Foreign direct investment is perhaps one of the most ambiguous and least understood concepts in international economics.
Common debate on FDI is confounded by several myths regarding its nature and impact on capital accumulation, technological progress, industrialization and growth in emerging and developing economies (EDEs). It is often portrayed as a long-term, stable, cross-border flow of capital that adds to productive capacity, helps meet balance-of-payments shortfalls, transfers technology and management skills, and links domestic firms with wider global markets.
However, none of these are intrinsic qualities of FDI. First, FDI is more about transfer and exercise of control than movement of capital. Contrary to widespread perception, it does not always involve flows of financial capital (movements of funds through foreign exchange markets) or real capital (imports of machinery and equipment for the installation of productive capacity).
A large proportion of FDI does not entail cross-border capital flows but is financed from incomes generated on the existing stock of investment in host countries. Equity and loans from parent companies account for a relatively small part of recorded FDI and an even smaller part of total foreign assets controlled by transnational corporations (TNCs). In 2008, retained earnings constituted 60pc of outward FDI stock for non-bank affiliates of US non-bank corporations. In the same year, total assets controlled by US affiliates were 8.6 times the net external finance from US sources.
Globally, in 2011, retained earnings accounted for 30pc of total FDI flows. In the same year, half of the earnings on FDI stock in EDEs were retained, financing about 40pc of total inward FDI in these economies. Thus, the notion that FDI is functionally indistinguishable from fresh capital inflows and represents a flow of foreign resources crossing the borders of two countries has no validity.
Second, an important part of FDI involves transfer of ownership of existing firms. Only the so-called greenfield investment makes a direct contribution to productive capacity and involves cross-border movement of capital goods. But it is not easy to identify from reported statistics what proportion of FDI consists of such investment. In particular, statistics provide almost no information on how retained earnings and loans from parent companies, two of the three sources of finance for FDI, are used.
Furthermore, even when FDI is in bricks and mortar, it may not add to aggregate investment because it may crowd out domestic investors, as shown by most studies on the effects of FDI on domestic investment. Evidence also shows widespread association between rising FDI and falling gross fixed capital formation (GFCF) in the developing world. All these suggest that the economic conditions that attract foreign enterprises may not always be conducive to faster capital formation and that the two sets of investment decisions may be driven by different considerations.
Third, what is commonly known and reported as FDI contains speculative components and creates destabilising impulses which need to be controlled and managed as any other form of international capital flows. Many of the changes in financial markets that have facilitated international capital movements have not only increased the mobility of FDI, but also made it difficult to assess its stability.
The FDI inflows to EDEs are subject to boom-bust cycles and closely correlated with non-FDI (portfolio) flows as they are also influenced by global liquidity conditions and risk appetite. Surges in FDI inflows could generate unsustainable currency appreciations in much the same way as surges in other forms of capital inflows. FDI in property is often motivated by speculative capital gains and subject to severe bubble-and-bust cycles. More importantly, financial transactions can accomplish a reversal of FDI.
What may get recorded as portfolio outflows may well be outflows of FDI in disguise: a foreign affiliate can borrow in the host country in order to export capital. Furthermore, foreign banks established in EDEs can be a major source of financial instability. They tend to contribute to build-up of fragility in host countries and transmit shocks from home countries, as seen during the eurozone crisis.
Fourth, the immediate contribution of FDI to the balance of payments may be positive, since it is only partly absorbed by imports of capital goods required to install production capacity. But its longer-term impact is often negative because of profit remittances and the high import content of production and exports by foreign firms.
Many countries with a long history of involvement with TNCs face negative net transfers on FDI; that is, their new FDI inflows fall short of profit remittances on the stock of inward FDI. Again, in a large majority of EDEs, export earnings by foreign companies do not cover their import bills and profit remittances. This is true even in countries highly successful in attracting export-oriented FDI such as China.
Finally, superior technology and management skills of TNCs create an opportunity for the diffusion of technology and ideas. However, spillovers are not automatic but need to be extracted through policy guidance and interventions. Foreign firms invest in EDEs in order to exploit their existing competitive advantages such as rich natural resources and cheap labour and infrastructure services rather than to move them up on the technological ladder. TNCs resist passing their technological and managerial know-how to host countries since these give them a competitive edge.
The high productivity and competition they bring could help improve the efficiency of local firms, but these can also block entry of these firms into high-value product lines or drive them out of business. They can prevent rather than promote infant-industry learning unless local firms are supported and protected by deliberate policies. They may help EDEs integrate into global production networks, but participation in such networks also carries the risk of getting locked into low-value-added activities.
To sum up, contrary to what is maintained by the dominant corporate ideology, FDI is not a recipe for rapid and sustained growth and industrialisation in EDEs. However, this does not mean that FDI does not offer any benefits to EDEs. Rather, policy in host countries plays a key role in determining the impact of FDI on industrialization and development.
Successful examples are found not necessarily among EDEs that attracted more FDI, but among those which used it in the context of national industrial policy designed to shape the evolution of specific industries through interventions. Encourage joint ventures rather than wholly foreign-owned affiliates in order to accelerate learning and limit foreign control.Do not use FDI as a way of meeting balance-of-payments shortfalls.
Performance requirements may be needed to secure positive spillovers including employment and training of local labour, local procurement, domestic content, export targets and links with local firms.
Edited extracts from a research paper by Ylmaz Akyüz, chief economist, South Centre — an inter-governmental body of emerging and developing countries based in Geneva.
Published in Dawn, Business & Finance weekly, March 23rd, 2016