The impacts of foreign direct investment on host country economies - Essay Example

?Using examples and case studies discuss and evaluate the impacts of foreign direct investment on host country economies Introduction The liberalization of markets worldwide, an effect of globalisation, has led to the elimination of the barriers for developing investment activities abroad, i.e. to a country different from the country of residence of the investor. Gradually, the foreign direct investment, or else the FDI, as this activity has been characterized, see also the next section, has become a common phenomenon in countries worldwide. It should be noted that the FDI has been related to a series of important benefits but it has been also found to have a series of disadvantages/ drawbacks for the host countries economy. This issue is explored in this paper. A series of examples and case studies are presented aiming to show the various aspects of the involvement of FDI in the economy of host countries. In general, the benefits of FDI are more compared to its disadvantages. However, the latter could lead to severe turbulences if they are not appropriately addressed. In this context, appropriate measures should be taken in advance for the control of such effects either in the short or the long term. 2. Foreign direct investment – description, criteria The term ‘foreign direct investment’ is used in order to show ‘the acquisition of assets by the residents of one country for the purpose of controlling the production and other activities of a firm in another country, the host country’ (Moosa 2002, p.1). FDI, as described above, can have many forms, including the Greenfield investment (indicating whole ownership of the acquired asset) and the Joint Venture (shared ownership of the acquired asset). The wholly owned direct investment is another form of FDI, being opposed by the Equity owned direct investment, a term denotes the ownership of just a part of the acquired asset (Jones et al. 2006, p.9). It should be mentioned that the type of investment used in each country is likely to be decided in accordance with the local political and economic conditions. For example, in South Africa, ‘60% of inward investment takes the form of mergers and acquisitions’ (Mwilima 2003, p.32). In other countries, the Joint Ventures may be preferred as a more appropriate mode of FDI (Buckley et al. 2006). The last decades, there is a trend towards the continuous expansion of FDI as a method of financing various projects. This fact is made clear in the Graph 1 below where the balance among the FDI, the bank loans and the portfolio investment as methods of financing, is analytically presented. Graph 1 – Forms of capital inflows from 1978 up to 1995 (Source: Loungani et al. 2001) The decision of an organization to proceed to FDI is usually based on the potentials for profit. Moreover, it seems that Western organizations are likely to use different criteria when having to decide their entrance in a foreign country through FDI. Bevan et al. (2004) tried to identify the factors that lead organizations in Western countries to get involved in FDI. The above researchers found that factors like ‘labour costs, market size and proximity’ (Bevan et al. 2004, p.775) are likely to have a decisive role for Western organizations to invest on a foreign economy in the form of FDI. On the other hand, it has been revealed that the potential risks of the host country economy are not expected to discourage Western organizations from proceeding to FDI. However, it seems that the documents and the commentaries published by international bodies can influence the decision of Western organizations on FDI. In the study of Bevan et al. (2004) reference is made to the influence of the announcements of the European authorities on the level of FDI outflows from countries of EU to third countries worldwide. Similar findings have been revealed through the research of Globerman et al. (2002). The above researchers tried to identify the level at which the political and legal environment of a country can influence the level of FDI towards the particular country. Through the examination of data referring to ‘FDI inflows and outflows from a series of countries for the years 1995-1997’ (Globerman et al. 2002, p.1899) it was revealed that the FDI inflows and outflows in regard to a specific country are strongly depended on the governance infrastructure of that country, especially the political and legal environment of the particular country. It is not made clear though whether the changes in the country’s political and legal conditions could negatively affect the FDI inflows and outflows even when the transition period is quite short. In other words, it should be made clear whether stability in regard to the political and economic environment of the host country should be absolute (meaning the lack of any change on the country’s political and legal environment) or whether minor changes in these sectors would be allowed in order to keep the relevant sectors aligned with the relevant trends and practices in countries internationally. The choice of the mode of FDI used in each case is depended on a series of criteria. Most commonly, the level of privatisation developed in the