post-autistic economics review
Issue no. 37, 28 April 2006
article 2



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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.



Source: UNCTAD, 2002.


            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, FDImay 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.



Table 1.2


Does FDI Generate Spillovers in Developing Countries?




Yes, No, Maybe



Aitken, Hanson  & Harrison



Foreign firms act as export catalysts for domestic firms (in Mexico)


Aitken & Harrison



No evidence of spillovers (Venezuela)


Amsden & Chu



Government industry policies actively promote nationally owned firms






Increases productivity of domestic firms


Kokko & Blomstrom



Depends on industry and country characteristics, especially policy environment






Increases productivity of domestic exporting firms (Mexico)






Kokko, Tansini and Zejan



Productivity gap between foreign and domestic firms can’t be  too big (Mexico and Uruguay)





Domestic investors are more efficient but foreign investors have superior cash position.


Lensink & Morrissey



Reduces costs of R&D and promotes innovation





Liberal investment climate must encourage integration of local firms into TNC global sourcing and production network


Razin, Sadka, and Yuen



Foreign investors can speculate on domestic stock prices, leading to over-investment and inefficiency.




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).

Table 1.3

Does FDI Promote Economic Growth in Developing Countries?


Study Author(s)


Yes, No, Maybe

Key Variables


Balasubrmayam, Salisu & Sapsford





Requires open or neutral  trade regime


Borensztein, Gregorio & Lee




Depends on education level of workforce


de Mello



Depends on degree of complementarity and substitution between FDI and domestic investment.


Graham and Wada



Raised per capita GDP in Chinese provinces with FDI concentration





TNC’s market power can generate negative



Lensink & Morrissey



Reduces costs of R&D and promotes innovation


Loungani & Razin








Depends on tax incentives, regulatory & legal impediments, macroeconomic instability





Requires open trade and investment policies


Mallampally & Sauvant



Requires human resource development; information and other infrastructure

Markussen & Venables



Raises productivity and exports of domestic firms; generates spillovers





Reverse causality: TNCs locate, rather than drive growth, in more productive and faster growing countries




            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:

·         Environmental performance of TNCS;

·         Impacts of economic growth on scale and composition of industry; 

·         Impacts on national and global environmental regulation.


            In this section, we sketch the key mechanisms at play in each of these routes and review some of the theoretical and empirical literature (for a deeper look at the FDI-environment relationship, see  Zarsky, 1999).


Performance of TNCs

            Two critical strategic and management decisions of TNCs affect their environmental performance.  First is the choice of technology, viz, whether to invest in newer, cleaner “best available” or to “dump” older, dirtier technologies.  In most industries, a range of technologies are in use. Efficiency and “clean-ness” may be a function as much of industry sector as of company choice: some industries are more technologically dynamic than others.

            The second decision has to do with management practice, viz, whether the corporate parent has implemented an effective EMS (environment management system) and required the same of its overseas subsidiaries and suppliers. NGO advocacy campaigns have increasingly demanded that  TNCs to adopt “voluntary initiatives” to go “beyond compliance” in global operations.

            One of the promises of FDI for sustainable development is that TNCs, especially from the OECD, will help to drive up standards in developing countries by transferring both cleaner technology and/or  better environmental management practices.  The evidence for such a trend, however, is mixed. A case study of foreign investment in Chile’s mining sector in the 1970s and 1980s  found that foreign companies not only performed better than domestic companies but diffused better environmental management practices (Lagos and Valesco,1999).  A volume of case studies of FDI in  Latin America in the 1990s, including bananas in Costa Rica and soybeans in Brazil, concluded that FDI promotes better management practices (Gentry, 1998).

            Other studies have failed to find a positive link between foreign firms and environmental performance in host countries.  In statistical studies of Mexico (manufacturing) and Asia (pulp and paper), World Bank researchers found that foreign firms and plants performed no better than domestic companies. Instead, environmental performance was found to depend on 1) the scale of the plant (bigger is better);  and 2) the strength of local regulation, both government and “informal” (Dasgupta et al, 1998; Hettige et al, 1996).

