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Foreign Direct Investment Advantages and Disadvantages Essay


Executive summary

Foreign Direct investment has both positive and negative effects on the economy of a country. The effects, however, differ from one country to another. When a country embraces FDI, it has an opportunity to gain a significant foothold in the world’s economy since it is accessible to a wider global market.

It also introduces the host country to top level technology. Because of the competition it creates; FDI stirs local companies to adopt quality as a requisite to stay in the market. It can, therefore, be concluded that FDI improves the quality of products. Because of exposing and training workers, FDI enhances the value of human resources in a host country. Moreover, other benefits connected with FDI include; creation of employment, sources of valuable technology and knowhow, physical capital and labor, among others.

There is, however, some negative effect connected to FDI. It has been argued that foreign investors are not genuinely interested in growing the economy of the host country (Balasubramanayam, 1996). Rather, they are interested in accumulating profits and investing in their own countries.

This is especially when there is political instability or any signs of a collapsing economy in a host country. Similarly, some governments look at Foreign Direct Investments as a form of modern day economic colonialism. Hence, they are skeptical about any foreigners who want to make investments in their countries. Local firms in the host countries face competition unfairly from the foreign investors. This puts a strain on the private sector and displaces its investments

Introduction

Foreign direct investment can simply be defined as a company making a physical investment in a country other than its own, which then goes into building a factory or investment in that country (Aitken and Harrison, 1999). The direct investment could be in the form of buildings, equipment and machinery, mines and land, which is acquired through mergers & acquisitions. It can also be defined as a measure of foreign ownership of domestic productive assets (Agarwal, 1996).

Foreign direct investment is different from making a portfolio, which is defined as an indirect investment (Aitken and Harrison, 1999). Foreign direct investment benefits the company that is making the investment with means of marketing, new products and technologies and cheaper facilities for use in production. The host country may also be a beneficiary of information, expertise, and job opportunities among others.

For a long time, Foreign Direct Investment has been directed at developing nations. Statistics indicate that the stock and flow of FDI is increasing and shifting towards these developing nations. Developed countries, however, still account for the biggest share of FDI inflows (Agarwal, 1996).

Various forms of FDI exist. Horizontal FDI comes to being when a firm or a company exports its activities or services to another country at the same value chain. A good example is “Toyota building an auto manufacturing plant in Kenya”. Horizontal FDI helps a country to save on transport costs and tariffs (Borensztein, 1998).

Vertical FDI occurs when an investor expands the activities of an industry. The expansion can be geared towards marketing the finished product or investing in the raw materials that make the product. Vertical FDI is advantageous in that it allows firms to exploit cross country differences in factor prices. FDI can also be classified into inward FDI and outward FDI.

This paper defines the term Foreign Direct Investment (FDI). It also explores the advantages and disadvantages brought about by the term in a host country. It is argued that FDI creates a series of opportunities for the host country through activities such as creating employment, advancing technology, investing in human capital and encouraging fair competition with local investors.

Despite the benefits it brings, FDI can negatively impact the economy of a nation. These effects are illustrated in biases and skewed investment, exploitation of cheap labor, environmental pollution and political interference.

Positive Effects of FDI on host country economies

FDI provides valuable benefits on host country development efforts. Balasubramanayam et al (1996) argues the benefits connected to FDI assist the host country towards achieving higher per capita growth, hence improving the economy. In addition to creating employment in a host country, FDI provides the host country with technological know-how, promotes physical capital and labor, builds human capital and enhances Greenfield and brown-field effect among other benefits.

Employment

FDI contributes to the economic growth of a host country by creating direct and indirect job opportunities. This is achieved through introducing new industries and establishing new firms in a host country. Besides, foreign firms may purchase inputs of goods and services from local firms, thus supporting local people.

According to Agarwal (1996), FDI introduces new and efficient quality inputs to be used in production of upstream local firms, making them more competitive and enable them to expand production and employment. Additionally, the inflows accruing from FDI increases the competitiveness of a host country.

This is achieved by combing firm and country-specific assets. The combinations make a host country access foreign markets and embrace new technology, whereas utilizing cheap labor. Such a combination of firm and country specific assets with the product and labor market ultimately improves and expands existing industries, introduces production in new industries and creates more job opportunities.

Source of valuable technology and know-how

Appropriable technology can be defined as any tangible or intangible resource that can produce economic rent in the host country. This is in terms of improving total factor productivity. Borensztein et al states that traditional appropriable technology can be termed as the personalized or disembodied knowledge about production and distribution (1998).

Foreign direct investments help the host country’s economy directly by injecting direct capital, giving advanced/ valuable technology and know-how and establishing linkages with the local firms.