host country is a strong incentive for foreign investors to proceed to FDI. However, other issues, like the cost involved in the specific activity and the legal rules regulating FDI in the host country are likely to affect the level of FDI inflows to the specific country (Mukherjee et al. 2009). In other words, FDI inflows towards a country are not standardized. Rather, their level is differentiated under the influence of the local political, economic and legal conditions but also the costs and the risks related to such project. Similar issues have been revealed through the research made by Demekas et al. (2007). However, the above researchers emphasize on the importance of the ‘host country policies, such as corporate tax burden and infrastructure’ (Demekas et al. 2007, p.369) as factors influencing the level that the host economy will be benefited from FDI. In other words, it is suggested that FDI can actually benefit the host country economy but the extension of these benefits will be depended on the regulatory and technological environment of the host country, among other factors, in accordance with the political, economic and social characteristics of the host country. In any case, the value of FDI as a tool for the development of the economy of the host countries cannot be denied, even if the specific activity could also have certain risks and drawbacks, as explained analytically in the next section. 3. Impacts of foreign direct investment on host countries economy – aspects, examples The impacts of Foreign Direct Investment on host countries economy are likely to be differentiated. More specifically, factors like the technology transferred, the level at which knowledge is shared and the type of jobs resulted from a FDI project can affect the relationship between the FDI and the host countries economy. These issues are analytically discussed below by referring to the relevant literature and the empirical research. Reference is made primarily to the benefits of FDI for the host countries. At the next level, the negative effects of FDI on the host countries economy are presented and evaluated. Lee et al. (2009) studied the effects of FDI on the economy of host country. Their research has been based on the following criteria: a small, but developed, country has been chosen as the home country whereas the host country has been a large one, but less developed. Their research revealed that the FDI from the small (developed) to the large (less developed) country can lead to the increase of employment in the latter. At the same time, a decrease in the employment of the home country has been identified but the level of this decrease has not been standardized. The increase of employment in the host country has been related to the transfer of technology to the particular country, in the context of FDI. The above study helps to understand the potential effects of FDI on host countries economy but does not make clear whether the benefits of FDI for the host country are depended on certain criteria or whether these benefits are likely to be standardized, i.e. common, in all cases that FDI has been used as a tool for the transfer of technology in a host country. Blomstrom et al (2000) examined the potential benefits from the transfer of technology to the host country, in the context of FDI. The case of the transfer of technology from 6 developed countries (including USA and Germany) to Mexico is used as an example in order to show the benefits of FDI for the improvement of technology in the host country and, thus, for the increase of productivity and of the performance of the economy of the host country (Blomstrom et al. 2000). It was revealed that indeed, the transfer of technology to Mexico in the form of FDI helped the country’s manufacturing industry to be significantly improved. At the same time, it was made clear that FDI can help the economy of the host country both directly and indirectly. In this context FDI can help to improve the technology employed in the production processes (direct effect), to support the local suppliers of the foreign firm’s branch (indirect effect) or to improve the skills/ capabilities of employees through the funding of the necessary training programs, also indirect effect of FDI on the economy of the host country (Blomstrom et al. 2000, p.136). In practice, the benefits resulted because of the introduction/ update of technology in the context of FDI can be limited if the ownership style involved does not support the specific initiative. For example, in a survey developed in China (among 442 multinationals) it was revealed that only the ‘foreign wholly owned firms’ (Moran et al. 2005, p.16) managed to develop their technology at the same level as the parent company. On the contrary, the joint-owned firms did not manage to develop their technology at the same level as the parent company (Moran et al. 2005, p.16). From another point of view, Mody (2007) notes that FDI results to the ‘augmentation of investment resources’ (Mody 2007, p.182), meaning that the capital available for investment in the host country is increased offering the chance for the development of various projects both in the private and the public sector. In this way, FDI is expected to support the