The Role of FDI of Economic Growth of The Host Economy

There has been a divergence of empirical findings with regard to the impact of FDI on the host economy. Some have identified a positive relationship between the influx of foreign capital and the growth of the host economy while others show no such effect. Spill over benefits have been identified by some studies while, on the other hand, other researchers do not discern such benefits (Nunnenkamp 2002).
Hence, researchers have for many years debated whether devoting substantial resources to attracting more of foreign capital may or may not be of significant benefits to the host economy. This paper focuses on examining the effect of influx of foreign investment on the growth of the host economy. In this paper, we examine whether, to what extent and under what conditions FDI does enhances the economic growth of the host economies.

This will include an examination of the benefits accruing from FDI including employment creation, human capital development, enhancing enterprise development, increased global integration, and increased corporate tax revenues. Technology spillovers, wage effect and the impact of FDI on balance of payments will also be critically examined. Finally, policy recommendations towards maximizing on the benefits of FDI in the host country are put forth.
The past two decades have seen FDI by Multinationals become the main source of funding in the developing economies. Yet evidence on the relationship between MNCs investment and the economic growth of the host economy is still far from conclusive (Fortanier, 2007). There has been a divergence of empirical findings on the effect of FDI on the host economy.
Some have identified a positive relationship between the influx of foreign capital and the growth of the host economy while others show no such effect. On the one hand, Sjoholm (1997b), Xu (2000) and De Mello (1999) found a positive contribution of FDI to the host economy. Consistent with the above, Baldwin et al. (1999) noted technology spillover benefits to the local firms. OECD (1998) and Borensztein et al (1999) presented evidence of a larger impact of FDI on the host economy than investment by the local firms.
On the converse, Kawai (1994), while examining the Asian and Latin American countries, found a negative association between FDI and economic growth (with exception of Taiwan, the Philippines, Indonesia, Singapore, and Peru). Consistent with this findings; Mencinger (2003) and Djankov and Hoekman (1999) noted that FDI had more negative than positive impacts to the economic growth of the Central and Eastern European Countries.
The divergence of empirical findings is due in part to the methodological issues such as research design; and partly due to the host country characteristics such as institutions, openness to trade and technological development. Whether there is a positive or negative association between FDI and the growth of the host economy is a fervently debated research question. The question of whether multinationals tend to generate more of positive or negative externalities to the host economy is subject to debate.
This paper thus revisits the relationship between FDI and economic growth. We focus primarily on FDI effects to the host economy. We examine the extent to which foreign investments can enhance the growth of the host economy. In doing so, we are able to determine whether devoting substantial resources to attracting more of foreign capital may or may not be of significant benefits to the host economy. Before examining the impact of FDI on the growth of the host economy, it is important first to understand what we mean by Foreign Direct Investment.
In this regard, foreign direct investment (FDI) can be defined as any investment abroad, and in which the foreign company retains ownership and control of the firm that is being invested in. That is, any investment from a foreign firm with the aim of acquiring a lasting management interest in the local firm that is being invested in (Brooks et al. 2003).
With the above in mind, it is worth noting that FDI plays a crucial role in global business as it acts as a major catalyst to development and is certainly the main driver of economic globalization (Brooks et al. 2003). On its own, FDI accounts for nearly half of all the investments across the border. Clearly, it is an integral part to a more effective and open international economic system. The effects of FDI on productivity of the host country will be discussed in detail below.
The influx of foreign investments affects the growth of the host economy through 3 key mechanisms (Fortanier, 2007):
Structural effects
Technology and skill effects
Size effects
This refers to the net contribution of foreign capital to the investment and savings of the host country (Fortanier, 2007). Take for example, FDI’s contribution to the host economy via increased corporate taxation. The profits that are generated from the high corporate taxation can be used in improving on the welfare of the country. Further, FDI may contribute to the economy by creating more job opportunities, developing the human capital and reducing the poverty levels, especially in the developing economies. The high corporate tax revenues collected may be used in funding poverty alleviation programs, hence reducing on the poverty levels (Bosworth & Collins, 1999).
