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Foreign investment disputed

Evert-jan Quak is now Research Officer for the K4D Programme at the Institute of Development Studies.

Foreign direct investment and developing countries

Foreign direct investment (FDI) is often seen as the best way to boost the economies of developing countries. But this is only true under strict conditions. If those conditions are not met, FDI can even hamper economic development.

In Western Europe or North America, if a business that is strategically important to the local economy threatens to fall into the hands of a foreign competitor, it always leads to heated discussions. This happened recently during the largest takeover ever seen in the banking sector. A consortium consisting of Fortis (Belgium), the Royal Bank of Scotland (UK) and Santander (Spain) acquired the Dutch bank ABN Amro. In the Dutch newspaper De Volkskrant an insider commented: ‘A great bank, which took nearly two hundred years to build up, is now being ripped apart like a deer by wolves’.

Why this emotional reaction? Politicians – and not only in the Netherlands – have spent the past three decades deliberately trying to make it easier for businesses around the world to invest abroad. The underlying notion is that foreign investments are good for a country’s economic growth. New capital flows into the country, greater competition leads to higher productivity, and the country benefits from the new technology and management know-how that foreign investors bring with them.

Foreign direct investment (FDI) is assumed to be especially beneficial for developing countries. The World Bank, the International Monetary Fund (IMF) and many other external advisers have therefore urged them to attract as much FDI as possible to stimulate the economic growth they so desperately need. In their view, FDI is better than all other capital flows because it is difficult to move around and therefore does not dissipate again quickly if the economic situation becomes unfavourable.

Levels of FDI remained very stable, for example, during the financial crises in Asia in 1997 and in Mexico in 1994, and during the debt crisis in Latin America in the early 1980s. Because of its stability, Cambridge economist Ha-Joon Chang has called FDI the ‘Mother Teresa of foreign capital’, while Ricardo Hausmann and Eduardo Fernández-Arias of the Inter-American Development Bank (IDB) have described FDI as working like ‘good cholesterol’ on the global economy.

10% equity stake

In the past ten years, many economic researchers have attempted to map out the precise effects of FDI on developing countries. The theory of FDI has been refined and can be tested against a large body of empirical research. But first it is important to explain exactly what FDI is and how it is distributed worldwide.

FDI does not always mean the construction of a new factory by a multinational concern, as is often assumed. It simply says something about the way an investment is financed. If a foreign company or consortium acquires an equity stake of more than 10% in a local business, then it is categorized as FDI. In fact, most FDI (80% worldwide) is in the form of takeovers of local businesses by foreign companies. This involves not the creation of new economic activity, but simply a change of ownership.

Such investments must also be financed abroad to count as FDI. If the money comes from local banks it is not seen as FDI, since the capital does not enter the country from elsewhere. In the case of a takeover, the former owner can use the money for consumption or investment abroad. If that happens – as it did in Latin America in the 1990s when a large number of public companies were privatized – FDI does not contribute to capital formation and growth in the country concerned.

FDI – an ‘inferior good’?

According to the 2006 edition of UNCTAD’s authoritative annual World Investment Report, the value of all FDI worldwide rose by 29% in 2005, to US$916 billion. Inflows to developing countries rose to a record US$334 billion, or 36% of the total. The lion’s share of FDI to developing countries went to those with buoyant economies, usually larger middle-income countries like Brazil, China, India and South Africa. Of the US$31 billion (just 3% of the total) invested in Africa in 2005, 21% went to South Africa. Egypt was the second largest recipient, followed by Nigeria. The 34 least developed countries (LDCs) in Africa attracted very little FDI. The largest proportion of FDI in Africa was in the primary sectors, especially oil, agriculture and mining, with little in the manufacturing or service sectors, especially in the LDCs.

Research by Hausmann and Fernández-Arias (IDB) shows that capital flows tend to increase with the level of development. However, the share of those flows that take the form of FDI tends to be higher for the poorest countries than for richer ones. A larger share of FDI in capital flows is typical of countries that are poorer, more closed, riskier, more volatile, more distant, less financially developed, with weaker institutions and with more natural resources. ‘FDI seems to be an inferior good in the sense that its share tends to fall with income’, say Hausmann and Fernández-Arias. ‘It is total capital that appears to go up with economic development while the share of FDI declines’.

In percentage terms, poor countries are therefore most dependent on FDI. But at the same time, they find it the most difficult to attract FDI because investment in these countries is very high risk, their infrastructure is poor, and they often lack stable institutions. Is that good or bad for the economic development of a country?

