Benefits of Foreign Direct Investment

Do Host Countries Benefit From Foreign Direct Investment? Evidence From Developing Economies

Executive Summary

The multinational companies (MNCs) and associated foreign direct investment (FDI) play an important role in international economy. It is well-known that FDI activity can bring many significant effects to host countries.

In this essay I estimate such effects from three different aspects:

The first part I focus on the relation between FDI and host country wages. Previous studies show that it is a universal phenomenon that the wages in foreign companies are higher than domestic companies. The FDI activity has a positive effect to the overall wage levels of the host countries, although wages spillovers to domestic companies are not always exist.

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The second part I focus on the relation between FDI and host country productivity. Foreign companies have higher productivity than domestic companies; it can be supported by most of the available studies no matter what measures have been used. Although some findings reflected that local firms in developing countries can benefit from FDI by productivity spillovers, in more cases, the productivity spillovers are not significant, even negative.

The third part I focus on the relation between FDI and host country’s economic Growth. The result shows that developing countries can benefit from FDI and achieve economic growth.

Overall, the host countries, especially the developing countries, can benefit from foreign direct investment.

1. Introduction

The worldwide spread of multinational companies (MNCs) and associated foreign direct investment (FDI) play an important role in reconstructing economy pattern of the world. It is well-known that FDI activity can bring many significant effects to host countries’ development. In this essay I will estimate such effects from three different aspects- the effect in wages, the effect in productivity and the effect in economic growth- by reviewing numerous relative studies and try to find out whether host countries, especially the developing countries, can get benefits from foreign direct investment.

2. FDI And Host Country Wages

In this section, I will explain to what extend does FDI influence host countries’ wages level. Whether local firms could benefit from the entrance or existence of foreign companies will be analyzed based on the previous studies.

Firstly, let us take a look at the difference between foreign companies and domestic companies in regard to wages level. Almost all the available studies proved that foreign companies did pay higher wages in developing countries.

Haddad and Harrison (1993) made a research on different companies’ performance in Morocco. They found that in unweighted means, foreign firms paid about 70% higher wages than domestic firms. According to weighted means, the foreign companies still paid higher real wages than domestic companies (PP.58-59). Higher wages paying by MNCs was also supported by some studies of other developing countries, such as Indonesia (Hill, 1990, Manning 1998, Lipsey and Sjöholm, 2001). Lipsey and Sjöholm (2001) reported that when taken the educational level into account, blue-collar workers can get 25% higher wages and white-collar workers can get 50% higher wages in foreign companies. In the conclusion part of this paper, the author stated “those higher wages for workers of a given educational level do not reflect only the greater size and larger inputs per worker in foreign plants, or their industry or location” (p.13). If considered all these factors, the foreign companies paid 12% and 20% more wages than domestic companies for blue-collar workers and white-collar workers respectively. Another evidence is taken by Ramstetter (1999), he did an research in five East Asian economies (Hong Kong, Indonesia, Malaysia, Singapore and Taiwan) and made a report that wages in foreign plants were higher than domestic firms over 14-23 years, but the differences were not so significant in Singapore and Taiwan.

It is a universal phenomenon that the wages in foreign companies are higher than domestic companies. Lipsey (2002) gave several explanations of this phenomenon. Firstly, higher wages may be caused by host-country regulations. Foreign firms are required to pay a higher price to the same quality workers in order to keep a good relationship with the host countries. Secondly, it could regard as compensation for the workers because they tend to choose local companies rather than foreign companies. Thirdly, as the foreign companies possess some advanced technology, they would rather pay more money to the employees to reduce the technology leaking resulted by stuff turnover. Last, the higher wages could count as an expense for attracting better employees because the foreign companies are not familiar with the labor market in host countries.

Whether higher wages paid by foreign firms would affect the wages level in domestic firms and then change the wages level in host countries is another important question. The effects in wages of the local firms in host countries are referred as wage spillovers. Many studies focused on such wage spillovers as well as the effect to the overall wage level of the host countries taken by FDI. Aitken, Harrison, and Lipsey (1996) investigated the relationship between wages level and FDI in Venezuela and Mexico and found “no evidence of wage spillovers leading to higher wages for domestic firm”(Aitken et al., 1996, p.369). The lack of wages spillovers is in line with the different wages level between foreign and domestic companies. But there was a positive relationship between foreign ownership shares and averages industry wages, which means higher foreign ownership tend to increase industry wages. Besides, the effect was more significant for well skilled workers. The wage differences can be explained by “the greater human capital formation in foreign firms and lower turnover” (Aitken et al., 1996, p.369), well the increasing industry wages can be explained by the raising demand of labor in the foreign companies. Lipsey and Sjöholm (2001) calculated the wage spillovers caused by FDI in Indonesia and found out foreign ownership could affect the wage level in domestic companies even if the difference in wage levels is not significant. Higher foreign ownership tend to increase the wage level of domestic companies, especially for white-collar than for blue-collar workers.