There is also the benefit of increased economic integration due to cross-border flows of foreign capital which has the impact of further strengthening the relationships between countries (Fortanier, 2007). Additionally, this global mobility of capital may restrain governments from pursuing bad policies. These benefits accruing from FDI including employment creation, human capital development, increased global integration, and increased corporate tax revenues will certainly improve on the welfare of the host economy (Rodriguez and Rodrik 2001).
However, this may not necessarily be true. For instance, it is not always the case that FDI may result in job creation. In fact, under certain circumstances it may result in more job losses probably due to outsourcing of expatriates and imported labour. Also, multinationals may deliberately evade or minimize their task liabilities by using tax planning techniques and transfer price manipulation. These multinationals may, for instance, may distort the allocation of expenses and revenues through transfer pricing policies hence giving a false reflection of the taxable profits (Eden 1998). In most circumstances, the profits are often manipulated to a value lower than the actual amount in order for under taxation to occur.
Nonetheless, this net contribution of FDI affects the growth rate of the host country’s production base. Baldwin et al. (1999) has however pointed out that most of the potential benefits of FDI to the host economy results from the more indirect effects. That is, either through the structural change in markets or through the transfer of technology and skills.
Technology spill-over benefits to the host economy has to do with the presence of transnational corporations (TNCs) (Baldwin et al, 1999). Generally, Transnationals/multinationals are often concentrated within the technology-intensive industries and certainly play a crucial in the transfer of skills and technology across borders (Baldwin et al, 1999). The technology brought in by TNCs/MNCs can “spill over” to the domestic firms through labour migration, demonstration effects and also through linkages with sellers and buyers (Blomstrom et al. 1999). The domestic corporations may utilize this technology towards increasing their productivity hence improving on the welfare of the host economy.
It should however be noted that technology spillovers may under certain circumstances be counterproductive to the growth of the host economy. For example, the technologies brought in by TNCs may not be appropriate to the welfare of the host economy (Ikiara 2003). With regard to the technology spillovers, Pavlinek (2004) notes that most of the investments by TNCs are often profit driven. He suggests that TNCs may thus employ strategies which may not necessarily coincide or be appropriate to welfare of the host economy. For example, technology transfer may be inappropriate to the stage of development in the host country, thereby creating more “cathedrals in the desert” and very little spill-over benefits to the host economy.
The structural effects comprise of the horizontal changes, in particular, competition; and the vertical changes, particularly the linkages with the sellers and buyers (Fortanier 2007). Investment of TNC can stimulate competition as well as improve on resource allocation, especially where the domestic competition is limited by high entry barriers (Fortanier 2007). The entry of TNCs and the opening up of new business enterprises will certainly increase the output and result in a net improvement in the welfare of the economy.
There is however a downside to this effect. Given their superior technology, access to larger financial resources and the exploitation of economies of scales; TNCs may out-compete the local firms hence resulting in “crowding out” (Agosin & Mayer, 2000). Crowding out may not be problematic in the economic sense. However, where there is an increase in market concentration as a result of crowding out, the risk of monopoly rents and deterioration in the allocation of resources will certainly increase (Agosin & Mayer, 2000).
Spillovers may also occur through linkages between the local suppliers and foreign affiliates (McIntyre et al., 1996). These linkages can improve on the local supplier’s overall output in terms of their productivity and quality; especially if paired with training (McIntyre et al., 1996). This however, may not necessarily be true as TNCs may as well source their inputs via their own production networks and this may, in the long run, have potentially negative effects on host country’s trade balance (De Mello & Fukasaku, 2000).
Despite the many benefits accruing from inward flow of FDI into the host economy, it should be noted that FDI may significantly impact on the balance of payments in the host country. Although, foreign direct investments may tend to create healthy external accounts, it should be noted that the profits generated by TNCs are usually remitted back to foreign owners (IMF 1993). Hence, while FDI may make the accounts to appear healthy, there might be a negative transfer of resources to the host economy which may then have adverse effects on the balance of payments. .
