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Foreign Direct Investment

Dan Deluca

Foreign direct investment (FDI) has increased dramatically in the past twenty-five years or so, to become the most common type of capital flowing across borders in both developed and developing economies. For the most part, politicians and economists welcome the increase in FDI to developing economies. It brings capital needed for economic development into the country in a way that is not as risky as borrowing from overseas. It may also bring a range of additional benefits. But as with most economic phenomena, there is conflicting evidence about the real-world effects of FDI. As one economist put it, the empirical evidence that FDI promotes national income growth is “encouraging rather than compelling.” Meanwhile, the effects on global investments patterns of the world economic crisis of 2008/09 have yet to be assessed, but figures for 2008 show FDI shrinking by more than 20 per cent, with developed countries the hardest hit.

The journalist covering FDI in a developing economy will have to confront this uncertainty. Familiarity with the benefits, risks, and possible side effects of FDI should help in sorting through the issues. Journalists may need to cover the benefits and risks of specific investments, as well as the overall foreign investment profile of a country.

Definitions

Cross-Border capital flows generally take one of three basic forms: official development aid (ODA), debt, or equity investments. Foreign Direct Investment is defined as any equity holding across national borders that provides the owner substantial control over the entity. This is generally defined as a 10% holding or greater. Most foreign direct investment ends up being 100% ownership by a multi-national corporation (MNC), though certain countries like to promote joint ventures with local entities. Cross-border investments providing less than 10% ownership of a foreign entity are referred to as portfolio equity investment.

There are two fundamentally different types of FDI, sometimes called “modes of entry”. The MNC can either buy an existing foreign company, or it can create a new company. The latter is often referred to as “build” (vs. buy), or as a “greenfield” investment. A greenfield investment can create additional productive capacity in a country, but it may also create new competition for existing local companies.

Another important distinction is the difference between the FDI “inflow” and FDI “stock”. Inflow measures the amount of FDI entering a country during a given period. The FDI stock is the total amount of productive capacity owned by foreigners. FDI stock grows over time, and is defined to include all retained earnings of foreign-owned firms, which can be held in cash and or investments by the company.

Economists and policy-makers often speak of “positive spillover” and “negative spillover”. These terms refer generally to the range of positive effects that a particular instance of FDI can have on local firms and on the local economy in general.

Trends

Prior to the early eighties, most capital flows to the developing world were in the form of either debt or official development aid. After the Mexican default of 1983, and the subsequent debt crisis throughout Latin America, debt flows to developing economies dried up dramatically, as lenders reassessed the risk of loans to developing nations.

The majority of FDI does go to the developed economies (e.g. Japanese automakers opening plants in the US and UK), but FDI to developing countries is still large and has increased substantially. Inward FDI to developing countries increased from about $8 billion in 1980 to nearly $40 billion in 1990, and more than $200 billion in 2001 before rising even more sharply to nearly $500 billion in 2007 (though diving in 2008 because of the global crisis).:

Foreign Direct Investment inflows in billions of US dollars 1990-2006

RegionFDI 1990 billionsFDI 2000FDI 2006
World2001,4001,300
Developing economies36256380
Transition economies0.7752
Developed economies1651,150875
Developing Africa2.89.835
Latin America9.79784
Developing Asia22148259

Source: Unctad 2008 (figures rounded)

Growth across most regions masks the high concentration of FDI in the case of developing nations. In 2007, about half of inward FDI to developing countries went to five countries: China, Russia, Turkey, Mexico and Brazil. Least developed economies, including many in Africa, continue to receive relatively little FDI. These tend to be shunned by MNCs, which prefer to invest in countries known to be “safe”, with relatively high levels of political stability, infrastructure, education, well-enforced property rights, etc. However, some figures suggest that relative to the size of their economies, low income countries get as much FDI as middle-income countries, and Africa attracted much more attention in the mid-2000s as demand for its commodities grew substantially in the pre-crisis boom.

Factors contributing to the growth of FDI

Starting in the early nineties a number of factors converged to make FDI increase dramatically. The first is the increased perception of risk associated with cross-border debt. The Latin American debt crisis in the 80's and the Asian capital crisis in 1997-8 made lenders much less eager to lend across borders.

Perhaps the most important factor contributing to the growth of FDI since the late 1980s has been globalization, or the internationalization of production and the introduction of the so-called “global supply chain” by MNCs. Technological change, especially lower transportation and communication costs, has enabled MNCs to locate specific stages of production in different locations, taking advantage of favorable local conditions to minimize costs and improve sales.

Another substantial contribution to the growth of FDI has been change in government policy, as countries have begun actively courting investment from overseas. Many countries have changed policies to allow investments that earlier might have been prohibited or been otherwise difficult. FDI has also come to be officially encouraged by governments, many of which have formal FDI promotion programs. Governments sometimes provide substantial incentives to companies locating in their countries, especially for facilities that will generate significant employment. These can include tax abatements (typically 5-10 years), infrastructure improvements, tariff exemptions, outright subsidies, or other favorable treatment. These incentives often are not publicized and so can be hard to quantify. A useful task for a journalist is to try to uncover these incentives, since some economists question whether in certain cases the value of the investment attracted might actually be less than the value of the incentives granted.

