KANGWON NATIONAL UNIVERSITY
Department: International Trade and Business
The Implication of FDI and Its Impact on the Economic Growth
Author: Khakimov Diyorbek
Professor: Joon Woo Park
Data: 01 December 2017
Subject: Asia Pacific Economy
Thesis name: Implication of FDI and Its Impact on the economic growth
Subject terms: GDP-Gross Domestic Product, Economic Growth, Development
The aim of this study to investigate the impact of Foreign Direct Investment (FDI) on the economic growth and its implication in the developed and developing countries. The theoretical framework shows that FDI has a positive impact on the economic growth because it serves as a channel through which new technology is transferred from one country to another and thereby, it increases output and Gross Domestic Product (GDP) in the recipient country.
Table of contents
Introduction ……..…………………………………………………. 4
What is FDI? ……………………………………………… 4
Theoretical background and review of FDI ……………. 4
Empirical studies on FDI and economic growth ………. 5
Purpose ……………………………………………………. 5
Importance of Foreign Direct Investment ……………..……….6
Review of FDI and economic grow …………….….…6
How important is FDI for developing countries ……..7
Major sources and destinations of FDI ………………8
FDI in China …………………………………………….9
Evaluating the impacts of FDI ………..………………………….10
3.1 Negative and positive impacts of FDI to host country ..11
3.2 Negative and positive impacts of FDI to home country 15
3.3 How to solve for negative impacts of foreign direct investment to home country ……………………………..….16
3.4 FDI and environment……………………………………..17
Conclusion ……………………………………………………..…. 18
References ………………………………………………………… 19
During the past two decades, foreign direct investment (FDI) has become increasingly important in the developing world, with a growing number of developing countries succeeding in attracting substantial and rising amount of inward FDI. Economic theory identified a number of channels through which FDI inflows may be beneficial to the host economy.
Foreign investment plays a significant role in development of any economy. Many countries provide many incentives for attracting the foreign direct investment. Need of FDI depends on saving and investment rate in any country. Foreign Direct investment acts as a bridge to fulfill the gap between investment and saving. In the process of economic development foreign capital helps to cover the domestic saving constraint and provide access to the superior technology that promote efficiency and productivity of the existing production capacity and generate new production opportunity
1.1 What is FDI?
A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. The origin of the investment does not impact the definition, as an FDI: the investment may be made either “inorganically” by buying a company in the target country or “organically” by expanding the operations of an existing business in that country. It is thus distinguished from a foreign portfolio investment by a notion of direct control.
Broadly, foreign direct investment includes “mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations, and intra company loans”. In a narrow sense, foreign direct investment refers just to building new facility, and a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. FDI is the sum of equity capital, long-term capital, and short-term capital as shown in the balance of payments. FDI usually involves participation in management, joint-venture, transfer of technology and expertise. Stock of FDI is the net (i.e., outward FDI minus inward FDI) cumulative FDI for any given period.
1.2 Theoretical background and review of FDI
According to Grazia Ietto-Gillies prior to Stephen Hymer’s theory regarding direct investment in the 1960s, the reasons behind Foreign Direct Investment and Multinational Corporations were explained by neoclassical economics based on macro-economic principles. These theories were based on the classical theory of trade in which the motive behind trade was a result of the difference in the costs of production of goods between two countries, focusing on the low cost of production as a motive for a firm’s foreign activity. For example, Joe S. Bain only explained the internationalization challenge through three main principles: absolute cost advantages, product differentiation advantages and economies of scale. Furthermore, the neoclassical theories were created under the assumption of the existence of perfect competition. Intrigued by the motivations behind large foreign investments made by corporations from the United States of America, Hymer developed a framework that went beyond the existing theories, explaining why this phenomenon occurred, since he considered that the previously mentioned theories could not explain foreign investment and its motivations.
