Foreign Direct Investment for Developing Countries - Essay Example

CRITICALLY EXAMINE THE DETERMINANTS, THE BENEFITS AND RISKS OF FOREIGN DIRECT INVESTMENT FOR DEVELOPING COUNTRIES USING AN EXAMPLE OF CHINA 1. Introduction Foreign direct investment (FDI) is a critical element used by policy makers in an economy for purposes of economic integration through establishment of long term relationships. Since the third wave of globalization began in the 80s, there has been a worldwide surge in FDI. Countries, both developing and developed ones, and multinational corporations, after the liberalization of trade engaged in direct investments across the borders. This period since the 80s has seen most economies participate fully in investments and expansion of their economies through the received inflows and outflows. USA and Japan among other powerful nations have an established past record in their lending and borrowing, which has contributed to their expanded growth over the last three decades. According to UNCTAD, FDI is “an investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor/ parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate)” (n.d., p. 245). It has been a way of economies engaging in cross border expenditures to extend their control to limited, but productive assets overseas. Apparently, developing countries FDI flow more than doubled by the end of the 20th century with the increased attraction to the investment. Mallampally and Sauvant record that “developing countries' share in total FDI inflows rose from 26 percent in 1980 to 37 percent in 1997, and their share in total outflows rose from 3 percent in 1980 to 14 percent in 1997” (1999). The paper investigates the determinants and effects (risks and benefits) of FDI to developing countries by focusing on China. Research indicates that FDI does generate positive effects to jump start economies, transfer technology, develop local enterprises and support financial stability for economic development among other positive spillover (OECD, 2008). It looks into the financial and economic consideration for determinants of FDI and risks involved in developing countries’ borrowing and lending of direct investments. 2. Determinants for FDI in developing countries 2.1 Openness The degree of openness for the host country to international global trading is sensitive for decision making to foreign investors. Depending on the type of investment, some direct investors may prefer economies with trade restrictions, while others opt for more open economies. Dermirhan and Masca vouch for economic’ trade openness surveyed to encourage more foreign investment, but suggest that marketing seeking and export oriented investment work well with trade restrictions and more openness respectively (2008). With trade barriers, economies decrease openness, which is suitable for horizontal FDI, while increased openness encourages vertical FDI. China has for the last three decades enjoyed high FDI inflow since it opened its doors to foreign investors. It formulated and implemented its export promotion development strategy which has achieved great success. It formulated open door policies and bilateral arrangements and is known to have reduced trade restrictions during the 90s, which attracted FDI flow to achieve its current economic development (OECD, 2000). 2.2 Market Size The market sizes for host countries to specific enterprises influence investor decisions. They evaluate the domestic demand for the investment locations, which in turn is affected by the population in a nation. Using the GDP per capita of a host country, those with greater purchasing power and larger markets based on demand tend to attract more FDI. A large market ensures that upon investment, economies of scale can be exploited and resources channeled to the host country and be fully and efficiently utilized. Though China’s GDP is relatively low, the purchasing power of consumers in the large population has been strengthening, creating extensive market base as a location that attracts market oriented FDI (OECD, 2000). China hosts the largest population in the world compared to any other country, hence generating a greater demand and large market for consumption and attraction of inward FDI. For example, investment channeled to manufacturing industries for food products would yield high and constant returns from the large and expanding market. 2.3 Economic growth It affects investment location. The economic growth of the host country has association with its FDI, demonstrating positive correlation in developing countries. Using a meta regression analysis, Iamsiraroj and Doucouliagos found the “average partial correlation of growth on FDI to be 0.18 for individual developing countries controlling for inflation, tariffs, market size, lagged growth, and taxation” (2015, p. 25). Most foreign investors consider the economic growth of a host country to determine their profit margin. Developing countries experiencing faster economic growth and those under transition like the BRICS with a higher degree of economic development offer better opportunities for foreign investors to make profits. China has an emerging economy that has witnessed expansive growth (real per capital GDP) since the 70s. 2.4 Infrastructure Developing countries with established physical infrastructure for transport purposes, technological infrastructure for communication and connection needs with the rest of the world offer vital business operation gadgets for the foreign investors in the host country. It sets the distinction for Countries like Somalia and China. Foreign investors prefer China’s location because there is developed infrastructure compared to Somalia where it’s a constraint. The past three decades has seen most in the population of China gain skills, technology has been developed and utilized in the nation, industries and infrastructure have been set up, all facilitating its rapid economic growth. In addition, China has numerous financial institutions connected to overseas markets and guided by a stable political and legal framework, to ensure secure and competent transactions/ or business operations with global investors. These infrastructures reduce costs of production, save time and increase production potential for investments, effectively stimulating FDI inflows to China. 