Foreign Direct Investment (FDI)
KeywordsMultinational enterprise (MNE) Trade agreement European Union (EU) North American Free Trade Agreement (NAFTA)
Foreign direct investment (FDI) refers to an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. A foreign individual or multinational enterprise (MNE) invests in the productive capacity of another country, either in existing industries and businesses or with the goal of promoting new industries. Both economic theory and recent empirical studies suggest that, whether an individual or a firm chooses to invest in a foreign country’s economy, buy into a foreign company, or expand business abroad, FDI has a beneficial impact on developing countries and provides benefits to investors. But FDI also carries potential risks, and it is important to evaluate the level of economic and political stability in a potential host country. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.
Foreign Direct Investment: An Overview
According to the International Monetary Fund (IMF), foreign direct investment (FDI) refers to an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. A foreign individual or multinational enterprise (MNE) invests in the productive capacity of another country, either in existing industries and businesses or with the goal of promoting new industries. The IMF established a benchmark of 10% ownership for individuals and business to qualify as FDI; otherwise it is classified as part of a stock portfolio.
Exchange rate – If the investor’s currency is stronger than the foreign currency, less investment is required. Depreciation of currency in a foreign country, in some cases, will attract more foreign investment.
Market size – When looking at growth of gross domestic product (GDP), developing and emerging economies will attract more foreign investments.
Fiscal policy – MNEs are subject to tax in both the parent country and the foreign country of investment. Countries that attempt to reduce this tax burden through their government’s fiscal policies, and alleviate the degree of double taxation, will also attract foreign investment.
Labor market – The educational levels and degree of specialization required, as well as local wage levels, will influence investor decisions.
Infrastructure – MNEs will evaluate the infrastructure of a state to determine whether or not it can support production and growth.
Stability – Political, financial, and economic stability can also shape investor confidence in foreign states.
Trade agreements are also a powerful mechanism to encourage and enable greater FDI. The European Union (EU) is both the largest provider and destination of FDI in the world, measured by stocks and flows. Recent international investments into the EU are worth €5.4 trillion or about 36% of the wealth produced annually by the EU. They also directly support 7.6 million jobs in the EU and provide capital and technology to foster European research, innovation, and competition. EU investments abroad are worth €6.9 trillion – about 46% of the wealth produced annually by the EU. Those investments directly support 14.4 million jobs abroad and allow European companies to optimize their production, to access raw materials and components, and to better serve foreign markets (European Commission, Commission Staff Working Document 2017).
A second notable example of the relationship between trade agreements and flows of FDI is the coupled-up increase in trade and FDI among the United States, Mexico, and Canada via the North American Free Trade Agreement (NAFTA). NAFTA’s terms, which were implemented gradually through January 2008, provided for the elimination of most tariffs on products traded among the three countries. Liberalization of trade in agriculture, textiles, and automobile manufacturing was a major focus. The deal also sought to protect intellectual property, establish dispute-resolution mechanisms, and, through side agreements, implement labor and environmental safeguards. Regional trade increased sharply over the treaty’s first two decades, from roughly $290 billion in 1993 to more than $1.1 trillion in 2016. Cross-border investment has also surged, with US foreign direct investment stock in Mexico increasing in that period from $15 billion to more than $100 billion. Experts also say, however, that it has proven difficult to tease out the deal’s direct effects from other factors, including rapid technological change, expanded trade with other countries such as China, and unrelated domestic developments in each of the countries (Villarreal and Fergusson 2017).
Advantages of FDI
Foreign direct investment benefits the global economy, as well as investors and host countries. FDI can act as a long-term source of capital, as large amounts of capital come through these investments and more industries are established. Host countries often see their standard of living rise, as FDI promotes international trade and can lead to greater employment in the region. Borensztein et al. (1998) found that FDI increases economic growth when the level of education in the host country – a measure of its absorptive capacity – is high. The World Bank’s Global Development Finance (2001) report summarizes the findings of several other studies on the relationships between private capital flows and growth and provides new evidence on these relationships. The report indicates that investors can be a source of advanced and developed technologies, bring global practices of management, and invest in water, energy, and infrastructure projects.
