Final fdi

Foreign Direct Investment 1. Introduction Foreign Direct Investment (FDI) in its classic definition is defined as a company from one country making a physical investment into building a factory in another country. Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor. The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a Multinational corporation (MNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The UN defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment. It can provide a firm with new markets and marketing channels, cheaper production facilities, access to new technology, products, skills and financing.

For a host country or the foreign firm which receives the investment, it can provide a source of new technologies, capital, processes, products, organizational technologies and management skills, and as such can provide a strong impetus to economic development.

The increased role of FDI in developing and emerging economies has raised expectations about its potential contribution to their development. FDI can bring significant benefits by creating high-quality jobs and introducing modern production and management practices. And many governments have developed policies to further promote inward FDI. It is argued that FDI can also enhance domestic investment and innovation. Thus, for the developing countries, most of which operate in the low-level equilibrium trap, that is low savings rate, followed by low investment rate and therefore, low per capita income growth rate, may escape from the trap by importing capital from abroad in the form of foreign direct investment. The benefits of FDI are not unknown to the developing

countries. In fact, most of the developing countries are competing with each other to attract handsome amount of FDI by adopting different promotional policies, such as by liberalizing trade regimes, establishing special economic zones and by offering incentives to the foreign investors.

The attitude towards inward foreign direct investment (FDI) has changed considerably over the last couple of decades, as most countries have liberalized their policies to attract investments from foreign multinational corporations (MNCs). On the expectation that foreign MNCs will raise employment, exports, or tax revenue, or that some of the knowledge brought by the foreign companies may spill over to the host country’s domestic firms, governments across the world have lowered various entry barriers and opened up new sectors to foreign investment.

Proponents of foreign investment point out that the exchange of investment flows benefits both the home country and the host country. Opponents of FDI note that multinational conglomerates are able to wield great power over smaller and weaker economies and can drive out much local competition. The truth lies somewhere in the middle.

The aim of this paper is to examine the overall impact of FDI. The paper is organized as follows, section 2 reviews the overview of FDI, section 3 discusses the Economies of Foreign Direct Investment Incentives, section 4 deals with the Determinants of Foreign Direct Investment and Its Impact on Economic Growth, and section 5 discusses the Foreign Direct Investment for Development. How Beneficial Is Foreign Direct Investment for Developing Countries is presented in section 6 and section 7 deals with The Social Impact of Foreign Direct Investment. Section 8 argues about whether FDI is a Lead Driver for Sustainable Development, section 9 discusses Growth and the Quality of Foreign Direct Investment while section 10 argues whether a casual link exists among FDI, Trade and Growth. Section 11 argues about whether Foreign Direct Investment

Help Emerging Economies and section 12 discusses about The Impact of Inward FDI on Host Countries. Section 13 provides an analysis of all the sections described. The last section provides a summary of the study and concludes the study.

2. Foreign Direct Investment A. History In the years after the Second World War global FDI was dominated by the United States, as much of the world recovered from the destruction brought by the conflict. The US accounted for around three-quarters of new FDI (including reinvested profits) between 1945 and 1960. Since that time FDI has spread to become a truly global phenomenon, no longer the exclusive preserve of OECD countries. FDI has grown in importance in the global economy with FDI stocks now constituting over 20 percent of global GDP. B.

The Importance of Foreign Direct Investment

Foreign direct investment (FDI) provides a major source of capital which brings with it up-to-date technology. It would be difficult to generate this capital through domestic savings, and even if it were not, it would still be difficult to import the necessary technology from abroad, since the transfer of technology to firms with no previous experience of using it is difficult, risky, and expensive.

Over a long period of time FDI creates many externalities in the form of benefits available to the whole economy which the TNCs cannot appropriate as part of their own income. These include transfers of general knowledge and of specific technologies in production and distribution, industrial upgrading, work experience for the labor force, the introduction of modern management and accounting methods, the establishment of finance related and trading networks, and the upgrading of telecommunications services.

FDI in services affects the host country's competitiveness by raising the productivity of capital and enabling the host country to attract new capital on favorable terms.

