Foreign Direct Investment Essay Sample

Foreign Direct Investment

One of the remarkable traits of globalization during the last decades is a flow of private capital in a form of foreign direct investment (FDI). FDI refers to an important source of economic development and productivity growth. Direct investment usually involves joint-companies, transfer of technologies, purchase of shares, etc. It is a tool that contributes to the new investment, innovative technology, management modernization, and market exchange. Furthermore, FDI results in the development of soft skills in a course of training and job relations. The greatest example of FDI positive spill overs is China that refers to the largest recipient of foreign investment. Despite the fact of being still a developing country, this country shows a persistent economic growth. However, the effect of FDI on home and host economies differs from a country to a country. Sometimes the presence of foreign firms may damp down the host market and cause some social tension. The paper discusses the changes in FDI over the past decades and the key aspects of OLI framework, provides a comparison between spill overs for home and host countries of FDI, and characterizes the main determinants of FDI and its effect on economic development.

Foreign direct investment plays a growing role in international relations. It provides a company with a new market, beneficial production facilities, innovative products, marketing channels, technologies, new abilities, and financing. FDI may have different forms, such as a direct acquisition of the organization, investment in a joint firm, collaboration with a local venture, mergers, building new factories, etc.

The magnitude of FDI inflows is relatively growing now. However, the highest peak was in 2007-2008 years, before the world crisis, as represented in the figure 1. During the whole period, there was a significant exchange of investment between developed countries due to a favourable and beneficial investment climate. Developing and transition economies have come increasingly to see foreign investment as a resource of economic growth and modernization.

The quick growth of population since 1960s has happened mainly in countries with developing economies. It has led to a rapid increase in total income, income per capita, and GDP. This factor has become an impulse to invest money into developing economies. The main direction of FDI inflows among developing countries are Asia and Latin America (primary, manufacturing and extractive industries). These states have made a rapid improvement over the 1980s and 1990s using the spill overs of foreign direct investment. Developing economies have many positive factors to present to potential investors, including the steady economic growth, upgraded technologies, a large scale of production, and expanding labour market. The leading countries in this sector include China, Singapore, Brazil, Mexico, India, and Indonesia. African states are less attractive to foreign investors and come up near 5% of total FDI inflows in developing economies (‘FDI in figures 2014’ 2014). Recipients of FDI often channel foreign investment into the infrastructure system or other projects that may develop domestic economy.

FDI in transition countries involves inflows in Southeast Europe into manufacturing and services. The main recipients are the Russian Federation, Kazakhstan, Turkmenistan, and Ukraine. The main investors in the region are neighbouring countries who are attracted by the region’s growing market and natural resources.

The list of main investors of FDI in the world begins with the United States, followed by the United Kingdom, Hong Kong, France, and Belgium. The net inflow of the investment in these countries is near $230 billion (‘FDI in figures 2014’ 2014).

OLI Framework

There are many theories, which explain the determinants of foreign direct investment. The way to study FDI is an eclectic approach developed by John Dunning. The eclectic approach or OLI framework underlines three potential sources of benefits for a company to become transnational. The first variable (O) stands for an ownership competitive advantage. This component assumes that the greater competitive advantages of the investing company the more likely it is to be engaged in foreign activities. The next element is a location advantage (L) which focuses on the question where to make an investment. The key point of this variable is that the more favourable foreign conditions are the more firms will opt for a form of a multinational enterprise (MNE). The last element is an internalization advantage that evaluates different forms of FDI that the company can organize in different countries. The OLI framework confirms that the greater advantages of international activities, the more likely the organization will prefer to be engaged in foreign production.

Regarding the eclectic approach, there are four main types of multinational enterprise activities:

  • FDI is demand oriented; hence, the market seeking goals prevail.
  • The purpose is to get new resources (the resource seeking activity).
  • A foreign-based activity is based on efficient specialization of assets. The FDI refers to efficiency-seeking.
  • The goal is to protect the existing positions of the company and reduce competition (strategic asset seeking) (Dunning 2000).

Determinants of FDI

Besides the OLI framework that describes the motives of the investing firm, there are a number of macroeconomic variables. Among them, according to Walsh and Yu (2010), the most important ones are:

  • market size of the host country and its potential for a great demand and low costs.
  • openness of the country, and its export/import conditions.
  • labour costs and productivity.
  • political stability and administrative efficiency.
  • an infrastructure that may be a great stimulus for investment if it is developed or a great obstacle if it is not.

