Foreign Direct Investment in Developing Countries - Article Example

Foreign direct Investment in Developing Countries Introduction Foreign direct investments refer to direct investment inbusiness or production in the country by a company or an individual of another country. That could either be by buying an industry in the target nation or by expanding operations of an existing company into that country. In simpler terms, it means that a firm makes an investment, physical in kind, such as building an industry in another country. The cord between a states economy and foreign direct investments is a strong one. A state requires inflows of foreign investments that are large in order to achieve a high trajectory of economic growth. This topic bears importance in that if wielded appropriately it may just be the ticket out of poverty lines for developing nations. Growth of the economy by seven or eight percent is achievable but only if there is investment of around 35 to 40 percent of the GDP. National savings undoubtedly fall short of this by a huge margin. Therefore, it is up to foreign borrowing and investments to meet this gap. Thus, it is imperative for the governments of developing nations to providing incentives to investors. This paper will focus on the foreign direct investments in developing countries and the impact it causes to both participating parties (Moran 75). The political and social changes of late 20th century and the recent technological advancements have brought about immense changes in the economic situation of the present world. The planned economies are failing and their retreat from the global economy. The development and the rising influence of free and open market economies and the ever stronger tendency towards a world economy. Predicts broad changes in various interacting phases (e.g. economical, political and social) of the global community in the future. The old restrictions and monopoly of the old world transformed into friendly smiles and gentle politics with policies of closed economies being dumped and nations embracing the open capitalist economies. This phenomenon has puzzled many. Everyone however seems to agree on a single point. There would be no foreign direct investment if the markets were perfectly competitive. Therefore, markets are to work efficiently and ensuring there is no barriers in the form of trade or competition; then the phenomenon of FDI is much more likely. Many theories have tried explaining this phenomenon. These theories attempt to explain this phenomenon based on different assertions such as perfect and imperfect competition of markets. The currency based methods as well as those that link FDI with international trade are also in place (Moran 75). In a globe dominated by perfect competition, FDI would be absent. Distortion is essential to enable direct investment. It is crucial to note that during the period of war in the twentieth century, a significant development was that Britain lost its status as the primary creditor. The USA emerged as the new dominant economic and financial power. In the period post-Second World War, a significant growth in FDI was fuelled by the improvement in infrastructure. This facilitated exercising control from a distance and the need for Europe and Japan for the United States of America’s capital to finance their reconstruction activities. However, as host countries started recovering in the sixties, FDI outflow from the United States slowed down. The eighties saw two significant developments. First, The united States became a new recipient of FDI and next was Japan emerging as a major state for FDI flows to Europe and the United States. The nineties saw Japan decline as an important source of FDI. The year 2000 onward, an increase in FDI flow from developing nations not only to fellow developing nations, but also to the developed countries was evident. It is against these odds that the FDI theories have evolved over time (Moran 75). Several theories of FDI also have their roots in imperfect markets. Hymer, who one among the pioneers who devised a systematic method towards the study of FDI, developed the FDI approach of Industrial Organization in his doctoral dissertation. This theory was first to describe international production in an imperfect market framework. The significance of this theory is that firms operating abroad have to compete with domestic companies that are in a better position in terms of culture, language, customer preference and legal system. With foreign firms also exposed to foreign exchange risk, it was imperative for some form of market power to offset these disadvantages so as to make international investment profitable. The sources of market power take the form of technological superiority, names of brands, skills in management and marketing, and cheaper sources of funds. Hymer identified technological superiority was the most significant advantage as it facilitated the introduction of new products. Since the market is imperfect, firms can maximize their market power to earn vast profits by investing across the borders. However, the choice between licensing or exports and FDI has a number factor that determine it. FDI will allow the firm to exploit its advantages to the maximum. However, of further concern to the organization is that the indirect control will increase the possibility of leaking of technology to competitors (De Schutter, Swinnen and Wouters 50). Another theory that still puts in place the factor of imperfect markets is one by Kindleberger presented in 1969 of FDI based on monopolistic power. This was an extension of Hymers work where he