Facing the challenges of his predecessors, Hymer focused his theory on filling the gaps regarding international investment. The theory proposed by the author approaches international investment from a different and more firm-specific point of view. As opposed to traditional macroeconomics-based theories of investment, Hymer states that there is a difference between mere capital investment, otherwise known as portfolio investment, and direct investment. The difference between the two, which will become the cornerstone of his whole theoretical framework, is the issue of control, meaning that with direct investment firms are able to obtain a greater level of control than with portfolio investment. Furthermore, Hymer proceeds to criticize the neoclassical theories, stating that the theory of capital movements cannot explain international production. Moreover, he clarifies that FDI is not necessarily a movement of funds from a home country to a host country, and that it is concentrated on particular industries within many countries. In contrast, if interest rates were the main motive for international investment, FDI would include many industries within fewer countries.
1.3 Empirical studies on FDI and economic growth
In a widely work, Borensztein (1998) examine the effect of FDI on economic growth in cross country regression framework, using data on FDI outflows from OECD countries to sixty-nine developing countries over the period 1970-1989. They find that FDI is an important vehicle for adoption of new technologies, contributing relatively more to growth than domestic investment. In addition, they find, through the relationship between FDI and the level of human capital, FDI has a significant positive effect on economic growth. However, they qualify their results in as much as the higher productivity of FDI only holds if the host country has a minimum threshold stock of human capital.
Li and Liu (2005) apply both single equation and simultaneous equation system techniques to investigate endogenous relationship between FDI and economic growth. Based on a panel of data for 84 countries over the period 1970-1999, they find positive effect of FDI on economic growth through its interaction with human capital in developing countries, but a negative effect of FDI on economic growth via its interaction with the technology gap.
However, as in most other papers, Bengoa (2003) find that the benefit to the host country requires adequate human capital, political and economic stability and liberalized market environment.
Most recent, Vu (2006) study sector specific FDI inflows for both China over the period 1985-2002 and Vietnam over the period 1990-2002. Using a production function specification and regression methodology, they conclude that FDI has positive and direct impact on economic growth as well as an indirect effect through its impact on labor productivity. They find that the manufacturing sector appears to gain more than other sectors from sector-specific FDI.
This paper investigates the FDI and economic growth relationship by examining the role FDI inflows play in promoting growth in the main economic sectors, namely primary, manufacturing and services. Often mentioned benefits, such as transfer of technology and management know-how, introduction of new processes and employee training tend to relate to the manufacturing sector rather than agriculture sectors.
Importance of Foreign Direct Investment
In the last two decades, world has seen an extensive inflow of FDI or foreign direct investment into developing countries. More and more developing countries are competing with each other to attract this investment. Restrictions which were earlier in place on these investments are now being removed as the importance of FDI is being realized.
Studies have revealed that FDI can help generate domestic investment in matching funds, facilitate transfer of managerial skills and technological knowledge, increase local market competition, create modern job opportunities and increase global market access for export commodities. Inward FDI not only serves the long-term financial interests of foreign investors, it can also play a significant role in the growth dynamics of host countries.
FDI is an important and effective way to stir up the economy as it is a major catalyst to development. This is because with the setting up of companies and factories, employment will rise. With foreign money being pumped into the economy to pay of wages and salaries to the employees, a multiplier effect will create an injection of several times that will cause a huge influx of foreign money. As more foreign money is being pumped into the local economy (assuming there are no outflows of money) GDP growth will soar that goes hand in hand with vision 2020 where Malaysia will achieve a developed nation status with a constant 8% growth rate every year. This will in turn, bring confidence into the economy, further generating more FDIs. As the economy is doing well, development will naturally take place to improve the quality of life.
Furthermore, the acquisition of knowledge for the transfer of technology is a tremendous advantage for the country. As companies and factories are being set up, heavy machineries and sophisticated technology are being passed on to the local employees to operate the business. In order to work the technology, the local employees will then have to go for training. Thus the passing on down of knowledge and technology to the country is an integral part for developing countries to further improve itself on a global scale.
2.1 Review of FDI and economic growth
Theoretically, FDI is concerned to directly impact growth through capital accumulation, and the incorporation of new inputs and foreign technologies in the production function of the host country. Inward FDI has positive effects on growth through its interaction with human capital and FDI contributed more to growth than domestic investment and it also had the effect of increasing domestic investment.