If the parent countries have a better or advanced technology, they influence the technologies in the host countries and make them better. Balasubramanayam et al (1996) alleges that contagion can be in two ways namely replication of processes and increased competition. These can drive other firms to take up new technologies and modernize their systems.

However, in recent surveys Borensztein (1998) argue that evidence that FDI generates positive results for host countries is weak. Haddad and Harrison (1993), after a review of micro data spill-over’s from both foreign and domestically owned firms, conclude that the effects are mostly negative.

Physical capital and labor

Borensztein (1998) cite that FDI is known to generate an inflow of human and physical capital to the host country. The rate of increase of physical capital stock of the host country is directly proportional to the capacity of production. Physical capital and labor can, however, not be used as a perennial determinant of per capita growth.

Accumulation of physical capital cannot act as a permanent source of growth in the long-run. Its growth enhancing effect of growing stocks of physical capital eventually ends. Physical capital thus, becomes a short term effect of FDI as the economy of the host country transit towards a steady state.

Haddad and Harrison (1993) after using a growth accounting framework, came to the conclusion that investing in physical capital is in a way not decisive in explaining long run economic growth. This was because technological progress gives an account for most of the cross-country disparity in growth.

Aitken (1999), however, does not seem to agree with Xu (2000). He argues that their modeling framework is excessively restrictive and hence their conclusion is not true. He says that an inflow from FDI is not likely to produce a large labor inflow into the country in which foreign investments are made (Xu, 2000). From this argument, an inflow from FDI is unlikely to alter the economic growth of a country by changes in the size of labour.

Greenfield and brown-field FDI

Greenfield FDI means that the Multinational Enterprise, MNE, builds new production facilities, distribution facilities or research facilities in the host country. This leads to a substantial growth of physical stock (Haddad and Harrison, 1993). In brown-field investment, investors are interested in existing business that has potential to grow. This leads only to a small or limited growth of stock of physical capital. The mode of FDI is, therefore, significantly beneficial for the effects on economic growth in the host country.

Investments in Human Capital

Technology is personified not only in equipment, machinery, technicians, expatriates and patent rights, but also in the human capital of the affiliate’s local employees. Employers facilitate this acquisition of human capital by training, either directly or indirectly, the employees (Haddad and Harrison, 1993). The employees end up paying for this through the low wages they receive.

According to Balasubramanayam et al (1996), the diverse skills gained while working for foreign-owned affiliates may, in turn, generate spill over benefits for the host country’s economy.

This is because trained employees transfer to local owned firms. In other cases, they form their own businesses using the skills and knowledge gained to improve their productivity in other organizations. For example, China, in an effort to increase the quality of their workers has taken an interest in training their workers to increase their quality. This is important because the status of human resources in a country is a critical factor in FDI in overseas countries.

Negative Effects of FDI on host country economies

Although FDI has provided a window for growth and development in host countries, many authors argue that it has created more negative effects. Balasubramanayam et al (1996) provides some effects such as environmental degradation as a significant negative effect of FDI. The FDI has contributed to environmental pollution, especially where they are involved in resource extraction. Other negative effects of FDI cited include; biases and skewed investment of their activities, exploitation of labor force and disparity in wages.

Environmental Pollution

As investors look around the globe for the highest possible returns, they are often attracted to places endowed with many natural resources but do not have strong environmental laws to control their explorations (Xu, 2000). Foreign investors may engage in economic activities that harm the surrounding communities.

For example, timber companies may clear forests to pave the way for constructions. Given that vegetative cover is important for the hydrological cycle; such activities affect the environment negatively. Similarly, FDI promotes western-style consumerism, boosting car ownership and paper use. This negatively affects the natural world, the stable nature of the earth’s climate, and food security (Xu, 2000).

Biases and Skewed Investment

It is not entirely true that FDI benefits the host country. Many foreign investors are not keen to invest in countries without a success story. They invest in countries that are either growing or showing a significant potential for growth, have a sizeable purchasing power and are politically stable. If there is any sign of the political instability of unrest in some countries, foreign investors are quick to withdraw to their own countries with their savings.

This makes FDI unreliable, just like portfolio investments. This has been termed by critics as dependent, or restricted, development enhancing bias and skewed investment. The most influential determinants of foreign direct investment are the size and the ability of the economy to grow in the host country.

It is, in most cases, assumed that if the host country has a vast market, it will have higher chances of quickly growing economy and hence investors would be able to make the most of their investments in the country of investment. Host countries with large dimensions provide opportunities for bigger economies of scale and spillover effects, and this is particularly helpful when the FDI is based on export.

