Abstract
When examining Foreign Direct Investment, many economists say that it is the cure all for a developing country’s economic system, a way to flood the market with capital so that business and innovation can thrive so that they can finally enter the world economic system. However upon closer examination the benefits become less and less clear. In this paper I will discuss the various effects that Foreign Direct Investment have on developing market and the country as a whole as it progresses. While the benefits most certainly cannot be denied, Foreign Direct Investment is ultimately a double edged sword, cutting a way to a stronger economy while simultaneously bleeding the resources and human capital of the host country on domestic market destroying scale.
Introduction
When looking through previous literature on this subject I was astounded by the amount of data that simply looked at Foreign Direct Investment as a godsend. People and countries alike were content to simply take the investment and turn a blind eye to whatever comes along with the capital. To be fair, there are numerous studies that support the benefits of Foreign Direct Investment, however upon examination of these studies, they show that they are simply on the benefits of outward FDI (Van Pottelsberghe and Lichtenberg, 2001; Nachum, 2000). The same literature hailing the effects of outward FDI also show that the effects of inward FDI are not as conclusive. There are many possible causes for this discrepancy, a crowding out of domestic firms, a decrease in innovation from the host country due to the outsourcing of ideas, or, in worse case scenarios, reduced labor conditions brought from increasing a foreign corporation’s bottom line. From this some would say that the only reason that countries invest in others is t take advantage of the host country to better themselves and that the only reason countries accept Foreign Direct Investment is because they believe that it will fix their own systems or at least give it the jump start that they need. Of course there is literature to support that positive conclusion such as Nadiri (Nadiri, 1993) who finds “positive and significant effects from US sourced capital on productivity growth of manufacturing industries in France, Germany, Japan and the UK”. Also Borensztein ( Borensztein, 1998) find a “positive influence of FDI flows from industrial countries on developing countries’ growth”. Yet even with these positives a minimum threshold has been found with levels of human capital in the country receiving the investment. This emphasizes a point called absorbtive capacity, or the amount of knowledge that a business or firm can absorb and put to use. This absorbtive capacity and minimum thresholds of a host country’s ability to profit from investment is highly documented in readings and can become a real concern when looking for aid (Blomström, 1994). In truth there are many factors that determine how Foreign Direct Investment affects the country that receives it but as stated above the purpose of this paper is to raise a hair of caution before developing countries grasp at whatever money a more developed country throws its way.
Main Body
If there has ever been a constant in economic systems it would be that companies are always looking for ways to increase profit. One method of doing this is to invest capital into other countries and their markets through a process known as Foreign Direct Investment. Long has this revenue stream been heralded as the jump that a developing country’s economy needs to enter the world economic system. And so in accordance with this developing countries have readily accepted this capital. After all why shouldn’t they? Such a steady stream of income would be welcomed by anyone. In fact it had become so welcomed that it even became the choice capital flow for developing markets (Dadush, Dasgupta, and Ratha, 2000; and Lipsey, 2001). But is such unrestricted flow of capital across national borders such a good thing? Free flow capital is highly favored due to the propensity of that capital to diversify and bring back high rates of return. The question is who gets the biggest return? Not only does Foreign Direct Investment allow for capital to flow across international borders but it also allows human capital and technological gains to transcend borders as well. Foreign Direct Investment also increases the competition in the host country’s domestic market and boosts that country’s tax revenue through corporate income taxes. As stated above human capital, or the knowledge, skill, and training held by the people in a population, tends to rise when Foreign Direct Investment is being received. This is from foreign companies coming in and training the new workforce in methods and skills that the workforce may not have had access to otherwise. This training also brings about the flow of new technology into system by corporations bringing their production methods and ways to direct capital through a market. In addition this global flow can bring in better business practices from across the globe raising the labor conditions of workers in the country.
If all of this sounds too good to be true then you’re more than likely correct. While this can and does happen in certain cases (Feldstein, 2000), there are a number of instances where the risks of these investments outweigh and even counter the benefits. A large problem is that a number of these investments are short term and used to test the waters of a developing market (Hausmann and Fernández-Arias, 2000). One of the drawbacks of short term lending like this is that they are based solely on speculations and not considerations of long term outcomes (hence why they are called short term investments). This short term lending can cause a market to experience a sudden loss of capital as it is growing which can lead to a sharp downward turn of the entire market. This in effect creates a cycle of loss on short term loans and investment due to the way in which these loans are considered. In contrast however a number of foreign investments are in fact bolted down to a country and cannot be withdrawn so quickly. This is due to the fact that with foreign investment comes foreign interference in the domestic market and surrounding area. Foreign companies may build factories and roads in an area. When a foreign market does decide to pull out of a country though, the effects are devastating. Many countries, like those in Africa, lack the infrastructure to properly maintain and care for the structures left behind by the company. Factories and roads rapidly deteriorate as do the environmental conditions in that area due to practices that the foreign company may have engaged in.
As stated previously, Foreign Direct Investment is supposed to increase the human capital in a region by bringing in training and new skills to the workforce in the host country. While this is true in some instances the actual practices put in place tell a far different story. When a foreign company or corporation comes to a developing one they seek out previously trained or already skilled workers in a process known as “skimming”. While the effect of Foreign Direct Investment is seen as positive in countries where the level of education is high (Borensztein, De Gregorio, and Lee 1998), the effect is far more negative when the host country has a fairly inequitable distribution of education (large separation of socio-economic classes). In those instances this skimming results in a net loss in human capital for the previously established domestic enterprises lowering their overall productivity and ability to compete. This leads to the next consequence which is the crowding out of domestic markets. By engaging in practices such as skimming coupled with an already strong and streamlined access to markets, foreign corporations can come into a developing country under the guise of Foreign Direct Investment and effectively crowd out all domestic competitors by making the market to competitive for them to be able to turn a profit.
