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issue 37
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Forum on Economic Reform In recent decades the alliance of neoclassical economics
and neoliberalism has hijacked the term “economic
reform”. By presenting political
choices as market necessities, they have subverted public debate about what
economic policy changes are possible and are or are not desirable. This venue promotes discussion of economic reform
that is not limited to the one ideological point of view. Rethinking Foreign Investment for
Development Kevin P.Gallagher and Lyuba Zarsky (Boston
University and Businesses for Social
Responsibility, USA) © Copyright: Kevin P. Gallagher and Lyuba Zarsky 2006 In the 1990s, foreign direct investment (FDI) came to be seen as a “miracle drug”—a jumpstart to
economic growth and sustainable industrial development, especially in
developing countries. Policies to
attract FDI became the centerpiece
of both national development strategies and supra-national investment
agreements. This paper examines case study and statistical
evidence about the impacts of FDI in developing
countries on economic growth, technology spillovers
and environmental performance.
Mirroring the heterogeneity of developing countries, we find that
there is no consistent relationship: the impact of FDI
on each variable has been found to be positive, neutral, or even negative.
Key variables are domestic policies, capacities and institutions. We conclude that the purported benefits of FDI are exaggerated and its centrality in development
strategies misplaced. Rather than attract FDI per se, development policies should
aim to promote endogenous local capacities for sustainable production. With
the right national and global policy framework, FDI
could help in that process. I. Introduction In the 1990s, foreign direct investment (FDI) came to be seen in much the same light as export-led growth in the 1970s—a jumpstart to sustained economic growth in developing countries. Optimism was fuelled by a surge in FDI inflows, outstripping other forms of public and private finance. Led by transnational corporations (TNCs), the hope was that FDI would transfer superior technology and management skills, stimulate domestic investment and growth, generate efficiency spillovers, and integrate developing country firms into global markets. An added twist was that, directly and indirectly, FDI would also boost environmental performance. The direct benefits would be gained from the transfer of cleaner technology and the better environmental management practices of TNCs. The expectation was that TNCs would implement and diffuse in their developing country operations the high standards required in Europe, Japan, and the US. The indirect benefits would be gleaned largely from the impacts of FDI on economic growth. By increasing per capita income, growth would promote cleaner consumer goods and greater citizen demand for environmental protection. Two standard prescriptions followed. First, since “more is better,” policies to attract FDI should be at the heart of national development strategies. An understanding of what these policies should be has changed over the decades. In the 1980s, the emphasis was on “getting the prices right,” that is, the elimination of domestic policies, such as energy and food subsidies, which create a cleavage between domestic and global prices. In the 1990s, the trend was toward “getting the macro-policies right”, especially the deregulation of financial markets. Currently, the focus is on fashioning the right
“enabling environment” for FDI; that is, creating
or strengthening legal, regulatory and political institutions which provide
transparency, property protection, and financial stability to foreign
investors. Even if desirable, the creation of such institutions is neither an
overnight nor costless affair. If success in attracting FDI
awaits their creation, many developing countries, especially the poorest,
will be waiting a long time. The second prescription is that investment agreements—global, regional, bilateral-- should aim to “make the world safe” for FDI, including by expanding the protections for and the rights of foreign investors. Greater rights for investors have come at the expense of flexibility and diversity of national development policies. Moreover, TNCs have used new rights to challenge national environmental and health regulation. This paper examines recent statistical and case study evidence about the impacts of FDI in generating efficiency spillovers, promoting growth and improving environmental performance in developing countries. The studies paint an ambiguous picture: FDI has been found to have positive, neutral, or even negative impacts on all three counts. The poorer the country, the more likely is the FDI impact negative. While further studies are needed, especially case studies of particular TNCs and sectors, the key variables appear to be the domestic institutional and policy context, on the one hand, and TNC practices on the other hand. The central argument of the paper is that FDI is no “miracle drug” for economic development, environmentally sustainable or otherwise. Structuring development strategies and investment regimes around the assumption that it is a miracle drug may act, ironically, to undermine the positive contributions that FDI could potentially make to nurturing local capacities for sustained economic growth. II. FDI
