The Influence of Foreign Direct Investment (FDI) on the Economic Growth of the Host Economies - Essay Example

? Introduction Globalization fosters economic and financial integration. The creation of multinational and transnational enterprises further facilitates the inflows and outflows of capitals across countries. Foreign Direct Investment (FDI) exemplifies a unique approach to financial cooperation and integration: through the inflow of foreign capital, host countries acquire a unique opportunity to strengthen their economic position and speed up their financial advancement. The most controversial is the relationship between FDI and economic growth. Positive effects of FDI on economic growth are often taken for granted. In reality, however, this relationship is not as simple as it may seem. Theoretically, FDI promotes economic growth through an increase in investment volumes, leading to increased efficiency of all economic and financial operations. Another theory suggests that economic growth is a direct result of the technological diffusions caused by FDI as highlighted by Blalock and Gertner (2008). Objectively, there is no single explanation to the effects of FDI on economic growth: numerous variables moderate the relationship between FDI and economic growth in host countries, and the current knowledge of financial markets and macro/microeconomics does not allow producing a comprehensive theory of FDI and its impacts on host countries’ economies. FDI and Economic Growth in Host Countries: Empirical Results The fact that FDI impacts and speeds up economic growth in host countries is often taken for granted. Nevertheless, the body of empirical literature supporting this relationship continues to increase. Li and Liu, (2005) investigated the effects of FDI on economic growth, based on the sample of 84 countries for the period between 1970 and 1999. Their conclusions are extremely useful in the analysis of FDI and its implications for host countries’ economies. Based on Li and Liu (2005) and Wang, Gu, Tse and Yim (2012), it is clear that the relationship between FDI and economic growth is uneven, but both in the developed and developing countries, this relationship is complementary. “Furthermore, FDI not only directly promotes economic growth by itself but also indirectly does so via its interaction terms” (Li & Liu, 2005, p.404). The effects of FDI on economic growth in host countries greatly depend upon the local conditions and contexts of doing business there: for example, human capital enhances the positive effects of FDI on host economies, while the existing technology gaps make it possible to implement even the simplest foreign direct investment reforms (Wang, Gu, Tse & Yim, 2012). Added to this is the role which market size plays in attracting FDI to host countries, whereas technology-absorptive abilities predetermine host returns from FDI (Li & Liu 2005; Blalock & Gertner 2008). These results have far-reaching implications for policy development and implementation, although all risks and factors changing the nature of FDI inflows to host countries need to be thoroughly considered. Even more interesting are the results of another study conducted in the three major countries-recipients of FDI. These include Malaysia, Chile, and Thailand (Chowdury & Mavrotas 2007). Again, the researchers confirm that the effects of FDI on economic growth are very heterogeneous and primarily depend upon the level of GDP in host countries (Chowdury & Mavrotas 2007). At least in Thailand and Malaysia, the relationship between GDP and FDI is very explicit (Chowdury & Mavrotas 2007). Again, these findings have far-reaching implications for policymaking, since understanding causality between FDI and economic growth is crucial for the creation of policies that encourage the inflow of investments from abroad in the developing world. Both studies confirm the importance of the FDI-economic growth causality but also imply that the nature of this causality and its direction should be placed under professional scrutiny. As long as the effects of FDI on economic growth in host countries are characterized by considerable heterogeneity as indicated by Nair-Reichert & Weinhold, (2005), private firms and public enterprises that seek to expand their presence to the developing world should understand how and why their performance will impact the economic prospects of host countries. Equally important is this knowledge for state policymakers. FDI and Economic Growth: Explaining the Complex Relationship In order to understand how and why FDI impacts host countries’ economic growth, the meaning of both terms needs to be clarified. For the goal of this paper, foreign direct investment is defined as “the process whereby residents of one country (the source country) acquire ownership of assets for the purpose of controlling the production, distribution, and other activities of a firm in another country (the host country)” (Moosa 2002, p.1). More specifically, FDI is a form of investment used by one country to acquire lasting financial and business presence in another country, by having a voice in the management of the enterprise creating by this investor (Neuhaus 2006). Here, it should be noted that FDI differs greatly from portfolio investments in the sense that the latter is short-term by nature and is usually associated with high securities turnover (Moosa 2002). Regardless of the way FDI is defined, the word ‘control’ is the principal aspect here, since countries that choose to invest their capital in other countries typically seek to control their investments and their results in the host countries’ land. The situation with economic growth is much more difficult, in the sense that