According to the World Bank (2007), global FDI flows reached a record of 1.1$ trillion in 2006 and there has been a continuing rise in FDI inflows to developing countries. In recent years, FDI outflows from large developing countries are also on the rise. This evolution and changing patterns in world FDI flows has been synchronous with a shift in emphasis among policymakers in developing countries to attract more FDI (through tax incentives and subsidies to foreign investors). Nowadays, the total FDI stocks represent more than 20% of the global GDP. The rapid growth of FDI and its overall magnitude had sparked numerous studies dealing with the relationship between FDI and economic growth. While the explosion of FDI is unmistakable, the growth effects of FDI still remain controversial.
During the last decades, the relation between FDI and economic growth has been extensively discussed in the economic literature. The positions range from an unreserved optimistic view (based on the neo-classical theory or, more recently, on the new theory of economic growth) to a systematic pessimism. There is a widespread belief among researchers and policymakers that FDI boosts growth for host countries through different channels. They increase the capital stock and employment; stimulate technological change through the adoption of foreign technology and know-how and technological spillovers, which can happen via licensing agreements, imitation, employee training, and the introduction of new processes, and products by foreign firms. As it eases the transfer of technology, FDI is expected to increase and improve the existing stock of knowledge in the recipient economy through labor training, skill acquisition and diffusion. It contributes to introduce new management practices and a more efficient organization of the production process. As a consequence, FDI can play an important role in modernizing a national economy and promoting economic development.
2.2 How important is FDI for developing countries?
A standout amongst the most pivotal parts of FDI is its commitment to the economic growth of the host nation. This commitment is essential and is one that is actually expected by any host nation particularly developing ones. In the most recent couple of decades, nations have been contending with one another for the reasons of drawing FDI, this is due to the essential commitment it makes to the general growth of economies. FDI not just offers a steady capital flows, but long term commitments to hosts nations, insuring a regular capital inflow to host nations. Access to new and cutting edge technological innovation is potentially a standout amongst the most vital reasons why a nation would need to draw in FDI.
According to Alfaro (2003), FDI can provide important innovation and ability to the host fostering so as to developing countries linkages with domestic firms. These mechanical advancements by MNEs assume a focal part in the economy and they are the absolute most imperative zones where MNEs serves as impetus to economic growth in developing nations. Moreover, MNEs have the monetary stability to put resources into vast plants. Scarce capital can be accessed by developing nations through FDI, and this is exceptionally essential to Economic Growth. The exchange of capital by MNEs may complement residential reserve funds and add to local capital arrangement for nations that are capital con-strained and this can expand household investment.
Furthermore, FDI provide employment open doors and job opportunities for host nation citizens. Workers are paid higher wages and this empowers them to have an enhanced way of life. New companies arise prompting the expanded improvement in production and manufacturing. FDI enhances and improves trading assets and resources of the host nation. Examination has demonstrated that, nations that get FDI from worldwide associations have lower financing costs, consequently their traded items are much less expensive and this improves exports. Increased capital inflow is generated by taxation in host nations is principally due to FDI as well. The advantages of FDI to host nations can be credited to the pro-foreign investment. The neo-classical school approach contends that FDI includes new assets, capital and enhances the showcasing expertise of host nation’s citizens. It additionally provides employment opportunity and improves the utilization of normal assets efficiently within to other factors.
2.4 Major sources and destinations of FDI
Not surprisingly, the major sources of FDI are the high-income developed nations. With the rapid growth of countries such as the People’s Republic of China (PRC) and India, and the resurgence of Southeast Asia after the 1997–1998 currency crisis, developing Asia has once again become one of the most dynamic economic regions in the world. It would not be an exaggeration to say that international trade and foreign direct investment (FDI) is a key determinant of trade and growth in much of the developing Asian region.
Asia retains its place as the continental grouping with the most FDI, with its $426bn inflows making it worth almost 30% of worldwide investment. Most of this was due to rising investment in China, the Republic of Korea and Taiwan.