            A recent study which examined the environmental performance of TNCs in India had nuanced findings (Ruud, 2002). On the one hand, TNCs were found generally to be transferring state-of–the-art production (though not necessarily pollution control) technologies, rather than dumping older and dirtier technologies. In addition, TNC affiliates were strongly influenced by corporate parents to improve environmental management.

            On the other hand, there was no evidence that better environmental management practices were diffused by TNC affiliates to local partners, suppliers or consumers. The author concludes that there is no evidence that TNCs drive a “race to the top”—or the bottom. Rather, the chief insight is that local norms and institutions are of central importance in determining TNC practices and therefore,  FDI inflows do not automatically create a general improvement in environmental performance (Ruud, 2002, p. 116).

            Many developing countries, especially the poorest,  lack the capacity and/or political will to enforce environmental oversight of industry. In this context, TNCs are largely able to “self-regulate” and have one of three choices: 1) follow local practice and norms; 2) adopt  company-wide global standards based on home country standards; or 3) adopt international standards or “best practice” norms for corporate social responsibility.

            Best practice may entail the embrace of broad and encompassing norms, not only for companies themselves but also for their suppliers,  such as the OECD’s Guidelines for Multinational Enterprises (MNEs) (Table 1.4). The Guidelines spell out eight good practices, including the implementation of an environmental management system and consultation with stakeholders. They also extend good practice to the supply-chains of MNEs. Other approaches to best practice include implementing standards developed by industry associations, such as the chemical industry’s Responsible Care initiative.



Table 1.4


OECD’s  Environmental Guidelines for MNEs 


1. Establish  an environmental management, which includes

       a)  information regarding environmental, health, and safety impacts

       b)  measurable objectives and targets for improved environmental performance

       c)   monitoring and verification of progress towards targets.


2. Provide adequate and timely information on the potential environment, health and safety impacts of the activities of the enterprise; and communicate and consult with stakeholder communities.


3. Consider full life cycle impacts of production processes, goods and services


4. Use precautionary principle


5. Maintain accident, emergency and contingency plans


6. Continually seek to improve environmental performance by

      a)  adopting  best practice.

      b)  developing products with low environmental impact, including recyclable

          and energy-efficient

      c)  promoting customer environmental

      d)  research ways to improve environmental performance  over the longer term.


7. Provide training to employees on environment, health and safety


8. Contribute to the development of environmentally meaningful and economically efficient public policy


Source:  OECD 2000



            Companies make different choices, depending on company culture and the industry they are in. In the petroleum and mineral industries, case studies suggest that TNCs have tended to follow—or even to worsen--local practice (Rosenthal, 2002; Leighton et al, 2002). In many parts of the world, mining operations have generated severe environmental degradation and pollution, including the discharge of toxic substances into river systems, large volume waste disposal, the inadequate disposal of hazardous wastes, and the long run impacts of poorly planned mine closure (Sandbrooke and Mehta, 2002).  Multinational oil companies have been the target of protest and criticism for widespread pollution and human rights violations in the Amazon region, Nigeria, Indonesia,. and, increasingly, the Caspian region.

            In the high tech sector, on the other hand, American and European TNCs tend to adopt either company-wide standards or international “best practice” for environmental management and community consultation. Within the industry, however, there are “leaders” and “laggards”  (Zarsky and Roht-Arriaza, 2002).

            One mechanism by which TNCs affect environmental performance in developing countries is via requirements on suppliers and sub-contractors.  An increasingly popular trend is for large TNCs to require that suppliers be certified to ISO 14,001, an international standard for environmental management systems.



Scale and Composition Effects

            One of the potential, if not automatic, benefits of FDI is that it stimulates economic growth. Without adequate global and national regulation, however, economic growth is likely to accelerate environmental degradation—even if TNCs are good performers--through scale effects. The experience of East Asia, often described as an “economic success story,” provides a tragic example. According to the Asian Development Bank, resource degradation and environmental pollution in both East and South Asia is so “pervasive, accelerating, and unabated” that it risks human health and livelihood (Asian Development Bank, 2001,  p. 2). 