defining the term “economic growth” is not easy. In this paper, economic growth is interpreted as a purely mathematical/economic term that implies changes (positive or negative) in some economic magnitudes (Ahiakpor 1990). Economic growth should not be confused with economic development, as the latter goes beyond monetary and mathematical terms and requires assessing changes in per capita income and quality of life. As a result, in the relationship between FDI and economic growth, the relationship between the money invested in host countries by their foreign partners is estimated in terms of the GDP and income per capita changes in these host countries (or countries-recipients). In the discussion of FDI and its effects on economic growth, the role of Multinational enterprises and Transnational corporations should not be disregarded. Actually, these enterprises and corporations play a huge role in the advancement of productive financial and economic relationships among countries. This is why they are often regarded as essential elements of FDI inflows and causal impacts on host countries’ economic growth. According to Fortanier (2007), FDI impacts economic growth in host countries through TNC (Transnational corporations). FDI impacts economic growth through structural effects, skill and technology, and size effects (Fortanier 2007). TNC play a huge role in the transfer of capitals and skills from one country to another. TNC corporations represent one of the most important sources of technology and skills (Fortanier 2007). Through labor migration and demonstration effects, these technologies are further distributed among firms working in host countries. These technologies enable local firms to increase their own productivity and, consequently, speed up their countries’ economic growth (Blomstrom et al. 2006). However, not all technologies brought by TNC are necessarily good and productive. Some technologies may appear to be inappropriate in the specific financial and economic conditions within host countries. In these situations, skill and technology transfers are of minor importance for economic growth. This is where the structural effects of FDI on economic growth come into play. Structural effects imply that FDI brought through TNC impact host countries’ economic competition (horizontal effects) and the relationships between buyers and suppliers (vertical effects) (Fortanier 2007). FDI has the potential to enhance and strengthen local market competition and, as a result, improve resource allocation and reduce entry barriers (Lall 2000). However, again, these structural effects of FDI on economic growth are extremely heterogeneous, and there is no guarantee that increased competition will eventually benefit the host country. It may happen that the TNC itself will outperform the firms located in host countries. At times, FDI may even lead to the monopolization of markets under the influence of foreign capitals. Nevertheless, FDI does have the potential to improve host countries’ economic growth potentials. The most recent findings in FDI research suggest that TNC and MNEs possess specific advantages that enable them to be profitable in host countries and, simultaneously, turn their profitability into a driver of host countries’ economic growth (Johnson 2006). These firm-specific advantages may include but are not limited to scale economies, new technologies, and perfect management (Johnson 2006). One of the major factors of sustained economic growth under FDI is the presence and diffusion of MNEs’ knowledge capital, which provides local companies with an opportunity to use this capital for their and the MNEs’ advantage (Markusen 2002). Through knowledge capital, the FDI potential of MNEs further increases. First, it becomes inexpensive for MNEs to transfer their financial and knowledge capital to the host country (Markusen 2002; Nunnenkamp & Spatz 2004). Second, MNEs have greater opportunities to protect their rights for innovative technologies (Rodrik 1999). Through technology transfer and brand name protection, MNEs and TNCs serve the primary means of impacting economic growth in host countries. MNEs and TNCs turn into the basic element, the main mechanism of establishing a profitable relationship between FDI and economic growth. FDI influence economic growth of host countries, by facilitating the transfer of financial and human capital from the countries-investors. With FDI, host countries’ physical and human resource stock increase, leading to the subsequent increases in the countries’ productive capacity (Johnson 2006). However, the process of the human capital and productivity inflow is not endless, and host countries’ growth capacity does have its limits. Solow’s model implies that the inflow of physical and human capital cannot ensure long-term economic growth (Easternly & Levin 2005). As a result, in most situations, FDI through physical capital is relatively unimportant for continued economic growth. Moreover, the nature of FDI suggests that host countries rarely face large inflows of labor; more often than not, foreign investments imply increased use of the local labor force. Therefore, FDI causes little changes in the stock of labor and can hardly affect the rates and consequences of economic growth. The mechanisms of FDI impacts on economic growth within host countries are extremely complicated. Apart from the inflow of technology and knowledge capitals, FDI result in considerable wage and productivity spillovers (Lipsey & Sjoholm 2008). The current state of research confirms the validity of the assumption that wage premiums in MNEs, TNCs, and other foreign-owned firms greatly influence the state of economic affairs in host countries. According