As well as including the amount invested in the country, the report also looks at the amount spent by companies and bodies in each country. These are called FDI outflows and despite a decline of 14.5%, North America remains the top region for outward investment for a second year with $381bn.
Other countries showing growth in inflows included Russia (up 57%), Spain (up 52%) and Mexico (up 117%). The UK was down 20% on 2012, which goes against the general growth in the European region.
Italy, grew by a massive 1,174% year-on-year, which was partially down to a return to normal levels after a huge drop off in investment in 2012.
2.3 FDI in China
Foreign direct investment in China increased by 1.9 percent year-on-year to CNY 678.7 billion (USD 102.15 billion) in January to October 2017. In October alone, FDI increased by 5 percent to CNY 60.12 billion. Foreign Direct Investment in China averaged 426.95 USD HML from 1997 until 2017, reaching an all-time high of 1262.67 USD HML in December of 2015 and a record low of 18.32 USD HML in January of 2000.
Although China remains a popular investment destination, as evidenced by increased FDI into the high-tech and service industries, macro-economic uncertainty and decreasing manufacturing competitiveness have led to a more cautious approach by foreign investors.
From January to April 2017, the number of newly approved foreign invested enterprises (FIEs) has increased at an average rate of 2,431 companies per month. There was a minimal year-on-year growth rate in January (0.1 percent), a negative rate in March (-1.5 percent), and sharp increases in February (33.3 percent) and April (42.7 percent).
Approximately 12 percent of all new foreign companies established in from January to April were from countries along the Belt and Road, a development strategy proposed by the Chinese government that facilitates connectivity and cooperation between Eurasian countries.
The growth in the number of newly established companies could be attributed to policy stimulus, the easing of investment restrictions in free trade zones (FTZs), and simplified corporate registration procedures for wholly foreign owned enterprises.
The 3.9 percent expansion shows that global investors increased their interests in China’s service industry. In particular, construction, transportation, information, and consulting services were among the most popular investment industries.
The high-tech service industry was another fast growing sector. Investment in the environmental monitoring and management service sector soared 172.8 percent, followed by a 62.9 percent rise in science and technology services, a 3.8 percent increase in R;D services, and a three percent rise in the information service sector. This is a positive sign: China’s market demands more high-tech support to increase its productivity as the country moved up the value chain.
Evaluating the impacts of FDI
Sustainable FDI is a relatively new term that is meaningful when considered in conjunction with sustainable development. In order to FDI to aid sustainable development, FDI projects must be commercially sustainable themselves while also promoting the host country’s development on economic, environmental, social and governance measures. Sustainable FDI can be defined as FDI projects that yield profits sufficient to maintain effective corporate engagement without harming vital host country interests while producing positive net benefits for the country’s long-term development goals as evaluated on prioritized economic, environmental, social and governance indicators. Sustainable FDI must serve the interests of both the foreign investor and the host country by establishing a “win-win” scenario where each party derives enough significant benefits to maintain the relationship over a substantial period of time. Private foreign investors usually calculate the benefits and costs of a particular foreign investment in terms of its contribution to the corporation’s global profitability. Although types of operational benefits vary, their impact on the corporate “bottom line” is generally quantifiable. Host country benefits and costs at the national, regional and metropolitan levels are more diverse and many are very difficult to quantify and compare. The tendency is often to focus on more easily quantifiable economic factors that directly correspond to the foreign investor’s project proposal. This approach can present an image of definitive certitude, even when time projections are uncertain, and often overlooks or undervalues potential project impacts on less quantifiable interests.
3.1 Negative and positive impacts of FDI to host country
Positive impacts of FDI to host country
FDI influences economic growth by increasing total factor productivity and the efficiency of resource use in the host country. It increases the capital stock of the host country and thus raises the output levels. The main trade-related benefit of FDI is that it contributes to the integration of host countries into the global economy by engendering and boosting foreign trade flows as well as the establishment of transnational distribution networks. This, in turn, implies that host countries will pursue a policy of openness to international trade to benefit from FDI.
