Benefits and costs of foreign direct Investment

Foreign direct investment (FDI) according to Hill(2007) takes place when a firm invests directly in facilities to produce and/or market a product in a foreign country. The facilities could include resources such as the factors of production; land, labour and capital. It could be said today’s major players in business seek not only to expand their territories in their home market but also have through FDI sought effective ways of improving existing products and breaking into new foreign markets. For example the import tariffs in China make it very challenging for other countries to serve the Chinese market through exports. Hill (2007). Via the use of FDI strategies foreign organisations are able to access pool of economic possibilities. Through the assessment of various sources the essay is going to critically assess the impacts of foreign direct investment (FDI) on a host country. It will critically discuss the benefits and disadvantages FDI has on the growth of a country.

According to Gorg and Greenway (2004) foreign direct investment is a key driver of economic growth and development. FDI assists in the economic progression of the country where the investment is being made. According to Mencinger (2003), a vast number of countries through various ways desperately seek to attract as much foreign direct investment as probable in the hope of advancing their economic growth. The economic growth could be advanced in that FDI leads to the creation of factors such as jobs and more investment into the economy. However it could be argued that the efficient adoption of FDI is most effective under certain conditions. For instance FDI contributes to economic growth only when a sufficient absorptive capability of the advanced technologies is available in the host country. Borensztein, Gregorio and Lee (1998). FDI strategy is more successful if it is carried out in economically developing countries. Developing host countries compared to developed countries are usually more keen to attract foreign investments in order to reap the benefits that come with it and this usually reflected in the legislation of one’s country. One could find that a business is more willing to first invest in a developing country as the legislation is more lenient compared to the first world countries. However it is important to note that this does not apply to all countries. China for example has a highly regulated environment, which can prove to be difficult when it comes to carrying out business transactions, and shifting tax and regulatory regimes. Hill(2007). It could be said that when making legislation those in power should regard the relative impact of the laws passed on potential FDI. On the other hand one could argue that more countries are becoming more aware of the importance of creating more favourable conditions for FDI. Gorg and Greenway in their report state that in 1998 legislation changes made by 60 countries, more than 90 percent of those changes created a more positive environment for FDI.

FDI if managed efficiently should aid to the hosts county’s economic development. “FDI inflows have been a major source of investment and economic growth in China…accounting for perhaps as much as 30 percent of the county’s growth.”(Hill, page 242, 2007). The mixture of cheap labour and tax incentives usually found in developing countries make an attractive base for foreign investors. The new economic investment brought in by foreign businesses will help in increasing the host country’s national income, at the same time bringing other economic benefits known as spillovers that will result in the increase of productivity within the country. Gorg states that, “…theoretical literature identifies four channels through which spillovers might boost productivity in the host country: imitation, skills acquisition, competition and exports.” These channels if recognised and implemented properly could lead to the increase of the host country’s productivity and economic growth. Through the imitation of foreign goods, services and processes the host country can increasing improve its processes, facilities and the way business is contacted in its own business environment. One of the worries for many foreign investors when wanting to invest in developing countries is that the host country will not have the facilities ( for example the equipment or the right business structure for the manufacturing and deploying of products) they need in order for business affairs to run smoothly. Through the imitation of the way foreign organisations handle their business affairs, host countries can improve their processes and facilities, arguably to the extent that they will make their country enticing to FDI. Imitation of products will improve the quality and range of products of the local organisations, making them competitive an appealing to customers. The increase of the productivity of more high quality products could lead to the attraction of not only local customers but global customers and this could also lead to more FDI in the host country.

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The flow of capital coming into the host country will provide room for the stimulation of economic activity into the country. The stimulation of economic activity in the host country could lead to a high rise of competition amongst local businesses as they thrive to keep up with the foreign investors in order to retain existing customers and attract potential customers. Through FDI the domestic producers could be forced to react to the changes brought in by foreign investors in turn transforming them into quality organisations that produce quality products and/or services depending on the country.

As mentioned above FDI will lead to the creation of jobs in the host country. The creation of jobs is a benefit for any country. The increase of the number of people working could raise the growth of the host countries Gross Domestic Product. However, “Borensztein (1998) find a weak positive correlation between FDI inflows and per capita GDP growth for a panel of countries in the 1970s and 1980s (although when they interact FDI and the level of schooling, FDI has a negative “direct effect” on growth and positive “indirect effect” through schooling).” Hanson (2001). It is also important to note that there is a link between income and consumption. A higher level of employment could lead to a higher level of consumption. The more people that are employed the more people that will purchase business products and services. The number people employed also tends to have a knock on effect on the inflation of a country. Generally the higher the employment rate of a country the more stable the economy will be become. When coming with their investments, foreign investors may also come with new skills for the host country. Investors if they want to effectively gain from their investments might find that there is a need to train the local workforce for them to carry out the job at hand. Local employees will be able to gain new skills through training and also through learning on the job. According to the Organisation for Economic Co-operation and Development (OECD) 2002, Employee enrichment can have further positive impacts on the host country as the skills learnt are transferred to other organisations and some employees become skilled and experienced enough to start their own businesses.