in Developing Countries FDI is a financial investment in a domestic enterprise by which a foreign investor gains a significant equity stake in the firm. In most national accounting systems, FDI is defined as an equity share of 10 percent or more. Besides selling equity, enterprises finance their operations via debt, including loans from banks and other financial institutions and corporate bonds. The major players in FDI are transnational corporations (TNCs). The world’s largest 100 TNCs held nearly $2 trillion in foreign assets at the end of the 1990s, and employed over six million people in their foreign affiliates. All of the top 10 and nearly 90 percent of the top100 TNCs are from the United States, Japan and the European Union (UNDTAD, 2002). Given the predominance of TNCs, a conventional definition of FDI is a “form of international inter-firm cooperation that involves significant equity stake and effective management decision power in, or ownership control of, foreign companies” (De Mello, 1999, p. 135). FDI, in short, is more than a flow of capital. It is a cross-border expansion of production undertaken primarily by large corporations. The internationalization of production is at the heart of the process of globalization. FDI takes place in two ways: “Mergers and Acquisitions” (M&As) that is, the purchase by TNCs of existing domestic companies, in whole or in part; and “Greenfield Investment,” that is, additions to the capital stock and the creation of new productive capacity. Why and Where? Determinants of FDI Why does a TNC decide to expand production overseas rather than exporting products it makes at home? What determines which countries TNCs will invest in? Mainstream trade theory suggests that FDI is driven by imperfections in markets for goods or factors of production, including labor and technology. To make FDI profitable, a firm must have some distinctive asset—technology, global marketing capacities, management skills—not possessed by domestic firms (Blomstrom and Kokko, 1996). The firm is thus able to earn a “rent” by producing in the host community. Because the superior technology and/or management skills of foreign firms raise the efficiency and productivity of domestic firms, at least in theory, FDI is sometimes said to be“efficiency-seeking”. In addition, FDI can be “market-seeking”. If a government restricts imports, FDI may be prompted by efforts to get under import barriers or high tariffs, or to gain preferential treatment to third country markets. If transport costs are high, local production would promote competitiveness in local markets, especially if there are economies of scale. Many developing countries seek to attract FDI on the basis of low labor costs. Lacking the technology and/or global marketing networks of the TNCs, developing countries conceive of FDI primarily in terms of providing capital to employ low or unskilled workers. Differences in labor costs between countries are kept large by immigration restrictions, that in, an “imperfection” in global labor markets. An understanding both of what drives TNCs to invest globally and what determines the location of FDI is murky. Traditionally, studies have found that the most unambiguous “pull” factor drawing FDI to particular countries—both developed and developing--is the market size (per capita GDP) of the host economy (Chakrabarti, 2001). For the most part, it seems, TNCs invest where markets are large, either to expand markets or to earn rents, or both. With globalization have come predictions that “non-traditional” factors would increasingly determine the location of FDI, opening up new possibilities for developing countries. These factors include cost differences between locations, the quality of infrastructure, the ease of doing business, and the availability of skills. However, a recent study found that globalization has not “changed the rules of the game” and confirmed that market size is still the dominant driver of the distribution of FDI in developing countries (Nunnenkamp and Spatz, 2002). There is also close to a consensus that macroeconomic and political stability are needed to attract FDI. Countries with volatile exchange rates and high and growing trade deficits tend to be negatively correlated with FDI. Evidence on whether low (or high) labor costs attract FDI, on the other hand, is ambiguous. A review of sixteen studies found that, in six studies, low wages attracted FDI, while four studies found FDI to be correlated with higher wages and six found labor costs to be insignificant (Chakrabarti, 2001). Other studies emphasize the importance of human capital, in particular the level of education, in attracting FDI. There has been much debate in recent years about the role of environmental factors, especially differences in enforced