Foreign Direct Investments Essay, Research Paper

We are living in a time where world trade is and globalization are rapidly increasing. Because of this, Foreign Direct Investment has also become an increasingly popular way of doing business. Foreign Direct Investment (FDI) can occurs two ways. a.) When foreign firms acquire a substantial ownership position in a domestic firm. or b.) when foreign firms locate production plants in the domestic economy. There are many reasons why firms decide to invest in foreign countries; one such reason would be better access to cheaper means to produce their products. Entities, which are involved in Foreign Direct Investment, are, Multi National Corporations, host countries, and their governments, etc. Each of these entities are affected as well as have an effect on FDI’s.

This paper begins with an overview of FDI and the policies in which it is involved. Next, the nature of multinational corporations will be outlined, along with a description of recent trends in FDI flows. It will then move on to discuss the costs and benefits of Foreign Direct Investments, from the host country’s point of view. Following will be the host countries’ policies toward multinational companies, and the effects of those policies will also be discussed.

This paper begins with a general overview of the topic of Foreign Direct Investments, economies that it effects and some ideas which have been discussed and are still being developed. One such requirement for economic development in a low-income economy is an increase in the nation’s capital. A developing nation may increase the amount of capital in the economy by encouraging foreign direct investment. Many developing economies have attempted to restrict foreign direct investment because of nationalist sentiment and concerns about foreign economic and political influence. One reason for this sentiment is that many developing countries have operated as colonies of more developed economies. This colonial experience has often resulted in a legacy of concern that foreign direct investment may serve as a modern form of economic colonialism in which foreign companies might exploit the resources of the host country.

In recent years, however, restrictions on foreign direct investment in many developing economies have been substantially reduced as a result of international treaties, external pressure from the IMF or World Bank, or unilateral actions by governments that have come to believe that foreign direct investment will encourage economic growth in the host country. This has resulted in a rather dramatic expansion in the level of foreign direct investment in some developing economies.

One agreement, which will help in the increase of foreign direct investment, is the Multilateral Agreement on Investment. It increases the rights and opportunities of multinationals but does not hinder them with any increased responsibilities, or restrict the investment incentives offered by host countries. This is partly due to the influence of MNCs on the negotiations. Foreign direct investment may encourage economic growth in the short run by increasing demand in the host economy. In the long run however, the increase in capital raises the use of labor which leads to higher incomes. Another long-run impact, however, comes through “technology transfer,” the transfer of technological knowledge from industrial to developing economies. Many economists argue that “this transfer of technology may be the primary benefit of foreign direct investment.”(4) It is often argued, however, that it is necessary to restrict foreign direct investment in a given industry for national security purposes.

Multinational corporations (MNCs, which can be defined simply as companies which have operations in more than one country) account for over 70% of world trade. “Multinational investment has grown 13% per year through the last two decades – twice the rate of growth of world trade”.(2) The vast majority of MNCs originate in the United States, Japan, and the EU. These countries are also the main hosts to MNCs, although many of the less developed countries have increased their involvement with FDI. Most of this new investment has been to China and the ‘tiger’ economies of South-east Asia. Many people have strong opinions about multinational corporations and there involvement in investing in foreign countries.. “International institutions such as the World Bank, IMF, and WTO tend to see MNCs as champions of free trade and mechanisms by which national economies will be forced to open up”.(1) On the other hand many others have expressed concerns about whether the benefits of FDI are as great as it has been said to be, or whether they exist at all. So what are the benefits and costs of FDI.

The below areas will be focused on when dealing with the benefits and costs of foreign direct investment and its effects on host countries. Including effects on a country’s growth rate, tax revenues created for host governments, a spill over effect of capital (knowledge, technology, expertise) changes in consumption patterns, and an increase in economic independence.