economy of the host country leading to the increase of the efficiency of this country in terms of its financial resources. However, it would be necessary that, in the particular country, financial resources are used for the promotion of the public interest and the public good and not for the achievement of targets of individuals. One of the key benefits of FDI for the host country economy is the provision of the funds required for the development of the local production mechanisms. In accordance with Moran (1998) one of the most common problems of developing countries is the lack of the sufficient funds for the support of the various phases of production. As a result the national economy is stabilized without prospects for recovery. The provision, through the FDI, of funds for supporting the production processes leads to the increase of employment, the improvement of technology and the increase of productivity in most industrial sectors. From this point of view, FDI can help towards the increase of the performance of the economy of the host country either in the short or the long term. The potential advantages of FDI have been revealed through a survey conducted in Africa (in Kenya, Uganda and Tanzania). Through this survey it was proved that foreign – owned firms have more skilled personnel compared to the firms owned by locals. Moreover, it was made clear that foreign-owned firms are more efficient in terms of their financial status but also of their infrastructure and they also tend to invest heavily on the development of technology used in the host country (Moran et al. 2005, p.17). The level of support provided by FDI to the host countries economy can be made clear through the Graph 2 below. It is clear that FDI is first among the other sources of capital available in developing countries. The relevant data refer to the period from 1990 up to 2004, i.e. for about 14 years. Graph 2 – FDI compared to other sources of capital in developing countries, from 1990-2004 (source: Kumar 2007) It is clear, from the above graph, that FDI can be a quite effective and valuable source of capital for developing countries. Kumar (2007) mentions the cases of China and India as indicative examples of countries, which are highly based on FDI. In fact the high dependency of these countries on FDI has been proved to be decisive for their economy, becoming key players in the export of products to developed countries where these products are sold (Kumar 2007). On the other hand, in accordance with Reiter et al. (2010) FDI can support the human development in the host country. However, this benefit is related to the following two facts: that restrictions exist regarding the potential involvement of FDI in certain economic sectors and that the level of corruption in the host country is low (Reiter et al. 2010, p.1678). It is assumed that if one of the above requirements is not met then the benefits of FDI for the human development across the host country may be limited or delayed. Apart from the benefits presented above, FDI can also have negative effects on the host countries economies. Such risk usually exists when the local legal environment (referring to the laws governing FDI in the host country) cannot respond to the needs of FDI, as developed across the particular country. Such problem exists for instance, in the case where the MNE is able to change the prices in the transaction developed in the internal organizational environment. A save in tax paid on profits is the targeted benefit for the firm where the above practice has been introduced. However, in this way, income is lost for the host country economy, which, in the meantime, has to suffer the loss of funds related to the compensation of the foreign workers employed in the particular organization. In other words, the benefits that are supposed to be provided by FDI to the host countries are not standardized. For example, in Mexico and Venezuela, the wage growth, as a result of the FDI, referred only to ‘the workers of the foreign – owned firms and not all workers across these countries’ (Goldberg 2004, p.6). On the other hand, in the long term, ‘MNE increases imports of intermediate goods and services, and begins to repatriate profits’ (WTO 1996), a fact that lead to the elimination of the relevant profits of the host country (referring to the profits from the limitation of imports and the increase of tax revenues). At the same time, by continuously increasing their investment on a particular country, foreign investors may get the control of the market, a fact that would be extremely negative for local producers (Kumar 2007). The above risk can be understood through the Graph 3, below where the increased role of FDI in countries with weak economy and higher risks is made clear. Graph 3 – FDI in countries with weak economy (source: Loungani et al. 2001) Furthermore, it is possible that through FDI other interests are served. Reference is made particularly to the national interests of the foreign firms, as reflected to the trend for ‘avoiding compliance with public policies’ (WTO 1996). This fact is made clear through the following fact: since the limitation of the number of M&A in Colombia and Argentina, the FDI in the particular countries has been reduced, probably because only the particular mode of FDI served the interests of the MNEs involved in the relevant investment plans. In accordance with a relevant report ‘FDI inflows to Colombia and Argentina decreased by 52 percent and 30 percent, respectively’ (The New Economy, 2007). It should be noted that the above trend followed the limitation of M&A in the above two countries. 