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Empirical Evidence: Does Human Capital Matter?

Written by: OECD Development Centre

Article Overview: Although the theoretical literature on FDI presumes human capital to be among the key ingredients of inward FDI (Dunning, 1988; Lucas, 1990; and Zhang and Markusen, 1999), there are only few cross-country analyses done to identify the determinants of inward FDI in developing countries.

Empirical Evidence: Does Human Capital Matter?

Although the theoretical literature on FDI presumes human capital to be among the
key ingredients of inward FDI (Dunning, 1988; Lucas, 1990; and Zhang and Markusen,
1999), there are only few cross-country analyses done to identify the determinants of
inward FDI in developing countries. Perhaps the reason for this lack of studies comes from
the difficulty in constructing quality explanatory variables, especially for the indicator of
human capital11. This becomes even harder when one tries to gather consistent crosscountry
variables. The literature on cross-country analyses can be divided into two groups.
The first uses datasets that cover the period between the 1960s and 1980s while the
second is based on datasets between the 1980s and mid-1990s. All studies adopt crosssection
and time-series analysis covering different sets of developing countries.
The first group includes Root and Ahmed (1979), Schneider and Frey (1985),
Hanson (1996), and Narula (1996). Root and Ahmed show that among the 58 developing
countries, none of their proxies for human capital: literacy, school enrolment, and the
availability of technical and professional workers, are statistically significant determinants
of inward FDI. Schneider and Frey, using data for 54 developing countries, find the share
of an age group with secondary education to be a less significant determinant as
compared with other economic and political influences. Hanson, using a sample of
105 developing countries, shows that the adult literacy rate was not an important
determinant of FDI as compared with other socio-political variables. Finally, Narula
demonstrates that the number of tertiary education per population was not a statistically
significant explanatory variable for FDI inflows among the 22 developing countries. Thus,
all four cross-country studies show that human capital is not necessarily an important
input for inward FDI. This conclusion is consistent with the fact that the period of the
1960s to 1970s was when FDI in the developing countries was concentrated on market
and resource seeking and/or lower-end manufacturing types and that cheap labour
and/or abundant natural resources were more important (Deyo, 1989; Ritchie, 2002; and
Dunning, 2002). Thus, demand for higher-educated labour appears to be less crucial
during this period.
The second group of cross-country analyses include Noorbakhsh et al. (2001),
UNCTAD (2002a), and Nunnenkamp and Spatz (2002). Using a dataset that covers the
1980s to mid-1990s, Noorbakhsh et al. find that both the stock and flow measures of the
human capital variable12 show statistically significant and positive effects on FDI inflows,
and that the effects became more significant over time. The major difference in the results
compared with the first group of studies, apart from the econometric precision, should
come from the fact that they used a more recent dataset that contains relatively more high
value-added manufacturing firms. Indeed most MNEs operating in developing countries
during the late 1980s and 1990s tend to be efficiency-seeking types and/or subcontracting
(Dunning, 2002; Nunnenkamp and Spatz, 2002) and high skilled labour force is expected
to be crucial. UNCTAD also finds a high correlation between human capital proxies
— tertiary gross enrolment ratio and science and engineering student ratio — and FDI
inflows13 among 140 developed and developing countries (UNCTAD, 2002a).
Nunnenkamp and Spatz uses Barro and Lee’s (2000) average years of education of total
population aged 15 and above in the 28 developing countries and finds that education
becomes an increasingly important determinant from the mid-1980s to the late 1990s.