standards, in attracting or repelling FDI. No consistent statistical evidence has been found that differences in standards affect TNC location decisions, presumably because, in most industries, environmental costs are a small component of total costs (Zarsky, 1999). However, case studies have found that in certain “dirty” industries, such as leather tanning, more stringent standards in OECD countries propelled companies to shift production to countries with lower standards (Mabey and McNally, 1999). Finally, there is the question of whether standards of treatment of foreign investors play a role in attracting FDI to particular countries. The surge in the number of Bilateral Investment Agreements (BITs) concluded in the 1990s was fuelled--at least on the part of developing countries--by the hope that expanding the rights and protections of foreign investors would attract FDI. However, there is no evidence that it has done so. Nonetheless, with over 2000 BITs in force, investor protections have become the norm. They may not provide marginal benefits, but their absence might have marginal costs in attracting FDI. FDI Trends in the 1990s
Inflows of FDI soared to unprecedented levels during the 1990s. From 1970 to 1990, global FDI inflows averaged $58 billion a year, or less than one half of one percent of global GDP. Between 1990 and 1995, FDI inflows averaged $225 billion per year and surged to $828 billion per year between 1996 and 2000. With a total of $1.5 trillion in 2000 alone, FDI inflows were 4 percent of global GDP (Figures 1.1 and 1.2). Originating from North America, Europe and Japan, the FDI boom affected both developing and developed countries. Indeed, the lion’s share— nearly three quarters on average—of FDI inflows went from one OECD country to another. However, the boom was big news in developing countries because FDI inflows started from a low base. In 1990, FDI comprised only about a quarter of all capital flows into developing countries. By 2000, the share of FDI had climbed to 60 percent (UNCTAD, 2002a, p. 12). Moreover, “official flows,” that is, multi-lateral and bilateral development aid (ODA), remained stagnant during the 1990s, with an annual flow of $54 billion. Many analysts began to predict—or hope--that FDI would “dwarf” or replace ODA as the primary source of global development capital. The promise of FDI as a replacement for ODA, however, largely remains to be fulfilled. For 55 of the world’s 70 poorest countries, ODA flows outstripped FDI in the late 1990s. For 42 poor countries, ODA flows were twice the size of FDI. Indeed, FDI “dwarfed” ODA in only seven of the poorest countries.[1] Source: UNCTAD, 2002 However, only a small part of
global FDI inflows—about 30 percent on average
between 1990 and 2001--went to developing countries. Indeed, the developing country share fell
off sharply between 1997 and 2000, falling from 39 to 16 percent. FDI
inflows are highly concentrated in ten, mostly large developing countries,
led by China, Brazil, and Mexico.
Between 1990 and 2000, the “top ten” garnered 76 percent of the total FDI flowing into developing countries. The trend towards
concentration seems to be intensifying: in 2001, the top ten share rose to 81
percent (Table 1.1).
Though they are miniscule in the global picture, FDI inflows to poor, developing countries may comprise a significant part of total national investment and/or GDP. For example, between 1996 and 1999, FDI comprised about 10 percent of GDP in Bolivia, 26 percent in Lesotho, and 26 percent in Thailand (Overseas Development Institute, 2002, Figure 9). Overall, the ratio of FDI to GDP in developing countries rose from about 1 percent to 3.5 percent between 1990 and 2000.
The 1990s FDI boom will probably prove to be a bubble, though the long term trend is towards expansion. [2] Global FDI inflows declined sharply in 2001, falling by nearly 51 percent. Data for 2002 suggest that this trend will persist: FDI inflows into developing countries fell from about $170 billion in 2001 to an estimated $145 billion in 2002 (World Bank, 2003b). However, Latin America accounted for nearly all of the contraction, while FDI in Asia held steady. Privatization Wave In both developed and developing countries, the 1990s FDI boom was led by cross-border mergers and acquisitions. According to UNCTAD, the share of cross-border M&As in world FDI flows increased from 52 percent in 1987 to 83 percent in 1999. Although most cross-border M&As occur within OECD countries, M&As accounted for close to 70 percent of FDI inflows to developing countries in 1999 (UNCTAD, 2000a, p. 14 and Table I.5). In developing countries, M&As were concentrated in newly privatized state-owned companies spanning water, energy, telecommunications and financial services. In Mexico, for example, the US company Citigroup acquired Banamex, Mexico’s largest bank, for $12.5 billion in 2001. The single transaction accounted for half of all FDI inflows to Mexico in that year (ibid). In many countries, the acquisition of formerly public
services by TNCs, especially water, has generated
widespread concern and popular resistance.