to Lipsey (2002), foreign firms offer better rewards than domestic firms which, in turn, shift the balance of wages and economic forces in host countries. Recent research evidence suggests that, after foreign-owned firms acquire domestic firms, wages for both white-collar and blue-collar workers increase significantly. Higher wages increase workers’ purchasing capacity and their monetary contribution to the host countries’ GDP. They may also motivate other domestically-owned firms to increase wages for their employees. In a similar vein, in the presence of advanced technologies and vast knowledge potentials, foreign-owned firms display better productivity compared with their domestically-owned rivals. However, whether or not the effects of FDI on wages and productivity are even greatly depends upon the very nature of FDI, their goal and the way they are delivered. In this context, a distinction between horizontal and vertical FDI needs to be mentioned. This distinction has profound implications for the relationship between FDI and economic growth in host countries. Vertical FDI “is traditionally related to the desire of MNEs to carry out unskilled-labor intensive production activities in locations that are relatively abundant with unskilled labor” (Beugelsdijk, Smeets & Zwinkels 2008; Braconier, Norback & Urba 2005). By contrast, horizontal FDI emerges to replace the exporting function and create production facilities that are closer to customers and, therefore, reduce transportation and trade costs, as well as transportation and trade barriers. Unfortunately, there is still little knowledge as to these distinctions and their value in the analysis of FDI impacts on economic growth. Despite the growing body of literature, many controversies surrounding the issue of FDI and its relationship to host countries’ economic growth continue to persist. Different variables moderate the way FDI impacts economic growth in host countries. The lack of uniform research frameworks further complicates the situation. FDI Impacts on Economic Growth: Research Controversies The current state of knowledge about FDI and its relevance for host countries’ economic growth is not without weaknesses. To begin with, the lack of data impedes the development of effective explanations to the FDI-economic growth relationship. The situation is particularly different with spillover studies, which require detailed output data, data related to exports and imports, differences in market values and sales values (Lipsey & Sjoholm 2008). In the absence of this data, explaining the fullness of the FDI impacts on economic growth is virtually impossible. Another problem with the current understanding of FDI is that different researchers use different samples of data to explore one and the same phenomenon (Li & Liu 2005). This is why the impacts of FDI on economic growth look extremely controversial. Most researchers implicitly assume that FDI has only positive impacts on economic growth and, for this reason, fail to account for other major variables (Durham 2004). For example, the role and effectiveness of R&D activities needs to be considered (Gao 2005). Also, financial markets size may play a role in the way FDI relates to economic growth (Alfaro, Chanda, Kalemli-Ozcan & Sayek 2006). Apparently, future research should focus on systematizing and harmonizing the existing knowledge about FDI, its potential and real impacts on the economic growth within host countries. There is no need investigating new FDI data and producing new empirical findings. First, the existing knowledge of FDI needs to be organized. Possibly, this will lead to the creation of new theories that will further shape the basis for the development of new empirical studies. Conclusion The goal of this paper was to explore the impacts of FDI on economic growth in host countries. Based on the results of this analysis, the relationship between FDI and economic growth in host countries remains extremely controversial. One of the greatest problems is the lack of sufficient empirical data. Another difficulty is the lack of organization and poor systematization of the existing knowledge. From this paper, it becomes clear that the current knowledge of FDI and its impacts on economic growth is mainly theoretical. Few empirical studies were conducted to understand how in reality FDI changes economic growth patterns in host countries. Another problem is that, even amongst these few empirical studies, the samples and data used vary considerably. Therefore, there is virtually no chance to organize this data around core issues. Finally, many researchers implicitly assume that FDI is positively related to economic growth while, in reality, numerous major and minor variables should also be considered. As a result, it is too early to say that there is a complete picture of the FDI-economic growth relationship in literature and real economic environments. Nonetheless, the current research suggests that the effects of FDI on economic growth are extremely complex. Their scope and magnitude depend on a number of factors, including the amount of knowledge capital, the complexity of R&D procedures, and even host countries’ financial market size. Therefore, before producing new empirical findings, economic researchers should focus on systematizing and reorganizing the existing knowledge. This is how they can develop new theoretical assumptions to be tested in future studies. This is also a complete picture of FDI impacts on host countries’ economic growth can be created. References Ahiakpor, JC 1990, Multinationals and economic development: An integration of competing theories, Taylor & Francis. 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