Assignment 5. Read the text and pick out pros and cons of foreign direct investment

Foreign Direct Investment
By D. Deluca

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. Foreign direct investment (FDI) has increased dramatically in the past twenty years, 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.” (Para 1)

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 $8.4 billion in 1980 to $37.6 billion in 1990, to $204.8 billion in 2001. This is spread throughout the globe, with substantial gains seen in many countries and in every region. (Para 2)

This growth across regions masks the high concentration of FDI to developing nations. In 2001, about 62% of inward FDI to developing countries went to five countries: China, Mexico, Brazil, Hong Kong, and Poland. Least developed economies, including many in Africa, continue to receive very little FDI. These tend to be shunned by Multi-National Corporations (MNC), which prefer to invest in countries known to be “safe”, with relatively high levels of political stability, infrastructure, education, well-enforced property rights, etc. (Para 3)

Advantages of Foreign Direct Investment

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 than economic growth usually leads to reduced poverty, though not necessarily to a more equitable distribution of income. (Para 4)

2. Incentive structure leads to productive investment. Because FDI is generally done by Multi-National Corporations, 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. (Para 5)

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. 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. 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 debt 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. (Para 6)

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. (Para 7)

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. (Para 8)

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. (Para 9)

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. (Para 10)

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. (Para 11)

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. (Para 12)

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. (Para 13)

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. (Para 14)

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. (Para 15)

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. (Para 16)

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. 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 for phone service. However, in each of these cases, it is probably the introduction of competition, rather than the introduction of foreign capital per se, that led to such dramatic service improvements. (Para 17)

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. (Para 18)

(Source: http://www2.gsb.columbia.edu/ipd/j_fdi.html)