C. Types of FDI Foreign direct investment (FDI) is a measure of foreign ownership of productive assets, such as factories, mines and land. Increasing foreign investment can be used as one measure of growing economic globalization. Table 1 presents the different types of FDI. Table 1: Types of FDI

By Direction

Type Inward

Description Inward foreign direct investment (inbound) is a particular form of inward investment when foreign capital is invested in local resources.

Inward FDI is encouraged by: • •

Tax breaks, subsidies, low interest loans, grants, lifting of certain restrictions The thought is that the long term gain is worth more than the short term loss of income

Inward FDI is restricted by:

Outward

• Ownership restraints or limits • Differential performance requirements Outward foreign direct investment, sometimes called "direct investment abroad", is when local capital is invested in foreign resources. Yet it can also be used to invest in imports and exports from a foreign commodity country.

Outward FDI is encouraged by: • Government-backed insurance to cover risk Outward FDI is restricted by: • Tax incentives or disincentives on firms that invest outside of the home country or on repatriated profits • Subsidies for local businesses • Government policies that support the nationalization of industries (or at least a modicum of government control) • Self-interested lobby groups and societal sectors who are supported by inward FDI or state investment, for example labour markets.

By Target

Greenfield Investmen t

Horizontal FDI Vertical FDI

Direct investment in new facilities or the expansion of existing facilities is called Greenfield investment. Greenfield investments are the primary target of a host nation’s promotional efforts because they create new production capacity and jobs, transfer technology and know-how, and can lead to linkages to the global marketplace. Criticism of the efficiencies obtained from Greenfield investments includes the loss of market share for competing domestic firms. Another criticism of Greenfield investment is that profits are perceived to bypass local economies, and instead flow back entirely to the multinational's home economy.

Horizontal FDI occurs when the multinational undertakes the same production to activities in multiple countries.

Vertical FDI occurs when the multinational acquires a stake in a foreign firm that either uses its output or provides its input. The primary activity of the foreign firm usually precedes or succeeds that of the parent company.

Backward Vertical FDI Investment in a firm whose industry output provides the input for the parent company's operations.

By Motive

ResourceSeeking

MarketSeeking

Forward Vertical FDI Where an industry abroad sells the outputs of a firm's domestic production, or uses the firm's output as input.

Investments which seek to acquire factors of production that is more efficient than those obtainable in the home economy of the firm. In some cases, these resources may not be available in the home economy at all. This typifies FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labor in Southeast Asia and Eastern Europe.

Investments which aim at either penetrating new markets or maintaining existing ones. FDI of this kind may also be employed as defensive strategy; it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one. This type of FDI can be characterized by the foreign Mergers and Acquisitions in the 1980’s by Accounting, Advertising and Law firms.

EfficiencySeeking

StrategicAssetSeeking

Investments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope, and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm.

A tactical investment to prevent the gain of resource to a competitor.

Easily compared to that of the oil producers, whom may not need the oil at present, but look to prevent their competitors from having it.

3. The Economies of Foreign Direct Investment Incentives The use of investment incentives focusing exclusively on foreign firms, although motivated in some cases from a theoretical point of view, is generally not an efficient way to raise national welfare. The main reason is that the strongest theoretical motive for financial subsidies to inward FDI. Spillovers of foreign technology and skills to local industry are not an automatic consequence of foreign investment. The potential spillover benefits are realized only if local firms have the ability and motivation to invest in absorbing foreign technologies and skills. To motivate subsidization of foreign investment, it is therefore necessary, at the same time, to support learning and investment in local firms as well.

An increasing number of host governments also provide various forms of investment incentives to encourage foreign owned companies to invest in their jurisdiction. These include fiscal incentives such as tax holidays and lower taxes for foreign investors, financial incentives such as grants and preferential loans to MNCs, as well as measures like market preferences, infrastructure, and sometimes even monopoly rights. Although some FDI promotion efforts are probably motivated by temporary Macroeconomic problems such as low growth rates and rising unemployment, there are also more fundamental explanations for the increasing emphasis on investment promotion in recent years.