Crowding-out

Empirical research can establish whether FDI really is the panacea for developing countries that the World Bank and the IMF have claimed for so many years. It shows that FDI can give an economy a strong boost, but only under certain strict conditions. If those conditions are not in place, FDI can even have an adverse effect on economic development.

In theory, knowledge transfer is the most important pillar of development. The presence of a multinational concern enables local businesses to imitate or adopt the latest technology and know-how. This can result in higher productivity in the sector and a better export position for the country. In practice, however, it is not that simple. Foreign investors do not voluntarily pass on their know-how to their competitors, but only to some suppliers. To reap the maximum benefit, those suppliers must be located as close as possible to the multinational concern.

But the multinational might choose to make little use of local suppliers and import as much of the inputs it needs as possible. If that happens, the transfer of knowledge is limited. It is also disadvantageous for the country’s balance of trade. Only strong countries can force foreign investors not to do this. When Nissan wanted to open a factory in the UK in 1981, for example, it had to agree to purchase 60% of its inputs locally, rising to 80% in the longer term. The same condition applied to Ford and General Motors – in a country governed at the time by a ‘liberal’ prime minister, Margaret Thatcher.

Developing countries do not have the power to impose such conditions. It is easier in these countries for foreign investors to out-compete local businesses. If a respectable number of efficient local companies can survive and continue to compete with multinationals, the disappearance of a large number of inefficient businesses can be beneficial in the long term. But if a multinational acquires a monopoly in the local market by crowding out local competitors, the advantages of competition no longer exist.

Countries in Latin America in particular, but also in Africa to a lesser extent, have not been able to benefit from FDI because of this crowding-out effect, Manuel Agosin and Ricardo Mayer of UNCTAD have shown. The only continent where local businesses have been able to reap significant benefits is Asia, where FDI regimes ‘have remained the least liberal in the developing world. Several Asian countries still practice screening of investment applications and grant differential incentives to different firms. … In Latin America, on the other hand, these practices have been eliminated in most countries. Nonetheless, liberalization does not appear to have led to crowding-in’ effects.

Resource-seeking FDI

Many of the poorest countries in Africa are caught in the trap of dependence on natural resources, claims Oxford economist Paul Collier in his book The Bottom Billion. As a result, the effect of FDI on the economic development of these countries appears to depend heavily on the sector in which investments are made.

The advantages of FDI apply more to the manufacturing sector than to the primary sector, and not only in Africa. In Central America, for example, banana producers such as Chiquita operate as enclaves with no linkages at all with other economic activities in the region. If these foreign companies were to leave, they would leave little behind to contribute to further economic growth.

This contrasts sharply with the labour-intensive manufacturing sector in Asia. Foreign investors only invest in the manufacturing sector of a country if they think that they can operate more efficiently than local producers. These investors will be more likely to help suppliers to perform better, because it is in their interests to do so. In other words, efficiency-seeking FDI can not function without interacting with the local environment. Resource-seeking FDI in the primary sector, on the other hand, is much less prepared to interact.

One problem with efficiency-seeking FDI is that it is attracted primarily by low wages and can therefore spark off a ‘race to the bottom’. If wages go up, the investor is likely to move production to other regions where labour is cheaper. If local linkages have not been created, the investor will depart without leaving anything behind.

There is also market-seeking FDI, in which investors seek new markets for their products or services, especially in the service sector. This can lead to knowledge transfer but, in the long-term, this form of FDI has no impact on the host country’s balance of payments because the investment is aimed purely at local consumers and not at exports of products or services.

Development paradox

Developing countries are therefore confronted with a paradox. In order to benefit from FDI, they need to have achieved a certain level of economic development, or ‘absorptive capacity’, as it is known in economic jargon. Countries that do not have enough capacity can not absorb the superior knowledge and technological know-how that foreign investors can provide, and which local businesses need to imitate. And it is developing countries that lack absorptive capacity. As Sanjaya Lall of the University of Oxford observed, in countries ‘with weak local capabilities, industrialization has to be more dependent on FDI. However, FDI cannot drive industrial growth without local capabilities’.

From the evidence emerges the idea that policy makers have for many years been asking the wrong question. For developing countries, the main challenge is not how to attract as much FDI as possible, but to decide on what kind of FDI to attract. This implies that it must be possible to regulate inflows of FDI. Yet the abolition of rules that impede FDI is one of the items on the agendas for the current rounds of talks on free trade agreements, both multilateral, through the World Trade Organization (WTO), and bilateral, such as the Economic Partnership Agreements (EPAs) between the European Union and the African, Caribbean and Pacific (ACP) countries.

