The Various Reasons for Foreign Direct Investment - Essay Example

Foreign Direct Investment Critically discuss using empirical evidence, the various reasons for Foreign Direct Investment In today’s competitive economic environment Foreign Direct Investment (FDI) plays an extraordinary and growing role in global business. FDI is considered an investment to create or expand a permanent interest in a foreign enterprise. It provides a firm with newer markets and marketing channels, cheaper production facilities, access to new technology, products, skills and financing. For a host country or the foreign firm which receives the investment, it can provide a source of new technologies, capital, processes, products, organizational technologies and management skills, and as such can provide a strong impetus to economic development. The effect of FDI on host economies has been the subject of extensive research. As pointed out by Hanson (2001), both theory and empirical evidence provide mixed results on the net welfare effect of inward FDI on recipient countries. The attitude towards inward Foreign Direct Investment (FDI) has changed considerably over the last couple of decades, as most countries have liberalized their policies to attract investments from foreign multinational corporations (MNCs). In fact FDI has proved to be resilient during financial crises. For instance, in East Asian countries, such investment was remarkably stable during the global financial crisis of 1997-98. This crisis mainly involved four basic problems (CRS Report, 1998): i. A shortage of foreign exchange that caused the value of currencies and equities in Thailand, Indonesia, South Korea and other Asian countries to fall dramatically, ii. Inadequately developed financial sectors and mechanisms for allocating capital in the troubled Asian economies, iii. Effects of the crisis on both the United States and the world, and iv. The role, operations, and replenishment of funds of the International Monetary Fund. Economists argue that the primary cause of the crisis was too much government intervention in economic activity, leading to misdirected and inefficient investments in both public and private projects. As an aftereffect of the crisis short-term capital inflows were viewed as unstable and thus dangerous; long-term capital movements were seen as stable and thus desirable. Therefore an emphasis was put on de-emphasizing short-term capital inflows and encouraging long-term capital inflows, especially FDI which was seen as directly enhancing domestic productive capabilities. There’s one school of thought which puts the blame for this crisis on FDI itself. They argue that the crisis had shown that over-reliance on FDI carried its own dangers. Rapid FDI inflows had been a major factor enabling these countries to maintain their overvalued exchange rates. No doubt such exchange rates helped keep domestic inflation under control, but they also increased East Asian vulnerability to speculative attacks. And therefore it was the drying up of FDI, largely as a result of competition from lower wage countries (especially China) and the mobility of regional investment by Japanese, South Korean, and Taiwanese companies, that forced the East Asian countries to open themselves up to heavy short-term capital inflows as a way of financing their growing trade deficits. In general, international firms are of three types; Resource seekers: firms looking for natural and human resources Market seekers: firms are looking for better opportunities to enter or expand within market Efficiency seekers: Firms attempting to obtain the most economic sources of production. If the latest trends are an indication Foreign Direct Investment (FDI) is on the rise again. Emerging market countries are the most attractive FDI locations in the world. Led by China and India, emerging markets have achieved unprecedented levels of investor confidence (ATKEARNEY, 2006). Host governments often lure foreign investors by large investment grants. Economists tend to favor the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several other advantages, as noted by Feldstein (2000). First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies. Foreign Direct Investments in general give room for enough maneuvering to the host nation as well as to the MNC. Some of the interesting features of FDI are; FDI allows the transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. Under fairly general conditions, FDI could be expected to act as a channel for technology transfers as well as influence the intensity of competition. FDI can also promote competition in the domestic input market. MNCs possess firm specific assets that confer them a competitive Edge. By their very nature, these assets can be easily transferred back and forth across space. Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country. World Bank report of 2005 states that, “China demonstrates the significant impact of investment climate improvements in increasing growth and poverty reduction. China’s investment climate reforms over the last two decades helped lift 400 million people out of poverty. China’s growth is officially reported at an average of eight percent a year for the past 20 years, and the share of its population below $1 a day fell from 64 percent in 1981 to 16 per cent in 2001.” Profits generated by FDI contribute to corporate tax revenues in the host country. FDI is considered an equity investment to create or expand a permanent interest in a foreign enterprise. Empirically, the bulk of FDI is “horizontal” and concentrated in sectors where product differentiation is pervasive, i.e. imperfectly competitive industries characterized by entry barriers such as fixed costs that are often sunk (and may be endogenous or exogenous). Since MNCs are firms that already operate in a foreign market, and have presumably already incurred fixed costs, they are in a privileged position to compete with established domestic concerns. From that perspective, an MNC is better positioned compared to a potential entrant with no previous experience. Received theory suggests that a change in ownership from domestic to foreign should bring long-run efficiency and therefore profitability gains, especially in industries where proprietary assets such as technology and other intangibles are perceived to be important. There is a general misconception that market-seeking FDI in domestic sectors such as retail, yields little development impact. But empirical evidence suggests that opposite is true. FDI in retail has been a key driver of productivity growth in Brazil, Poland, and Thailand, resulting in lower prices and higher consumption. Large-scale foreign retailers are also forcing wholesalers and food processors to improve. And they are now becoming important sources of exports: Tesco in Thailand and Wal-Mart in Brazil are increasingly turning to local products to feed their global supply chains. An increase in the stock of capital enables a country or region to employ more people and thus reduce unemployment, boosting output growth, etc. From the point of view of a less developed host country like India, Malaysia, Brazil etc. FDI is seen as a medium of technology transfer and thus contributing to higher production efficiency and productivity not only to the foreign owned firms but - via spillovers - also to locally owned firms and establishments. This increases the competitiveness of a particular industry, region or country which again is of importance in industries with global competitive pressures. FDI also allows outsourcing particular activities (e.g. labour intensive activities) to be performed more cheaply in other regions or countries, to exploit economies of scale and scope more efficiently. Factors affecting the FDI decisions: Foreign Direct Investment decisions are taken by governments with utmost precaution, taking into account a host of factors like the extent to which FDI can assist or threaten the host economy. Indeed there are apprehensions from some quarters in allowing big MNCs. There apprehension is not unfounded either. If we go into history, we find that during the 18th and 19th century British business tycoons spread their reach in different parts of the world. Once established it was followed by hegemony of British rulers resulting in occupation of many countries by British forces. Economy is therefore a vital factor in deciding the fate of the country. For this very reason countries, particularly developing nations, put caps on the FDI limit. An MNC decides on investing in any particular economy depending mainly on marketing factors like; Growth and profit motivations Circumventing government-erected barriers to trade Access to low-cost resources and supply Local customers preference for domestic goods and services Attempts to obtain low-cost resources and ensure their supply To identify itself more with the local populace the MNCs try to bring the R&D activities also in the local ambit. While companies make overseas investments, particularly in R&D, several factors dominate their location decisions like; Lower costs, Higher-quality labor, Protection of intellectual-property rights, Reliable educational systems and sophisticated IT infrastructures. Developing countries in Asia and Eastern Europe are experiencing the largest increases in R&D investments as these countries become integral to multinational companies global innovation processes. FDI decisions also results in derived demands in the market i.e. when businesses move abroad they encourage their suppliers to follow them, which in turn creates a chain or pattern of direct investment in a market. This often results in an economically sound position for the host nation. Governments look towards FDI as an important tool to strengthen the economy and to attract FDI they provide; Fiscal incentives like tax holidays, allowances, credits and rebates to MNCs Financial incentives like special funding for land or buildings, loans and guarantees, wage subsidies. Non-financial incentives like guaranteed purchases, protective tariffs, import quotas, local content requirements, infrastructure. Special Economic Zones where even the country’s labor laws do not apply and the MNC can work with laws suiting its business. Governments in general want the private sector to invest in infrastructure activities like Telecommunication, Power, Insurance, Finance, Banking, etc. but the host nation investor may not have enough financial strength to make the large investments these sectors demand. This generates the demand for FDI. As