The list of determinants may also include additional variables, such as taxation, clustering effects, exchange rate or institutions. The range of determinants depends on the host-country, a sphere of industry, and a size of a multinational company. The effect of above-mentioned variables on FDI flows may be both positive and negative. The role of investment in host economies is represented by definite indicators, such as the share of inward FDI in the gross fixed capital formation (GFCF) and the share of inward FDI stock as the percentage of GDP.

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Home and Host Countries Effects of FDI

Generally, the home country effects may be divided into separate parts, i.e. firm effects and external effects. A model of exporting and foreign direct investment, developed by Helpman, Melitz, and Yeaple (2004), predicts that the least efficient business sells only to the domestic markets. A more efficient company is engaged in export; and the most efficient firm provides outward FDI.

Own-firm effects of making FDI refer to new markets, cheap labour, extended resources, and diffusion of new technologies. In addition, MNE positively affects the productivity of home-country through opening new channels of technological, managerial knowledge, skills, and professional experience (Vahter & Masso 2006).

Regarding host countries, there are many possible effects of FDI. Although the theories of FDI point to benefit foreign investment, spill overs could be small in practice. The possible impacts may be the production of goods of higher quality and raising the level of output. Moreover, the presence of foreign firms may stimulate domestic companies to work better. FDI brings a new experience in management and organizing skills, develops infrastructure and create workspaces. In developed countries, the productivity of domestic businesses is positively related to the existence of foreign companies. For developing countries, the effect is generally positive as well. However, there are somewhat mixed spill overs. On the one hand, a high foreign presence in countries increases productivity. On the other hand, in a short run, foreign firms may adversely affect the host market. Foreign firms often increase competitiveness and take away a share of the market (Lim 2001).

Governments of developing countries find it difficult to manage FDI to their advantage. It happens because of a huge asymmetry in the bargaining power of home and host countries. States trying to engage investors through the system of subsidies and tax cuts can cause a significant deficit in the government budget. Hence, fiscal difficulties do not lead to FDI anyway.

FDI and Economic Development

The issue of the FDI contribution to development involves multiple economic researches. It should embrace investigations in the forms of investment in extractive industries, infrastructure, manufacturing or services. First, there is a question whether FDI in extractive industries generates sustainable government revenues that are managed reasonable. Moreover, one may inquire if FDI in infrastructure provides businesses and families with reliable services and whether FDI in manufacturing enhances the overall productivity of the host-country. Finally, there is a question whether FDI in services forces out or stimulates indigenous investment and what brings more benefits for the country. Regarding these issues, there are main principal channels for FDI to impact on the standards of living shown in the table 1.

Channel 1 Extractive industry: resources rent fund government expenditure in social and economic sphere; positive or negative externalities in the environment
Channel 2 Infrastructure: an access to electricity, transport, water, and other facilities becomes more consistent and cheaper.
Channel 3 Manufacturing: the use of indigenous resources is more or less efficient; extended export and labour market; diversification of products.
Channel 4 Services: improvement of productivity of specific services.
Channel 5 All sectors: an increase of the real income; introduction of automatic machinery; improvement of entrepreneurship experience.

Table 1

The principal channels through which foreign direct investment impacts development (Moran 2011)

Hence, there is a growing thought that FDI is a positive phenomenon for the growth of host-countries. The key points of FDI spill overs are the improvements in technologies, efficiency, and productivity. However, Alfaro states that often-mentioned advantages as innovations of technology and management tend to relate mainly to the manufacturing industries rather than the extractive or agriculture sphere. The reason is that not all industries have the same potential to accept foreign technologies, management experience or built linkage with the country’s economy. Thus, the effect of FDI on the economic growth varies from industries. There are little positive spill overs in the primary industries (such as extractive and agriculture), a significant evidence of a positive impact on growth in manufacturing and ambiguous facts in a service sphere (Alfaro 2003).

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Foreign capital plays an important role in modern international relations and countries development. Over the past decades, the inflow of FDI has been mostly directed to developed countries. However, the share of FDI in developing and transition economies has increased from year to year. Modern theories distinguish many different determinants of FDI flows. The well-known approach is the OLI framework by Dunning that explains the incentives of MNE to make an investment. Regarding the macroeconomics system, there is a range of variables that may have a positive or negative effect on FDI. Spill overs of FDI for home and host countries dramatically vary. However, for both members, the impact is mainly positive. The home country receives new channels for development and extension from one side. The host country improves a technological level, management performance, and labour skills. However, the state should not let the market move freely and concentrate its efforts only on attracting more and more investors. As there are reasonable doubts whether the economic growth provided by FDI happens every time and in every country.

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