The Impact of Inward Foreign Direct Investment on Host Countries - Essay Example

Examine the impact of inward foreign direct investment on host countries and suggest policy measures for host countries to maximize the net benefit from such investment Foreign Direct Investment (FDI) has seen an increasing trend in recent years; in 2006 alone gross FDI flows were double the amount they were in 2001. Inward FDI increased from 9.6% of GDP in 1990 to 26.7% in 2006. (Woodward, 2011). There has also been a recent flow of FDI towards developing economies and this has had a plethora of effects, both for home and host countries. (Raj and Sager, 2005). Foreign Direct Investment has over the last three decades aroused conflicting responses from the first and third world. In essence, FDI gives the investor the power to operate a company in another country for the long term. Developed host countries are not too welcome to the idea on the premise that they fear foreign firms will end up dominating their local firms. In contrast to this, developing countries are more welcome to the idea on the grounds that FDI will bring additional capital, expertise and new technology into their country. (Contessi & Weinberger, 2009). Host countries record FDI flows as liabilities along with similar items in their balance of payments. In host countries like these FDI flows make up a large percentage of the total investment in the economy as compared to more developed countries; the effects of FDI on these countries differ as well, with developing countries showing a steady growth trend as compared to developed countries who showed boom and bust cycles as a result of engaging in FDI. (Contessi & Weinberger, 2009). Growth is normally measured by looking at the trends in per capita GDP growth. Analysts relate FDI to per capita to GDP growth by looking at figures of gross FDI inflows and FDI inflows per capita to see if they have any impact on the economic growth of a country. Research has revealed a positive relationship between FDI levels and growth levels in an economy, in some cases these results have been insignificant as well but these variables have never shared a negative relationship. Extraneous variable have a magnitude changing effect on this relationship. It has been seen that, the more developed a country is, the better and greater positive effect FDI will have on its economic growth. (Contessi & Weinberger, 2009). Most studies that have analyzed the impact of FDI on the economic growth of the host country have found the results to be pretty elusive. Most established relationships are based specifically on the host country’s own specific economic characteristics. Thus it is difficult to generalize these effects and apply them to other countries as the findings of a study. However, the probable effects are not completely elusive, as the endogenous growth theory provides framework for the positive linkage between growth and FDI inflows. (Johnson, 2005). A study found that FDI can have a positive effect on growth, given that the host country promotes exports simultaneously. (Balasubramanyam et al, 1996). Another study showed that FDI had a positive impact on growth, but this effect was to be directly proportional to the host country’s level and quality of human capital. (Borensztein et al, 1998). A further study conducted on 50 developed and developing countries also found FDI to be positively impacting host country’s growth rate. (Olofsdotter, 1998). Research revealed that FDI and growth have a positive relationship, the magnitude of which depends on the specific economic conditions of the country in question. (Zhang, 2001). Another study based on research on Latin American countries also had similar findings. (Bengoa & Sanchez-Robles, 2003). Some studies on the other hand, found a weak link between FDI and economic growth based on research done on a mix of developed and developing countries. (De Mello, 1999). Other studies, like the one which conducted research on a mix of 72 developing and developed countries found that FDI inflows do not have any independent impact on economic growth. (Carkovic & Levine, 2002). An adverse effect that FDI has on an economy is that it crowds out domestic investment. (Contessi & Weinberger, 2009). Various studies over the years have had some what varying findings regarding this subject; however, some generalized benefits of FDI inflows in economic growth have been summarized as a result. It has been seen that some advantages of FDI are specific to firms, knowledge capital and other external factors. The concept of knowledge capital is particularly relevant when looking at FDI made by multinational companies, because they spend a lot on research and development, have trained and technical staff and produce products that are technologically advanced. Consequent technology spillovers and transfers of this knowledge based capital and superior technology to the host economy may benefit economic growth. Benefits can also be derived from the employment of physical capital and labor. Theoretically, when the size of the physical capital of the economy increases, its productive capacity also expand and this leads to economic growth. Unemployment also decreases as the MNC engaging in FDI employs people from the local labor force to work in their factories. In the long run, decreases in unemployment will reduce poverty and increase standard of living, per capita GDP and thus economic growth. (Johnson, 2005). However, it is to be noticed that the result of technology spillovers and increases in physical capital will have different effects for developing countries as compared to developed countries. Developed countries are more technologically advanced and will be better able to absorb and realize the technology spillovers. However, benefit gained from these spillovers won’t be substantial because the country is already technologically advanced. In comparison, developing countries will derive greater benefit from smaller technology spillovers because they were not so advanced in the first place. However, since they are not developed enough to realize these benefits appropriately, the advantages of these effects may not be fully realized by the host country. In the case of increases in physical capital, developed countries have an operating market structure that will ensure increasing returns to investment; where as in developing countries there will be constant returns to scale. (Johnson, 2005). Some studies and research material on the other hand, have shown results which point towards the notion that FDI is damaging for host countries and that MNCs exploit host countries in their favor and no benefits are left to spill over to the host economy. It is said that MNCs depress wages and abuse host country’s cheaper labor. Studies and research that develops along these lines has an inherent negative stance where globalization and world trade is concerned. This particular study discusses the effects of FDI on host countries with respect to factors of productivity, exports and introduction of new industries. Capital inflows are particular to specific countries according to their natural or built resource endowment level and entrepreneurship depends on the