Advantages of Foreign Direct Investment

To help evaluate the merits of particular investments, or a particular country's inward FDI portfolio, look for some of the key benefits of FDI to a developing country that are listed here.

  1. Can contribute to growth, higher incomes, and reduced poverty – Perhaps the most you could hope for any economic activity in a developing country is that it contributes to economic growth. This is the heart of the matter, but as with many economic phenomena, there is not conclusive evidence here one way or another. But the empirical evidence is good that FDI often, though definitely not always, contributes to economic growth. To the extent that FDI contributes to economic growth, the evidence is indeed good that economic growth usually leads to reduced poverty, though not necessarily to a more equitable distribution of income.
  2. Incentive structure leads to productive investment – Because FDI is generally done by MNCs, those companies are usually concerned with making investments that will create profits. Therefore, the investments are usually well-targeted towards setting up a business that will make money and create jobs. This contrasts especially with aid and loans to governments, which have often been squandered through corruption or spent inefficiently on unneeded infrastructure or other “vanity” projects.
  3. Less volatile than other capital flows – Because FDI is generally spent on “hard assets” such as plant and equipment, the capital embodied in FDI cannot flee a country in times of crisis as easily as debt capital or portfolio capital. A company can’t sell off a factory and pull out of the country as quickly as a bank can sell off the country’s bonds, or refuse to roll over short-term loans or an investment fund can sell off its shares, for example. Even in instances where the FDI is in a service-related industry such as banking or advertising, substantial effort and time is spent to develop an ongoing business, and owners will not easily pull the plug. Thus FDI is said to be much less likely than other forms of capital to exacerbate a crisis situation, as happened in the Asian crisis in the late 90's. Experience through the nineties showed FDI to be much less variable than debt flows and portfolio investment.
  4. Can lead to increased tax revenues – A successful foreign-owned firm should generate profits, and hence generate tax revenue for the host country. Those taxes can then be spent on needed infrastructure, social programs, education, etc. This is a strong incentive for government encouragement of FDI. However, in some cases the tax benefits can be disappointing. One risk is that the government may provide too great a tax amnesty as an incentive. Also, if the foreign-owned entity produces an intermediate good purchased by its parent company, such as car parts that are shipped to an assembly plant in another country, then profits can be affected by transfer price manipulation. That is what happens when the subsidiary sells its product at an artificially cheap price to the parent company, so that it can pay lower taxes.
  5. Can lead to “technology transfer” and “management skills transfer” – These are components of “positive spillover”, or the positive effect on local firms that is often cited as a key advantage of FDI. Because MNCs typically have greater technological and management expertise than local firms, such expertise can be transferred to other parts of the economy. This appears to happen most clearly when the MNC has close ties to local partners, suppliers and customers. But even in cases where the MNC is not tightly integrated with local firms, there is evidence that technology and skill transfer takes place, most likely through labor mobility, professional contacts, or a general raising of competitive pressure.
  6. Can improve skill and wages of labor force – FDI is often encouraged because MNCs are thought to provide training and better employment opportunities for development of the labor force. Evidence is strong that MNCs pay better and train employees more thoroughly than domestic firms in developing economies. It is also claimed that the presence of MNCs in the labor market provides incentive to local firms to improve conditions and wages of workers.Note that from the perspective of local firms this can be a negative – if MNCs “skim” the local workforce of skilled workers, labor costs for local firms can increase.
  7. May improve access to export markets – MNCs almost by definition require substantial skill in importing and exporting. Many economists and policy-makers believe that a key benefit of FDI is that the presence of export-oriented foreign firms in a country can help improve efforts by local firms to sell overseas. There is good evidence that this is the case. One way this happens is through improvements in shipping and logistics infrastructure - e.g. increased presence of international shipping firms and agents. There is probably also some knowledge transfer, where managers of local firms learn from the example of the MNC how to open new export markets.
  8. Can provide additional demand for output of local producers – Another key component of “positive spillover” is the increased demand for inputs from local suppliers that a new MNC can create, which can lead to increased revenue and profits for local firms. Some studies have suggested that a key determinant of the benefits to national income from FDI is the extent to which the foreign enterprise sources locally, rather than importing its inputs.
  9. Can provide lower-cost inputs for local suppliers – Similar to the previous benefit, if the MNC creates a product previously imported by local producers or otherwise in short supply, the FDI can lead to a decrease in production costs for local firms and correspondingly higher productivity and profits.
  10. Can improve the balance of payments and capital account – Because exports will typically bring in hard currency, an export-oriented foreign-owned entity can improve the balance of payments and capital account of a nation. This balance of payment benefit is reduced, however, by the extent to which the firm imports its production inputs. In addition, the initial FDI investment itself can also be an important source of hard currency, since the MNCs will typically need to convert hard currency to the local currency to either purchase a local entity or contract for work and equipment in setting up a new entity. Note also that MNCs will eventually repatriate profits and retained earnings periodically, which causes a reduction in hard currency reserves.