argues that advantages enjoyed by multinational co-operations are only useful in the case of imperfect markets. These benefits encourage a firm to invest directly in the state to enable full exploitation rather than sharing the opportunity with potential competitors. Thus, direct investments are magnified by the chances of earning monopoly facts being great. Internalization theory of FDI by Buckley and Casson in 1976 also provides additional explanation of the FDI phenomenon. They stress internalization with regard to the creation of MultiNational Co-operation, and their theory was based on three postulates. The firms maximize their profits in a market that is imperfect, when markets in intermediate products are imperfect, and they are motivated to bypass them by creating internal markets. Finally, the fact that internalization of markets across the world eventually produces MNCs. For instance, a firm involved in research and development may discover a new technology or a process. However, transfer of the technology or selling the inputs to unrelated companies may result to transaction costs multiplying proving difficult. This leads to the firm choosing to internalize by taking up backward or forward integration, that is, technology by one subsidiary may be used in others. When internalization involves operations in another country, then it refers to FDI (De Schutter, Swinnen and Wouters 50). Knickerbocker also developed his theory basing it on market imperfections called the oligopolistic theory. There are two principal motives for choosing a particular country as a location for a new facility asserted in economic literature. The firms seek increased access to the host country’s market and that the companies want adequately to utilize the relevant abundant factors available in the host country. Knickerbocker also said to match a rival move might be a third motivation for choosing a location to be another country. To summarize Knickerbocker’s theory, firms often display imitative behaviour of their competitors so that they may not be at a loss with their strategic advantage. A final approach to imperfect market is the eclectic paradigm where Dunning suggested that three conditions that if fulfilled would suggest that the country would have engaged in FDI. The firm should possess ownership advantages over other companies, internalizing these benefits is beneficial than transferring them to foreign companies using the market (Mottaleb, Khondoker and Kilirajan 157). Other theories tried explaining FDI on the basis of the strength of the currency and Aliber in 1970 made one of the earliest attempts. He put forth his theory in terms of the difference in strength of the currency of the source and host countries. He stipulated that weaker currencies are much more capable than stronger investing countries in attracting FDI in order to take advantage of the difference in the rate of capitalization of markets. Some theories also tried to relate FDI with international trade. Smith and Ricardo in 1776 and 1817 invented a theory to explain trade flows among countries (Mottaleb, Khondoker and Kilirajan 157). Empirical examples Africa bears countries with economies that rank amongst the poorest in the world owing to the authoritarian or totalitarian rule that these countries have been through since attaining freedom from colonial domination. This has led to countries becoming heavily indebted to the western states and international organizations. In the recent past, however, African countries have shown remarkable improvements, decreasing their debts and raising per capita income as well as attracting foreign investors. Mozambique is one African country that has adopted FDI, though still one of the poorest countries. It has noted a steady rise in the economy through the late eighties and nineties. There was a significant increase in FDI flows through that period. In Uganda, however, the rate of academic growth and FDI flows steadily declined. The years 1994 and 1995 saw the exports from Uganda increased significantly, from $254 million to $537 million. The GDP growth between 1994 and 1995 increased from 6% to 10.4% and the rate of growth in GNP more than doubled, increasing from 2.6 to 7.6 percent. Moreover, the early nineties saw Ugandas foreign direct investment rise from $0 to $121 million (Mottaleb, Khondoker and Kilirajan 157). The figures above clearly suggest that there is a cord between levels FDI in the economies of Uganda and Mozambique and their respective levels of development and economic growth. A good example, there was a rapid increase in foreign direct investment to Mozambique between 1985 and 1995. By receiving no foreign direct investment in 1985, there were inflows of $35 million in FDI in 1994 and $45 million in 1995. In turn, the average annual growth of the economy of Mozambique also increased dramatically. The increasing from negative growth in the eighties to a positive 5 percent in 1996, a higher growth than the high-income states. Increase in rates of trade and export, local investment, and the GNP suggest that a positive relationship exists with improved FDI in Mozambique. Similarly, compared to the rates of FDI, economic growth rates in Uganda suggest a similar relationship. This increase in FDI in the Ugandan economy from negative 4 million dollars in 1985 to 5 million dollars in 1995 reaching 121 million dollars by 1996. It is positively proportionate to the rate of growth of GDP from 3.1 to 6.6 percent by the year 1995. Uganda experienced significant growth rates during these years. Growth rate of GNP in Uganda at the end of the year came to 9.4 