            The scale impacts of economic growth on the environment derive largely from unsustainable production and consumption patterns. If FDI was channeled into  sustainably produced and sustainably transported goods and services, then the overall impact--even of rapid and high growth--on the environment would presumably be neutral or low. To date, however,  rapid growth, in developing and developed countries alike, has tended to be associated with an increase in unsustainable production and consumption patterns (WWF, 2002).

            Potential environmental benefits of FDI may flow from changes in the structure or “composition” of industry.  In theory, FDI flows to more efficient companies and industries. Greater economic efficiency translates into greater environmental efficiency via reduction per unit output of productive inputs such as energy, water, and materials, as well as reductions in wastes. The “pollution intensity” of an economy overall, in other words, can be reduced by a change in the relative mix of industries, as well as by changes in the “eco-efficiency” of companies within industries.

            While acknowledging that environmental impacts can worsen with an increase in the rate of growth, some economists argue that, over time, economic growth generates environmental improvements. The “Environmental Kuznets Curve” posits that environmental quality first worsens and then improves as per capita income (GDP) rises. [6] Reasons include the substitution of less polluting consumer goods; changes in the structure of industry; and greater political demands for environmental regulation. Early studies put the “turning point” at between US$3000 and US$5000 (Grossman and Kruger,

            If true, the EKC suggests that, to a large extent, the pursuit of economic growth is itself a sustainable development strategy. One major concern, however, is that the environmental and resource degradation at lower levels of income often results in irreversible losses. Examples include loss of biological and genetic diversity and potable water due to degradation or destruction of “old growth” forests; depletion or destruction of fish stocks due to coastal degradation; and human deaths resulting from severe air pollution. Given the number of people on the planet living today at very low levels of per capita income, the potential environmental (and human)  losses which must be endured before the global “turnaround” are staggering.

            Another concern is that a positive relationship between income and environmental quality in one country or region might mask a relocation of dirty industry to another country or region, resulting in an overall neutral or even negative global environmental impact. Many East Asian studies in the 1980s and 1990s, for example, documented the correlation between improved environmental quality in Japan and the relocation of Japan’s pollution-intensive industries to South East Asia (Mani and Wheeler, 1997).

            Most important, a number of studies question the validity of the EKC hypothesis itself, especially for developing countries (Stern, 1998). The evidence in support of   a “turning point” is limited to a small number of localized pollutants, primarily sulfur and particulate matter.  For many other environmental problems such as water pollution, municipal waste, carbon dioxide, and energy use, no consistent evidence has been found that performance increases with higher levels of income.



Environmental Regulation: Stuck in the Mud?


            Environmental and resource management is largely the preserve of nation-states. How does FDI affect national (and-sub-national) environmental regulation? There is evidence that TNCs themselves, wielding their substantial bargaining power, can help to drive local standards up—or down. In Chile in the 1970s and 1980s, foreign mining companies pressed for more coherent environmental regulation. In the Russian Far East, on the other hand, oil TNCs involved in obtaining leases for exploration and drilling off of Sakhalin Island in the 1990s flouted and undermined Russia’s fledgling environmental laws Rosenthal., 2002). 


            The asymmetric bargaining power of TNCs vis-à-vis local governments is most troublesome in the context of the intense competition for FDI in both developed and developing countries.  Given the absence of global environmental standards, would-be host governments seeking to attract FDI may be reluctant to make higher-than-average environmental demands on individual TNCs. They may even be tempted to offer lower-than-average environmental demands to enhance the attractiveness of an overall package.  

            Dubbed by one of the authors of this paper as the “stuck in the mud” problem,  the impact of intense global competition for FDI—absent common environmental norms--is thus likely to inhibit the rise of environmental standards (Zarsky, 2002; Oman, 2000). The problem afflicts both developed and developing countries: efforts in the 1990s to put a modest tax on carbon were roundly defeated in both the US and Australia by worries that investment would move offshore.