On the other hand, if the host country has less market and dimensions, investors have a tendency of avoiding it. Hence, FDI, in this case is anchored on discrimination. This is a critical challenge to countries which face political instability and unrest.

Besides, the population of a country plays a vital and undeniable role in attracting foreign investors to a country. Here, the investors are attracted by the hope of a vast customer base (UNCTAD, 2001). If the country has a high per capita income or has citizens belonging to either upper or middle class, then it would give foreign investors a high prospect of success. Therefore, a country with a low population growth is disadvantaged in attracting FDI because it has low per capita income, a small labor force and fewer spenders.

Wage differences

Most foreign owned companies focus their investments on machinery and intellectual property but not on wages. They source their workers from across continents. This move prevents the local people from enjoying the benefits of FDI. According to Balasubramanayam et al (1996), only skilled laborers get a decent pay.

Short-term and unskilled workers are exploited because of the poor wages they receive. This is a negative picture of FDIs in host economies. In order to maximize their profits, just like any other investment entity (UNCTAD, 2001). FDIs may enter the host country for different and unique reasons, but, the ultimate goal is to generate returns on investments.

Although foreign investors pay a premium on top of local wages, the premium does not benefit the host economy (Caves, 1974). Premiums slightly increase the earnings of workers but on the other side, it disrupts the local employment or labor market. This disruption easily leads to unemployment because other local jobs no longer match with the created jobs.

Unfair Competition with Local firms

It has been argued that FDI does not by design translate to net foreign exchange inflows. Some investors do not self-finance their investments but instead they get loans from the local governments at local rates, which are more favorable, to fund their investments. This puts a lot of pressure to the domestic sectors because of the unfair competition.

According to Agarwal (1996), local firms in most countries lack the expertise in terms of technology, capital and other resources needed for growth and expansion. Hence, because foreign firms have all the needed resources to jump-start and expand their business interests, it establishes unhealthy competition.

Conclusion

Different countries experience different effects of FDI on their economic growths. Attitudes and policies towards FDI have changed drastically over time. Some countries started with being skeptical of the whole foreign domestic investors. Upon observing other nations some confidence was developed that FDI was a positive course towards building their economies. Before making an FDI, an investor needs to assess the viability of the venture in order to have a competitive standpoint.

One needs to factor in the company’s competitors, availability of internal resources in the host country, market analysis and market expectations. Agarwal (1996) alleges that most investors have utilized this information and have contributed to the growth and development of host countries’ economies.

This has been achieved through the creation of employment opportunities, investing in technologies and improving human capital through trainings among others. However, though these positive contributions are evident in a host country, FDI has established other undesirable effects on a host country. Clear evidence is seen through the exploitation of the labor force, biases and skewed investment, environmental pollution, and wage differences among other undesirable effects.

References

Agarwal, J P 1996, “Impact of “Europe agreements” on FDI in developing countries”, International Journal of Social Economics, Vol. 23, no. 10/11, pp. 150 – 163

Aitken, B J and Harrison, A 1999, “Do Domestic Firms Benefit from Direct Foreign Investment? Evidence from Venezuela.” American Economic Review, Vol. 89, pp. 605- 618.

Balasubramanayam, V N Salisu, M and Spasford, D 1996, “Foreign Direct investment and Growth in EP and IS Countries.” Economic Journal , Vol.106, pp. 92-105.

Borensztein, E, De Gregorio, J and Lee J-W 1998, “How Does Foreign Direct Investment Affect Economic Growth?” Journal of International Economics, Vol. 45, pp. 115-35.

Caves, R 1974, “Multinational Firms, Competition and Productivity in the Host Country.” Economics, Vol. 41, pp. 176-193.

Haddad, M and Harrison, A 1993, “Are There Positive Spillovers from Direct Foreign Investment?” Journal of Development Economics, Vol. 42, pp. 51-74.

UNCTAD, 2001, Trade and Investment Report. New York: The United Nations

Xu, B 200, “Multinational Enterprises, Technology Diffusion, and Host Country Productivity Growth.” Journal of Development Economics, Vol. 62, pp. 477- 493

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IvyPanda. (2019, August 20). Foreign Direct Investment Advantages and Disadvantages. Retrieved from https://ivypanda.com/essays/foreign-direct-investment-essay-2/

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IvyPanda. "Foreign Direct Investment Advantages and Disadvantages." August 20, 2019. https://ivypanda.com/essays/foreign-direct-investment-essay-2/.

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IvyPanda. 2019. "Foreign Direct Investment Advantages and Disadvantages." August 20, 2019. https://ivypanda.com/essays/foreign-direct-investment-essay-2/.

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