Human capital contribution
FDI’s contribution to human capital in host countries is significant. MNEs increase workplaces, thereby reduce the unemployment in the host country. They usually provide higher wages and working conditions due to their higher productivity which is explained by greater technological know-how and modern management skills that enables them to compete effectively in foreign markets. The transfer of technological and managerial know-how through affiliates also gives rise to direct benefits and increases competitiveness in host countries. For example, domestic employees can move from foreign to domestic firms. Local firms might increase their productivity through learning from foreign firms by collaboration. The presence of MNEs may also cause a useful demonstration effect, forcing the government to invest in education more, as the demand for skilled labor by these firms is very high.
MNE’s usually possess a higher level of technology, especially “clean”, which is the main factor of their higher productivity. One of the positive effects of FDI is that it generates significant technological spillovers in the host countries. MNE’s usually provide technical assistance, training and other information to increase the quality of the suppliers’ products.
Local firms might increase their productivity as a result of gaining access to modern, improved, or cheaper intermediate inputs produced by MNE in upstream sectors. Sales of these inputs by MNE might be accompanies by provision of complementary services which might not be available through imports. Local sub-contractors can also benefit from MNE’s international contacts, thus gaining more access to foreign markets. FDI can also increase research and development initiatives of local companies
FDI exerts a significant influence on the competition level in the host country. The presence of MNEs assists the economic development by stimulating the domestic competition and thereby leading to higher productivity, innovation, lower prices and more efficient resource allocation.
Management and governance practices
FDI through acquisition of local firms result in the changes in management and corporate governance. MNEs generally impose their own company policies, internal reporting systems and principles of information disclosure. This effect improves the business environment and develops the corporate efficiency. Moreover, different cases show that foreign investments also create a more transparent environment in the host country as MNEs encourage more open government policy, raise corporate transparency and assist in the fight against corruption.
Since foreign investments provide needed resources to developing nations such as capital, technology, managerial skills, entrepreneurial ability, brands, and access to markets, they are important for these economies to industrialize, develop, and create jobs reducing the poverty level in their countries. Therefore, most developing economies recognize the potential value of investments and have liberalized their investment regimes and conducted investment promotion activities to attract FDI from developed countries.
Negative effects of FDI
Crowding out effect of FDI
FDI can have both crowding in and crowding out effects in host country economy. The main negative effect of crowding out effect is the monopoly power over the market gained by MNEs. Empirical evidence in that regard is mixed. Econometric test by Agosin and Mayer (2000) covering 39 countries for a long period (1970-1996) demonstrated that crowding out and crowding in was detected in 10 economies, but in 19 the effect was neutral. Crowding out effect did not exist in Asia, but it was quite obvious in Latin America. Another study of 83 economies over the period of 1980-1999 found no impact of FDI on host country for 31, crowding out for 29 and crowding in for 23 countries (Kumar and Pradhan, 2002).
This diversity might be due to the fact that various economies attract different types of FDI. Countries that attract mostly domestic market-seeking investments will experience crowding out as the establishment of foreign subsidiaries results in tough competition with domestic firms. But for export-oriented investment, it might be less so (Bhalla and Ramu, 2005).
MNE with lower marginal costs increases production relative to its domestic competitor, when imperfectly competitive firms of the host country face fixed costs of production. In this environment, foreign firms that produce for the domestic market draw demand from local firms, causing them to reduce the production. The productivity of local firms falls as their fixed costs are spread over a smaller market which forces them to back up their average cost curves. When the productivity decrease from this demand effect is large enough, total domestic productivity can diminish even if the MNE transfers technology or its firm-specific asset to local firms (Aitken and Harrison, 1999).
In general, crowding out might take place due to two reasons: 1) when domestic firms disappear because of higher efficiency and better product quality of foreign subsidiaries, and 2) when they are wiped out because these foreign affiliates have better access to financial resources and/or engage in anticompetitive practices. In the first case, the net impact on welfare is positive as firms with higher efficiency and better product quality contribute to the economic development of the host country. But in the second case, there is welfare loss and governments intervene through different channels in order to help the local firms. For example, they might establish or subsidize financing for domestic small and medium firms.