In particular, it appears that the globalization and regionalization of the international economy have made FDI incentives more interesting and important for national

governments. Trade liberalization be it globally, through GATT and WTO, or regionally, in the form of EU, NAFTA, AFTA and other regional agreements has led to increasing market integration and reduced the importance of market size as a determinant of investment location.

Hence, even a small country may now compete for FDI, given that it can provide a sufficiently attractive incentive package. At the same time, national decision-makers have lost many of the instruments traditionally used to promote local competitiveness, employment, and welfare. The scope for active trade policy has diminished as a result of successful trade liberalization, and the internationalization of capital markets has limited the possibilities to use exchange rate policy as a tool to influence relative competitiveness.

However,

national

decision-makers

remain

committed

to

promoting

the

competitiveness and welfare of their constituencies, and are likely to put more emphasis on those policy instruments that remain at their disposal, including FDI incentives. The fact that most others subsidize foreign investment is another important reason why more and more countries are drawn into the subsidy game.

There are also more substantial theoretical arguments in favor of public support to FDI than globalization and the wish to increase local employment and growth rates in cyclical downturns. The strongest ones are based on the prospect for knowledge spillovers. Since the technology and knowledge employed by foreign firms are to some extent public goods, foreign investment can result in benefits for their host countries even if the MNCs carry out their foreign operations in wholly-owned affiliates. These benefits take the form of various types of externalities or spillovers. For instance, local firms may be able to improve their productivity as a result of forward or backward linkages with MNC affiliates; they may imitate MNC technologies, or hire workers trained by MNCs.

The increase in competition that occurs as a result of foreign entry may also be considered a benefit, in particular if it forces local firms to introduce new technology and work harder. However, the foreign MNCs will not include these spillovers in their private assessment of the costs and benefits of investing abroad, and may therefore invest less than what would be socially optimal. The motive for public subsidies to foreign investors is to bridge the gap between the private and social returns, thus promoting larger inflows of FDI. A. Investment Incentives and FDI Theory suggests that in order to compete successfully in a foreign market a firm must possess some ownership-specific assets in knowledge, technology, organization, management or marketing skills. A firm blessed with such assets has several alternative ways (apart from exporting) to claim the rents that they will yield in foreign markets, including subsidiary production, joint ventures, licensing, franchising, management contracts, marketing contracts, and turnkey contracts. Of these, subsidiary production and joint ventures involve varying degrees of foreign presence, and force the firm to decide where to locate their foreign activity. Until recently, there was a strong consensus in the literature about why multinationals invest in specific locations.

The view was that MNCs are mainly attracted by strong economic fundamentals in the host economies. The most important of these are market size and the level of real income, with skill levels in the host economy, the availability of infrastructure and other resources that facilitate efficient specialization of production, trade policies, and political and macroeconomic stability as other central determinants. This hierarchy of host country characteristics largely assumed that FDI was market-seeking; it was recognized that foreign investors seeking an export base would be less focused on local market size and more concerned about the relative cost of production.

Still, investment incentives were seen as relatively minor determinants of FDI decisions.

While they might tilt the investment decision in favor of one of several otherwise similar

investment locations, the effects were considered only marginal. However, the views on the importance of incentives have begun to change in recent years.

One indication is the proliferation of investment incentives across the world. More than 100 countries provided various FDI incentives already in the mid-1990s, and dozens more have introduced such incentives since then. Few countries compete for foreign investment without any form of subsidies today. In industrialized countries where financial incentives are more common, the subsidies per FDI-related job often reach tens of thousands of US dollars.

With the exception of export processing zones and industrial estates, where infrastructure and land are subsidized, developing countries are more likely to base their incentive schemes on tax holidays and other fiscal measures that do not require direct payments of scarce public funds.

For obvious reasons, there are no reliable calculations of how costly these programs are: it is almost impossible to determine the quantity of FDI that would have flowed to each country in the absence of incentives. Due to the lack of published data on the form and amount of FDI subsidies, it is also difficult to make explicit comparisons of how different kinds of incentives influence investment flows and firm behavior, although it is likely that there are significant differences between subsidy programs.