2.5 Fiscal incentives Tax policy in host developing countries could promote or hinder further investment. Tax rates often have negative effects on the FDI flows, meaning when corporate tax rate of the host country is high, it is more likely to deter potential FDI. China has in the past employed a wide range of tax incentives for foreign enterprises and FDI firms, which have promoted investments through FDI inflows. Since the 80s, most FDI firms in China have benefited from VAT rebate system including income tax reductions and exemptions for investment in targeted industries of the economy, in turn encouraging further FDI flows through reinvestment of investors’ profits (OECD, 2000). Similarly, when the currency of the investor’s developing country appreciates against the host country, it encourages FDI flows, making investment cheaper in the host country due to the effect on the exchange rate. Stronger Chinese Yuan against the African currencies has promoted its investment oversees, with African countries experiencing high FDI inflows from China through the wide mergers and acquisition (Feng, 2014). With a stronger appreciating Yuan, the expansion process becomes easier due to enhanced purchasing power for China and access to cheaper factors of production in African countries and available raw materials. Others entail political and country risks for foreign investors. Investors seek stable hosts where the risks of suffering losses to human calamities are low. Developing countries with repetitive patterns of political wrangles and war are less likely to attract FDI flows. This has been a major problem for many developing African countries like Sierra Leone, Sudan, Somalia and others fighting terrorism and autocratic regimes in North and West Africa. 3. The benefits of FDI in developing countries 3.1 Capital source Developing countries have put attractive measures for their economies to secure FDI necessary to boost their development. FDI provides direct capital to an economy, which is used to support domestic capital and other flows for the purpose of development. Considering the limited funds provided by the governments of developing countries and private corporations, foreign investors finance boosts provide capital to jump start economies and ensure their transformation. For example, African countries rely heavily to FDI today for their past record in accelerating their growth, transformation and development efforts (Aryeetey, 2012). FDI inflows in China constitute the proportionate share in domestic capital formation for the critical role in economic development. China is the top recipient of FDI among the developing countries since the 90s, which in 2002, clinched first in the globe to receive FDI, over taking USA, BRICKS and Asian economies to access huge stimulus packages to jump start its growth (The Treasury: Australian Government, n.d). In return, its economic growth has been fruitful over the years to provide sufficient capital to invest and export its FDI over to developing countries like those in Africa. 3.2 Improvement in labor sectors 3.2.1 Job Creation Governments and private sectors in developing countries seek to expand their industries and set up new enterprises that can promote the growth of economy. The received FDI flows are channeled in diverse sectors, agriculture, mining and exploration, manufacturing, construction and telecommunication among others, allowing more jobs to be created as research activities, new business establishments and expansion take place. It evident that for specific amounts of investment, certain jobs either for skilled or unskilled laborers can be created. This has been the case of South American countries which received 12 % of global flows in 2012 (about $170 billion) (O’Neil, 2013). FDI creates opportunity for mixed jobs, where both skilled and semi-skilled work force gets employment. Increased FDI flow in China has created and increased employment opportunities for millions of the urban and rural population in China in the FDI firms. Flows of FDI today contribute to hundreds of millions of job creation and employment in private domestic and foreign firms. 3.2.2 Higher wages Beginning FDI firms in developing countries seek to attract productive and competent employees to compete effectively with domestic companies. Even in developing countries, though foreign investors have access to cheaper labor than their home countries, they are pushed to offer high wages relative to host countries domestic firms. Reasons entail to spur higher productivity for profits and competition, motivate employees, prevent labor turn over and to attract skilled workers (Javorcik, 2013). Employees’ compensation for those working in FDI firms in China is relatively higher than that offered by domestic firms in most sectors (OECD, 2000). In turn, FDI firms manage sell themselves in the labor market, attracting competent labor force to achieve high productivity and a competitive advantage. 