“A country’s growth rate is strongly influenced by past investment levels. Therefore, if the level of investment in a country is increased, future output will be higher.”(3) However, FDI may not raise the level of output in the host country. Because MNCs aim to maximize profits as well as the fact that many investors may be attracted to the same sector for investment. Predatory pricing, combined with large grants and subsidies from host governments, allow multinationals to offer lower prices and higher wages than indigenous competitors. As a result, MNCs often displace existing companies, or prevent the emergence of new competitors. By buying intermediate products from overseas associates, MNCs may also prevent the natural emergence or expansion of domestic suppliers. Profits that would otherwise have been given to local entrepreneurs, and probably been reinvested locally, are instead reallocated abroad. The host country becomes more dependent on multinational companies for employment and output.

With the high profits, which multinational corporations and their subsidiaries have, a generation of large amounts of tax revenue for host governments is created. However, MNCs can use transfer pricing to switch their profits to countries with very low rates of corporation tax. Furthermore, they usually receive generous tax concessions and allowances from host governments and, in many cases, the corporation tax paid by the foreign firm is actually outweighed by the subsidies and grants it receives from the government. By displacing local competitors, MNCs further reduce the host government’s revenues.

Multinational companies bring with them a slue of specific factors such as: managerial skills, business knowledge and technological information, which benefit to host countries a great deal. Different economic theories stresses the importance of technological advancement for economic development. However, for advancement of technology to occur with ought the help of other countries would require large amounts of research and development on the part of indigenous companies. It is much cheaper and easier to allow MNCs to “transfer” their technology by establishing subsidiaries, employing and training local people and forming linkages with the domestic economy(Spill Over effect). Can host countries rely on MNC’s for their technological advancement?, multinational companies are naturally reluctant to share their knowledge. They have, as one individual said, “no commercial interest in diffusing [their] knowledge to potential native competitors”(Site 5). The multinational company’s technical knowledge is often of little (external) benefit to the host economy. When technology is transferred to the host country, it is often incompatible with the needs of the host economy. For example, technologies used by multinationals are usually developed in richer countries, where capital is relatively abundant. The introduction of this non-labor intensive technology to developing economies can lead to increases in unemployment.

The introduction of multinational corporations may have an effect on the host countries patterns of consumption. MNCs that produce luxury goods (for example, processed foods) in developing countries often try to sell them locally. They advertise their products in order to create demand. The result is that people on very low incomes often find themselves encouraged to buy luxury items and other goods which are available to the developed countries. In fact these consumers in the,LDC’s should be concentrating on fulfilling their more immediate needs. “Those who cannot afford these luxury goods become dissatisfied”.(5) The consequences of buying products which aren’t affordable can be deadly, In an article about FDI the author talks about a particular case which glorifies the idea in the previous sentence. He states that “…when food companies from the North encouraged Third World mothers, many of whom had no access to clean water, to feed their children with powdered milk instead of breast milk.”(3) Some argue that, “these changes in consumption patterns of host countries are the result of economic development and increased prosperity”, rather than MNC activity. Multinational corporations cater to the changing demands of consumers and they do not have a hand in effecting the consumers demand. While this may be true it is also true that if an individual is presented with a better way of living it will be increasingly difficult to turn down. Simple human nature would support this fact because we are all trying to better ourselves in some way. This might be an ethnocentric view, but it is a valid point.

One of the last effects placed on the table, that Multinational corporation intervention can produce, is the idea that the host country’s sovereignty and economic independence will be affected. Multinationals often make decisions, which affect the long-term welfare of citizens in host countries, particularly about environmental matters. Multinationals often have no incentive to consult host governments about the use of non-renewable resources. Furthermore, multinationals often influence the political processes of host countries. In 1973, for example, “American multinational, International Telephone and Telegraph, backed a military coup in Chile, during which the democratically elected president, Salvador Allende, was assassinated and replaced by the notorious General Pinochet. IT&T’s”(3). Continued financial support allowed Pinochet’s dictatorship to survive until 1990, much as “Shell’s generosity is facilitating the present military dictatorship in Nigeria”(3).