We can conclude that the FDI activity has a positive effect to the overall wage levels of the host countries as the higher wages in foreign companies can increase the average wage level of the host countries, although wages spillovers to domestic companies are not always exist. As Lipsey (2002) summarized, the positive effect might caused by the higher wages paid by the foreign firms if there are no wages spillover to domestic companies; if there are positive wage spillovers, both higher wage level in foreign companies and the positive spillovers to domestic companies can contribute to the overall wage increasing; even when foreign companies take a negative effect to the wages of domestic companies, the negative spillovers could be offset by foreign companies’ higher wages, so it could not impact the wage level increasing in the host countries.

3. FDI And Host Country Productivity

In this section, I will review the previous literatures based on two questions. The first one is whether the productivity is higher in foreign companies than domestic companies in developing countries. Only if the existence of higher productivity has been proved in foreign companies could the productivity spillover of FDI take place in developing countries. The second one is whether the higher productivity in foreign companies spills over to domestic companies.

According to previous studies, comparisons of productivity between foreign-owned plants and domestic-owned plants were focused on the manufacturing sectors in developing countries.

Lipsey (2002) gave a summary of Blomström and Wolff’s working paper. They found that by measuring both value-added and gross output from manufacturing data of Mexcican in 1970, the productivity of foreign companies was more than twice of domestic companies on average. When comparing with domestic companies, the labor productivity in foreign companies was much higher in 20 manufacturing industries. They also found that the capital intensity in foreign companies was 2.5 times higher than Mexican domestic companies.

Sjöholm (1999, p.55) in his article examined intra-industry spillovers from FDI in the manufacturing sector of Indonesian. He used micro-level data to examine the difference in labour productivity between foreign and domestic companies in 28 industries. It was proved that technology level was higher in foreign firms than domestic firms in 26 out of 28 industries. A similar conclusion can be found in a working paper written by Okamoto and Sjöholm (1999) which published in the same year. They reported in Indonesia, higher foreign shares of gross output than foreign share of employment between 1990 and 1995 indicated that foreign-owned companies had higher labor productivity.

Many other studies also showed that in developing countries, the foreign companies have higher productivity than domestic companies. For Morocco, Haddad and Harrison (1993) compared the “deviation of firm productivity from each sector’s best-practice frontier” in 18 industries from 1985 to 1989. They found a higher output per worker and a smaller deviation from best-practice frontiers in foreign companies than in domestic companies among total 12 industries. For Uruguay, value added per worker was used to estimate the difference in productivity between foreign and domestic owned companies. Result revealed that in 1988, the productivity in foreign firms was about 2 times as in domestic firms on average (Kokko, Zejan, and Tansini, 2001). According to a research of Taiwan manufacturing sector in 1991, Chuang and Lin (1999) found that labor productivity of MNCs was much higher than local firms, but total factor productivity of foreign companies was only slightly higher than local companies. The study for Turkey between 1993 -1995 in which different elements of the production function were taken into account by Eridilek (2002), as well as the study for five Ease Asian economies (Hong Kong, Indonesia, Malaysia, Singapore and Taiwan) in which Ramsteteer (1999) used value added per employee to measure labor productivity, both found that the average productivity of were significant higher in MNCs than in domestic firms.

From all evidence mentioned above, the conclusion that “foreign companies have higher productivity than domestic companies” can be supported in developing countries no matter what measures have been used. This phenomenon may be resulted from “larger scale of production” or “higher capital intensity” in the foreign companies (Lipsey, 2002, p. 40).

Before move to the research on whether host countries could get benefit from FDI in respect of productivity growth, we should first make clear when the productivity spillovers take place. Blomström and Kokko (1998) expressed that the productivity spillovers occur when establishment of foreign companies result in promoting the productivity and efficiency of the local companies in host countries, and the foreign companies can not completely internalize the value of these benefits. Another reason that productivity spillovers take place is the domestic companies are forced to improve the efficiency of using their existing technology and resources because the entry of foreign companies carried fierce competition to the host countries. The severe competition also leads the domestic companies to pursue new technologies which can result in the productivity spills out.

Besides, we should also classify the different types of spillovers. Horizontal spillovers are the effects from foreign to local firms belonging to the same industry. Vertical spillovers occur both in upstream industries and downstream industries (Javrcik, 2004). For horizontal spillovers studies, Aitken and Harrison (1999) used a panel data of Venezuelan companies during 1976 to 1989, concluded that there are “no evidence supports the existence of technology spillovers” between foreign and local companies (p.617). Konings (2001) also used panel data to study the effect of FDI in Bulgara, Romania and Poland. According to their conclusion, they did not find any evidence of spillovers in these emerging market economies. Such results have also been supported by Djankov and Hoekman (2000). However, this conclusion can not be generalized from all the developing countries. Damijan et al. (2003) used firm-level data to study 8 transition countries between 1994 and 1998, found spillovers from foreign to local companies were positive in Romania ( p.11). Besides, Kinoshita (2001) proved that the R&D-intensive sectors of Czech Republic have positive horizontal spillovers.