Despite promises of more efficient, reliable and equitable access to
water, social advocates are concerned that privatized water systems under TNC management will price the poor out of the
market. In Cochabamba,
Bolivia, for example, a “water war” erupted after the city’s water system
came under the management of an international partnership involving Bechtel
Corporation. When the price for water rose by between 35 and 400 percent,
city residents took to the streets and the municipal government canceled the contract (Dolinsky,
2001).[3] The privatization wave changed the sectoral
composition of FDI in developing countries,
substantially increasing the share going to the service sector. In 1999, services accounted for 37.3
percent of FDI inflows, up from 20.7 percent in
1988 (UNCTAD, 2000). Though shrinking in relative
terms in all regions except Africa, the manufacturing sector continues to
account for the largest overall share, about 55 percent in 1999. In all regions except Latin America, the share of FDI in the “primary” sector, mostly
agriculture and mining, decreased in the 1990s and accounted for only 5.4
percent in 1999 (ibid). Despite its small share in aggregate flows, FDI in the primary sector forms the largest share of overall inflows in particular countries, including some of the poorest. Among the 49 “Least Developed Countries”, four oil-exporting countries—Angola, Equatorial Guinea, and Sudan--receive nearly half of all FDI inflows. According to a recent report by UNCTAD, there is a strong link between dependence on primary commodities and poverty (UNCTAD, 2002b). III. Does FDI Promote
Economic Development?
The pursuit of FDI as an engine of growth is a formula prescribed by mainstream economic theory, as as well as the IMF and other global development organizations. “The overall benefits of FDI for developing country economies are well documented,” claims a 2002 report undertaken for the OECD’s Committee on International Investment and Multinational Enterprises (OECD, 2002b, p. 5). Based on consultations with OECD member governments and business, labor and NGO advisors, the report, titled Foreign Direct Investment for Development, Maximising Benefits, Minimising Costs, nicely sums up conventional wisdom about the promise of FDI: Given the appropriate host-country policies and a basic level of
development, a preponderance of studies shows that FDI
triggers technology spillovers, assists human capital formation, contributes
to international trade integration, helps create a more competitive business
environment and enhances enterprise development. All of these contribute to
higher economic growth, which is the most potent tool for alleviating poverty
in developing countries (ibid). In addition, the report goes on, FDI “may help improve environmental and social
conditions in the host country by, for example, transferring ‘cleaner’
technologies and leading to more socially responsible corporate policies” ( ibid;
emphasis added). The more qualified endorsement of FDI’s social and environmental benefits likely stems from the OECD’s own commissioned work in this area, including by one of the authors of this paper, which shows that the environmental impacts of FDI may be positive, negative, or neutral, depending on the industrial and institutional context (Zarsky, 1999;OECD, 2002a). But caution is also warranted in assessing the relationship between FDI and economic development. An examination of recent studies shows that, in this case too, the benefits of FDI are far from well-documented. Efficiency
Spillovers: Is Knowledge “Contagious”?