3.3 Technology transfer Through existing mergers and acquisition of foreign investing companies with domestic corporations in the host developing countries, transfer of technological knowledge begins to occur between the firms. In the joint ventures, the party from the host country can access technology transfers through the shared patents, designs and blueprints in the venture. Transfer of technology can also occur through people such as employees and managers taken from a parent company to affiliate or joint ventures in developing countries abroad. Their services and skills transferred from investing firms abroad are a rich source of technology and knowledge that can be exploited for production and management in host countries. Dutse and Tafawa state that transfer of technological knowledge can occur through “physical goods, organizational arrangements, people and services, codified blueprints, technical documents, and flow of tacit knowledge” (2008, p. 77). China has been a host and home country for FDI flows. Its governments and private firms have numerous joint ventures with foreign corporations both in China and other nations. Chinese investment in Africa has enabled local companies to copy and implement production technologies to accelerate their growth. With the labor turnover from joint ventures and foreign affiliate companies employees transfer and diffuse technological knowledge across domestic firms, the relationship established through FDI flows from China to Africa not only supports infrastructure development, but transfer and cheaper access of new technologies and skills to local companies (Tembe and Xu, 2013). China ends up generating more of non-financial capital inputs to Africa and other 3rd world countries, promoting transfer of technology. There are hundreds of Chinese skilled labor forces operating in African countries in infrastructure development, established Chinese training centers in areas of technology and tonnes of physical goods especially in electronics traded internationally that enable transfer of technology to developing countries through supply, purchase and tacit knowledge. 3.4 International trade More FDI flows in a country translate to more production either directly or indirectly. This may not accrue instantly, but with training of employees in the foreign invested firms or MNEs, development of infrastructure and transfer of technologies among others, financial and non-financial inputs may result to increased production across economic sectors that can be exported outside the country. FDI inflows in developing countries can facilitate growth from their international trading in the long term. In China, increase in foreign invested firms has been directly proportionate to its trade performances, especially in the period between 1992 and 1998 (OECD, 2000). FDI growth has enabled China to gradually become competitive in production of goods and services, diversify its investment through stock trading, contributed to growth of China’s trade surplus and investment in electronic industries that has experienced rapid increase in exportation offering China a comparative advantage. 4. The risks of FDI in developing countries Any investment within a country or at the international level operates based on uncertainty of the economic environment. Whether inflow or outflow FDIs, there are potential investment risks involved operating in the host country or associated with the investors’ home country. 4.1 Political risks Foreign investors are sensitive to the quality of institutional environment within the hosting location. They rely on sound institutions and political stability of a country to predict their framework of interaction and protection of their investments. According to Lukac as cited by Robock and Simmonds, “political risks in international investments exists when discontinuities occur in the business environment, when they result from political change and when they are difficult to anticipate” (2008, p. 114). In case host countries experience political instabilities like civil and post-election wars that lead to destruction of foreign invested firms, investors suffer sinking costs that may have negative long term effects on their returns on investment. There are numerous uncertainties involved in governments with poor institutions and recurring cases of destructive political instabilities. The risk can cause negative effects on operating costs, cause delays and impair effective operation of foreign businesses in case of corruption in a host country (Hayakawa, Kimura and Lee, 2011). When political risks increase in host countries, investing multinationals risk expropriation of the assets through enforced nationalization by the state (Krifa-schneider and Matei, 2010). This in turn hinders attraction of FDI to the host country. Most investors from developed economies prefer their FDI to flow in States like China, South Africa and selective developing nations, based on the certainty of their stable political environment and sound institutions. However, China’s investment in Africa goes contrary to the principle as it has invested in politically risky nations that are affected by terrorism and civil wars (Quer, Claver and Rienda, n.d.; Kang and Jiang, 2011). China has a record of applying protection function to unfair competition, where MNEs risk low profits and losing market share to local corporations, and has used legal power and taxes to attack MNEs to limit their activities (Liu, 2013) 4.2 Financial risks Some governments in developing countries have accrued massive foreign liabilities that at periods of inflation in the countries or linked economies, they suffer considerable financial crisis. Extensive FDI inflows to state owned enterprises or their entire economies mean that the foreign capital, equity or loans invested are exposed to similar frustrations upon financial devaluations and linked crisis. High inflation rates in host countries may translate to weak currencies, creating higher profit margins for investors but greater financial burden for hosting economies to repay. The greater the financial liability for host countries to investments, the less likelihood there is for investing MNEs to recover their capital or be attracted to further investment. Despite great diversification, China’s investments abroad have not been without financial risk obstacles. China has experienced losses in premium value transactions due to fluctuation of prices in the international market and analysis of negotiated deals with corporations in foreign countries (Duanyong, 2011). Chinese overseas enterprises also lose huge finances with the fluctuating exchange rates that are unfavorable for their profit maximization. 