Since the success of FDI is so dependent on specific characteristics that vary between countries, sectors and investments, developing countries must have in place adequate FDI-related policy instruments. They can then extract maximum benefit from FDI by encouraging it where they expect to profit from foreign investors. But they must also be able to refuse FDI if it is likely to distort local markets and out-compete local businesses.

Selective protectionism

This is what many Asian countries and almost all developed countries have done. As Ha-Joon Chang showed in his book Bad Samaritans, countries like the US and the UK, which are the greatest advocates of removing obstacles to FDI, have themselves not been open to FDI in important sectors such as banking or the automobile industry.

The recent success of Nokia, the Finnish mobile phone company, provides a good example. The company took 17 years to make a profit, but it could afford to take that long because it was protected against hostile takeovers by the government. It is now the world’s largest producer of mobile phones. Like Nokia, many of today’s multinationals were protected in their early years against foreign takeovers. If they had been taken over, they would not have been the multinationals they are now.

Do we need a new political agenda? Sanjaya Lall, one of the pioneers of research into FDI, and Rajneesh Narula answered this question by noting that many researchers are ‘unanimous in their skepticism of the Washington consensus and the rather simplistic view taken by certain mainstream economists that FDI is a sine qua non for economic development. Market forces cannot substitute for the role of governments in developing and promoting a proactive industrial policy’.

It is therefore ironic that developing countries are now having to adjust their investment policies to allow foreign investors unlimited access to their markets, while there is sufficient research evidence to show that targeted policy is a far better way to ensure that countries gain the maximum benefit from foreign investment.

The author wishes to thank Fabienne Fortanier (Amsterdam Business School, Universiteit van Amsterdam), Robert Went (Scientific Council for Government Policy (WRR) and the Amsterdam School of Economics, Universiteit van Amsterdam) and Professor Rob van Tulder (Rotterdam School of Management, Erasmus University Rotterdam) for their comments on this article.