compared to infrastructure activities MNCs find retail trade and real estate as more lucrative sectors for investments. They are ready to invest as much as required to capture retail trades. For this reason governments put FDI limits on certain sectors. Similarly in other sectors like finance and banking, the pillars of the economy of a country, governments put restrictions in place so that the economy doesn’t become hostage to a cartel of MNCs which may result in crisis like situations. Economists also argue that there are some drawbacks from FDI in both the host as well as the sending countrys perspective. For example; i. An increase in the share of foreign capital does not necessarily mean that the capital stock is increasing. Average productivity rises if a higher than average productive unit of capital is added (or a takeover raises the efficiency of capital usage). However, FDI may also drive out local firms: If FDI drives out local firms at the lower end of the productivity range, the average productivity level of domestic firms increases; however, if FDI drives out the best domestic firms (because these are the firms serving the same market segments as the incoming firm) average productivity of the domestic firms may decrease and the effect on overall productivity becomes ambiguous. ii. FDI may also discourage local firms from further investments, e.g. by increasing the cost of capital, by attracting skilled workers which are no longer available for other local firms, etc. iii. Monitoring behavior may become more difficult, particularly since the MNC has no previous “history” in the domestic market. iv. FDI may lead to a crowding-out of domestic firms, followed by their exit. In such a situation, successful predation will only dampen competition if re-entry costs are high. Also, FDI may reduce competition in the event that entry into the foreign market facilitates collusion. v. Raising the productivity level of a limited number of employees may imply a reduction of employment opportunities for jobless people. This is particularly worrying for highly populated countries. Such opportunistic approaches by MNCs affect not only the developing nations but developed nations as well. For example the recent trend of outsourcing IT services to less costly and better skilled labor destinations like India, Malaysia etc. from USA, UK etc. has resulted in war cries from employees unions from USA, Germany, UK etc. They contend such policies are resulting in joblessness in these nations. World Bank report of 2005 (WDR 2005) also points out towards the incidence of jobless growth in Central and Eastern Europe. This, together with a tendency to lower wage rates or less strong rising wage rates combined with a rising wage spread favoring a few (more skilled workers) may reduce overall demand and thus output and employment growth in general in that particular region or country. This becomes even more problematic if the particular sector is export oriented and uses a high share of intermediates from imports (which decreases the output and employment multipliers). vi. The leftist block also dislikes FDI and MNC. They contend that MNCs drain resources from host countries, starve smaller capital markets, discourage local technology development, bring in outmoded technology and create new and tougher competition for local firms. Resources: 1. Alessandro Sembenelli and Georges Siotis, Foreign Direct Investment, Competitive Pressure, and Spillovers. An Empirical Analysis on Spanish Firm Level Data. Available online at: http://web.econ.unito.it/sembenelli/sesi03.pdf#search=%22empirical%20evidence%20reasons%20for%20FDI%22 2. Robert Stehrer and Julia Woerz, ‘Attract FDI! - A Universal Golden Rule? Empirical Evidence for Europe and Asia’, October 28 2005, 3. Hanson, G., (2001), “Should Countries Promote Foreign Direct Investment?” G-24 Discussion Paper Series, No 9, February 2001. 4. Magnus Blomström and Ari Kokko (Stockholm School of Economics), January 2003, The economics of foreign direct investment incentives, available online at http://web.hhs.se/eijswp//168.pdf 5. Martin Feldstein, 2000, "Aspects of Global Economic Integration: Outlook for the Future," NBER Working Paper No-7899 (Cambridge, Massachusetts: National Bureau of Economic Research). 6. Omer N. Benkato and Ali F. Darrat, October 2000, On Interdependance and Volatility Spillovers Across Capital Market: The case of Istanbul Stock Exchange, Presented to the ERF’s 7th Annual Conference in Amman-Jordan, Oct 26-29 2000. 7. World Bank, Development Outreach: Putting knowledge to work (March 2005), World Bank Institute, Washington DC, Vol-7, No-1. 8. The World Bank Group Private Sector Development Vice Presidency, September 2004 (Note No-273), FDI Trends, available online at; http://rru.worldbank.org/documents/publicpolicyjournal/273palmade_anayiotas.pdf 9. 2005 FDI Confidence index, available online at http://globaledge.msu.edu/ and http://www.atkearney.com/main.taf?p=5,3,1,138 10. The Hindu (An Indian English daily), (March 6, 2006) ‘Why FDI is the best bet: available online at http://www.thehindubusinessline.com/2006/03/06/stories/2006030601410800.htm 11. CRS (Congressional Research Service) Report, Federation of American Scientists, available online at http://www.fas.org/main/home.jsp Read More