Foreign Direct Investment - Assignment Example

? ECP001N Table of Contents  ECP001N Table of Contents 2 Answer to Question 3 Costs and Benefits of FDI 3 Determinants of FDI 4 Answer to Question 2 5 Answer to Question 3 6 Answer to Question 4 7 Answer to Question 5 8 References 10 Answer to Question 1 Foreign Direct Investment is regarded as one of the most essential of all factors that assist in economic development of a nation. However the role of FDI behind economic development of an economy is only a recent recognition; this had not been the scenario, for example, immediately after World War II. Post World War II, USA beat Britain and gained status as the greatest contributor to FDI inflows in economies across the world. Nonetheless, most of the FDI during this period flowed into industrial economies located in Europe, North America and Japan in Asia. During the years immediately before the war and past the aftermath of the Great Depression, foreign investment had gained momentum from the industrial nations to their respective colonies. After the war however, when many nations gained their independence, the new administrations disapproved of FDI on the grounds of neo-colonialism. At that time the newly independent nations, classified as the Third World economies, could not imagine compromising upon their independence in order to boost up economic growth. One such nation, Soviet Union, completely pulled curtains over the inflow of FDI within their premises and nationalised the existing foreign properties out of resentment for anything not of native origin. Simultaneously, the unpopularity of a capitalist form of society during the same era intensified the use of domestically produced goods, so that the activities of MNCs were remarkably stunted. In addition, the freshly freed nations were struggling to retain political stability after the war which discouraged the industrial nations towards pouring in resources in them, as well. However, the world saw a turnaround in the attitude of these anti-FDI economies during 1980s, when some of them uplifted their restrictions towards foreign investment (Twomey, 2002). Costs and Benefits of FDI FDI is associated with some costs and benefits both for the host and the source economy. For the recipient economy, FDI inflows could trigger economic growth, through stimulating investment and employment in the economy. In other words, FDI inflows might supplement the limited financial resources which retard the growth of an economy. Moreover, FDI inflows could assist in technology transfers that could prove to be more efficient in terms of production and thus, be of high assistance to the developing economies especially in case of LDCs (Assadourian, 2005). On the other hand, too much dependence upon FDIs for economic development, from a particular host nation might turn detrimental in case that the latter exploits the former on such grounds. In addition, the recipient country also suffers if FDI inflows invigorate production processes which ultimately injure the environment. Moreover, in case the benefits of FDI inflows trickle down to any particular segment of the economy only, possibilities of social uprisings grow intense among those who are not directly benefitted out of the same (OECD, 2002). FDI outflows could be turn to be beneficial for the source economy through boosting its current account position in terms of profit returns from sales made in the host economy. Moreover, prospects of rise in employment are also multiplied in the source economy when the raw materials produced in the host nation are brought in for manufacture of final goods. Lastly, technology and skill from the host nation are also passed into the home country, thus benefitting the latter. One of the highest costs incurred in FDI outflows is that of capital account deficits owing to a massive outflow in the initial phase. Secondly, the home country suffers from a current account deficit if the purpose of FDI outflow is to import low-cost raw materials (Vaidya, 2006). Determinants of FDI The primary factors which determine the flow of FDI within an economy are – At the face of competition, the foreign investors often consider foreign investment to be beneficial for their long run growths against their rivals. Such a measure could help them in securing their foothold in a non-domestic market. Such measures are often adopted in order to maintain a long term relationship which might prove to be profitable in the future, either in terms of a sustained flow of cost efficient inputs or technology. Moreover, a long term commitment could be advantageous at times of bargain as well. In addition, involvement in new product in a foreign market is associated with economies of moving in first (Moosa, 2002). Answer to Question 2 The association between openness to trade and economic growth of an economy is a highly debatable topic. There exist theories as well as empirical evidences supporting and opposing the facts, so that the applicability of any one of them cannot be asserted in the true sense of the term. One robust theory which could be raised in support of the hypothesis is that lower the degree of trade restrictions in an economy, higher will be the inflow of export revenues in the nation which in turn boosts the national income of the economy. Moreover, abolition of restrictions over trade such as import tariffs or export quotas could help in extracting the benefits of comparative advantage which is beneficial in lowering the cost of production. For instance, if the raw materials needed for the production of a particular commodity X, are available at lower costs in Country A, then it is beneficial for A to indulge in the production of X and not Y. Instead, A can import the required volume of Y from Country B which probably manufactures Y at a relatively cheaper price. Such a strategy could prove to be cost efficient and thus promote economic growth in the nation. However, in the absence of free trade such a scenario cannot be expected and the economic growth rate slows down (Rodriguez & Rodrik, 2000). A study conducted by Edwards on a sample of 93 countries found that proxy variables representing trade openness create a positive impact over the growth rate of total factor productivity in the respective nations. Moreover, to draw a comparison between the open and closed economies, Sachs and Warner examined on the basis of a sample drawn for a 20 year span between 1970 and 1989, that the annual economic growth rate of open economies were on an average 2 percentage points below those for the closed nations (Aghion & Durlauf, 2005). On the other hand many economists believe that a high degree of trade liberalisation lowers the prospects of economic growth, given that the Infant Industry Argument no longer holds in that case. Infant Industry Argument is more often applicable in case of the developing economies or those in a phase of transition. There are some primitive industries located in these economies, which cannot rival against their more developed foreign peers and hence, need protection until they grow matured enough. In case of free trade, it will no longer be possible to provide protection to these industries which cannot operate as efficiently as the more matured firms. On the other hand, not protecting these economies could prove harmful for the long run economic prospects of the economy (Baldwin, 2003). Moreover, trade openness could leave an economy susceptible to external shocks which could take a toll over the economic growth rate of the concerned nation (Calderon, Loayza & Schmidt-Hebbel, 2005). There are also instances when the economies were simply left indifferent after the promotion of free trade within their premises. Nations like USA, Taiwan and Mexico, for example, were found not to be benefitted by the technological transfer made possible by means of trade liberalisation (Rodriguez & Rodrik, 2000). Hence, empirical evidence about the association between economic growth and openness to trade cannot be considered as robustly proven through empirical evidence. Answer to Question 3 Theoretically speaking, there exists an indirect but strong association between openness to trade and poverty alleviation. Openness to trade leads to greater efficiency in economic operations and thus, helps in improving the prospects of growth in the economy. Improvements in the economic growth rates of the nation boost its income levels as well which trickles down to the poorer sections of the society and thus helping in brushing off the degree of poverty in the economy. Moreover, openness to trade leads to greater chances of investment in the economy which triggers employment prospects and thus, chances of reducing the degree of poverty in the nation. A strong theoretical background is also corresponded by robust evidences in this respect. Chile, which had liberalised its economy during 1974 which took a toll upon the domestic rate of employment initially as many people employed in the protected sectors of the nation, faced the brunt of this measure. However post 1985, the nation grew by more than 7% annually and eventually was able to cut back on its poverty figures by more than 50 percent. China too shares a similar experience with trade liberalisation being realised in the form of 7% escalated annual GDP growth rate and a reduction in the degree of poverty by 30%. However, China also witnessed an increase in the degree of income inequality over the years post liberalisation. In case of India, trade liberalisation partially brought about in 1980s led to a reduction in the level of poverty as well, although there had been a remarkable rise in the extent of income inequality over the years. Bangladesh too experienced a downfall in the degree of poverty in the nation, post trade liberalisation, with the head count index of poverty falling from 88 percent in 1974 to just 59 percent in 1992 and 50 percent in 2000 (Ahmed & Sattar, 2004). In fact, empirical evidence shows a rather strong proof of negative association between the degree of trade liberalisation and incidence of poverty in a given economy. However, it might not simultaneously be implied that liberalisation of trade indeed leads to reduction in the extent of poverty in the nation given that the causal relation is not established statistically. The most that could be established is that trade liberalisation has the power to alter the distribution pattern of income and theoretically thus, it might even more impoverish the poor (Winters, McCulloch & McKay, 2004). Answer to Question 4 Eradication of income inequality and protection against import competition are considered as tools assisting in the economic development and growth rates of an economy. Income inequality often takes a toll upon the productivities of the input factors and hence leads to adjustments in the output structure. This in turn leads to reductions in the income level of the economy and hence, poor productivity levels for many years to come. On the other hand, an egalitarian society could prove to be highly beneficial in terms of increased economic growth rates and reduced levels of poverty in the society. Reduced levels of poverty, owing to reduced income inequality, assures the nation of an increased economic development over future (World Bank, 2005). One of the most effective ways through which income inequality could be tackled is that of imposing rules for boosting productive activities in an economy. Policies to protect import competition in the concerned nation are also aimed at boosting its economic prospects over the long run. When the government of a nation imposes these policies, the prime motive is to protect many infant industries located within the economy, from foreign competition. This measure helps to build up the economy’s area of comparative advantage and thus, assists in building up its competence to make exports thus, enhancing its economic potentials over the long run. However, there are certain political aspects which hinder the adoption of these policies. A primary one is that about the diversity in the interests of different political groups in an economy. For example, while one of them demands protection for a particular industry, there are some other rival groups who oppose the benefits focussed upon a particular domain. The opposition is found to be higher in case that the national administration allows the components of one industry group to artificially raise