Determinants, Benefits and the Risks of Foreign Direct Investment for Developing Countries - Assignment Example

Determinants, Benefits and the Risks of Foreign Direct Investment for Developing Countries Introduction Foreign direct investment (FDI) is an investment established to accrue a lasting management interest in a business enterprise operating in a country other than the investor’s, defined according to residency (Mwilima, 2003). FDI plays an important role in the open and effective operations of the global economic system. It can provide the firm which intends to invest in another country with cheap facilities of production; cheap raw materials and labour force, new channels of marketing, and markets and access to current technology, skills, products and services (Mwilima, 2003). For the host country, it provides new technologies, products, skills of management, capital, strengthens its currency and thus leads to economic development. However, these benefits are not realized automatically and evenly. Architecture of international investment and national policies are important in attracting FDI to many developing countries and in realization of its full benefits for development (Aaron, 1999). Although FDI is beneficial to both host and home countries, it also arise some costs to them. The benefits which a host country expects rely on the co-operation of its government. In developing countries such as Kenya, FDI contributes a lot in their economic development and the governments are working extremely hard to attract it. Actually, the global market for these investments is highly competitive and countries seek them to improve their development efforts. Foreign Direct Investment is regarded to be less prone to crisis because the direct investors usually have very long term plans when engaging in such investments in host countries. It is also believed that FDI greatly contributes a lot to the economic growth of a host country than other types of capital inflows (Mwilima, 2003). Therefore, this paper seeks to critically examine the determinants, the benefits and the risks of Foreign Direct Investment in developing countries. It tends to broadly analyze the factors that attract foreign investments, the benefits that the country intends to gain from direct foreign investment and the dangers associated with these kinds of investments. Determinants of Foreign Direct Investment Foreign direct investment determinants refer to the factors (political, economical and social factors) that can attract or deter foreign investors from investing in a particular country. Stable economy, political stability and good social status are likely to attract foreign investments. However, instability in these three areas will scare investors away. With the benefits of FDI in mind, it is important for any country especially developing countries to provide good environment for doing business so as to attract direct foreign investment. To do this, they must identify the determinants of FDI and improve on the ones that may scare a way the investors (Root and Ahmed, 1979). The determinants of FDI include the following: Inflation Inflation reduces foreign investment by raising risks, lowering average lending maturities and interfering with the informational content of relative prices thus increasing economic instability (Dornbusch and Reynoso, 1989). For instance, the 2007 post election violence that occurred in Kenya after a disputed election disrupted business and led to an increase in inflation rate thus scared away investors. Studies have shown that the variability of inflation has very negative effect on investment. Therefore, for a country to attract investors, its inflation rate should not be too low. Political stability Political uncertainty has significant negative impacts on investment. Political stability is one of the major determinants of investment in developing countries since investors would only invest countries where market uncertainty is lower. Therefore, countries experiencing instability in their politics are likely to scare away new investors and even loose the existing ones (Bleaney, 1993). For example, since the 2007 presidential election, the political stability of Kenya has become very unpredictable. This has scared away new investors and made the existing ones to run to other countries. However, some investors will not run away from politically unstable countries. An investor can continue to invest in such countries as long he or she is confident of operating profitably without a lot of risk to its capital and personnel (Levis, 1979). For instance, some mining companies usually overcome political risks by employing their own security forces and building and maintaining their infrastructure. Market Size Market size as measured by GDP or GDP per capita is one of the main determinants of FDI. Higher GDP per capita of a country implies that the country has better prospects for FDI. Most investors will only invest in counties that have larger and expanding markets and greater power of purchasing. Thus countries such as Liberia with a population not greater than 4 million are very unlikely to attract more foreign investors. With such large markets, the firms can get higher returns on their capital and thus realize higher profits from their investments (Root and Ahmed, 1979). For a country to efficiently utilize and exploit its economies of scale, its market size must be large and as the market size continues to grow, FDI will begin to increase thereafter with its expansion. Therefore, as the market size enlarges, it increases the rate of attraction of FDI to the economy. Labor Cost and Productivity An indicator of labour cost is wage or salary. Wage has been the most contentious of all the FDI determinants. Theoretically, it is argued that cheap labour attracts investments particularly efficiency seeking FDI flows. However, this is not unanimously agreed upon because as some scholars argue that higher host country wages discourages FDI other such as (Owen, 1982) say that wages have no significant effect on FDI. But empirical research from developing countries has shown that relative labour costs are statistically significant especially for foreign investment and export oriented subsidiaries (Flamm, 1984). Therefore, when labour cost become insignificant then the skills of the labour force will have an impact on the FDI’s location. Infrastructure Infrastructures include roads, railways, ports, telecommunication systems and institutional development such as accounting. Poor infrastructure may be viewed as both a hindrance and an opportunity for FDI. For most countries with low income, poor infrastructure is usually considered to be a major constraint. However, to attract foreign investment, the host governments should allow