FDI generates rents to transnational corporations by virtue of their possession of superior technology, management and/or access to global markets. According to economic theory, host communities get “spillover” benefits of the superior asset(s). Indeed, “efficiency spillovers”, which occur through the transfer of technologies and management practices, are increasingly seen as the primary way in which to gauge the contribution of FDI to economic growth. Dubbed a “contagion” effect, knowledge is diffused to local firms and workers, raising the efficiency, productivity and marketing skills of domestic firms (Findlay, 1978). While knowledge diffusion is postulated for TNC investment in both developed and developing countries, it is the transfer from industrialized to developing countries that promises the greatest hope for global economic development. Efficiency spillovers can occur through several routes, including the copying of TNC technology by local firms and the training of workers who then find employment in local firms or start their own. The most important conduit, however, is the linkage between TNC affiliates and their local suppliers (Lall, 1980). TNCs generate spillovers when they: - Help prospective suppliers set up production facilities; - Demand that suppliers meet high quality standards and develop capacities for product innovation—and provide training to enable them to do so; - Provide training in business management; - Help suppliers find additional markets, including in sister affiliates in other countries. To what extent do TNCs actually undertake these activities in developing countries? Put another way, what is the empirical evidence that efficiency spillovers exist? Studies have been of two types: 1) statistical studies which examine trends in key macro-variables, such as domestic investment (gross fixed capital formation) and productivity; 2) case studies of particular industries, such as autos (Moran, 1998) and high-tech (Amsden and Chu, 2003). In developed countries, limited evidence suggests that the productivity of domestic firms is positively correlated with the presence of foreign firms, though one study found no independent growth effect of FDI (Carkovic and Levine, 2002). However, some studies found the magnitude of spillovers to be very small (Lim, 2001). Moreover, tax policies and other incentives to attract FDI distort firm technology and investment choices and generate negative spillovers—a loss in the efficiency of local firms (Blonigen and Kolpin, 2002). For developing countries, the evidence is mixed. Some studies have found clear evidence of spillover effects, while others have found limited or even negative effects (1.2). An IMF study found “overwhelming” evidence of productivity increases through technology transfer (Graham, 1995). However, a later literature review took a much more nuanced view, finding that a host of country- and industry-specific variables determined whether FDI generated technology transfer and diffusion in developing countries (Kokko and Blomstrom, 1995). Several studies suggest that the capture of spillovers depends on host country conditions. One found that the larger the productivity gap between foreign and domestic firms, the less likely were spillovers (Kokko, Tansini, and Zejan, 1996). Moran (1998) found that export performance requirements helped Mexico to capture spillovers from investment by US auto-makers. In their case study of Taiwan, Amsden and Chu (2003), found that spillovers were captured as a result of government policies, especially support for research and development for nationally-owned companies. Some studies find that, rather than generate positive spillovers, FDI generates negative spillovers. Krugman (1998) argues that, generally, domestic investors are more efficient than foreign investors in running domestic firms—otherwise, foreign investors would have purchased them. However, in a financial crisis, such as the crisis which swept East Asia in the late 1990s, domestic firms may be cash-constrained and be available for purchase at “fire-sale” prices. Krugman concludes that a superior cash position, rather than efficiency-enhancing technology or management, drives FDI. Another study argues that FDI is driven by the information advantage of foreign investors, who are able to gain—and leverage--inside information about the productivity of firms under their control. With their superior information, foreign firms can inflate the price of equities sold in domestic stock markets. The expectation of future stock market opportunities then leads to over-investment and efficiency (Razin, Sadka and Yuen, 1999). Overall, of the eleven studies reviewed for this paper, only three found unequivocably found that FDI generates efficiency spillovers in developing countries. Two found the opposite, while six found that FDI may or may generate spillovers, depending on local productive, policy or financial conditions (Table 1.2). The evidence suggests that there is no automatic or consistent relationship between FDI and efficiency spillovers, either for developing countries as a whole or for all industries within a county. Realizing the promise of FDI to transfer technology and diffuse knowledge requires conducive policy, institutional and market environments. Like the benefits of FDI itself, however, there is little consensus on what constitutes a “conducive” policy. Moran (1998) argues that a liberal trade and investment regime which allows TNCs maximum flexibility has the best chance of increasing the efficiency of local firms and integrating them into global supply chains. On the other hand, Moran also found that export requirements may work to speed up TNC host country investments which generate spillovers. Amsden and Chu (2003) conclude that the most important ingredient in capturing spillovers and indeed, in increasing productive capacity in “latecomer” states is a strong state acting to nurture domestic firms through effective, market-friendly and performance-related subsidies.
Crowding In--or Crowding Out--Domestic Investment?
