Pros and cons of foreign direct investment


What is foreign direct investment?

Foreign direct investment (FDI) occurs when an investor based in one country (the home country) acquires an asset in another country (the host country) with the intent to manage the asset. FDI is undertaken predominantly by transnational or multinational corporations (TNCs or MNCs).

Pre-1970s FDI perception in developing countries

Prior to the 1970s, FDI and, hence, TNCs were seen by developing economies as part of a problem to development, to be solved by minimising the role of TNCs. They were perceived by developing country politicians and development economist as an unnecessary evil that:

  • made huge profits,
  • imported obsolete technology,
  • introduced unfavourable balance of payments,
  • was a neo-colonial vehicle,
  • milked the developing economies through transfer pricing, and
  • introduced a dependencia syndrome which eroded their self-reliance.

The policy strategy in developing countries revolved around home industry protection through import-substitution, which was later replaced by export-promotion when the domestic markets got saturated.

FDI intensity drivers

FDI activity started to intensify in 1973 particularly in the developed countries. This intensity was partly in response to the formation of the European Community (EC) whose membership increased to 9 in 1973. FDI was defensive in nature, aimed at accessing the market and, hence jumping the anticipated tariffs concomitant with the formation of the EC.

In the 1970s substantial FDI was also directed to the major oil producing countries because of the booming oil industry (resulting from the 1973 and 1979 oil crises). Not surprisingly, countries including the Netherlands, United Kingdom (UK) and the US, which are home to major petroleum TNCs led outflows

Another turning point came after 1985 following the Plaza Accord, which resolved to have an orderly appreciation of the major non-dollar currencies. This made the production of labour-intensive products more costly in the developed countries. Consequently, developed countries (particularly Japan) were forced to shift from their traditional approach of serving foreign markets explicitly through exports towards a greater reliance on FDI.

The expansion of the EC to 12 members (1986) triggered fears of stronger protectionism. This not only stimulated more FDI into the EC but, forced Japanese TNCs to also create their own ‘fortress’ in Asia. Therefore, production particularly by Japanese firms was relocated to the neighbouring labour-intensive countries endowed with semi-skilled or skilled labour, particularly in Southeast Asia (Singapore, Taipei China, Malaysia, Thailand, The Philippines) – facilitated by fast-tracked liberalisation (opening up to foreign investment) in the recipient countries. The USA also emulated Japan to a lesser extent with investment in certain South American countries, particularly Mexico, Brazil and Argentina.

***Note that the TNCs acted in their own interests in all the above incidences***

FDI and economic growth

The Southeast Asian economies witnessed unprecedented and sustained high rates of economic growth (for more than two decades) most notably with substantial involvement of FDI in the post-1985 period. This provided as empirical evidence of the link between FDI and economic growth.

Many of the growth promoting factors were identified to form the foundation of the key positive spillover effects of FDI including:

  • new technology transfers,
  • capital formation,
  • human resources development,
  • employment creation,
  • tax payments,
  • expanded international trade,
  • clean technologies, and
  • modern environmental management systems.

The Southeast Asian experience acted as a turning point, which made other developing countries to recognise that FDI can provide a package of external resources that can contribute to economic development. They changed their attitude and considered FDI as part of the solution to their economic development.

What is the truth about FDI/TNCs?

FDI (like GMOs – although certain scientists don’t want to accept the fact) offers a mixture of positive and negative effects. The onus is then upon the host country to disentangle these effects, and take measures that maximise the positives but minimise (or eliminate) the negatives.

In addition the TNCs’ benefits come as spillovers rather than deliberate strategies.

I have already written about this in a different context and communicated to the original bedside readings email list. Please access the document here to avoid replication. The answers presented below assume that you have read that document.

Answers to your questions

Q1: As an economist/statistician, could you please explain to me how these so called investments could be beneficial to the nation while at the same time hurting local people?