their prices for certain period of time. Such measures are likely to lower the demand for substitute goods. Government measures might also induce the imposition of import tariffs on certain substitute goods which are again needed for manufacturing some other commodities. In a global context moreover, such measures might trigger the possibilities of a tariff war amongst different economies of the world. Hence, government policies aimed at boosting the economic growth prospects of an economy are not necessarily beneficial from a political context and could raise many controversies (Grossman & Helpman, 1994). Answer to Question 5 Heckscher-Ohlin Model primarily predicts that in a scenario comprising of two countries, two commodities and two factors of production, a country will produce and export the commodity that employs its more abundant factor and simultaneously imports the other good from its peer nation. The additional assumptions that the theory makes are those of both the countries employing their factors of production to their optimum levels, being characterised by identical consumption patterns and featured by constant returns to scale technologies of production. In fact, this intuitively appealing model had also been tested empirically by Samuelson and seemed to be almost accurate in the real world. Nonetheless, the application of H-O Model is not found to be the case in many instances. A good example could be sought from that of OECD nations which have over the time grown an identical base of raw materials. If the Heckscher-Ohlin model is applicable, then ideally, the volume of trade across the OECD nations should be reduced significantly. However, over the years the volume of trade across these economies has gained pace by an annual average rate of 5 percent, which is really striking. Other studies have found that H-O model hold well in case of a pair of economies which are starkly different in terms of their income levels. For instance, a developing and a developed economy could together make such a model successful empirically. However, if such is the case, then the underlying assumptions of similar economic backgrounds gets hampered. Trade occurring between nations of similar economic background and income stature are strictly on the basis of increasing returns to scale rather than on terms of factor abundance. But, a recent study introduced knowledge as one of the most important of all resources contributing to the production activities taking place in an economy. In fact, the OECD nations have highly unequal knowledge bases which is why it had been argued that trade between two countries of similar income structure are possible. USA for instance, consists of 45 percent of the knowledge base concentrated in the OECD nations so that it could be considered as one that has a relative factor abundance compared to its peer nations. This is also evident from the examples of Germany and Vietnam, both of which specialise in the production of cutlery. However, given the higher knowledge base of Germany, it is capable of producing better quality goods than in the case of Vietnam. Hence, it might not be said in the present context that both economies are endowed with equivalent input resources and hence, Germany gets an edge over Vietnam in this case. In fact, after the introduction of knowledge base as one of the most important factors contributing in the production process, Heckscher-Ohlin model of trade was found to be applying for 11 out of 15 OECD nations (Nishioka, 2005). References Aghion, P. & Durlauf, S. N. (2005). Handbook of economic growth, Volume 1, Part 2. London, UK: Elsevier. Ahmed, S. & Sattar, Z. (2004). “Trade liberalisation, growth and poverty reduction: The case of Bangladesh” [PDF]. Available at http://siteresources.worldbank.org/INTSARREGTOPINTECOTRA/34004324-1120490724746/20926223/TradeLiberalization.pdf [Accessed: July 28, 2011]. Assadourian, E. “Foreign Direct Investment Inflows Decline” in Vital signs 2005-2006: the trends that are shaping our future by Worldwatch Institute (ed.). London, UK: Earthscan Publishers. Baldwin, R. E. (2003). “Openness and Growth: What’s the empirical relationship?” [PDF]. NBER Working Paper Series, WP/9578. Available at http://www.nber.org/papers/w9578.pdf [Accessed: July 27, 2011]. Calderon, C., Loayza, N. & Schmidt-Hebbel, K. (2005). “Does Openness Imply Greater Exposure?” [Online]. World Bank Policy Research, Working Paper 3733. Grossman, G. M. & Helpman, E. (1994). “Protection for Sale” [PDF]. The American Economic Review, Vol. 84 (4): 833-850. Available at http://www.eui.eu/Personal/Fellows/MicheleRuta/Welcome_files/teaching/papers/grossman-helpman.pdf [Accessed: July 28, 2011]. OECD. (2002). “Foreign Direct Investment for Development: MAXIMISING BENEFITS, MINIMISING COSTS” [PDF]. Available at http://www.oecd.org/dataoecd/47/51/1959815.pdf [Accessed: July 27, 2011]. Moosa, I. A. (2002). Foreign direct investment: Theory, evidence, and practice. New York, USA: Palgrave Macmillan. Nishioka, S. (2005). “An Explanation of OECD Factor Trade with Knowledge Capital and the HOV Model” [PDF]. Center for Economic Analysis, Working Paper No. 05-06. Available at http://www.colorado.edu/Economics/CEA/WPs-05/wp05-06/wp05-06.pdf [Accessed: July 28, 2011]. Rodriguez, F. & Rodrik, D. (2000). “Trade Policy and Economic Growth: A skeptic's guide to the cross-national evidence” [PDF]. Available at http://www.hks.harvard.edu/fs/drodrik/Research%20papers/skepti1299.pdf [Accessed: July 27, 2011]. Twomey, M. J. (2002). A Century of Foreign Investment in the Third World. London, UK: Routledge. Vaidya, A. K. (2006). Globalization: encyclopedia of trade, labor, and politics. California, USA: ABC-CLIO. Winters, L. A., McCulloch, N. & McKay, A. (2004). “Trade Liberalization and Poverty: The Evidence So Far” [PDF]. Journal of Economic Literature, Vol. XLII (March 2004): 72–115. Available at http://sard.ruc.edu.cn/zengyinchu/files/Kecheng/Agricultural%20International%20Trade/Trade%20Liberalization%20and%20Poverty-%20The%20Evidence%20So%20Far.pdf [Accessed: July 28, 2011]. World Bank (2007). Global economic prospects: managing the next wave of globalization, 2007. The Washington D.C., USA: The World Bank Publications. Read More