The central promise of FDI is that it promotes economic growth, not only through efficiency spillovers but by stimulating or “crowding in” domestic investment. By increasing the productivity and efficiency of local firms, spillovers themselves can help to stimulate domestic investment. But the “crowding in” effect of FDI on investment may be gained whether or not there are technology spillovers or even if much value beyond labor is added in local production. Assembly operations, for example, where workers put together components made elsewhere, can still drive domestic investment and growth via increases in local consumer demand.[4] On the other hand, TNCs may undermine local savings and “crowd out” domestic investment by competing in product, service and financial markets and displacing local firms. The loss of domestic firms can undermine market competition, leading to inflated prices and lower quality products. TNCs can also crowd out domestic investment by borrowing in domestic capital markets, thus driving up interest rates and cost of capital to business. High domestic interest rates may also be the result of deliberate government policies to attract foreign capital. The higher-than-global-average interest rates will also cause the exchange rate to be overvalued, further crowding out domestic firms producing for export. While foreign firms will also suffer from loss of competitiveness, the impact is cushioned by their access to foreign sources of financing. While much is made of the potential for FDI to increase foreign exchange earnings, there is a risk that it will instead contribute to crises in the balance of payments by repatriating profits and by increasing the rate of imports faster than the rate of exports.[5] Taken together, the risk is that FDI could lead to an overall contraction, rather than an increase, in domestic investment and economic growth. Indeed, in a study that generally argues for the potential benefits of FDI, Moran (1998) cautions that “the possibility that FDI might lead to fundamental economic distortion and pervasive damage to the development prospects of the country is ever present” (p. 2). What is the more likely “face” of FDI? A host of studies over the past decade have examined the nature of economic benefits and the conditions under which they are—or are not—captured (Table 1.3). Moran (1998) reports on the findings of three separate “net assessments” of the impact of FDI covering 183 projects in some 30 countries over the past 15 years. Two studies found that FDI had a positive impact in 55 to 75 percent of the projects they studied. But one study found that FDI had “a clearly negative impact on the economic welfare of the host” in an astonishing 75 percent of the projects studied (p. 25).
Economy-wide studies generally have found both positive and negative impacts of FDI on domestic investment. For example, a study by the Brookings Institution covering 58 countries in Latin America, Asia, and Africa found that a dollar of FDI generates another dollar in domestic investment (Bosworth and Collins, 1999). On the other hand, many studies have found that the investment and/or growth impacts of FDI could be positive or negative, depending on a variety of variables, mostly having to do with host country policies. One study found that the impact of FDI is significantly positive in “open” economies, and significantly negative in “closed” economies (Marino, 2000). Others have found that positive impacts depend on the effectiveness of domestic industry policies; and on tax, financial or macroeconomic policies A World Bank study found that the impacts of FDI depend on the structure and dynamics of the industry, as well as host country policies (World Bank 2003a). In its recent report on the role of FDI in development, the OECD concluded that the overall benefits of FDI, while depend on “the appropriate host-country policies and a basic level of development” (OECD 2002b, p. 9). Several studies suggest that, to capture the benefits of FDI, a country must already have reached some kind of “development threshold”. One found that FDI raises growth only in countries where the labor force has achieved a minimum level of education (Borensztein. Gregorio and Lee, 1998). Another found “significant cross-country diversity” in terms of the catalytic role of FDI in developing countries and concluded that the key variables are “country-specific factors”, including institutions and policies (de Mello, 1999, p. 148). Overall, of the twelve studies reviewed for this paper, three found positive links between FDI and economic growth, while one found a negative link and eight studies found that “it depends” Like efficiency spillovers, the positive benefits of FDI on domestic investment and growth depend largely on domestic policies, capabilities, and institutions. IV.
FDI and the Environment In the last decade,
a surge of regional and bilateral investment agreements have promoted the
liberalization of investment regimes. These agreements increase expand the
rights of foreign investors but, with few exceptions, articulate no
environmental or social responsibilities of either investors or governments.
Many in the sustainable development community are concerned that, without an
environmental framework,
liberalization will accelerate environmental degradation (Mabey and McNally, 1999).
The impacts of FDI on the environment can
be traced through three routes: ·
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