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FDI & Benefits to the Developing Economies

| March 14, 2015

Among the different forms of capital flows, Foreign Direct Investment (FDI) has attracted greater attention amongst the academics and policymakers. This is due to its many benefits and its importance in the world economy in comparison to the other forms of capital flows (Brooks et al. 2003). FDI has in the recent years been the dominant form of capital flow in the world economy, especially in the developing economies. In spite of this, studies have in the past produced contradictory results with regards to the linkage between foreign direct investment and development.
Some have shown that FDI spurs economic growth to the developing economies while others show no such effect. Other studies have identified spill over benefits, benefits that have not been appropriated by investors, while others do not discern these benefits (Nunnenkamp 2002). Hence, for many years, it has been unclear whether devoting substantial resources to attracting FDI has significant benefits to the developing economies. This analysis is thus an attempt to untangle this knotty question that has plagued this field of research and present insights on how the developing countries can maximize the benefits of FDI.
During the 1960s and 1970s, FDI was viewed with great wariness by most developing countries. It was perceived that the presence of multinational corporations was impinging on security and national sovereignty (IMF 1985). FDI was seen as a threat to these economies due to the sheer size and magnitude of MNCs that raised concerns over their capacity to influence both the economic and political affairs (IMF 1985). These fears were driven to a large extent by the experience colonialism and by the view that FDI amounted to the modern form of exploitation and economic colonialism. Additionally, FDI was viewed as engaging in unfair business practices including price fixing and rigged transfer pricing through their parent companies (IMF 1985).
As a result, there was a general trend towards greater restrictions of FDI. This has however changed in the recent years as a result of a host of factors such as the emergence of globally integrated productions and marketing networks, accelerating technological change, the existence of bilateral investment treaties and other positive impacts associated with FDI in the developing countries (OECD 2002). Additionally, the drying up of lending by commercial bank due to debt crises has opened doors to FDI as an alternative to bank loans.
Economists largely favour the free flow of capital across the national borders. There are certainly multiple advantages of unrestricted capital flows. First, the owners of capital are able to reduce risks facing them by diversifying their lending and investment (Rodriguez and Rodrik, 2001). Second, the global integration of capital markets leads to the spread of best practices in accounting rules, corporate governance and legal traditions (Rodriguez and Rodrik, 2001). Thirdly, governments are limited from pursuing bad policies by the global mobility of capital (Rodriguez and Rodrik, 2001). These benefits apply, in principle, to all kinds of private capital inflows.

The benefits of inward FDI to the developing economies can take on several other forms:
FDI is considered key to bridging the resource and technology gap of underdeveloped economies (Ikiara 2003). This critical role that FDI plays in promoting and facilitating the transfer of technology is an important strategy towards economic revival and growth of developing countries. Nigeria’s economy, for instance, largely relies on FDI for its industrial growth and development. The need to set up industrialization process in Nigeria calls for more technology spill-over via Foreign Direct Investment (Ikiara 2003). Furthermore, FDI may enhance environmental and social conditions in the developing countries through the transfer of “cleaner” technologies and more socially responsible corporate strategies (Ikiara 2003).
In the course of operating new business as a result of FDI, the host economies often gain from employee training. Employees are trained for technological know-how, marketing and management skills among others. This significantly contributes to the development of human capital in the developing countries.
The profits that are generated from Foreign Direct Investment contribute to the corporate tax revenues in the developing economies. The high corporate tax revenues that result from FDI will significantly improve on the domestic income of the small, developing and transitional countries (Loungani & Razin, 2001).