FDI can also offset volatility created by “hot money,” when short-term lenders and currency traders create asset bubbles. These individuals invest significant amounts of money at once and then sell their investments just as quickly, creating a “boom-bust” cycle that leads to economic and political instability. Because FDI takes more time to establish, it can have a more permanent financial footprint in a host country.
FDI has proved to be resilient during financial crises. For example, in East Asian countries, such investment was remarkably stable during the global financial crises of 1997–1998. In sharp contrast, other forms of private capital flows – portfolio equity and debt flows and particularly short-term flows – were subject to large reversals during the same period (see Dadush et al. 2000; Lipsey 2001). The resilience of FDI during financial crises was also evident during the Mexican crisis of 1994–1995 and the Latin American debt crisis of the 1980s.
Disadvantages of FDI
There are both restrictions and disadvantages to FDI for firms and for states. According to an IMF report, host countries should not allow foreign ownership of companies in strategic industries, typically related to energy, space, transportation, and so on. Strategic, in this reference, can mean different things to different states. For example, the European Council recently published a report where it applauded the European Commission’s initiative to harness globalization and specifically to analyze investments from foreign states in strategic sectors (Union 2014, p. 20). For its part, the European Parliament called on the commission, together with the member states, “to screen third country foreign direct investments in the EU in strategic industries, infrastructure and key future technologies, or other assets that are important in the interests of security and protection of access to them” (Union 2014, p. 20). Still, there is concern that FDI in strategic industries could result in lowering the comparative advantage of a nation (Loungani and Razi 2001).
Beyond these concerns, there is also a possibility that foreign investors may strip an investment of its value without adding any. They could sell unprofitable portions of a company to local, less informed investors or use the company’s collateral to get low-cost, local loans. Instead of reinvesting it, they lend the funds back to the parent company.
From the investors’ side, depending on the level of political instability and economic volatility in a foreign country, FDI is subject to rates of higher risk than other forms of investment. In some instances, this can include expropriation or a situation where the government can assume control over property and assets.
Petrović and Stanković (2009) further identified classifications of “country risk” and “political risk,” as well as the effects of foreign direct investment in their research. Citing Longueville, they first explain “country risk” as both (1) risk of sovereignty (this represents the risk of possible expropriation and profit restriction) and (2) transfer/convertibility risk (when the central bank cannot mobilize enough foreign reserves in order to convert financial funds in local currency to foreign currency). Second, they identified forms of political risk at three levels: (1) micro risk (at the company level); (2) macro risk (at the country level), such as transfer risk, cultural risk, and institutional risk; and (3) global risk (at the global level) – the risk of armed conflicts, terrorism, Internet misusage, ecological risk, etc. Depending on the firm, political risk can also be classified in three ways: (1) transfer risk, which arises from uncertainty about cross-border flows of capital, payments, know-how, and the like; (2) operational risk, which is associated with uncertainty about the host country’s policies affecting the local operations of multinational companies; and (3) control risk, which arises from uncertainty about the host country’s policy regarding ownership and control of local operations (Petrović and Stanković 2009, p. 12).
Without limits in place, even the economically efficient use of resources is likely to result in overexploitation and over-pollution of the environment. The inefficient use of scarce natural resources, and the coupling of economic benefits with environmental and social costs, can harm the most disadvantaged in host countries (Mabey and McNally 1999). Correspondingly, many developing countries in the Global South, or at least those with a history of colonialism, worry that FDI could result in a new form of economic colonialism that exposes host countries and leaves them vulnerable to exploitation by foreign company operations.