Benefits to the nation

As stated above FDI can stimulate economic growth through the creation of dynamic comparative advantages that lead to:

  • new technology transfers
    • the companies bring along machinery, equipment and production and marketing processes which although obsolete in the home country could contain what constitutes new technology in the host country. The local employees learn this new technology.
  • capital formation
    • the companies have to invest in machinery, property etc – they have no choice
    • additional employment can occur in the supply chain if local suppliers are used
  • human resources development
    • the companies train local employees to improve their productivity – productivity increases output per employee and increases profitability
  • employment creation
    • the companies employ some local people because their wages are under-priced relative to their productivity – reduced overall costs and increases profitability
    • additional employment can occur in the supply chain if local suppliers are used
  • tax payments
    • the companies have to pay taxes – they have no choice
    • additional taxes can occur in the supply chain if local suppliers are used
  • expanded international trade,
    • the companies have to export due to limited domestic market – they have no choice
  • clean technologies
    • same as new technology transfer but questionable
  • modern environmental management systems
    • same as new technology transfer but questionable

The extent to which this spillover process can be enhanced depends to some extent upon the degree of the linkages the TNCs have within the host country.

Negative impact on local people

  • Environmental issues (eg Shell in Niger Delta, Nigeria)
    • Developing countries may be desperate to achieve projected economic growth rates and securing FDI, and in the process accept to undertake environmentally risky activities.
    • TNCs may not be willing to pursue environmental-friendly policies in host developing countries unless they are put under considerable pressure.
    • TNCs may pursue a deliberate strategy of shifting the location of their pollution-intensive production in response to lax environmental standards.
    • TNCs’ imported technology may be vintage and therefore, environmental-unfriendly.
    • Developing countries may simply lack the resources and technical expertise to inspect, monitor and enforce appropriate environmental legislation.
  • Worker exploitation
    • TNCs may suppress unions to hold down wages, benefits, and labour standard – case of South Africa
    • Working conditions in some sub-contracted factories are harsh, atrocious and detrimental to their health – recent case in Bangladesh
  • Economy
    • TNCs can use their transfer pricing to their own benefit, affecting the amount of profit reported in the host country, which in turn affects the tax revenue of the host country.
    • Profits are returned to the shareholders, very little of the money remains in the host countries.
  • Local firms
    • The presence of TNCs in a host country may conflict with building strong national firms. TNCs may force local competitors out of business through predatory practices.
    • In a sub-contracting relationship, it is more often the case that supplying firms stay at the bottom of the technology ladder. This deters technological enhancement in the domestic firms.
    • TNCs may not use the local supply chain after driving out local competitors.
  • Employment
    • Negative multiplier effect if TNCs close their production or force local companies out of business or do not use the local supply chain

Q2: When does an investment become so detrimental that it must be revamped or dumped all together?

When its negatives outweigh the benefits. The investment agencies should be able to quantify the costs and benefits using cost-benefit or impact assessment approaches.

Q3: Would you consider this to be the type of investment strategy you would advise a nation to take: “The details of NTD’s 49-year lease of 600,000 hectares–nearly 1.5 million acres, with a possibility of almost 1 million acres more–for USD 25,000, include unencumbered rights to exploit all natural resources in the leased land”?

This particular ‘open cheque’ example is very unconventional. The modern approach is for the host country to identify a few priority competitive sectors/industries, and target companies whose objectives and potential benefits support the country’s development objectives. But this is a case of ‘here is land, do anything you want with it’.

On a general note, developing countries have got to a stage where it isn’t necessary, in my view, to lobby TNCs into agriculture (particularly plant husbandry). Developing countries have institutions which if well incentivised and well managed can deliver large scale agricultural projects while addressing the needs of the local people. One such institution is the old district based corporative unions in Uganda. This institution is localised and has more knowledge on the key issues of the local communities. The technologies required for such large scale agricultural projects (including irrigation) are now fairly standardised and can almost be bought off the shelf.

Q4: How does Under-pricing of commodities and land deprive Africa and what can be done about it?

I have written about this and communicated to the old bedside reading email list in my early article on commodity prices. Access the document here. My recommendations are in the last half of the document.


One response to “Pros and cons of foreign direct investment

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: