Sample Economics Paper: The advantages and disadvantages of FDI for host and home countries

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The advantages and disadvantages of FDI for host and home countries

 

Foreign Direct Investment (FDI) is simply an investment abroad where, for example, a local company being invested in is under the control of a foreign corporation. FDI plays a critical role in today’s global business scene. It provides firms with new markets, cheaper production facilities, marketing channels, access to new technologies, skills, products, and financing (Goldberg 2004, p. 18). For the foreign firm or the host country, FDI becomes a source of new technologies, capital, as well as organizational and management skills. It can also provide an impetus for economic development.

In a classical definition, FDI is the economic engagement whereby a company from one country makes a physical investment in establishing a firm, company, or factory, which entails investment in such assets as land, buildings, machinery, and equipment in another country. FDI contrasts sharply with portfolio investment, which is an indirect investment. This paper explores the advantages and disadvantages of FDI for both host and home countries.

In recent years, there has been a trend towards rapid growth in global investment patterns. These patterns have influence the practice of FDI in many ways. Today, owing to these changes and dynamics, the scope of FDI is seen to cover even lasting management interest in an enterprise or company outside the home country of the investing firm. For this reason, FDI is seen to take many forms, including construction of a facility, direct acquisition of foreign firms, strategic alliance with local firms, investment in a joint venture, and licensing of intellectual property.

For host countries, the advantages of FDI are manifold. One of them is that it helps particular countries to develop economically. This is the case especially in developing countries. During the 1990s, FDI was one of the main sources of external financing for most developing countries (Szanyi 1998, p. 41). During this time, FDI greatly helped countries that were facing economic hardship. An excellent example is the case of the East Asian region during the Asian financial crisis in 1997. During this time, the amount of FDI made in these countries remained constant even at a time when other forms of cash flows continued to face major setbacks. A similar positive effect had been observed in Mexico in 1995 and Latin America in the 1980s.

Moreover, for host countries, FDI creates many job opportunities, sometimes followed by an increase in wage rates. This is especially the case through the motivating power of resource transfer, especially in the form of capital and technical expertise. The increase in levels of employment has also been triggered the trend towards the use of a marketing strategy at the expense of investment strategy. In spite of the ongoing decline in barriers to trade, FDI continues to increase at a much higher rate compared to the level of global trade. This arises because efforts within business circles to circumvent protectionist measures through FDI. In this regard, employment opportunities are increasingly becoming available across national borders.

FDI is brings about the benefit of economies of scale to host countries. The direct way in which investments are channeled into the host countries makes it possible for FDI to build a highly integrated corporate supplier network (Barry 1997, p. 1805). This brings about the benefit of reduced cost. This reduced cost is achieved easily upon coordination of supply chains. It is not surprising, therefore, that the direct investment approach is preferred o licensing and franchising. In FDI, there is strategic control, whereby management rights allow for an in-house approach in the way aspects of intellectual property and technological know-how are handled.

An excellent example of economies of scale at work is in the auto and electronics companies (Kimura 1989, p. 302). The operations of these plants depend largely on their competitive position within the international markets. For this reason, their parent companies have to design them in such a way as to capture all available economies of scale. They tap into these economies of scale by using quality control techniques and cutting-edge technology. The companies normally insist upon majority or whole ownership, thereby deriving freedom from any mandatory local content requirements. In order to succeed in this approach, the parent companies have to upgrade their technology as well as quality control procedures on a real-time basis as a way of serving their larger corporate self-interest.

FDI is also advantageous to the host country by serving its protected market. An excellent example is the automotive plants in Mexico, Thailand, and Brazil, which were designed to accommodate the policies of import substitution of these countries (Alfaro 2004, p. 106). In these countries, the automotive plants were forced to use alternative production processes for automotive components in order to comply with local standards. They could not use the same automated technologies as those of world-class plants. For instance, computer-assisted welding was replaced with hand-held welding. Although this led to an increase in production costs, it helped a great deal in protecting the local market as well as creating employment for the local population.

For countries where there is often a need to protect local industries, the pace of innovation is normally slower, the economies of scale tend to be smaller, and product differentiation much less pronounced (Moon 1997, p. 54). This situation is also common in industries relating to basic chemicals, paints, household appliances, generic pharmaceuticals, tires and rubber products, industrial equipment, electrical devices, and unbranded garments. In such a situation, FDI brings new products, lower prices, and improved qualities to host-country consumers. The foreign investor also provides additional resources such as technology, capital, and management, with the underlying effect being to raise the level of domestic output. A good example is a situation where an investor in London partakes to invest in a chain of restaurants in Baghdad by providing capital for use in construction work.

The benefits of FDI for host countries are best achieved when clearly-defined policies have been put in place. Various approaches have been used by scholars to explore the issue of policymaking in FDI.  Gastanaga (1998, p. 1302), for instance, discusses the ‘eclectic theory’ of international investment with regard to the advantages of foreign ownership, internalization, and host country location. In this regard, Gastanaga argues that host country policies may greatly influence FDI flows by virtue of influencing the advantages of location within the host country. In studies aimed at assessing relevance of the eclectic theory, the main variables should ideally include corporate tax rates, tariff rates, exchange rate distortions, the degree of openness to capital flows in the international markets, the risk of nationalization, contract enforcement, corruption, and bureaucratic delays.

However, FDI sometimes turns out to be disadvantageous to host countries. The main disadvantages for the host countries relate to nationalistic sentiments and growing concerns over foreign political and economic influence (Baltagi 2007, p. 272). Anxiety over this form of influence has been the key motivating factor for restrictions, and sometimes resistance, to FDI in developing countries. The main reason for this nationalistic sentiment is that many less developed countries have a history of colonialism, and they fear that FDI may well be said to be modern-day economic colonialism (Cooke 2001, p. 708). This feeling creates the fear that this influence exposes the host countries and ultimately leaves them very vulnerable to exploitation by foreign companies.

Those who oppose FDI-for-developing-countries argue that FDI increases aggregate demand only on the short-run. They express concerns over the efficacy of the purported advantages of direct investments with regard to technology transfers and productivity improvements. Moon (2001, p. 202) asserts that if one assesses the benefits of FDI to host countries from the perspective of ownership-specific advantages, FDI will always appear to be disadvantageous to these countries, most of which are in the developing world. In retrospect, Moon proposes the imbalance theory as the ideal yardstick for analyzing FDI with the aim of determining if it is actually of any benefit to host countries. This theory, Moon observes, can help in unraveling the truth about whether the problem of economic dominance of developing countries outweighs the benefits of creating a balance in the distribution of global investments.

Nevertheless, those who are afraid of economic and political dominance argue that in the long run, the balance of payment position in the host country falls into jeopardy immediately the investor recovers the initial outlay of the investment (Kokko 2006, p. 9). Once the initial investment begins to generate profits, it becomes inevitable that the capital will start returning to the home country. The core implication of this situation is that while FDI levels are normally resilient in times of economic uncertainty, FDI runs the potential risk of having an adverse effect on the developing economy’s net capital flow. This is the case especially if the developing country lacks a health and sustainable FDI policy and schedule.

Critics of FDIs also argue that they create negative externalities in the host economy’s labor market (Morgan 1997, p. 71). They argue that this is so because for all multinational enterprises that function as profit-maximizing entities, this is one of the key ways through which a direct approach can be used for cost reduction purposes. Although FDIs may venture into host countries for strategic reasons, there is normally ultimate need to achieve maximum returns on investment.

Regarding employment and wage-rate benefits, although multinational enterprises pay a premium over local wage rates, there are doubts on whether this is really beneficial to host economies (Cuervo-Cazurra 2008, p. 978). The main reservation is that although payment of a premium for the labor price can increase the workers’ consumption power, it also tends to have a detrimental effect of disrupting local employment markets. In essence, the demand-supply theory applies in the labor market as well, such that when labor prices increase in the form of wage premiums, a distortion is created that leads to disequilibrium in the labor market.

Similarly, for home countries, FDI’s come with certain advantages, although they also possess some disadvantages. In terms of advantages, it is important to note from the outset that the level of FDI depends first and foremost on the benefits that it is projected to bring to the home country. Moreover, the main advantages for the home country relate to production interactions that arise from outward investment, balance of payments, knowledge, technology, and political decision-making processes within the home country.

For the investing multinational enterprises, FDI is normally beneficial, and these benefits end up trickling back into the home country economy. However, some sort of variation may be seen with regard to advantages to the home country (Harrison 1994, p. 9). The benefits for the home country vary depending on the prevailing business both at home and in the host countries as well as the nature of the investment project. In many cases, FDI tends to have a small impact on the production and total exports in the home countries that are highly developed.

Conversely, it may tend to have a mildly negative impact on employment. Just like in the case of host countries, this manifests itself in a shift in the production structure. However, in this case, labor-intensive activities tend to be outsourced to host countries, where wage levels tend to be lower. Only more advanced operations in the production process are retained at home. Although most home countries tend to encourage outward investment, they fear the negative effects, particularly those relating to balance of payment. In fact, this fear has at time been a motivating factor for restrictions on FDI. Indeed, the advantages of FDIs for home countries are likely to coincide with their impact on developed economies. One of the main exceptions is technology-sourcing investments, which are normally of more importance to developing countries compared to developed ones.