Compared with horizontal spillovers, “It is quite upbeat about the existence of vertical spillover” (Javrcik and Spatareanu, 2005, P.54). Since many existing articles have provided evidence of vertical spillovers in developing countries. In another paper of Javrcik (2004), firm-level panel data was used in testing the productivity spillovers in Lithuania. The results revealed positive spillovers from FDI in upstream sectors but the positive productivity spillovers were associated with partially owned foreign investments. Such existence of vertical spillovers has also been provided by Blalock and Gertler (2004) and Schoores and van der Tol (2001).

Although most of the articles have a common idea on the existence of vertical spillovers, they cannot reach agreements in some questions, such as whether there are some positive spillovers carried by FDI in upstream industries. Javrcik and Spatareanu (2005) gave a theoretical assumption that if multinationals can benefit from the better performance of intermediate input suppliers, they would not take measures to prevent productivity spillovers from happening. Thus, a spillovers-channel would be established between foreign companies and their suppliers belonging to local firms. In their opinion, positive effects of FDI might take place in upstream industries as the foreign companies would impose an increasing demand and better quality of intermediate products, such requirements would stimulate local suppliers to improve their technology in productive activity, meanwhile, they can benefits from scale economies. It seems reasonable but is not always the case in reality. Lipsey (2002) in his article cited an unpublished paper written by Aitken and Harrison (1991), which showed “negative effects of foreign direct investment in an industry on productivity in upstream industries” in Venezuela (p.41). They also provided a possible reason that “foreign firms shift the demand for intermediate inputs from domestic to foreign producers, reducing the scale of output, and there fore productivity, in domestic production” (p.41).

Other factors that could influent spillovers are also existent. Xu (2000) used data from 1966 to 1994 of US manufacturing MNCs in 40 countries to investigate whether MNCs can help international technology diffusion. The paper found a weak evidence of technology diffusion from US MNCs in less developed countries (LDCs). The explanation given by the author is most LDCs cannot reach “a human capital threshold of about 1.9 years (in terms of male secondary school attainment) to benefit from technology transfer of US MNE affiliates” (p. 491). A conclusion that “the technology spillover effects brought by FDI are not significant in less developed countries” could be abstracted from this paper.

Some studies did support that local firms in developing countries can benefit from FDI, because productivity spillovers from foreign firms can help local firms to improve their existing technology as well as achieve scale economies. However, in more cases, the spillovers are not significant, even negative. So we can not make a simple conclusion as whether the positive spillovers are really existent is depend on different factors in different circumstances.

4. FDI And Host Country’s Economic Growth

Economic growth, which is a common objective for all developing countries, can be achieved from productivity spillovers. Several authors have studied the interaction between FDI and economic growth in developing countries. De Mello (1999) found that spillovers of technology and knowledge from the foreign countries were two determinants of long-term growth in host countries and FDI has positive effects on economic growth in developing countries. Bende-Nabende (2001) used annual data from 1970 to 1996 studied on Asian countries and showed that in Indonesia, Malaysia and Philippines there is a positive impact carried by FDI. Bengoa and Sanchez-Robles (2003) used data between 1970 and 1999 of Latin American countries and find that positive effect only take place in countries with more economic freedom. According to Kohpaiboon (2003) and Marwah and Tavakoli (2004), a positive correlation between FDI and GDP growth were showed in Thailand, Malaysia and Philippines. Moreover, several papers focused on FDI effect in China also reflected positive effect on economic growth (Vu et al., 2008, p. 546).

However, not all the studies supported the positive effect of FDI in developing countries. In the research of Blomström, Lipsey, and Zejan (1994), developing countries were separated into two groups – the higher income countries and the lower income countries -and reported that only the higher-income group FDI inflow lead to economic growth. Through the analysis on 69 developing countries in the period of 1970 to 1989, Carkovic and Levine (2002) used panel data to test the correlation between FDI and developing countries’ economic growth. The results showed that the effect of FDI inflows was not significant.

The different methods and data choosing may lead to such different results. Some unknown factors would also affect the results. But they do not have so much impact to our conclusion. Based on the findings of previous studies, generally speaking, developing countries can benefit from FDI and achieve economic growth,

5. Conclusion

The propose of this essay is try to estimate whether developing countries can get benefits from foreign direct investment. The effect of FDI has been classified into three aspects. Firstly, it is a universal phenomenon that the wages in foreign companies are higher than domestic companies. The FDI activity has a positive effect to the overall wage levels of the host countries, although wages spillovers to domestic companies are not always exist. Secondly, “foreign companies have higher productivity than domestic companies” can be supported by most of the available studies no matter what measures have been used. Although some findings reflected that local firms in developing countries can benefit from FDI by productivity spillovers, in more cases, the productivity spillovers are not significant, even negative. Thirdly, developing countries can benefit from FDI and achieve economic growth. Overall, we can get a positive conclusion that the host countries, especially the developing countries, can benefit from foreign direct investment.

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