more substantial foreign participation in the sector of infrastructure. Good and properly developed infrastructure increases the chances of a country to attract foreign investments. Therefore, to simulate FDI towards a country, the infrastructure of that country must be of good quality and well developed (Owen, 1982). Tax Whether tax FDI is sensitive to tax incentives still remains indecisive. Whereas some studies show that corporate taxes of a host country have significant negative effect on the flow of FDI, others have argued that taxes have no significant effect on FDI. However, a few have reported a positive correlation. For instance, the Kenyan government’s move to cut down management remittances level and technical fees of foreign firms by imposing a 14% percent tax on them in 1974 did not work but rather discouraged the foreign investors (Bradshaw,1988). Openness There is mixed evidence concerning the impacts of this determinant of FDI as well. Openness is usually measured by the ratio of imports and exports to GDP. The degree of openness of a country to international trade determines the number of investors it is likely to attract. The significance of openness on FDI relies on the type of investment. For instance, when the investment is market seeking then trade restrictions may pose positive impacts on FDI (Dunning, 1993). The reason originates from the hypothesis of tariff jumping which proclaims when the cost of importing materials from a host country is high then foreign firms which aim to serve the local market can create subsidiaries in the host country to cut down the cost. In contrast, companies involved in export oriented investments often prefer to invest in more open economies because increased imperfections that are tied to trade protection raise the cost of transaction associated with exporting. Therefore, open economies stimulates more foreign investment. Growth Rapidly growing economies create better opportunities for making profits than those which grow slowly or fail to grow at all. Therefore, a rapidly economy will encourage more foreign investment. Corruption The level of corruption in a country has effects on both foreign and domestic investments in that country. Corruption makes it difficult to deal with government officials in obtaining permits and trade licenses. Foreign investors find it very costly to deal with corrupt officials since they are not transparent and will always demand bribes. Rise in the level of corruption in a country decreases inward FDI. For example, high rates of corruption in Kenya have discouraged foreign investment in the country. According to Transparency International, in 2008, Kenya’s corruption index ranked 147 out of 180 countries. Corruption is a key factor to increasing tax rates and an increase in the level of corruption leads to increase in tax rate which in turn raises the cost of doing business and reduces incentives to invest. Benefits of Foreign Direct Investment Today, FDI is a part of most global economies and it plays an important role in the development of an economy of a country. It is now a fundamental part of the world’s financial system. FDI has raised the growth rate of the economies of developing countries and allowed them to grow faster than developed countries. There are many benefits of FDI in developing countries. Some of these benefits include: Transfer of Technologies The transfer of technology is not only restricted to actual technologies but also involve transfer of skills, methods of manufacturing and even entire facilities. It may as well refer to knowledge passed by institutions of higher learning and research. The inflow of FDI helps in transferring of these technologies and knowledge from one country to another. For example, Asians had vast knowledge in IT sector and this knowledge was transferred to other countries of the world. FDI offers developing countries with cheap access to new technologies and knowledge thus improving their technological capabilities and ability to compete with others in the global markets (Blomstrom and Kokko, 1998). Creation of New Jobs FDI assumes the responsibility of creating new jobs as well. As new firms establish their corporations in host countries, they create new jobs and opportunities. In 1997, it was estimated that close to 27 million jobs in developing countries were directly created by FDI (Aaron, 1999). A real case is Botswana where between 2003 and 2009, LionOre mining company from Canada created the highest number of jobs of about 4667. In addition, it was also reported that for job directly created by FDI, about 1.7 other jobs were indirectly created. The created new jobs increase the income of the workers and leads development of competition. New jobs also raise the buying power of the population which in turn boosts the economy of the host country (Morrisset, 2000). However, FDI is often attracted to developing countries with more and highly skilled and literate labor force. FDI will only increase the growth of an economy if the level of education in the host country is high. FDI also offers most women with employment in developing countries. With the increase in salaries, the employed citizens access better lifestyle and more facilities. Source of Tax Revenue Taxation of foreign investments increases the revenues of a government. With increased flow of FDI, income generated from taxation increases hence earning higher revenues for the government. The revenues obtained can in turn be used in funding many different social development programmes. However, higher rates of corporate tax are likely to deter foreign investment. Thus to avoid scaring away investors a country must ensure that its tax rates are in line with those prevailing in other countries. Whether a government sufficiently gains from taxation of foreign subsidiaries or not greatly relies on the policies and agreements put in place by the country to ensure that tax revenues and loyalties are collected (Aaron, 1999). Economic Growth This sector enormously benefits from foreign direct investment. Inflow of FDI in various industrial units in developing countries boost the economy the countries. By offering additional capital to the host countries, FDI may open new employment opportunities leading to higher economic growth. FDI influences economic growth by increasing total factor productivity and the efficiency of using the resources in the host country. Most studies have shown that the contribution of FDI to both productivity and income growth in host countries is usually higher than what domestic investments contribute (Root and Ahmed, 1979). Access to International Markets Foreign firms usually improves the ability of the host country to access international markets because most of them are well connected in the global market