The problem of employment is particularly of great concern to home countries. This concern arises because of the fact that virtually all multinational companies that choose to invest abroad in activities relating to production and marketing opt to hire labor from the foreign countries of operation. This translates into loss of employment opportunities in home countries. At times, the MNC’s even choose to relocate these production facilities from the home countries to host countries so as to maximize benefits arising from low material-sourcing costs and cheap labor.

Another major disadvantage to host country relates to repatriation of profits, whereby host countries put in place policies restricting the level of profit, dividend, and royalty outflow (Choong 2004, p. 289). These policies are normally put in place as a way of saving their respective foreign exchange for use in other more pressing issues. In this scenario, the profits and gains that are made in the host country remain trapped there, and they can never be transplanted and deployed elsewhere in the event that other more profitable opportunities arose.

Loss of competitive advantage is another key disadvantage for home countries (Konrad 2009, p. 236). In today’s globalized world, technological advancements are making continuous shake-ups continue to shape the world of business and technologically advanced countries are no longer sure of retaining their positions as the most competitive sources of investment opportunities (Peter 2002, p. 11). Yet for the developed countries, the task of coming up with new technologies is a very costly affair. As a way of reducing costs, these developed countries are forced to license these technologies to various developing countries within the realm of their FDI strategy. In this way, these host countries take custody of vital information regarding these technologies, thereby increasing the risk of imitation. However, some observers point out that there are Intellectual Property Rights in place that these countries can use to safeguard their ownership of new technologies. The main problem, though, is that many developing countries lack the financing and machinery for upholding this protection through IPR laws and acts.

Concerns regarding deterioration of balance of trade when exports are replaced by FDI are also rife. This concern has been growing with the advent of globalization, which increases the rate of formation of institutional, economic, and legal inter-linkages. This anxiety has manifested itself so clearly that the debate has found its way in World Trade Organization (WTO) sessions (Sauvant 2009, p. 23). In these sessions, a persistent debate has been on whether member governments should continue resorting to bilateral FDI arrangements. In recent times, the fear of deterioration of balance of trade was expressed explicitly in the wake of the global Economic Recession between 2007 and 2009. This recession greatly affected the US economy, which is leading source of Foreign Direct Investments in the world.

In summary, this paper has critically examined both the positive and negative impacts of FDI on both host and home countries. It is clear that host countries have for a long time been looking up to foreign companies for economic growth in the form of FDIs. Although FDIs are seen to have many benefits relating to employment and the eventual growth of the economy, many critics are concerned that FDI are a manifestation of a new form of economic colonialism. For home countries, there are many benefits, including the ability to tap into low productive and marketing costs as well as cheap, readily available labor. However, when these benefits are taken to the extreme, they lead to a complete relocation of operations into host countries, thereby robbing home-country citizens of employment opportunities.

 

References

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Baltagi, B, 2007, ‘Estimating models of complex FDI: Are there third-country effects?’, Journal of Econometrics, Vol. 140, No. 1, pp. 260-281.

Barry, F, 1997, ‘FDI and Trade: The Irish Host-Country Experience’, The Economic Journal, Vol. 107, No. 445, pp. 1798-1811.

Choong, C, 2004, ‘Foreign Direct Investment, Economic Growth, and Financial Sector Development: A Comparative Analysis’, ASEAN Economic Bulletin, Vol. 21, No. 3, pp. 278-289.

Cooke, W, 2001, ‘The effects of labor costs and workplace constraints on foreign direct investment among highly industrialized countries’, The International Journal of Human Resource Management, Vol. 12, No. 5, pp. 697-716.

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Kimura, Y, 1989, ‘Firm-Specific Strategic Advantages and Foreign Direct Investment Behavior of Firms: The Case of Japanese Semiconductor Firms’, Journal of International Business Studies, Vol. 20, No. 2, pp. 296-314.

Kokko, A, 2006, The Home Country Effects of FDI in Developed Economies, Working Paper No. 225, April 2006.

Konrad, K, 2009, ‘Competition for FDI with vintage investment and agglomeration advantages’, Journal of International Economics, Vol. 79, No. 2, pp. 230-237.

Moon, H, 1997, ‘The Choice of Entry Modes and Theories of Foreign Direct Investment’, Journal of Global Marketing, Vol. 11, No. 2, pp. 43-64.

Moon, H, 2001, ‘Unconventional foreign direct investment and the imbalance theory’, International Business Review, Vol. 10, No. 2, pp. 197-215.

Morgan, R, 1997, ‘Theories of international trade, foreign direct investment and firm internationalization: a critique’, Management Decision, Vol. 35, No. 1, pp. 68 – 78.

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