Risks of Foreign Direct Investment

  1. If foreign ownership becomes too extensive, “decapitalization” can occur – As foreign-owned firms become established and profitable, they begin to repatriate earnings to the home country of the owner. In so doing, local currency is converted to the home country currency, and capital leaves the country. If the base of foreign-owned companies is large enough, this can lead to a serious capital drain. This is especially a concern if in times of crisis foreign-owned companies repatriate retained earnings suddenly. The effect of this can be similar to the effect of foreign lenders refusing to roll over short term loans -- the country can be starved of capital, and a bad economic situation can be made dramatically worse. This is sometimes cited as one of the primary risks of a country becoming too reliant on FDI.
  2. May create damaging competition for local firms – This is often cited as a primary “negative spillover” from FDI. Because MNCs often have skill, technology and capital that local firms cannot match, FDI can create damaging competition for local firms. This is noted as one of the most significant risks, but it is a complex one to evaluate. It is certainly true that local firms can be damaged, even put out of business, and that unemployment can result. But it is also true that in many instances competition from more efficient foreign-owned producers can be seen as a benefit to the economy as a whole, improving overall productivity, and forcing local firms to modernize and improve efficiency. The question to ask here may be whether local firms will be able to improve enough to compete, or will they just be decimated by the competition from the MNC. If it is the latter, then the FDI may deserve additional scrutiny.
  3. Can lead to market dominance by MNC – Utilizing deep pockets and advanced technical and management expertise, MNCs can possibly force all local competitors out of business. Once such monopoly power is obtained, the MNC can then raise prices, extracting excessive profits, potentially eliminating any overall benefit of the FDI. Monopoly power, however gained, appears to be a risk associated with FDI, one that should be closely scrutinized in most cases.
  4. Social protest and disorder can occur – When MNCs are seen as exerting too much power, especially monopoly power over something considered a “public good” – e.g. water, electricity, phone service – then public resentment and protest can occur. This can lead to a hostile business environment, social disorder, and in the worst case political instability. This happened dramatically in Cochabamba, Bolivia in 2000, when local water service was taken over by a multinational conglomerate led by Bechtel, which immediately doubled prices, precipitating a general strike and transportation shut-down. In this case the Bolivian government reversed the privatization and Bechtel was forced to exit the country. (Note – See also background piece on privatization.) A counter-example is phone service in several countries around the world, including Mexico, Brazil, and India, where foreign entry into the industry previously controlled by the government dramatically reduced cost and improved service. However, in each of these cases, it is probably the introduction of competition, rather than the introduction of foreign capital per se, that lad to such dramatic service improvements.
  5. New production facilities may lead to environmental degradation – A frequent argument against FDI is that MNCs attempt to locate polluting facilities where environmental controls are the weakest. It is true that most developing countries have fewer environmental regulations, and less ability to enforce those that they do have, than developed countries. However, while there may be some instances of terrible accidents and great environmental harm being caused by MNC’s (e.g. the Bhopal chemical disaster, oil-related pollution in southern Nigeria), for the most part there is not good evidence of MNCs being more likely to pollute than domestic firms. Evidence may actually point the other way, because MNCs, due to their higher profile, may be more sensitive to environmental issues than local firms.

Questions and Issues for Journalists

  1. Will the foreign-owned entity be export-oriented, or will it sell locally? Export-oriented firms generally have the advantage of generating hard-currency income for the host country. Also they tend to compete less directly with local firms, which may lessen negative economic spillover.
  2. Will the foreign-owned entity compete with local firms? This is a complex issue, because often competition leads to increased productivity and higher national income. But, if the local firms are significant employers or otherwise economically or socially important, displacement of these firms by MNCs can have significant short-term negative effects. Also investigate whether the MNC will compete with local firms for skilled labor, which might have the effect of raising labor costs for local firms.
  3. Will the foreign-owned entity buy from or sell to local firms? The more closely an MNC works with local suppliers, the more likely the transfer of technical and management skills will occur. This is in addition to the expected increase in revenue to local firms. If the MNC sells to local firms, especially in cases where the input was previously imported, local costs of production may decrease.
  4. Is the government offering incentives? What kinds? What are the anticipated costs? Some governments have let themselves be pulled into bidding wars, especially for high-profile investments such as auto plants. If these incentives are too generous, a country and its economy can experience a net loss from the investment. Governments often will not publicize these incentives, but they deserve public examination.
  5. Will the MNC become sole provider of an essential public good such as water or electricity?If this is the case, the social environment may become an issue, especially if the MNC is expected to raise prices. Journalists should investigate whether any service or pricing guarantees are offered, and if not, whether there are any other countervailing controls in place to protect the public interest.
  6. Is the over-all level of foreign ownership sustainable? There are no clear guidelines as to how much foreign ownership is too much. At some point, though, there may develop a risk of “decapitalization” as mentioned above – where repatriating of capital by foreign owners becomes excessive.

Publication Information

Type Backgrounder
Program Journalism Backgrounders
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