The wage effect of FDI may either be positive or negative (Gopinath & Chen 2003). There certainly is a consensus amongst scholars that foreign firms do provide higher wages to the domestic labour relative to the domestic firms (Gopinath & Chen 2003). Given that these firms pay higher wages, there might be “wage spillovers” whereby the higher wages paid by the foreign firms lead to increased wages in the local firms (Gopinath & Chen 2003).
On the negative side, however, foreign investments might result in increases in wage inequality in the host economy. Although economists largely contend that foreign firms do provide higher wages relative to the local firms, empirical evidence has identified a positive relationship between foreign investment and wage inequality (Gopinath & Chen 2003). In this respect, Gopinath and Chen (2003) analyzed the impact of foreign investment on wages in a sample of 11 developing countries. They found that the influx of foreign investment increased the wage gap between skilled and unskilled labourers. Having said the above, it can be noted that although foreign investments may lead to higher wages, it may result in increases in wage inequality in the host country.
Despite a few negative externalities described above, it is worth noting that FDI plays a vital role in the growth and development of the host economy. The overall effects of FDI including the size effects, structural effects and the technology and skill effect will certainly improve on the welfare of the host economy and further enhance growth.
The benefits outlined above however are dependent principally on certain factors. Chief among these are the policies, institutions and the regulatory framework of the host economy (Velde 2001). To maximize on the net benefits of FDI on the host economy, it is imperative for the government to ensure best-practice policies towards.
Industrial policies such as the ownership and administrative procedures must be aligned towards attracting more of FDI (Velde 2001). Administrative procedures may significantly affect the investment of TNCs in the host country. Take for example, Uganda and Ghana where it takes upto 2 years to have a business operational. The overly complex registration procedures are a huge impediment to the success of foreign firms in the developing economies.
Common Procedural hurdles can be located with the general investment approval, expatriate work permits and the overly complex tax registration and business licensing procedures as well. Other procedural hurdles may also be located with the more specialized approvals including access to land and site development (Velde 2001). Given the above, there is an imperative need to ensure convergence of procedures towards best-practices so as to maximize on FDI benefits in the host economy.
Investors, both foreign and domestic, often suffer from potential uncertainties (Safarian 1999). Foreign investors, however, usually suffer from a higher degree of uncertainty than the domestic counterparts because they are usually more disadvantaged about the host country’s information. Therefore, in many cases, foreign investors would wait until the domestic investors have tested the ground. Interventions such as offering modest grants and providing information incentives are needed so as to speed up the process of investment (Safarian 1999).
The government may signal their commitment to liberal trade by ensuring a stable economic environment and coming in aid of multinationals by developing the financial markets (Velde 2001). An important point to note is that if the financial markets of the host economy are weak there would be hesitance to channeling funds on the part of the foreign investors due to the fear of devaluation (Velde 2001). Therefore, as a trade policy instrument, there is need for the government to ensure a stable economic environment and commitment to free-trade and liberalization.
The importance of convergence of policies towards attracting more FDI can be seen in China where the electronic industry has become very successful. China’s open door policy prioritizes on securing more of inward FDI in order to upgrade its domestic manufacturing capabilities. Today, Samsung, Toshiba, Siemens, NEC, Hitachi, Philips and IBM amongst others have invested heavily in China. This has led to a dramatic growth of the electronic industry in China (Fortanier 2007). The open door policy allows china attract more FDI which is then used in enhancing the domestic manufacturing capabilities.
From what can be discerned, FDI can affect the economic growth of the host country through the 3 mechanisms discussed above. That is technology and skill effect, size effect and structural effect as well. There is however no single FDI effect on the host economy. It all depends on the host country’s characteristics. For instance, it can be argued that FDI brings more spillover benefits to the host economy only if the minimum threshold level of human capital and the host country itself is more export oriented. Further, it can be argued that effects are more pronounced if FDI is focused on technology intensive sectors. It can therefore be concluded that FDI effects on the economy differ across host countries depending on their specific conditions.
Equally important to note is that the benefits of the FDI to the host economy do no accrue automatically and that they are dependent principally certain factors such as the policies, institutions and regulatory framework. Policy recommendations for the host economy should thus focus on convergence of procedures towards best practices, if they are to maximize on the benefits of FDI.
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