4.3 Cultural risks Cultural differences in a host country for the foreign invested firm can serve as barriers to its entry or easier access to a proportionate market share of the host country. Keillor, Hausa and Griffin consider cultural risks to be “country specific attributes related to the market actions and conditions based on the populations values, practices and beliefs” among others (2009, p. 49). Investing in countries with incompatible cultures risks financial losses for the investing MNEs. Employees in the hosting country have their customs, values and practices, whose drastic change may trigger rejection of rules and cultures of the foreign investing firms. There are risks involved when individualism and high degrees of uncertainty avoidance occur in the host country, which tend to be less attractive to FDI inflows. Liu comments on the wrong cultural view by Chinese people, which is associated with the generated vicious circle of the profit chain in IT industry (2011). Similarly, certain MNEs from the western world have failed in China’s investment due to rigid market penetration, where the government promotes and the society embraces the culture on consuming their own local productions. 5. Conclusion FDI inflows and outflows of developing countries have extensive impacts to the countries’ economies and society. However, developing countries have to place attractive measures for FDI inflows and take caution while seeking to invest abroad. It is evident that the fiscal policies, market oriented factors and economic progress of developing countries all play a considerable role in influencing investors decisions to a location. The political, cultural and financial risks involved have to be addressed or circumvented to protect foreign investments and returns from potential losses. References Aryeetey, E. ed., 2012. The Oxford Companion to the Economics of Africa. Oxford: Oxford University Press. Dermirhan, E. and Masca, M., 2008. Determinants of Foreign Direct Investment Flows to Developing Countries: A Cross-Sectional Analysis. Prague Economic papers, 4. [online] Available at: < https://www.vse.cz/.../download.php?> [Accessed 22 March 2015]. Duanyong, W., 2011. China’s Oversea’s foreign Direct Investment Risk: 2008-2009. Occasional paper (73): pp.1-32. Dutse, A. Y. and Tafawa, A., 2008. Nigeria’s Economic Growth: Emphasizing the Role of Foreign Direct Investment in Transfer of Technology. Communications of the IBIMA, 3: pp. 76-83. . Fend, Z., 2014. Chinese Currency on the Up and Up. [online] Available at: [Accessed 22 March 2015]. Hayakawa, K., Kimura, F. and Lee, H., 2011. How Does Country Risk Matter for Foreign Direct Investment? IDE Discussion paper (281). [online] Available at: [Accessed 23 March 2015]. Iamsiraroj, S. and Doucouliagos, H., 2015. Does Growth Attract FDI? Economic E-journal (18): 1-41. Javorcik, B., 2013. Does FDI bring Good Jobs to Host Countries? [online] Available at: [Accessed 22 March 2015]. Kang, Y. and Jiang, F., 2011. FDI location choice of Chinese multinationals in East and Southeast Asia: Traditional economic factors and institutional perspective. Journal of World Business. Krifa-schneider, H. and Matei, L., 2010. Business Climate, Political Risk and FDI in Developing Countries: Evidence from Panel Data. Internationals Journal of Economics and Finances 2(5): pp. 54-65. Liu, H. T., 2011.The Importance of Properly Assessing Social, Environmental and Political Risks in Foreign Direct Investment in Chinese IT Industry. International Journal of Trade, Economics and Finance, 2 (3): pp. 254-256. . Lukac, D., 2008. Key Success Factors for Foreign Direct Investment (FDI): The Case of FDI in Western Balkan. Hamburg: Deplomica verlag. Mallampally, P. and Sauvant, K. P., 1999. Foreign Direct Investment in Developing Countries. Finance & Development, 36 (1). [online] Available at: [Accessed 22 March 2015]. O’Neil, S. K., 2013. Foreign Direct Investment and Jobs in Latin America. [online] Available at: [Accessed 22 March 2015]. OECD, 2000. Main Determinants and Impacts of Foreign Direct Investment on China’s Economy. Working Papers on International Investment. [online] Available at: [Accessed 22 March 2015]. OECD, 2008. OECD Benchmark Definition of Foreign Direct Investment. [online] Available at: [Accessed 22 March 2015]. Quer, D., Claver, E. and Rienda, L., n.d. Chinese Multinationals: Host Country Factors and Foreign Direct Investment Location. [online] Available at: [Accessed 23 March 2015]. Tembe, P. E. and Xu, K., 2013. China-Africa Economic Cooperation: Chinese Companies’ Contributions to African Development - The Cases of Mozambique and Angola. Research in World Economy, 4(2): pp. 61-74. http://www.sciedu.ca/journal/index.php/rwe/article/viewFile/3198/1884 The Treasury: Australian Government, n.d. East Asian Capital Flows. [online] Available at: [Accessed 22 March 2015]. UNCTAD, n.d. Definitions and Sources. [online] Available at: [Accessed 22 March 2015]. Read More