Thus, cross-country evidence indicates that human capital is an important
determinant for inward FDI especially among efficiency-seeking MNEs, while not being
an important determinant among market or resource-seeking MNEs. This is consistent
with evidence that none of the Southeast Asian countries had institutions for industrial
upgrading with skills development before the influx of FDI, at least in the low-end
manufacturing sector (Deyo, 1989; Ritchie, 2002). This is also consistent with the
experience in the African region, where much of the growth in FDI was in natural
resources and market-seeking MNEs that were accompanied by stagnant growth in
human capital.
Does this evidence indicate that countries seeking natural resources and/or
market-seeking MNEs do not necessarily need to improve the level of human capital,
while countries that seek higher value-added MNEs need to have a solid human capital
base? To the extent that increased human capital contributes to civil liberties, political
stability, health and reduced crime/corruption, all of which are considered to be key
determinants of any type of FDI, human capital can still be a determinant for any type of
FDI. One possible reason why human capital was not a significant determinant among
studies using FDI data for the 1960s and 1970s is that other control variables may have
captured the effect of improved socio-political stability due to improved human capital.
Another reason may be that it may take longer time for improved human capital to have
an impact on improved socio-political stability.
Although supported by limited evidence, education at the secondary school level
appears to be the minimal level of education that is necessary for attracting relatively
high value-added, efficiency seeking FDI. The evidence, however, does not inform us
which type of human capital, be it level or types of education or firm-based training
experience, is most effective in facilitating inward FDI. Most cross-section studies use
secondary or tertiary level of schooling as a proxy of human capital. None of the studies
compare different levels or types of human capital to identify the most effective level/type
of human capital.
While cross-country analyses provide a general idea of the importance of human
capital on inward FDI, inconsistencies in the definitions of each explanatory variable are
likely to plague their results. In this sense, country-specific studies are likely to reduce
this bias. Unfortunately, there are equally less country-specific studies that delve into the
role of human capital. Broadman and Sun (1997), and Coughlin and Segev (2000)
provide evidence for China in the early 1990s, where they show that adult literacy is one
of the key determinants for geographic determinants of FDI. Mody et al. (1998), identify
the determinants of Japanese MNEs’ expected investment in Asia. A variable
representing labour quality14 shows strong impact on expected investment for China,
India, Indonesia, Malaysia, Philippines, Thailand and Vietnam. While a limited amount of
evidence exists for other Asian countries, to the author’s best knowledge, none exists for
the Latin American and African regions. Thus, the experience in limited country case
studies is consistent with the importance of human capital on inward FDI, while giving no
clear picture of the minimal level of human capital that is essential nor the level/type of
human capital that is most effective.

Recently, a number of international organisations and bilateral donors have
initiated surveys related to FDI and the host-country investment climate. They include the
World Business Environment Survey by the World Bank in the year 2000, Foreign Direct
Investment Survey by the Multilateral Investment Guarantee Agency15 in 2001, and JBIC
FY2001 Survey by the Japan Bank of International Cooperation (JBIC, 2002) 16. The
attractiveness of these surveys is the wide coverage of countries in developing countries,
the relatively large sample size, and the recentness of survey years17. The latter two
surveys contain direct questions regarding the firm’s motive of location selection.
Although detailed analyses on location determinants have not yet been undertaken,
preliminary analyses using these surveys show that the quality of human resources is an
important criteria for MNEs investment decisions. The Foreign Direct Investment Survey
shows “ability to hire technical/managerial staff, and skilled labourers” to be among the
critical factors of location choice18. JBIC FY2001 Survey show that many Japanese
MNEs considered “availability of superior plant workers and managerial personnel” to be
an important factor for future investment choice of production bases19.
To sum up, the literature on human capital and FDI indicates that human capital is
an important determinant of FDI, especially among efficiency-seeking FDI that requires a
skilled workforce as one of its key inputs. Although higher human capital does not appear
to affect inflows of resource/market seeking FDI directly, it can indirectly affect FDI by
improving civil liberties, health and crime rates. Basic schooling (until lower-secondary
school level) appears to be the minimal level of schooling required for FDIs after the mid-
1980s. Given that the tendency of FDI in recent years is towards relatively skill-intensive
production and services, and less towards primary and resource-based manufacturing,
basic schooling should be the absolute minimum level of education the developing
countries must provide. For countries seeking to attract higher value-added MNEs, it is
necessary to upgrade human capital way above the basic schooling level.

OECD DEVELOPMENT CENTRE
Working Paper No. 211
HUMAN CAPITAL FORMATION
AND FOREIGN DIRECT INVESTMENT
IN DEVELOPING COUNTRIES
by
Koji Miyamoto

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Article Tags: 1960s, adult literacy rate, cross country, datasets, determinant, determinants, explanatory variable, fdi in developing countries, fdi inflows, frey, mid 1990s, narula, political variables, professional workers, proxies, school enrolment, secondary education, tertiary education, theoretical literature, time series analysis



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