percent in 1996, which was a higher rate compared to most developing nations (Craig and Susanna 511). Outcome FDI has become a crucial source of investible finance for developing countries. It is different from other external sources of funding in that its primary incentive is the investor’s long-term prospects for making profits in production activities that they control. This has provided a steady source of investment for the developing nations, which assist in building their economies. For example, if a large factory has constructed a plant in a remote country. They may have to utilize local resources such as local labour, equipment and materials to build it and this translates to revenue for the recipient country (Moran 75). It has also provided a means of passing on the technology in production, skills, capacity of innovativeness and managerial and organizational practices between places as well as of accessing international networks in marketing. Another benefit is that it allows money free movement to whichever business has the best ambitions for growth in any part of the world. This is because investors continuously and aggressively seek to maximize profits for their invested money with a minimal risk. The motive is non-racist, does not care about form of government nor religion. This gives well-run businesses, regardless of creed, race or colour, a competitive advantage. This reduces (does not eliminate) political effects, bribery, and cronyism. This result in the smartest money going to the best businesses in the world, therefore bringing these services and goods to market closer and faster than if unlimited FDI were not available (Abenaa 112). Improved living standards was evident in the recipient nation due to by the tax revenue of the firm that receives the foreign direct investment. However, countries may sometimes neutralize that increased income by offering tax incentives to make the country attractive to investors (Abenaa 112). Offsetting the volatility caused by "hot money" is another advantage. Currency traders and short-term lenders can result in an asset bubble in the country by investing lots of money in a short period, and then they sell their investments quickly. This creates a boom-bust cycle that can destroy political regimes and economies. FDIs take long to set up, and have a much more permanent footprint in the country (Chaudhuri and Mukhopadhyay 19). The investors receive additional incentives in terms of benefits. The risk is minimal in that they can make their holdings diverse outside of a particular country, industry or political system. Diversification always increases return without increasing the risk (Chaudhuri and Mukhopadhyay 19). For the investors, this is the development of a new industry which not only means a higher level of income, but a larger network in terms of market for their products and labour reducing production cost. This, therefore, maximizes the productivity. However, despite the numerous advantages there are also some disadvantages attached to FDI (Chaudhuri and Mukhopadhyay 19). One major problem is uncertainty, as the investing country may not be able to project the future of the economy of the host country. Therefore, the investors have to invest with risk being a factor. Legal and political instability of the host country may be a potential hindrance to the success of the investment. Many countries in Africa portray this characteristic, which discourage investment. This is because such political systems increase insecurity to both property and the investors (Asiedu 311). Sophisticated investors of foreign origin can use their resources to strip the company of its value and worth without adding any. This implies that they can sell off unprofitable sections of the enterprise to the local and less sophisticated investors (Asiedu 311). Conclusion A foreign direct investment involves making a physical investment by the investing country to a host country. This results in a cordial relationship that is beneficial to both parties. The various theories basing on either proper or improper market conditions help us understand and better appreciate FDI. They can also be quite useful grounds that can help modifying FDI to be more profitable to both parties. These theories should be under scrutiny, and positive aspects of them are amplified and incorporated in modern society. As illustrated above, it is clear that foreign Direct Investments are much more beneficial with the numerous advantages. Works Cited Theodere, H. Moran. “Harnessing foreign Direct Investment for development” The impact of foreign direct investment to countries and industries (2006) Olivier De Schutter, ‎Johan F. M. Swinnen, ‎Jan Wouters. “Foreign Direct Investment and Human Development” The Law and Economics of International Investment Agreements (2012) Asiedu, Elizabeth. "On the Determinant Foreign Direct Investment to Developing Countries: Is Africa Different?" SSRN Electronic Journal (2006): n. pag. Print. Laaksonen-Craig, Susanna. "Foreign direct investments in the forest sector: implications for sustainable forest management in developed and developing countries." Forest Policy and Economics (2007): n. pag. Print. Mottaleb, Khondoker A. and Kaliappa Kalirajan. "Determinants of Foreign Direct Investment in Developing Countries: A Comparative Analysis." (2010): Print. Oti-Prempeh, Abenaa A. "U.S. Foreign Direct Investment in Developing Countries: a Case Study of Malaysia, Mexico and South Africa." (2006): Print. Sarbatij Chaudhuri, Ujjain Mukhopadhyay. “Foreign Direct Investment in Developing countries: A Theoretical Evaluation (2014) Read More