characteristics of investing firms and countries. This paper also discusses the effects of FDI on host countries. It is seen that FDI affects wages, and it is discussed whether FDI firms give higher wages to employees, which will cause wages in the industry to rise or cause any wage spillovers otherwise. FDI also impacts the productivity in the host country, which usually results from superior efficiency and technology level of the FDI firms. The more important point to ponder is whether this increase in productivity spills over to local industry and firms in the host economy. In order to determine these values and productivity levels, studies conducted comparisons between the productivity levels of domestic firms in the host to country with the foreign owned firms that were engaging in FDI. Another factor that gains importance when looking at productivity spillovers is that of knowledge spillovers. A study found that the higher the industry’s skill level the greater and more beneficial the spillovers from it. This leads to the conclusion that the size and characteristics of the firm and the industry it operates in becomes crucial in determining the impact of a spillover. It was also found that low technology gaps also promoted the benefits of spillovers, so did the existence of a healthy level of competition and capability in the host economy’s market. It was also seen that the lesser the gap between foreign and domestic firms and the greater the level of vertical integration between them, the greater the benefits reaped from the situation. (Lipsey, 2002). Further study looks at the fact why there are such differing opinions on the effects of FDI on the economic growth of host countries. This study talks about how the biggest theoretically positive effects (for example wage and productivity spillovers) are doubtful in nature because of inconclusive evidence in their favor to prove otherwise. According to this study differences arise to inherent differences in the nature of the labor market, protective measure, economic condition of the country, ability to absorb spillovers, starting position of the country that is, how the country was before FDI and the economic flexibility of the host country. (Lipsey & Sjoholm, 2004). A research paper on the subject studies the situation of the United States and Japanese MNCs. It says that the effects of inward FDI depend upon many factors relating to the host economy and the foreign firm that engages in FDI. It goes on further to say that benefits of welfare come forward in three ways in the economy; improved marketing, improved productivity and improved infrastructure. Another important factor that comes into consideration is the economic policies that have been implemented in the host country. In this study, total FDI flows from the U.S and Japan were studied. The study did not yield results in favor of FDI being beneficial however, positive effects were observed due to FDI by the U.S. It proposed that host countries should invest in bilateral or multilateral investment agreements so that they can secure their own benefit from the inflow of FDI. It also said that success of spillover effects depends upon the state of the domestic industry and thus it should be considered before signing an FDI agreement. (Lemi, 2004). An OCED paper that talks about maximizing benefits from inward FDI elaborates on the topic and says that this requires some policy measures. These policies are designed to achieve high and sustainable economic growth, contribute to economic expansion and enhance world trade. This report talks about how the positive effects of inward FDI can be maximized by the host country. It follows that the benefits that can be derived from FDIs do exist but they do not manifest themselves in the economy automatically. And thus an adequate economic environment has to be created where they can manifest themselves and bring about the benefits that they promise to the host economy. Countries that do not have a favorable economic standing with foreign investment otherwise can benefit from inward FDI by limiting access to foreign funds. Domestic economic environment must be flexible enough to reap the benefits of a foreign firm. If the domestic market structure is too rigid and has too many strict policy measures implemented then the FDI will not be able to sufficiently have a benefit for the host economy. FDI is not a complete solution for developing economies and they should have other economic policies in the works that will help them attain sustainable growth levels. The paper also suggests some policy measures that should be made effective; these policies should be aimed at increasing sustainable growth and price stability, increase employment in the economy, promote tax discipline in the economy, make domestic financial system stronger, implement policies to improve governance, become more friendly to the concept of world trade without barriers as a benefit to be realized globally and implementing non-discriminatory policies. Host countries also need to improve the infrastructure, enhance the educational sector so that provision of education can be improved and impose strict performance requirements so that the products meet quality standards. (Christensen, 2002). References Balasubramanyam, VN, Salisu, M & Sapsford, D 1996, Foreign direct investment and growth in EP and IS countries. The Economic Journal, 106, 92-10. Bengoa, M & Sanchez-Robles, B 2003, Foreign direct investment, economic freedom and growth: new evidence from Latin America. European Journal of Political Economy, 19, 529-545. Borensztein, E, De Gregorio, J & Lee, J-W 1998, How does foreign direct investment affect economic growth? Journal of International Economics, 45, 115-135. Carkovic, M & Levine, R 2002, Does foreign direct investment accelerate economic growth? Christiansen, H 2002, FDI for Development: Maximizing Benefits, Minimizing Costs. Organization for Economic Cooperation and Development. Contessi, S & Weinberger, A 2009, Foreign Direct Investment, Productivity and Country Growth: An Overview. Federal Reserve Bank of St. Louis Review, 91(2). De Mello, LR 1999, Foreign direct investment-led growth: evidence from time series and panel data. Oxford Economic Papers, 51, 133-151. Johnson, A 2005, The Effects of FDI Inflows on Host Country Economic Growth. Lemi, A 2004, FDI, Host Country Productivity and Export: The Case of U.S and Japanese Multinational Affiliates. Journal of Economic Development, 29(1). Lipsey, RE & Sjoholm, F 2004, The Impact of Inward FDI on Host Countries: Why Such Different Answers? Lipsey, RE 2002, Home and Host Country Effects of FDI. National Bureau of Economic Research, Working Paper. Olofsdotter, K 1998, Foreign direct investment, country capabilities and economic growth. Weltwirtschaftliches Archive, 134(3), 534-547. Raj, N & Sager, E 2005, FDI Incentives: A Framework for Governments to maximize “good” Investments. International Financial Management, Final Paper. Woodward, D 2011, Foreign Direct Investment for Development? G-24 Policy Brief No. Zhang, KH 2001, Does foreign direct investment promote economic growth? Evidence from East Asia and Latin America. Contemporary Economic Policy, 19(2), 175-185. Read More