For instance, direct financial subsidies are likely to have their main influence on the location decision itself, while tax holidays may well effect operational decisions for several years (in particular at the time when the tax holiday is running out). This notwithstanding, while MNC executives used to downplay the role of incentives, they now readily admit their increasing importance for investment decisions.

Moreover, recent econometric studies on the effects of FDI incentives, in particular fiscal preferences, suggest that they have become more significant determinants of international direct investment flows. This is interesting, not least since most FDI incentives apply in particular to Greenfield investments rather than foreign acquisitions of existing companies: the latter dominate aggregate FDI flows, especially in developed countries.

The main reason for the increasing prominence of FDI incentives, as noted in the introduction, is arguably the internationalization of the world economy. Global trade liberalization has made it easier for MNCs to set up international production networks, so that a larger share of output is shipped to international customers or affiliated companies in other countries rather than sold to local customers.

This has reduced the impact of market size and allowed smaller countries to compete for investments that would automatically have been directed to the major markets some decades ago. Regional integration has similar effects, allowing MNCs to supply all or several member states from a single location within the region. Incentives have also become increasingly important for national policymakers who are trying to promote local production, employment, and welfare.

The scope for active national trade and exchange rate policy has diminished. Most clearly for present and potential EU members, who are largely bound by decisions taken by the EU Commission and the European Central Bank and shifted attention to industrial policy, including measures such as investment incentives.

As a result, the incentives provided by many countries have become more generous over the years, and decisions that would not have been influenced by a mere two-year tax holiday may well be swayed by a 10-year holiday.

Considering that market integration has reached further at the regional rather than global level, it is also clear that the effects of incentives are likely to be particularly

strong in the competition for FDI within regions (or even countries), when the initial investment decision has been taken and the investor is choosing between alternative locations in a given region.

The question is whether the host country’s costs for providing the incentives in terms of grants, subsidies, and other expenses are justified. Are investment incentives likely to yield benefits that are at least as large as the costs? To answer this question, it is convenient to begin by considering a hypothetical case where foreign MNCs do not differ in any fundamental way from local firms (although we know that MNCs typically possess firm-specific intangible assets that are not generally available in the host countries).

Even in this extreme case, it may be possible to construct theoretical arguments in favor of investment incentives that are based on various kinds of externalities or market imperfections. The costs of the initial investment incentive could arguably be recouped over time as the economy (and thereby the tax base) grows thanks to the FDI inflows.

However, there are at least two arguments against this type of incentives.

Firstly, it is difficult make reliable calculations about the expected future benefits in terms of growth, employment, or tax revenue, which is necessary to determine how large the subsidies should be. This is particularly complex in cases where FDI projects that are driven by investment incentives rather than economic fundamentals of the host country. The reason is that these investors are likely to be relatively footloose, and could easily decide to move on to other locations offering even more generous incentives before the expected benefits in the first location have been realized.

Secondly and most importantly - if foreign investors do not differ in any fundamental way from local investors, subsidizing FDI may distort competition and generate significant losses among local firms.

Thus, it is hard to justify investment incentives focusing on foreign MNCs that do not differ fundamentally from local companies. At the same time, it should be noted that

this conclusion does not rule out public policy intervention in the form of investment subsidies in situations where unemployment, insufficient investment, or weak growth are central policy problems. Instead, the policy prescription is that the problems should be addressed with policies that do not differentiate between foreign and local investors.

In the more realistic case where conditions for foreign firms differ from those for local firms, it is easier to motivate FDI incentives with the argument that there may be some distortion or market failure that is specific to MNC production. The most obvious distortions occur if rules and regulations are biased against foreign owners in such cases, FDI incentives may well be needed to overcome the various obstacles faced by foreign investors. Although this motive for incentives has probably been important in the past, we will simplify the subsequent discussion by assuming that there is no formal discrimination of foreign owners.