A recent publication by the United Nations Conference on Trade and Development articulated two important related considerations – promoting foreign direct investment in developing countries while also achieving sustainable development. The authors argue that cross-border environmental management tends to be seen as a difficult balancing act for multinational enterprises (MNEs) and host countries, an act that requires the right mix of policies and goals in terms of investment, output, job creation, and environmental protection. Home countries, too, have an important role to play through their laws, regulations, policies, and guidelines. The report indicated that a strict environmental policy in the home countries of MNEs can influence the environmental standards such as companies use in the FDI host countries. Furthermore, it can give the host countries of FDI valuable information about the conduct of environmental policy: “These countries often have fairly modern regulations, but in some cases lack the capacity to enforce them” (xvi). Thus, an exchange of experiences between industrialized and developing countries might also help improve the environmental performance of FDI.
FDI and International Security
Almost all economic activity, including foreign direct investment, requires supporting institutions of governance to protect property rights and enforce contracts. These institutions, whether formal ones provided by the state (laws and regulations and courts and agencies that enforce them) or informal social ones (networks with their norms of behavior and sanctions for violations), never function perfectly, and this creates varying degrees of insecurity. As Avinash Dixit (2011) writes, the interests of nation-states – geopolitical, domestic political, and economic – “influence their trade and investment policies and outcomes; conversely, trade and investment opportunities feedback on interests” (1).
One of the most common frameworks for understanding peace and trade is that, holding other things equal, countries that trade more with each other are less likely to go to war with each other. Thomas L. Friedman published his Golden Arches Theory of Conflict Prevention, which states that “No two countries that both have a McDonald’s have ever fought a war against each other.” The rationale, according to Friedman, is that when a country reaches the level of economic development required to support a McDonald’s, people in that country will stop fighting wars for fear of the resultant economic and personal losses. Both countries enjoy aggregate economic gains from their mutual trade, and the volume of trade between them may be a measure of how much each would lose if this trade was disrupted, as it would be in the event of a war between them. Therefore, their mutual dependence makes conflict more costly to them. McDonald’s, as a global food service retailer, represents not just a quality standard of living but also “a symbol of something—an economic maturity and [openness] to foreign investments” (Li 2008).
Empirical studies of the relationship between FDI and conflict support this theory to a degree. Polachek (1980) finds that “on average, a doubling of trade between two countries leads to a 20% diminution of hostility between them.” Several scholars have attempted to study the impact of globalization on international conflict, particularly whether or not FDI acts as an intervening variable. Most studies find that the flow of FDI reduces the degree of international conflict and encourages cooperation between dyads that trade and FDI complement one another in reducing conflict and that a higher level of economic openness is associated with a lower risk of civil war (Polachek et al. 2007; Blanton and Apodaca 2007; Bussman and Schneider 2007). Further, Lee (2005) examined the Correlates of War MID data coupled with FDI data by the World Bank (1970–2000) and found that the more FDI host countries receive, the less likely they are to initiate militarized interstate conflicts.
Sources for locating statistical information on FDI include the UN Conference on Trade and Development’s Global Investment Trends Monitor, the Organization for Economic Cooperation and Development’s FDI Regulatory Restrictiveness Index, the IMF’s Worldwide Survey of Foreign Direct Investment Positions, and the US Bureau of Economic Analysis reporting on activities of foreign affiliates of US companies. They recently revealed that global FDI fell by 16% in 2017, to an estimated $1.52 trillion – a stark contrast to other macroeconomic variables such as GDP and trade – which saw substantial growth in 2017. FDI flows to developing economies remained relatively stable, with marginal increases in Asia, Latin America, and the Caribbean. Developing Asia regained its position as the largest FDI recipient in the world, following the European Union and North America (Global Investment Trends Monitor 2018).
Both economic theory and recent empirical studies suggest that, whether an individual or a firm chooses to invest in a foreign country’s economy, buy into a foreign company, or expand business abroad, FDI has a beneficial impact on developing countries and provides benefits to investors. But FDI also carries potential risks to both companies and host countries, and it is important to evaluate the level of economic and political stability in a potential host country. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.
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