Of course this can also be written off by the governments of the countries receiving the investment due to their new revenue stream of corporate taxation. This is until the governments realize that their entire economic system is now dominated by foreign companies while their own domestic enterprises are struggling, or in the case of many countries when they realize that Foreign Direct Investment has become the number one source of capital flow in the country as stated previously. This total control of an economic system allows countries to set their own rules in the host country by using the threat of “Listen to us or we leave”. This hardball game of tug and war results in a weakening of the government’s power as a whole. This viewpoint is supported by research that demonstrates that when foreign markets were introduced to developing East Asian countries, the government’s power to control both their own domestic economic system and the direction of their domestic market structure was significantly diminished (Yueng 2014). This research points towards an ability to control the country that receives the highest share of Foreign Direct Investment through a combination of fear tactics and market domination.
This should be of utmost concern for developing countries as it has been found that riskier markets are those that receive a greater influx of funding through Foreign Direct Investment (Hausmann and Fernández-Arias, 2000). Risk in this instance is measured by indicators such as a country’s sovereign debt credit ratings. So why would a risky market receive more investment? The answer is tied back to the previous statement of Foreign Direct Investment crowding out domestic markets. This process is much easier, and much more profitable, when the host country contains missing or inefficient markets. When investors find markets and countries such as this they are able to operate directly rather than through local markets, supply chains, or legal teams. This raises an important flag in terms of policy making according to a report by Albuquerque (Albuquerque, 2000). In this report it was stated "that countries trying to expand their access to international capital markets should concentrate on developing credible enforcement mechanisms instead of trying to get more FDI." Similarly Hausmann and Fernández-Arias (Hausmann and Fernández-Arias, 2000, page 5) report that "Countries should concentrate on improving the environment for investment and the functioning of markets. They are likely to be rewarded with increasingly efficient overall investment as well as with more capital inflows." With proper respect given to foreign investors, not all blame must rest on their shoulders. The host country could well in fact be much, much poorer. However, it is due to these poor markets that Foreign Direct Investment is able to run amok and hold as much power as it does.
Finally, as previously stated foreign companies are able to operate directly in these weaker countries but it is not only their own companies that they are then able to control. Foreign Direct investment in these weak institutions may result in a not only a transfer of ownership from domestic to foreign residents but also a mechanism that allows these foreign investors to manage and dictate over the host country’s firms through the leverage they are able to wield over the host government. Krugman (Krugman 1998) makes note that this transfer of control is likely to arise during a time of crisis, something common in developing countries and asks the question:
“Is the transfer of control that is associated with foreign ownership appropriate under these circumstances? That is, loosely speaking, are foreign corporations taking over control of domestic enterprises because they have special competence, and can run them better, or simply because they have cash and the locals do not? . . . Does the firesale of domestic firms and their assets represent a burden to the afflicted countries, over and above the cost of the crisis itself?”
Even outside of such conditions, Foreign Direct Investment can still cause harm to domestic firms as pointed out by Razin, Sadka, and Yuen (Razin, Sadka, and Yuen, 1999). Through investment, foreign companies are able to receive inside information about the productivity of the enterprises under their control which allows for an advantage over traditional domestic investors who would not have enough information to know if the company they are buying into is one of high or low productivity. This uninformed buying of companies by domestic investors serves as a constant stream of stream of revenue for foreign investors. If one of the companies that was previously sold for not being as productive suddenly becomes productive once more it can simply be bought back the returned to its low producing state and sold back once more. A problem can sometimes arise from this cycle of buying and selling by foreign investors in the fact that they sometimes overinvest which creates a capital vacuum or deficit. To counteract this deficit foreign investors can profit off purposely depreciating their own collateral when they have control over a company. This process is accomplished by borrowing against the collateral of a company they invested in and then lending that money straight to their own parent company before selling the company to domestic investors. Because a large portion of investment is intercompany debt, the parent company can recall the loan as soon as the sale goes through and cashing in on a debt that they artificially created. This process is known as leveraging down.
Conclusion
For years it has been perpetuated by both economic theory and research that Foreign Direct Investment is nothing but beneficial to a country. However upon close examination of recent studies and the numbers involved in previous studies, dangers and drawbacks emerge from what was once considered a free market capital source that could do no wrong. There are certainly benefits from Foreign Direct Investment. It brings much needed capital into starved or stagnant economic systems, it transfers knowledge, skills, training, practices, and technology across borders, it boosts competition and productivity in the host country’s domestic production, it increases government tax revenue, and it has become the number one source of private capital funding for many markets despite market flux and many a time of financial uncertainty and crisis however governments cannot take solely benefits into account. The truth is that Foreign Direct Investment can bring just as much devastation to a developing country, from preying on weak governments and institutions, skimming trained workers from domestic markets, trading with insider information, creating sweatshop like conditions in labor markets that become next to impossible for a member of the workforce to escape from, destroying domestic competition, or even taking control of an entire country’s economic system and using it as a bargaining chip against policymakers. While the relevance of some of these findings and studies remain to be demonstrated in full, these risks should encourage developing markets and government systems to take a more cautious approach when examining the likely effects of accepting or seeking solely Foreign Direct Investment. It is in my opinion that when handling recommendations for economic policy, countries should shift their focus to building a suitable environment and economic system to encourage the inflow of all kinds of capital, both domestic and foreign.