Controlling for this, the most common source of market failure is related to externalities or spillovers of FDI. As theory suggests, a firm must possess some asset in the form of knowledge of a public-good character to be able to compete in foreign markets. If the multinational corporation cannot capture all quasi-rents due to its productive activities in the host economy, or if the affiliate increases the competitive pressure and removes distortions, the host country’s private sector can gain indirectly when productivity spills over to locally owned firms. Thus, when markets fail to reflect the social benefits of the FDI, government action can be justified to bridge the gap between social and private return for FDI projects that create positive spillovers.

The entry of a foreign MNC raises the demand for domestically produced intermediates in the host country, which leads to the entry of new firms (and product varieties) in the imperfectly competitive intermediate sector, and a reduction in the cost of production.

The increase in competitiveness may attract further foreign investors into the country, raising national income and welfare.

This motivates the host country to subsidize FDI, in competition with other host countries that see the same potential gains. In fact, in equilibrium, the subsidies may be large enough to exhaust all the gains to the host country that manages to attract the foreign investors, effectively transferring all benefits to the MNCs. The subsidy games between governments aiming to attract FDI have also been subject to detailed formal analysis. One conclusion from these studies is that differences in country size, production costs, and expected gains from FDI inflows influence each country’s optimal incentive scheme.

Moreover, the equilibrium distribution of FDI between countries with subsidies may well be significantly different from that without subsidies even in a perfect information setting, where each country implements its optimal incentive scheme. In other words, FDI incentives can be expected to have a significant impact on the pattern of international investment.

Although the rationale for subsidizing inward FDI is to correct the failure of markets to reflect spillover benefits, it should be noted that neither policy making nor formal theory have focused much effort on matching the size of subsidies to the amount of expected spillover benefits: instead, it is assumed that the spillover benefits are sufficiently large to justify investment incentives. In other words, few commentators have assessed the empirical evidence regarding spillovers in connection with this particular policy debate. This gives reason to make a brief review of literature on FDI spillovers with the explicit purpose to reinterpret the evidence in light of the debate on FDI incentives.

B. Foreign Direct Investment and Spillovers The earliest discussions of spillovers in the literature on foreign direct investment date back to the 1960s. The first author to systematically include spillovers (or external effects) among the possible consequences of FDI was MacDougall (1960), who analyzed

the general welfare effects of foreign investment. Other early contributions were provided by Corden (1967), who looked at the effects of FDI on optimum tariff policy, and Caves (1971), who examined the industrial pattern and welfare effects of FDI. Productivity externalities were discussed together with several other indirect effects that influence the welfare assessment, such as those arising from the impact of FDI on government revenue, tax policies, terms of trade, and the balance of payments. The fact that externalities were taken into account was generally motivated by empirical evidence from case studies rather than by comprehensive theoretical arguments.

Yet, the early analyses made clear that multinationals may improve allocative efficiency by entering into industries with high entry barriers and reducing monopolistic distortions, and induce higher technical efficiency if the increased competitive pressure or some demonstration effect spurs local firms to more efficient use of existing resources. They also proposed that the presence may lead to increases in the rate of technology transfer and diffusion.

More specifically, case studies showed that foreign MNCs may: •

Contribute to efficiency by breaking supply bottlenecks (but that the effect may become less important as the technology of the host country advances);

•

Introduce new know-how by demonstrating new technologies and training workers who later take employment in local firms;

•

Either break down monopolies and stimulate competition and efficiency or create a more monopolistic industry structure, depending on the strength and responses of the local firms;

•

Transfer techniques for inventory and quality control and standardization to their local suppliers and distribution channels; and,

•

Force local firms to increase their managerial efforts, or to adopt some of the marketing techniques used by MNCs, either on the local market or internationally.

Although this diverse list gives some clues about the broad range of various spillover effects, it says little about how common or how important they are in general.

For instance, many analyses of the linkages between MNCs and their local suppliers and subcontractors have documented learning and technology transfers that may make up a basis for productivity spillovers or market access spillovers. However, it is seldom revealed whether the MNCs are able to extract all the benefits that the new technologies or information generate among their supplier firms, so there is no clear proof of spillovers, but it is reasonable to assume that spillovers are positively related to the extent of linkages.