References

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Footnotes

Unfortunately, due to the age of this contribution and several migrations to online content management systems, the footnotes in text may have been lost. The footnotes below are listed in its original order of appearance in text.
  1. The literature on FDI addresses microeconomic and macroeconomic aspects. Microeconomic studies focus on market imperfections and on the desire of multinationals to expand their market power. FDI studies centre on firm-specific advantages due to product superiority or cost advantages stemming from economies of scale, multi-plant economies and advanced technologies, or superior marketing and distribution. For examples of early microeconomic FDI theories, see Caves (1971); Helpman (1984); Brainard (1997). Macroeconomic studies focus on institutional, cultural and transaction cost factors, in particular attitudes to takeovers, conditions in capital markets, liberalization policies, privatization, regional integration, currency markets and the role of investment bankers’ in analyzing the composition of aggregate international flows into FDI. For examples of early macroeconomic FDI theories, see Froot and Stein (1991); Bosworth and Collins (1999). For a good overview of the theory, see Razin, A. and Sadka, E. (2007) Foreign Direct Investment: Analysis of Aggregate Flows, Princeton, NJ: Princeton University Press.
  2. In contrast with FDI, other forms of capital flow, such as foreign portfolio investments and debt flows, are short term and therefore extra sensitive to financial and economic crises. When such crises occur they flow out of the country again very quickly, thus exacerbating the problem. FDI, in contrast, stays in the country because it is more difficult to move around and can therefore have a stabilizing effect.
  3. Krugman (1998) concludes that, during the Asian crisis in 2007, more FDI actually flowed into the region. This is because business values fall sharply during crises, making them easy prey for takeovers. Krugman, P.R. (1998) Fire-Sale FDI , MIT.
  4. This is how FDI is (not entirely seriously) described by Ha-Joon Chang (2007) Bad Samaritans: Rich Nations, Poor Policies and the Treat to the Developing World. London: Random House Business Books
  5. Hausmann and Fernández-Arias describe cyclical short-term capital flows such as foreign portfolio investments, which reinforce crises, as ‘bad cholesterol’ and anti-cyclical FDI as ‘good cholesterol’. See Hausmann, R. and Fernández-Arias, E. (2000) Foreign Direct Investment: Good Cholesterol? Working Paper 417, Inter-American Development Bank
  6. ‘FDI is defined as an investment involving a long-term relationship and reflecting a lasting interest and control of the foreign investor or parent firm in the host country. … In national and international accounting standards, FDI is defined as involving an equity stake of ten percent or more’. Razin, A. and Sadka, E. (2007) Foreign Direct Investment: Analysis of Aggregate Flows, Princeton, NJ: Princeton University Press.
  7. FDI mainly took the form of takeovers, especially in the 1990s. ‘Greenfield’ activities, like building a new factory, primarily take place in the oil or mining sectors. In addition, FDI from one developing country to another (South–South capital flows) tends to be in the form of greenfield activities. For more information, see UNCTAD (2006).
  8. Even more so, if local banks have to lend from foreign banks to finance the investment, it is considered as foreign portfolio investment or debt flow and cannot be called FDI.
  9. Agosin, M.R. and Mayer, R. (2000) Foreign Investment in Developing Countries: Does it Crowd in Domestic Investment? Discussion Paper 146, UNCTAD.
  10. UNCTAD (2006) World Investment Report 2006: FDI from Developing and Transition Economies: Implications for Development , UN Conference on Trade and Development, New York: United Nations Publications.
  11. Of the total US$916 billion FDI in 2005, South, East and Southeast Asia received US$165 billion, or about one-fifth, with East Asia (including China and Hong Kong) accounting for about three-quarters of the regional share. South and Central America followed with US$65 billion. Africa received US$31 billion, the largest ever FDI inflow to the continent. UNCTAD (2006) World Investment Report 2006, ibid.
  12. In Latin America most investments are made in the manufacturing sector (40%) while remarkably little is invested in the service sector (35%). A considerable proportion (25%) goes to the primary sector, especially in the poorest countries in the region. In Asia, the majority of FDI ends up in the manufacturing and service sectors. UNCTAD (2006) World Investment Report 2006, ibid.
  13. Hausmann, R. and Fernández-Arias, E. (2000) Foreign Direct Investment: Good Cholesterol? Working Paper 417, Inter-American Development Bank.
  14. Some developing countries only get more money from remittances – financial transfers from nationals working abroad.
  15. For a good summary of how local businesses can benefit from the presence of multinational companies, see Görg, H. and Greenaway, D. (2003) Much Ado About Nothing? Do Domestic Firms Really Benefit from Foreign Direct Investment? Discussion Paper 944, Institute for the Study of Labor (IZA), Bonn, Germany.
  16. The UK is not the only Western country to have applied such a condition on foreign investment. See Ha-Joon Chang (2007) Bad Samaritans: Rich Nations, Poor Policies and the Threat to the Developing World. London: Random House Business Books.
  17. Agosin, M.R. and Mayer, R. (2000) Foreign Investment in Developing Countries: Does it Crowd In Domestic Investment? Discussion Paper 146, UNCTAD.
  18. Collier, P. (2007) The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done about It. Oxford: Oxford University Press.
  19. Alfaro, L. (2003) Foreign Direct Investment and Growth: Does the Sector Matter?Harvard Business School, Boston, MA.
  20. Nunnenkamp, P. and Spatz, J. (2003) Foreign Direct Investment and Economic Growth Developing Countries: How Relevant Are Host-Country and Industry Characteristics? Working Paper 1176, Kiel Institute for World Economics.
  21. Eduardo Borensztein et al. (1998), for example, show that FDI only enhances growth in countries with a sufficient supply of qualified employees. Luiz de Mello (1999) concludes that the wider the technology gap between the host and home countries, the smaller will be the impact of FDI on economic growth in the host country. Finally, Laura Alfaro (2003) concludes that FDI only has an impact on growth in countries with sound institutions, especially in the financial sector.
  22. Lall, S. (2003) Foreign direct investment, technology development and competitiveness: issues and evidence, in S. Lall and S. Urata (eds.) Competitiveness, FDI and Technological Activity in East Asia, Cheltenham: Edward Elgar.
  23. See Evert-jan Quak (2007) Equal partners?The Broker 2: 16.
  24. Agosin, M.R. and Mayer, R. (2000) Foreign Investment in Developing Countries: Does it Crowd In Domestic Investment? Discussion Paper 146, UNCTAD.
  25. Ha-Joon Chang (2007) Bad Samaritans: Rich Nations, Poor Policies and the Threat to the Developing World. London: Random House. Also see Ha-Joon Chang (2002) Kicking Away the Ladder: Development Strategy in Historical Perspective, London: Anthem Press
  26. Lall, S. and Narula, R. (2004) FDI and its role in economic development: Do we need a new agenda?European Journal of Development Research, 16(3): 447–464.

 

 
Author: Evert-jan Quak

About the author

Evert-jan Quak is now Research Officer for the K4D Programme at the Institute of Development Studies.

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