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FOREIGN sources of finance in economic development
FOREIGN direct investment
Foreign direct investment (FDI) is an investment made by a company or individual in one country in business interests in another country, in the form of either establishing business operations or acquiring business assets in the other country, such as ownership or controlling interest in a foreign company.
What is FDI?
A multinational corporation (MNC) is usually a large corporation incorporated in one country which produces or sells goods or services in various countries. The two main characteristics of MNCs are their large size and the fact that their worldwide activities are centrally controlled by the parent companies.
What is an MNC?
Why mNCs operate in developing countries
MNCs seek expansion in developing countries to pursue opportunities to increase their profitability. Developing countries offer the following opportunities for MNCs:
Essential statement: Many MNCs will locate to developing countries in pursuit of lower average costs which will increase competitiveness and profitability
Essential statement: Many MNCs will locate to developing countries in pursuit of large and growing markets that will increase sales revenues and profitability
Why attract FDI?
Competing for FDI
Characteristics of developing countries that attract FDI
Factors affecting foreign direct investment:
1. Wage rates.
A major incentive for a multinational to invest abroad is to outsource labour intensive production to countries with lower wages. If average wages in the US are $15 an hour, but $1 an hour in the Indian sub-continent, costs can be reduced by outsourcing production. Therefore, many Western firms have invested in clothing factories in the Indian sub-continent.
However, wage rates alone do not determine FDI, countries with high wage rates can still attract higher tech investment. A firm may be reluctant to invest in Sub-Saharan Africa because low wages are outweighed by other drawbacks, such as lack of infrastructure and transport links.
2. Labour skills.
Some industries require higher skilled labour, for example pharmaceuticals and electronics. Therefore, multinationals will invest in those countries with a combination of low wages, but high labour productivity and skills. For example, India has attracted significant investment in call centres, because a high percentage of the population speak English, but wages are low. This makes it an attractive place for outsourcing and therefore attracts investment.
3. Tax regulations:
4. Transport and infrastructure.
A key factor in the desirability of investment are the transport costs and levels of infrastructure. A country may have low labour costs, but if there is then high transport costs to get the goods onto the world market, this is a drawback. Countries with access to the sea are at an advantage to landlocked countries, who will have higher costs to ship goods.
5. Size of economy/potential for growth.
Foreign direct investment is often targeted to selling goods directly to the country involved in attracting the investment. Therefore, the size of the population and scope for economic growth will be important for attracting investment. For example, Eastern European countries, with a large population, e.g. Poland offers scope for new markets. This may attract foreign car firms, e.g. Volkswagen, Fiat to invest and build factories in Poland to sell to the growing consumer class. Small countries may be at a disadvantage because it is not worth investing for a small population. China will be a target for foreign investment as the new emerging Chinese middle class could have very strong demand for the goods and services of multinationals.
6. Political stability/property rights.
Foreign direct investment has an element of risk. Countries with an uncertain political situation, will be a major disincentive. Also, economic crisis can discourage investment. For example, the recent Russian economic crisis, combined with economic sanctions, will be a major factor to discourage foreign investment. This is one reason why former Communist countries in the East are keen to join the European Union. The EU is seen as a signal of political and economic stability, which encourages foreign investment.
Related to political stability is the level of corruption and trust in institutions, especially judiciary and the extent of law and order.
One reason for foreign investment is the existence of commodities. This has been a major reason for the growth in FDI within Africa – often by Chinese firms looking for a secure supply of commodities.
8. Exchange rate.
A weak exchange rate in the host country can attract more FDI because it will be cheaper for the multinational to purchase assets. However, exchange rate volatility could discourage investment.
9. Clustering effects.
Clustering effects arise from the geographic concentration of interconnected businesses, suppliers, and associated institutions in a particular field. These are considered to increase the productivity with which companies can compete, nationally and globally.
Foreign firms often are attracted to invest in similar areas to existing FDI. The reason is that they can benefit from external economies of scale – growth of service industries and transport links. Also, there will be greater confidence to invest in areas with a good track record. Therefore, some countries can create a virtuous cycle of attracting investment and then these initial investments attracting more. It is also sometimes known as an agglomeration effect.
10. Access to free trade areas.
A significant factor for firms investing in Europe is access to EU Single market, which is a free trade area but also has very low non-tariff barriers because of harmonisation of rules, regulations and free movement of people. For example, UK post-Brexit is likely to be less attractive to FDI, if it is outside the Single Market.
There are many different factors that determine foreign direct investment (FDI) and it is hard to isolate individual factors, given there are many different variables. It also depends on the type of industry. For example, with manufacturing FDI, low wage costs tend to be the most important, as they are a labour-intensive industry. For service sector FDI, macro-economic stability and political openness tend to be more important.
Also, it depends on the source of FDI, American firms may value political openness more than Chinese firms. Or American firms may prefer countries where English is spoken more.
FDI in Brazil
Who gains from FDI?
The impact of FDI for economically less developed countries
Skills and technology. MNCs have managerial and technical expertise and access to new technology that many less developed countries do not. These skills and technologies can be learned and adopted by the local workforce and transferred to local firms. Human capital increases in the developing country as new skills are learned. This increase in human capitals is one of the most important benefits that accrues to less developed countries with FDI from MNCs.
However, if in practice the links between the MNC and the local economy are limited, then the skills transfer to the host country and the development of human capital will be low. This would likely be the case in a situation where the MNC has capital intensive production processes and relies heavily on imported labour skills from the home country to operate technology. Any local labour would be employed in menial occupations that require little new skills to be learned. A good example would be US car manufacturing plants in Mexico.