Negative wage spillovers
Wage spillovers of the FDI are considered to be mostly positive as workers of MNEs can leave their workplace and become entrepreneurs in future, which will increase the competitiveness of domestic firms. However, it might cause negative consequences as well, especially, if MNEs hire the best workers due to their high wages and thereby leave lower-quality workers at the domestic firms. In response to that domestic firms can increase or copy MNEs’ wages artificially to prevent their high-quality employees from changing the workplace in favor of foreign firms. But this action can lead to competitiveness decrease of them as MNEs have productivity advantages over the domestic firms.
Gorg and Greenaway (2001) reviewed six studies on wage spillovers and reported that three panel studies of those studies found negative spillovers, while two cross-sections studied showed positive ones. One possible reason of the negative results in some developing countries is that the gap between MNE and domestic firms is very large for one party to influence another. Moreover, the labor markets in some developing economies are too segmented for wages in one party to influence another.
When MNEs make investments in foreign countries their main objective is to maximize their profit. Some advantageous characteristics of these countries, such as cheap labor force, natural resource abundance or high quality expertise, allow MNEs to enhance their economic performance. MNEs regularly repatriate their profits from investment to the account of their parent companies in the form of dividends or royalties transferred to shareholders as well as the simple transfer of accrued profits. It also helps them avoid larger taxes by using transfer prices. However, this profit repatriation results in huge capital outflows from the host country to the home country and negatively affects the balance of payment of the former. Thus the host countries often set limits on the amount of profits that MNEs can repatriate in order not to have balance of payment deficits or reduced foreign exchange reserves. Such policy can induce these MNEs to invest profits in different projects within the host country.
But there is also a possibility that such limitations might discourage MNEs from investing in these countries, which will move FDI to the countries with less profit repatriation limitations. For example, a survey of chief executive officers from 193 American MNEs revealed that nearly 70% of them viewed profit repatriation as a main factor positively motivating the FDI behavior of them. One of the biggest FDI receivers in the world, India, permits 100% profit repatriation for foreign investors in most sectors.
Dual economy effect
FDI, especially, made in the developing countries can lead them to have a dual economy, which has one developed sector mostly owned by foreign firms and underdeveloped sector owned by domestic firms. Since the country’s economy becomes overly dependent on the developed sector, its economic structure changes. Often this developed sector is the capital-intensive, while another one is labor-intensive. Therefore, dual economy effect hampers the economic development of countries as most of their citizens are located in the non-developed labor-intensive sector. This effect is visible in most oil-rich countries, where foreign investments made in the oil and gas sector resulted in the resource boom and left the agriculture and manufacturing sectors underdeveloped. That negative effect of FDI can lead to Dutch Disease effect in natural resource abundance countries.
Dutch Disease model postulates that a resource boom, mostly after the huge investments in the sector, diverts country’s resources away from activities that are more conducive to growth in long run. First symptom of this phenomenon is an appreciation of the country’s exchange rate caused by resource boom, which in turn causes a contraction in the manufacturing exports. The booming resource sector draws capital and labors away from manufacturing, leading its costs to rise. The result is that the competitiveness of country’s non-tradable commodities rises, while that of tradable – manufacturing commodities falls in the world markets, reducing the potential for export-led growth of manufactures in the long run. Since manufacturing sector is regarded as the main “engine of growth”, its decline causes consequently a growth decline in country’s economy in the long run (Sachs and Warner, 1999). One possible solution to the problem is a diversification of the economy by investing in different sectors.
Balance of payment effect
Empirical studies reveal that a bidirectional relationship exists between foreign investments and imports. An increase in FDI inflows from the home country will result in an increase in imports in the host country from the home country. It can be due the fact that the MNE purchases inputs from its traditional suppliers or increased inflation rate speeded up by foreign capitals in the home country. As more investment flows in, the host country economy becomes more and more dependent on the production technology of MNE’s home country. The host country will have to import more inputs and intermediate goods from the MNE’s home country, which might constrain the development in the domestic industry. If these investments are not export-oriented, the host country can suffer from trade deficits.