4. Conclusion The development of FDI worldwide has been related to a series of benefits for the host countries economy, such as increase of tax revenues and improvement of infrastructure, technology and training skills of employees in the host country. However, at the same time, FDI has the power to cause severe turbulences in host countries due to limitation of permanent work for local employees, limitation of the work load of local producers and the increased control over key market sectors, as explained above. Moreover, it has been made clear that FDI is likely to affect differently the host countries economy in accordance with the modes of FDI developed within a particular country. In this context, it has been proved that in countries where foreign-owned firms were well developed in the local market, the benefits for the local economy were more (in terms of infrastructure, technology and tax revenues). The case of China has been mentioned above as an indicative example of such case. It is made clear that FDI can benefit the host countries economy but when its involvement in a host country’s economy is high, then the effects for the particular country will be negative. Reference is made not so much to the short-term effects as, especially, to the long term effects, as for instance the loss of the control of the host market by the local businesses. References Bevan, A., Estrin, S. (2004) The determinants of foreign direct investment into European transition economies. Journal of Comparative Economics, Vol. 32, Issue 4, pp. 775-787 Blomstrom, M., Kokko, A., Zejan, M. (2000) Foreign direct investment: firm and host country strategies. New York: Palgrave Macmillan Buckley, P., Clegg, J., Wang, C. (2006) Inward FDI and host country productivity: evidence from China's electronics industry. Transnational Corporations, April 2006 [online] < http://findarticles.com/p/articles/mi_6790/is_1_15/ai_n28379106/> Demekas, D., Horvath, B., Ribakova, E. (2007) Foreign direct investment in European transition economies – The role of policies. Journal of Comparative Economics, Vol. 35, Issue 2, pp. 369-386 Globerman, S., Shapiro, D. (2002) Global Foreign Direct Investment Flows: The Role of Governance Infrastructure. World Development, Vol 30, Issue 11, pp. 1899-1919 Goldberg, L. (2004) Financial-sector FDI and host countries: new and old lessons Linda Goldberg. Working Paper 10441. NATIONAL BUREAU OF ECONOMIC RESEARCH [online]. Available from < http://www.nber.org/papers/w10441.pdf?new_window=1> Jones, J., Wren, C. (2006) Foreign direct investment and the regional economy. Hampshire: Ashgate Publishing Kumar, A. (2007) Does Foreign Direct Investment Help Emerging Economies? Federal Reserve Bank of Dallas, Vol. 2, No. 1 < http://www.dallasfed.org/research/eclett/2007/el0701.html> Lee, H., Lin, K., Tsui, H. (2009) Home country effects of foreign direct investment: From a small economy to a large economy. Economic Modelling. Vol. 26, Issue 5, pp. 1121-1128 Loungani, P., Razin, A. (2001) How Beneficial Is Foreign Direct Investment for Developing Countries? Finance & Development, Vol. 38, Number 2 [online]. Available from < http://www.imf.org/external/pubs/ft/fandd/2001/06/loungani.htm> Moosa, I. (2002) Foreign direct investment: theory, evidence, and practice. New York: Palgrave Macmillan Moran, T., Graham, E., Blomstrom, M. (2005) Does foreign direct investment promote development? Washington: Peterson Institute Moran, T. (1998) Foreign direct investment and development: the new policy agenda for developing countries and economies in transition. Washington: Peterson Institute Mukherjee, A., Suetrong, K. (2009) Privatization, strategic foreign direct investment and host-country welfare. European Economic Review, Vol. 53, Issue 7, pp. 775-785 Mwilima, N. (2003) Foreign direct investment in Africa. Africa Labour Resource and Research Institute (LaRRI) [online]. Available from < http://www.sarpn.org.za/documents/d0000883/P994-African_Social_Observatory_PilotProject_FDI.pdf> OECD (2002) Foreign Direct Investment for Development Maximising benefits, minimising costs [online] < http://www.oecd.org/dataoecd/47/51/1959815.pdf> Reiter, S., Steensma, K. (2010) Human Development and Foreign Direct Investment in Developing Countries; The Influence of FDI Policy and Corruption. World Development, Vol. 38, Issue 12, pp. 1678-1691 The New Economy (2007) Finding FDI hotspots [online]. Available from < http://www.theneweconomy.com/international-affairs/3-finding-fdi-hotspots/> Vu, T., Noy, I. (2009) Sectoral analysis of foreign direct investment and growth in the developed countries. Journal of International Financial Markets, Institutions and Money, Vol. 19, Issue 2, pp. 402-413 World Trade Organization (1996) “Trade and foreign direct investment” 9 October 1996 [online] Available from < http://www.wto.org/english/news_e/pres96_e/pr057_e.htm> Read More