadhwa and Reddy, 2011; Zheng and Ismail, 2019). The impact of factors varies depending on the space and time of the study. Based on the overview, it can be seen that some of the main factors affecting FDI in services found in empirical studies are as follows:

a. Economic factors:

Market size and potential: Market size and potential are considered as one of the factors that have a decisive influence on the location of FDI inflows. Large market size can have a positive impact on FDI inflows into the service sector due to the potential for larger demand and lower costs due to economies of scale (Kolstad & Villanger (2004), Bhasin (2014), Kafait (2018). However, Walsh & Yu (2010) found that in developed economies, economies with lower GDP per capita will attract more capital inflows. In addition, economic growth

Rapid growth also increases domestic demand and business opportunities for foreign firms. Since FDI is a long-term commitment, promising future market potential in host countries will be an important factor attracting MNEs to invest. In service industries, Yin et al. (2014) found a positive relationship between growth prospects and the willingness of foreign firms to invest.

Trade openness: International trade is often considered an important indicator of a country’s market openness. Some theories suggest that trade openness has a positive effect on export-oriented FDI, while it has a negative effect on market-seeking FDI (Lauridsen, 2002). In other words, the impact of trade openness on different types of investment is different. In the service sector, some studies have shown a positive impact of trade openness on FDI (Kolstad & Villanger, 2004; Ramasamy & Yeung, 2010; Abdul et al., 2018; Kafait, 2018). Yin et al.’s (2018) study, however, found the opposite effect.

Human resources: Human resources factors include (i) cost and (ii) quality of human resources. Labor costs: The relationship between labor costs and FDI inflows is ambiguous, depending on whether the FDI enterprise's investment motive is efficiency-seeking or market-seeking. FDI focusing on highly skilled labor can accept high wages in the host country, leading to a positive relationship between FDI and labor costs (Yean et al., 2018; Kaliappan et al., 2015). In contrast, MNEs aim to transfer low-skilled production processes to other countries with low wages to reduce production costs, leading to a negative relationship between FDI and labor costs (Ramasamy and Yeung, 2010; Walsh and Yu, 2010; Yin, 2011). Labor quality: In general, investment projects that require capital, knowledge and skills require highly skilled labor to respond to rapid changes in service demand and improve service quality. Many studies have shown that high labor skills have a positive impact on attracting FDI in the service industry (e.g. Yean et al., 2018; Bhasin, 2014; Ramasamy and Yeung, 2010). However, many studies have also shown that labor skills have no significant impact on attracting FDI in the service industry (e.g. Walsh and Yu, 2010, Yin et al., 2010).

Infrastructure: Infrastructure is also a common factor in studies on attracting FDI into the service sector. An economy with a complete and developed infrastructure is expected to attract more FDI into the service sector (Ramasamy and Yeung, 2010; Kaliappan et al., 2015; Kafait, 2018). However, studies

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