Infrastructure development constraint
FDI constrains basic infrastructure development by diverting resources from public investment in infrastructure. Since FDI is attracted mostly to wealthy parts of the host country, the infrastructure in these regions will require a greater effort to be improved, especially depriving the poorer regions and the rural regions.
A large volume of FDI is concentrated in natural resource sectors of developing and less developed countries. Most of these countries have a less strict or non-existent regulatory regime. Sometimes countries deliberately attempt to exempt or loosen their regulatory requirements to attract FDI. However, while these countries can benefit from positive effects of investment, the negative effects of FDI on host country’s ecosystems and environment might bring disaster in the long run.
The solution to these problems is to raise host country capacity to regulate and construct international environmental standards. NGO’s and other civil society groups from home and host countries can also play a significant role in the improvement of government regulations and increase of MNE’s responsibility on environmental issues.
Other possible negative impacts
FDI can cause political, social and cultural unrest and divisiveness in the host countries by introduction of unacceptable Chart values, which include advertising, business customs, labor practices and etc., and by direct interference of the MNEs in the political regime or electoral process in the host country. For example, some least developed countries with the economy overly dependent on powerful multinational enterprises are threatened of losing political sovereignty.
3.2 Negative and positive impacts of FDI to home country
Positive impacts of FDI to home country.
Improve both economic and political power of home country which depends on the effectiveness in operation of firms that they have influence on management.
Enter new market and extend the product life cycle: This factor is very important for a company that is aggressively seeking to expand its business or one that has seen a stagnation in its home country. A company that is facing off competitiveness in its home country can open new market in foreign country where there is high demand for its products and services.
Overcome trade barriers and enjoy investment promotion: Nowadays, a number of countries impose import quotas and high tariff rates on the importers. Companies are trying to build their production inside of foreign marker in order to avoid tariff quotas and high tariff rates. For example, many Japanese textile, television sets, watches moved production facilities into Malaysia, Indonesia, Thailand, Singapore and the Philippines.
Enhance diversification when the political situation is unstable at home: MNEs prefer to have exposure to many countries. The reason to get this exposure is diversification. diversification leads to company having minimized its operational risks. For example, MNEs operate in 20 countries, during the financial crisis say 4 of countries might suffer from that but other 16 countries may more than offset the losses from 4 countries. thus, diversification helps protect the interests of shareholders of the foreign investing entity.
Improve market structure and toward international labor diversification:
Improve in the balance of payments as a result of inward flow of foreign earnings (repatriation or profits)
FDI positively affects home-export performance through direct effects on trade as well as indirect effects through various channels.
The outward FDI also leads to creation of new job market with great expertise and necessary skills.
Protect market share in competition with other MNEs
Negative impacts of FDI to home country
Brain drain and technology leakages: Transferring technology can greatly raise the effectiveness and products’ quality. However, this include not only such easy benefits and advantages but also potential risks and threats to home country. First of all, along with transferring technology, human resources also brought to host countries. This lead to brain drain. Brain drain is the emigration of skilled and professional workers from a home country. In this way home country losing human capital.
Another example is technology leakages: For example, when Apple invests in building headquarters and factories in China copy-cat problem leads to leaking confidential technologies and products widespread. Not only does this Apple to lose their reputation and sales turnover.
Problems related to capital management: Since host country enjoy capital inflow of FDI, home country suffer from outflow of it. In generating capital for foreign investment, domestic investors may have illegal methodologies, such as corruption or illicit business. This leads to capital loss which government can hardly control.
Balance of payment: the home country’s balance of payment may suffer in three ways;
The capital account of the balance of payment suffers from the initial capital outflow required to finance the FDI.
Balance of payment suffers if the purpose of FDI to serve the home market from a low production location.