Savings and investment. Often, less developed countries have low savings rates which leads to low rates of investment. FDI by MNCs supplements low savings and investment and the capital stock of the less developed country increases leading to increased productivity and economic growth.
Tax revenues. If the government is successful in taxing the profits of MNCs then overall tax revenues for the host country will increase.
However, many MNCs establish themselves in less developed countries because they have been offered significant tax advantages to do so. This limits the amount of tax that host governments will be able to collect from MNCs operating locally. MNCs are also very good at lowering the amount of tax that they pay through various accounting procedures. For example, transfer pricing is a method used to sell a product from one subsidiary to another within a company. It impacts the purchasing behaviour of the subsidiaries and will lower the income tax implications for the MNC. It is done by inflating the costs of inputs from a subsidiary in a low tax country such as the Republic of Ireland to lower reported profitability in a higher-taxed country such as South Africa. Reduced profitability means reduced corporate income tax and the benefits to the host country in terms of tax revenue generated could be significantly less than was originally anticipated.
Local industry. MNCs that require inputs into their production processes may acquire those inputs from local firms. Firms and industry in the host country will become more developed and grow in scale and scope.
However, MNCs can have a negative effect on local firms and industries. Local firms that compete with a MNC may be forced out of business, and a MNC may use its monopoly power to restrict the ability of new local firms to enter the market and compete with it.
Employment. FDI lowers unemployment in the host country. MNCs hire local workers. Often MNCs will chose to invest in a less developed country because wage rates are relatively low, and operations are relatively labour-intensive. Thus, MNCs may require a large pool of labour and significantly reduce unemployment in an area.
However, it is not necessarily the case that MNCs will significantly increase employment. This would likely be the case in a situation where the MNC has capital intensive production processes and relies heavily on imported labour skills from the home country to operate technology. A good example would be US car manufacturing plants in Mexico.
Economic growth. Increased investment, technological improvements, increased productivity, improved human capital and expanding domestic firms and industry all increase aggregate supply in the less developed country where such FDI occurs. Increased aggregate supply leads to increased real economic growth as national output and income increases. Higher tax revenues from MNCs enables governments to increase spending on goods and services, and transfer payments – aggregate demand increases. Further, increased employment leads to higher household income and consumer spending will increase – aggregate demand increases. With increased aggregate demand and increased aggregate supply, real economic output and incomes increase with relatively little impact on inflation.
Foreign exchange earnings. In the balance of payments, inflows of FDI are credits in the financial account. Such inflows will reduce a current account deficit. Further, the activities of many MNCs are export-oriented and the host country’s export revenues will increase, having an additional positive effect on the host country’s balance of payments situation.
However, MNCs also contribute to foreign outflows of capital and profits are repatriated to the home country, import payments are made to source inputs into the production processes and/or the MNC borrows from the parent company and interest payments are sent abroad. Thus, the net positive effect on foreign exchange earnings may be rather more limited than initially anticipated.
Environmental degradation. Some MNCs pursue activities that pollute the environment and/or deplete the natural resources of the host country. It is often more profitable for a MNC to invest in countries what have few environmental regulations and/or a poor track record in enforcing such regulations. For example, there are many rules and regulations that must be adhered to when mining in developed countries. Compliance costs can be high and reduce the profitability of such operations. Whereas in a less developed country such compliance costs may be much reduced leading to increased economic activity by MNCs and increased environmental damage. A good example would be the palm oil industry in Southeast Asia where much native forest has been cleared to accommodate the new plantations.
Inappropriate consumption. MNCs are often extremely good at marketing their products. When they bring their marketing powers to bear on consumers in less developed countries they can create new consumption wants. Fast food, sugary soft drinks and breakfast foods and expensive branded goods are effectively marked in less developed countries. Of course, they do the same in developed countries, but the key difference is that in less developed countries, where incomes are so low, households can less afford to spend a portion of their incomes on unnecessary goods and services when basic needs are still unsatisfied.
Use of government resources. To successfully operate anywhere, many MNCs will require good infrastructure such as road and rail networks, ports and airports, and telecommunication networks. Developing countries need to make such infrastructure available to attract MNC to invest. To develop such infrastructure, scarce resources will need to be devoted to building and providing such infrastructure, and as such, less money will be able to be devoted to important education and health services. Thus, the more infrastructure investment a developing country makes, the less it can spend on schools, hospitals and sanitation services.
Economic and political power. MNCs are by their nature very large and this provides them with considerable political and economic power. This power can be wielded to influence the policy of host governments – policies that may benefit the MNC but work against the economic development of the host country. Such policies may include weakened labour protection regulations (e.g., ability to unionise) and environmental regulations.
If a MNC is successful in lowering such regulations, then its costs of production will be lower and profitability higher. For example, multinational mining companies have threatened to relocate if stricter environmental regulations were to be introduced and enforced. The governments of less developed countries may perceive themselves to be in a relatively weak bargaining position with MNCs when there is are conflicting objectives such as the profitability of a MNC and protecting the health of citizens. If the government of the host country is not willing to compromise, the MNC can threaten to relocate to another country that is more accommodating to its demands.
Competition and the ‘race to the bottom’. MNCs can pick and choose in which country to invest. Less developed countries may see that they must compete to attract such foreign investment. Countries will compete on infrastructure (expensive and with opportunity costs), low taxes, trade liberalisation, labour laws and environmental regulations benefiting MNCs but lessening the positive effect that MNCs can have on economic growth and development.
Chinese investment in Africa
Chinese investment in Cambodia
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