Similarly, there is much written on the relation between MNC entry and presence and market structure in host countries, and this is closely related to the possible effects of FDI on competition in the local markets.

The statistical studies of spillovers, by contrast, may reveal the overall impact of foreign presence on the productivity of local firms, but they are generally not able to say much about how the effects come about. These studies typically estimate production functions for locally owned firms, and include the foreign share of the industry as one of the explanatory variables.

They then test whether foreign presence has a significant positive impact on local productivity (or productivity growth) once other firm and industry characteristics have been accounted for. Although the data used in these analyses are often limited to few variables, aggregated to industry level rather than plant level, and in several cases of a cross-section rather than time series or panel character, they do provide some important evidence on the presence and pattern of spillover effects.

Almost all of the statistical analyses of spillovers have focused on intra-industry effects, but there are a few exceptions. One of them is Katz (1969), who notes that the inflow of

foreign capital into the Argentine manufacturing sector in the 1950s had a significant impact on the technologies used by local firms. He asserts that the technical progress did not only take place in the MNCs’ own industries, but also in other sectors, because the foreign affiliates forced domestic firms to modernize .by imposing on them minimum standards of quality, delivery dates, prices, etc. in their supplies of parts and raw materials.

Also Aitken and Harrison (1991) include some discussion about inter-industry effect in Venezuelan manufacturing, and argue that forward linkages generally brought positive spillover effects, but that backward linkages appeared to be less beneficial because of the foreign firms high import propensities (although there were differences between industrial sectors).

Moreover, Sjöholm (1999b) identifies a geographical dimension of positive inter industry spillovers in Indonesian manufacturing. His results suggest that the presence of foreign multinational companies may raise the productivity of locally owned firms in other industries, presumably through various linkages, but only if they are located in close proximity of the foreign multinationals.

Foreign presence is simply included among other firm and industry characteristics as an explanatory variable in a multiple regression. All three studies conclude that spillovers are significant at this aggregate level, although they cannot say anything about how spillovers take place.

Some more recent studies also claim that inward investment has made an important and significant contribution to economic growth in the recipient countries. For instance, Driffield (2001), Liu et al. (2000) and Pain (2001) all find statistically significant spillovers in the UK, as do Chuang and Lin (1999), Dimelis and Louri (2002), and Lipsey and Sjöholm (2001) in their studies of Greece, Taiwan, and Indonesia, respectively. Similar results are reported in Blomström and Wolff (1994), who also try to determine the size of these effects by asking whether the spillovers in the Mexican manufacturing sector

were large enough to help Mexican firms converge toward US productivity levels during the period 1965-1982.

Their answer is affirmative: foreign presence seems to have a significant positive impact on the rates of growth of local productivity. Similar conclusions is reached by Nadiri (1991), in a study of the impact of US direct investment in plant and equipment on the manufacturing sectors in France, Germany, Japan, and the UK between 1968 and 1988.

Increases in the 13 capital stock owned by US multinationals seem to stimulate new domestic investment in plant and equipment, and it appears that there is also a positive impact of FDI on the growth of total factor productivity in the host countries’ manufacturing sectors.

On the other hand, there are several studies that find negative effects of the presence of multinationals on domestic firms. For instance, Haddad and Harrison (1991, 1993), in a test of the spillover hypothesis for Moroccan manufacturing during the period 19851989, conclude that spillovers do not take place in all industrial sectors. Like BlomstrÜm (1986), they find that foreign presence lowers the average dispersion of a sector’s productivity, but they also observe that the effect is more significant in sectors with simpler technology.

This is interpreted to mean that foreign presence forces local firms to become more productive in sectors where best practice technology lies within their capability, but that there are no significant transfers of modern technology. Furthermore, they find no significant effects of foreign presence on the rate of productivity growth of local firms, and interpret this as additional support to the conclusion that technology spillovers do not occur. Examining the geographical dispersion of foreign investment, they suggest that the positive impact of FDI accrued mainly to the domestic firms located close to the MNC affiliates. However, effects seem to vary between industries. Also Perez (1998), in a study of UK industries and Cantwell (1989), who investigates the responses of local

firms to the increase in competition caused by the entry of US multinationals into European markets between 1955 and 1975, argue that positive technology spillovers did not occur in all industries.