Not only do multinationals themselves influence the political processes, but home country governments often become involved, too. For example, “…the United States, backed General Pinochet’s coup in 1973, largely because President Allende’s plans to nationalise the Chilean telecommunications industry would have threatened IT&T’s profits.”(4)

FDI clearly has the potential to benefit as well as cost the host countries. It can lead to increased output,as well as an increase in the overall well being of the country.

However, how beneficial is FDI? Because MNCs often distort or prevent the emergence of indigenous enterprise, distort consumption patterns, and exacerbate inequality and other social problems in the host country, it is unclear in practice whether FDI benefits the host economy.

There are different policies which the host governments institute towards MNCs. Most governments adopt policies aimed at both encouraging and discouraging inward FDI. They offer incentives (such as financial and tax incentives as well as market preferences) and they place restrictions on MNC activity. These policies can dramatically distort economic activity and reduce the efficiency of international investment.

There is quite a large number of incentives that a government can offer to multinational investors. Fiscal incentives include tax reductions, accelerated depreciation, investment and reinvestment allowances, and exemptions from import and export duties. Financial incentives include subsidies, grants and loan guarantees. Market preferences include monopoly rights, protection from import competition and preferential government contracts. Governments also offer low-cost infrastructure (electricity for example). The gains to the country offering these policies are usually at the expense of another potential host country. Furthermore, a 1985 World Bank study found that “…an increase in one country’s investment incentives tended to lead to increases in other countries’ incentives”(2). Because investment incentives usually benefit companies that would have made their investment anyway, the result is wasteful competitive bidding among nations. This leads to a dilemma, where every country would be better off if each country reduced its incentives by the same amount. This is only possible through multilateral policy co-ordination, which could lead to huge welfare gains for all host countries.

Many developing economies have attempted to restrict foreign direct investment because of nationalist sentiment and concerns about foreign economic and political influence The other side of all of this are the restrictions which are caused by the institution of policies. Host countries can restrict multinational companies’ activities in a number of ways. They often restrict entry to certain sectors, or require that primarily domestic investors own firms operating in those sectors. This is usually done for cultural reasons or for reasons of national security. More importantly, national governments impose performance requirements on foreign firms operating in their territory. A few of the most widespread performance requirements have been related to trade. To name a few, some governments insist that MNCs, export a minimum proportion of their output, or source a minimum proportion of their inputs locally. While these requirements discourage FDI and reduce the efficiency of international investment, they enable the host country to maximize the benefits of FDI.

In conclusion there are many intricacies, which go into FDI. In this paper there has been a discussion about the effects that FDI has on the host countries in which MNC’s penetrate. It has been found that there are many benefits and costs for the MNC’s(source country) as well as the host countries. While FDI increases there should also be an increase in government awareness. This increase occurs because of the increase in investment in the host country and investments have an effect on the host country. In lieu of this certain policies and interventions are introduced to deal with this foreign investment. To conclude this paper I have included an article I found about foreign direct investment, which has been included below.

Bibliography

1. Ahiakpor, James C.W. (1990) Multinational Corporations and Economic Development. Routledge: London.

2. Anonymous. Will foreign Direct Investment keep on booming

3. Buckley, Peter, J. and Clegg, Jeremy (eds.) (1991) Multinational Corporations in Less Developed Countries. Macmillan: Basingstoke.

4. Graham, Edward, M. and Krugman, Paul, R. Foreign Direct Investment in the United States. Institute for International Economics: Washington D.C.

5. Jefferson, Gary H. Behind The Open Door. Journal of International Economics

6. Pugel, A Thomas,Lindert, H Peter. International Economics eleventh edition

Internet Sources

1.”MAI home page”

http://www.oecd.org/daf/cmis/mai/maindex.htm http://web.uvic.ca/german/hendrik/mai-1097.txt

MAI Draft, (October 1997)

2.OECD “Foreign Direct Investment” http:/www.oecd.org//daf/investment

3.Foreign Direct Investment around the world, www.neweconomyinde.org/section1