in terms of access to consumer outlets, financial markets and transportation networks. Research has proved that foreign firms can help domestic exporters in accessing international markets by giving externalities that augment the exporting prospects (Aitken et al., 1997). Foreign firms also provide the host countries with information about foreign consumers, markets and technologies. They also provide the domestic firms with channels through which they can distribute their goods. Through this, the potentiality of a country to increase its foreign exchange earnings is raised. Human Capital Enhancement Foreign direct investment enhances the human capital resources by allowing their employees to get training on the operation of specific businesses. These subsidiaries can as well have positive effects on enhancing human capital in other enterprises with which they have links. Also, through the trainings, FDI raises the skills of local work force thus increasing their level of productivity. The notion that FDI improves labour force productivity is supported by empirical findings which suggest that workers in firms that are owned by foreigners are more productive than those working in domestic owned firms (Harrison, 1996). Other benefits of foreign direct investment include: Integration into The World Economy: The openness of a country to FDI promotes international trade thus contributing to its integration into the global economy (Morrisset, 2000). Enhancing Efficiency: Openness to FDI increases the degree of competition in product markets thus compelling domestic enterprises to allocate and use their resources more efficiently. Benefits to Businesses: Inflow of FDI provides business entities with an opportunity to get loans easily and low interest rates. These facilities are of great advantage to small and medium sized firms that usually have problems in getting the loans (Morrisset, 2000). Benefits for Investors: countries that invest in other countries also benefit from FDI. FDI provide their companies with opportunities to explore new global markets thus generating higher incomes and profits (Mwilima, 2003)s. Risks of Foreign Direct Investment Although FDI has been of great benefit to developing countries, it has as well carried with it some risks or disadvantages. Thus governments in developing countries must be very keen when they decide the magnitude, conditions and patterns of foreign investments. The following are some of the risks of FDI: Large Foreign firms usually influence the political decisions of developing countries. Due to their great size and power, the foreign firms often jeopardize the host’s country national sovereignty and control over economic policies. In some cases the foreign firms can bribe government officials in order to receive undue favours. Similarly, can offer help to political parties that are friendly to them thus subverting the political process of the host country (Mwilima, 2003). The competition that foreign investment poses on the domestic or home investment threatens the survival of these firms. It lowers the profits in domestic firms which in turn lead to the fall of domestic savings. What the foreign companies contribute to the public revenue through corporate taxes is usually low. This is because of the liberal tax the host governments often provide them with liberal tax concessions, tariff protection, investment allowances and disguised public subsidies (Mwilima, 2003). The excessive advertisements and monopolistic market power of foreign firms lead to improper consumption patterns. The products that are usually made by foreign firms for the home market are not obviously low in price and of good quality. Their technology is usually capital intensive and does not meet the needs of labour surplus economies. Foreign firms create dualistic economic structures and increase income inequalities. They promote the interests of a few executives against the interest of others by making the wage difference wider. Foreign companies are usually located in urban centres thus cause imbalance in economic opportunities between urban and rural areas and promoting the rural-urban migration (Mwilima, 2003). Conclusion Both economic theory and recent findings suggest that FDI has been of great benefit to developing countries. However, the recent findings also identify some potential sources of risks to the host country. For instance, through financial transactions FDI could be reversed; there could be excessive FDI due to adverse selection and fire sales; the advantages of FDI may also be minimized by leverage; and FDI may also take the largest share of a country’s total capital inflows. Therefore, as a government seeks to provide friendly environment to attract FDI, it should also put in mind the risks that these foreign firms may pose to domestic investments as well. The extent to which a country sufficiently benefits from FDI depends on the policies that the country has laid down to govern the operations of the foreign firms. Although the empirical significance of some of the risks of FDI still remain to be demonstrated, they seem to create a nuanced view of the likely impacts of FDI. Therefore, developing countries should focus their policies to improving all types of the investment climate of capital, domestic as well as foreign. Reference List Aaron, C. (1999). The Contribution Of FDI To Poverty Alleviation Report from the Foreign Investment Advisory Service presented at a conference in Singapore Aitken, B; Hanson, G.H; and Harrison, A. (1997). Spillovers, Foreign Investments, and Export Behaviour, Journal of International Economics, 43 Bleaney, M (1993), Political Uncertainty And Private Investment in South Africa, Credit Research Paper no. 93/15, University of Nottingham Blomstrom, M. & Kokko, A. (1998). Multinational Corporations and Spillovers. Journal of Economic Surveys 12 Bradshaw, Y.W (1988) Reassessing Economic Dependency and Uneven Development: The Kenyan Experience. American Sociological Review, 53 Dornbusch, R and Reynoso A. (1989). Financial Factors in Economic Development, American Economic Review Papers and Proceedings, vol.79 Dunning, J (1993), Multinational Enterprises and the Global Economy, Reading, Mass: Addison-Wesley Flamm, K. 1984. The Volatility of Offshore Investment. Journal of Development Economics.16 Harrison, A. (1996). Determinants and Effects of Direct Foreign Investment in Cote D’ivoire, Morocco, and Venezuela. In M. Roberts & J. Tybout (Eds.), Industrial evolution in developing countries, micro patterns of turnover, productivity and market structure. New York: Oxford University Press. Levis, M. 1979. Does Political Instability in Developing Countries Affect Foreign Investment Flow? An Empirical examination. 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