In today’s business environment consumers and organisations are becoming more aware of the impact various ways of conducting business have on the environment and in the societies in which they operate. OECD state that FDI could assist in improving a host country’s ecological and social conditions. Technologies and system brought in by foreign investors could lead to a more greener way of producing and distributing products. However could be argued that this is more effective in more developed countries than developing countries where their priorities are not on becoming more green but attracting investment. With FDI there is need to worry about the possible damaging impact of foreign businesses on the environment in developing countries. Foreign businesses if not managed properly that could have the potential of damaging a host country’s environment are organisations such as oil industries. “In this case, and especially where host-country authorities are keen to attract FDI, there would be a risk of a lowering or a freezing of regulatory standards.” OECD (2002). One of the costs identified by OECD (2002) occurs when the host country loses some of their legislative power due to their dependency of FDI.

When talking about spillovers one will need to be aware that it is not all the time that domestic firms largely benefit from spillovers. Cases where foreign firms did not find much or any competition in the same lines of business are not unheard of. In order to limit competition and to make sure they retain their high standards, secrets and competitive advantage foreign organisations can put strict processes to make sure that there are no spillovers. Gorg and Greenway (2004), argue that in spite of various academic arguments for FDI spillovers, the arguments and theories may merely be ineffective with little importance in reality. This statement is supported by Hanson(2001), who argues that the proof used to support positive spillovers on host countries through FDI is feeble. However OECD (2002) argues that there is evidence that given the appropriate host country conditions (for example the necessary level of development), FDI generates a lot of positive spillovers such as, increasing domestic business development and assisting with global trade integration or mixing.

In some cases if not most cases especially with developing countries foreign investors are more likely to send back the majority of the profits earned back to their own country. Hanson argues that despite the mandatory capital requirements like rent, wages and tax, all the profits acquired through FDI will be sent to shareholders abroad. With this in mind, it could be argued that is then essential for host country governments if they hope to reap more of the benefits of FDI in their country to put strict measures in process to make sure that certain groups (for example employees) in their country benefit more from FDI and not just the shareholders in other countries. However the challenge for the host country government will arise in that they will need to be careful in making sure their policies are not strict to the extent that they will push away future investment. It is no secret to those that know the business environment that foreign direct investment seems to be responsive to a country’s environment. For instance through tax incentives of a corporate tax rate of 12.5 percent, Ireland was able to attract a number of manufacturing organisations.

Hanson (2001) argues that micro-level data is in disagreement with experiential support for positive overall output spillovers from foreign direct investment. He argues that through FDI foreign organisations force host businesses to less cost-effective sections in the business environment. When it comes to FDI there are mixed emotions as to whether the benefits outweigh the costs. Mullen and Williams (2005) state that “researchers remain divided on whether FDI has an overall positive impact on employment ,whether domestic firms benefit ultimately from a greater foreign presence within their industry, and whether spillovers exist at all or in what direction.” Some view FDI as just another way for foreign investors to expand their territories by cross country ownership of businesses at the expense of the local businesses and yet it is hard to ignore the benefits that also come with FDI. Countries such as China and Brazil one could argue have benefited from FDI. According to Hills(2007) the sum supply of China’s FDI totals to about 30 percent of China’s total GDP. In Brazil international automobile producers launched and increased the manufacturing ability in the country. In the 1990s the number of manufactures, such as the likes of VM, Ford and Fiat, had increased to be more than a dozen. Hanson (2001). All these producers came with employment opportunities for the country. With manufacturing products such as cars specialist skills are needed, you also need specialist skills to ensure continuous improvement of products in order to remain competitive. They would have needed to train employees in order for them to achieve the high quality standard of work these organisations are associated with.

Despite mixed emotions when it come to FDI, it could be said that “FDI is a [fundamental] part of a open and effective international economic system and a major catalyst to development.” OECD (2002). It could be said that the reason(s) why FDI is more effective in one country but not as effective in another country is due to the conditions and characteristics of the host country. Through FDI host developing countries can be introduced to technologies and systems that will pave a way for them to be able to access international markets. Effective management of FDI by host countries could lead to the modernisation of domestic businesses. Although it is important to note this is not always the case in all countries.