Balance of payment suffers if the FDI substitute for direct exports. this factor can also effect employment of domestic production. This kind of FDI reduce employment of home country. For example, Toyota’s investments in Europe.
3.3 How to solve negative impacts of FDI for home country:
1. Deal with technology leakages:
* Picking the right partners: First step to protecting Intellectual Property (IP) in a technology transfer, it is important to choose right partner at the outset.
* Contracts: It is recommended that companies use IP licenses with their partners. IP license ensures that technology transferred is documented in case issues arise later on.
* Confidentiality: Investing companies often go to great lengths to protect their confidential information, trade secrets and know-how including using key card access.
2. Solution for currency imbalance:
* Take coordinated fiscal policy measures, rather than currency intervention, to support domestic demand and thereby, global demand.
* Increase the depth and liquidity of financial market as a prerequisite for a multi-currency reserve system, so that countries with large currency reserve could diversify their holdings.
* Apply insurance measures and instruments
3. Deal with drain brain:
* Apply delay strategies involving some element of public service.
* A relaxed, market-driven solution is to ignore the emigration of skilled workers and let a brain-drain from poorer countries replace lost skills.
3.4 FDI and Environment
Foreign direct investment and the environment involves international businesses and their interactions and impact on the natural world. These interactions can be observed through the stringency applied to foreign direct investment policy and the responsiveness of capital or labor incentive for investment inflows. The laws and regulations created by a country that focuses on environmental regimes can directly impact the levels of competition involving foreign direct investment they are exposed to. Fiscal and financial incentives stemming from ecological motivators, such as carbon taxation, are methods used based on the desired outcome within a country in order to attract foreign direct investment.
External funding sources that come from foreign direct investment, stimulates the increase of innovative ideas surrounding technological advances while it also holds the potential to decrease unemployment. when financial and fiscal motives are combined with environmental consciousness, the promotion of green and sustainable innovations increases. Such environmental consciousness can result in the decrease of industrial pollutants, which contributes to infant mortality and other health issues. Policies created that attract innovative and environmentally conscious technological advancements have been stated as a great way to encourage increase in the abundance of environmentally friendly foreign direct investments. The Organization for Economic Co-operation and Development promotes policies that can have positive social and economic impacts.
Foreign direct investment does have the potential in initiating negative effects on countries as well. Foreign direct investments allow for the chance of compromise and collaboration between policies of negotiating countries which brings the opportunity for new perspectives on green innovation. However, intensifying regulations around production costs, such as environmental effect, can decrease the attraction of foreign direct investment to that country. Businesses or governments may wish to negotiate with a country with less complicated policies therefore decreasing a country’s competitive edge on the international market.
FDI helps in increasing the output through usage of advanced technology and management techniques and on the other it is a threat to local companies in the country. Government should take steps in the direction of integrating foreign investors with local businesses. This will help in overall economic development as well as preservation of country’s heritage. MNCs should be allowed to set up in such a manner that they help increase the standard of living of our country instead of sole profit making.
Both economic theory and recent empirical evidence suggest that FDI has a beneficial impact on developing host countries. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.
Although there are contradictory thoughts about the impact of FDI on the economic growth, it is broadly believed that investments positively contribute to the economic development of host countries. However, countries do not benefit from the investments at the same level. Foreign investments are not advantageous or disadvantageous by themselves. Their contribution depends on the policy and behavior of host country governments and MNEs.
The same foreign investment may bring lots of benefits to one country, while it might be quite harmful for the other. Therefore, it does not mean that if you get more FDI, your economy will boost. For example, Azerbaijan’s economy grew significantly due to foreign investments, but if the government does not diversify the economy and take measures against the negative effects of FDI, its economy will be worsened in long term. The inflation is increasing, non-oil sector is hardly growing, and the economy is becoming more and more dependent on the oil and gas sector, owned mostly by foreign firms.
The study implies that an appropriate policy and gradually improved “absorptive capacity” of governments will minimize the negative effects of FDI and allow these economies to reap the benefits of investments at the maximum.
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