Cantwell´s analysis differs notably from the other studies discussed in this section - he does not focus on productivity, but rather on changes in the market shares of foreign and local firms - but his conclusions are interesting. He asserts that the technological capacity of indigenous firms was the major factor in determining the success of the European corporate response to the US challenges, and that the size of the national market was an additional determinant.

So the results on the presence of spillovers seem to be mixed. However, recent studies suggest that there is a systematic pattern where various host industry and host country characteristics influence the incidence of spillovers. For instance, the foreign affiliate’s levels of technology or technology imports seem to influence the amount of spillovers to local firms.

The technology imports of MNC affiliates, in turn, have been shown to vary systematically with host country characteristics. These imports seem to be larger in countries and industries where the educational level of the local labor force is higher, where local competition is tougher, and where the host country imposes fewer formal requirements on the affiliates’ operations.

Some recent studies have also addressed the apparent contradictions between the earlier statistical spillover studies by exploring the hypothesis that the host country’s level of technical development may matter as a starting point. For example, argues that spillovers should not be expected in all kinds of industries.

In particular, foreign MNCs may sometimes operate in enclaves where neither products nor technologies have much in common with those of local firms. In such circumstances,

there may be little scope for learning, and spillovers may not materialize. Conversely, when foreign affiliates and local firms are in more direct competition with each other, spillovers are more likely.

Kathuria (1998, 2000) suggests that the indirect gains or spillovers from FDI are not an automatic consequence of MNC presence in the Indian economy. Rather they depend to a large extent on the efforts of local firms to invest in learning and R&D activities so as to decode the spilled knowledge.

Moreover, no evidence of spillovers to low-tech Indian companies was reported.

Another possible explanation for the divergent findings from the earlier statistical spillover tests is suggested by Kokko (1996), who analyzes the effects of competition in Mexican manufacturing. The earlier studies have tested the hypothesis that productivity spillovers are strictly proportional to foreign presence, but Kokko argues that this is not always the case. Spillovers from competition, in particular, are not determined by foreign presence alone, but rather by the simultaneous interactions between foreign and local firms.

Hence, it is possible that the spillovers are larger in cases where a few foreign MNC stir up a previously protected market than in a situation where foreign affiliates hold large market shares, but refrain from competing hard with local firms. In fact, in some cases, large foreign presence may even be a sign of a weak local industry, where local firms have not been able to absorb any productivity spillovers at all and have therefore been forced to yield market shares to the foreign MNCs. Analyzing the operations of foreign and domestic firms in Mexican manufacturing in a simultaneous framework, Kokko (1996) finds support for these hypotheses. The labor productivity of foreign and local firm appears to be simultaneously determined, and competition from foreign affiliates seems to have an independent effect on the

productivity of local firms, even after accounting for the demonstration and contagion spillovers that are directly proportional to foreign presence. SjĂśholm (1999a) also concludes that competition enhances the positive productivity spillovers from FDI. Yet another possible determinant of spillovers is the trade orientation of the investing firms. Kokko et al. (2001) note that local market oriented foreign investors in Uruguay have apparently had a stronger impact on local technology and productivity levels than have export oriented local firms. One reason could be that local market oriented MNCs may have relatively strong interactions with local firms, both as competitors and collaborators, whereas export oriented foreign investors may often be relatively isolated from the local market.

While most of the studies mentioned above have focused on differences between industries in a given host country, BlomstrÜm et al. (1994) have examined the role of the host country’s overall development level as a determinant of spillovers. The results of their comprehensive cross-country study of 101 economies suggest that spillovers are concentrated to middle-income developing countries, while there was no evidence of such effects for the poorest developing countries. Just as the analyses of individual host countries, these findings highlight the importance of local competence and competition for spillovers.