            There is some evidence that, despite regulators’ fears,  high environmental standards do not, in fact, deter investors and in some cases, are even preferred by investors (Bradford and Gentry, 1998). Moreover, with the rise of the global corporate social responsibility movement, TNC and host-government expectations may be changing.

            Overall, an examination of all three of the channels linking FDI and the environment suggests there is no determinate trend: FDI  can improve, worsen or have no impact on environmental quality. Other factors—government regulation, the rate of economic growth, company culture, the particular industry in which the FDI takes place, the rules that govern FDI—are key variables.

            The paper has also shown that there is a “disconnect” between the globally integrated and the domestic parts of the economy. As a result, hoped for employment and income benefits did not materialize. Most worrisome, FDI has not stimulated backward linkages or increased the endogenous capacity for innovation. In addition to its economic role, the capacity for innovation is crucial to reducing the environmental impacts generated by increasing the scale of economic activity.



V.  Conclusions


            The overwhelming evidence makes it easy to conclude that FDI is no “miracle drug”. What needs fleshing out are the subtle and difficult questions that flow out of this analysis:

·         What kinds of local policies would best capture the potential growth benefits and efficiency spillovers of FDI?

·         Are the poorest, least developed  countries better off without FDI? 

·         How much “room to move” do developing countries have to shape local policies towards FDI, given the constraints on national policy in regional and bilateral (and potentially global) investment agreements? 

·         Can voluntary TNC practices raise the probability that FDI will deliver environmental, social and economic benefits to host communities and countries?

·         To best garner the potential development benefits of FDI, how should investment be governed at the supranational level?


            Fully developed answers to these questions  are beyond the scope of this paper.  What our analysis does suggest, however,  is that a first step is to eschew the search for a “miracle drug” and to embrace the need to develop more fulsome,  domestically-oriented development strategies. Moreover, our analysis make clear that structuring investment regimes solely around the interests and concerns of foreign investors will not necessarily deliver economic, environmental or social benefits to host communities.


            The centerpiece of a more fulsome, sustainable development strategy should be the nurturance of endogenous capacities for production and innovation.  Rather than skew policies towards attracting foreign investment,   macroeconomic policies should aim to enhance the overall climate for investment, both domestic and foreign. Rather than encouraging FDI to flow towards export platforms for the assembly of imported inputs, industry and technology policies should aim to develop local skills, local markets, and solid, world-class domestic firms. With the right set of local—and global—policies, FDI could potentially help in that process.





1. Vietnam, Angola, Lesotho, Ecuador, Turkmenistan, Azerbaijan and China. 

2. For developed countries, the drop-off was 49 percent; for developing countries, it was 82 percent.

3. In response, Bechtel sued the city under a bilateral investment agreement between Bolivia and the Netherlands, where the partnership is incorporated.

4. Such operations, however, have “shallow roots”  and are vulnerable to being relocated to other locales where labor and other production costs are cheaper.

5. This is precisely what happened in Mexico’s manufacturing sector in the 1990s.

6. A landmark article  by Simon Kuznets in 1955 posited that inequality first rises, then falls with increases in per capita income. Development policymakers evoked the theory for decades to argue that inequality could be ignored in the short term. More recently, empirical evidence has faded, leading economists to conclude “there is no empirical tendency whatsoever in the inequality-development relationship” (Fields, 1995). 

7. This section draws from Kevin P Gallagher and Lyuba Zarsky, Sustainable Industrial Development? FDI and the Integration Strategy, paper presented to conference on “New Pathways for Mexico’s Sustainable Development,” Science, Technology and Development Program (PROCIENTEC), El Colegio de Mexico, Mexico City, October 20-21, 2003.

8. Criteria air pollutants are non-toxic air pollutants such as  NOx, SOx, SO2, NO2,

VOC, HC, all particulates, and carbon monoxide.

9. Authors’ calculations, based on Corbacho and Schwartz (2002).





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Author contact:


Kevin P.Gallagher and Lyuba Zarsky, “Rethinking Foreign Investment for Development” post-autistic economics review, issue  no. 37, 28 April 2006, article 2, pp.10-32,