Empirical evidence has shown that insufficient job opportunities in the developing economies are the main causes of poverty. Such insufficiency in the available job opportunities result from the inadequate levels on investment. FDI is able to contribute to higher economic and employment growth through the creation of employment opportunities, development of human capital and through poverty alleviation government programs financed by the corporate tax revenues (Bosworth & Collins, 1999). Widening access to employment through FDI is thus an important strategy to alleviating poverty
FDI also leads to increased competition in the developing countries. The entry of a new firm and the opening up of new business enterprises in a nontradable sector will lead to an increase in the output of the industry and hence resulting in a reduction of the domestic price and a net improvement in welfare (Loungani & Razin, 2001).
Economic growth is perhaps one of the greatest benefits of Foreign Direct Investments to the developing economies. The benefits accruing from FDI including employment creation, human capital development, acquisition of knowledge and new technology, enhancing enterprise development, international trade integration, increased corporate tax revenues and the creation of more competitive business environment contributes to higher economic growth and development in the developing countries (Rodriguez and Rodrik, 2001).
FDI can also be useful in times of financial crisis and economic hardships. For example, in the 1997 Asian financial crisis, FDI proved to be resilient while other forms of private capital inflows such as portfolio equity and debt flows suffered major setbacks (Borensztein, et al., 1998). Similarly, in the 1980’s when Latin America experienced a financial crisis, the same observations were made. A similar observation was also made with Mexico in 1994. Given the financial turmoil, there is need for newly industrializing and developing economies to increase their reliance on FDI so as to supplement their national savings and promote economic development through capital inflows (Nunnenkamp, 2002).

Following these financial crises, the developing countries in Asia, Latin America and Africa have come increasingly to see FDI as a source of economic development, employment, income growth, modernization and poverty alleviation (Nunnenkamp, 2002). This is evident through their currently pursued economic policies which are intended to attract and maximize the benefits of FDI in the domestic economy.
These countries have in the past two decades implemented a wide range of economic reforms such as the liberalization of foreign trade and investment regimes and privatization of state companies (Stiglitz, 2000). For instance, since the 1997 Asian financial crisis, the economic policies in Indonesia have become more liberal to attracting more FDI so as to increase on economic growth and alleviate poverty (Stiglitz, 2000).
The benefits of FDI, however, do not accrue automatically and evenly across countries. The impact of FDI on the economic growth of the developing countries depend principally on a number of factors including the country policies and institutions, the regulatory framework, quality of investment, and the labour market flexibility among others (Hausmann & Cortes 2001). In order to maximize the benefits of FDI, there is an imperative need to establish a broad, transparent and effective investment policy enabling environment and to put in place appropriate framework for implementation.

Such an environment must provide for incentives for innovations and contribute towards improved competitiveness as well as improvement of skills. The government, for instance, can put in place a liberal and transparent investor friendly FDI policy that allows for FDI to be automatically routed to most of the sectors and wherein the investor doesn’t require any prior approval (Hausmann & Cortes 2001). This will attract more FDI into the country which will in the long run contribute to the growth of the economy. It is worthy to note that the key to encouraging foreign investment and building investor confidence is providing for a stable economic environment and adopting appropriate financial and exchange rate policies
Clear we have identified a number of benefits of FDI to the developing countries including employment creation, human capital development, acquisition of knowledge and new technology, enhancing enterprise development and international trade integration, increased corporate tax revenues, creation of more competitive business environment and enhancing economic growth.
These benefits however depend principally on a number of factors including the country policies and institutions, the regulatory framework, quality of investment, and the labour market flexibility among others. In order to maximize the benefits of FDI, there is an imperative need to adopt more flexible policies and incentives that attract foreign investment. An important point to remember is that the key to encouraging foreign investment and building investor confidence is providing for a stable economic environment and adopting appropriate financial and exchange rate policies.

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Brooks, D.H., E.X. Fan and L.R. Sumulong, 2003. Foreign direct investment in developing Asia: Trends, effects, and likely issues for the forthcoming WTO negotiations. ERD working paper series No. 38.
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Stiglitz, J.E., 2000. “Capital Market Liberalisation, Economic Growth, and Instability”. World Development Journal 28 (6), pp. 1075–1086

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