Thus, FDI is a rich country good and only the most advanced developing countries are able to benefit from FDI. It seems clear from these studies that host country and host industry characteristics determine the impact of FDI, and that systematic differences between countries and industries should therefore be expected. There is strong evidence pointing to the potential for significant spillover benefits from FDI, but also ample evidence indicating that spillovers do not occur automatically. A reasonable conclusion from the mixed findings of earlier studies is that the ability and motivation of

local firms to engage in investment and learning to absorb foreign knowledge and skills is an important determinant of whether or not the potential spillovers will be realized.

C. Are International Investment Incentives Justified?

Based on the argument that foreign firms can promote economic development and growth, many countries have introduced various investment incentives to encourage foreign MNCs to invest in their market. As it is argued previously, such incentives can mainly be justified if the foreign firms differ from local companies in that they possess some firm specific intangible asset that can spill over to local firms.

In that case, the foreign investor’s private benefits are lower than the social benefits (including the spillovers) and total foreign investment will fall short of the optimal amount unless various investment incentives compensate the foreign investor. Given the positive empirical evidence on spillovers presented before, there are therefore reasonable arguments in favor of investment incentives.

At the same time, there are good reasons to remain cautious in granting incentives focusing exclusively on foreign investors. It is not easy to determine where and how spillovers will occur, which creates problems of .picking winners, i.e. identifying firms that are likely to yield spillover benefits. It is also difficult to calculate the value of these externalities, which is important, since national welfare will increase only if the investment incentive is smaller than the value of the externality.

If the subsidies are larger than what is motivated by the externalities, the host country will not only lose public revenue, but the incentives will also discriminate against local firms that may lose jobs and market shares. Another problem with international investment incentives is that they prepare the ground for rent seekers. It is well known from the trade literature that selectivity, in combination with lack of transparency, increases the risk for rent-seeking and corruption.

Policy measures that focus on broad and general forms of support that are available to all firms, irrespective of nationality, tend to reduce rent-seeking and corruption. Some of the main problems in this context are related tax holidays and tax breaks, which may appear to be simple and innocuous forms of incentives.

Moreover, competition among governments (national or local) to attract FDI may create problems. When most governments compete actively for FDI, it is difficult for any individual country to stay out of bidding contests, which effectively shift profits from the host country to multinational enterprises. One reason is of course that strong promotion efforts show that the government is actively doing something to strengthen employment, productivity, growth, or some other policy objective (whether or not they get any FDI).

Another reason is that some of the perceived benefits (in particular, the jobs created by FDI) are easily observable while some of the costs (particularly related to tax breaks and other fiscal incentives) are distributed over long periods of time and hard to measure.

Consequently, there is a tendency to overbid and the subsidies may very well surpass the level of spillover benefits, with welfare losses as a result.

These problems are in many ways similar to those discussed in the trade policy debate.

In the same way as investment incentives may be politically attractive in the short run, but costly in the long run, protectionism may also promote local employment and production in the short run at a high long run cost. In fact, several authors have drawn parallels between trade barriers and international investment subsidies, noting, for example, that it is possible to calculate tariff equivalents for each FDI subsidy.

Both policy areas are also characterized by coordination problems, where no country gains from unilateral liberalization unless they expect others to follow. In the trade area, the path away from beggar-thy-neighbor policies has been multilateral negotiations

where trade liberalization is coordinated across countries. It is clear that a similar solution would be first best also in foreign direct investment policy, in particular at the regional level (where competition is most fierce).

However, although several multilateral agreements include clauses on incentives and investment rules, their coverage remains limited. More comprehensive regulation of FDI incentives is found only in advanced regional integration agreements like NAFTA and EU, where extensive market integration has made it necessary to harmonize incentive policies as well.

For instance, in the EU, investment incentives are in principle restricted to areas qualifying for regional assistance. This notwithstanding, substantial subsidies amounting to tens of thousands of Euros per job created are common, and restrictions on subsidies are eased when EU governments explicitly compete for FDI with non-EU countries.

In the absence of multilateral agreements on investment, it is therefore likely that many countries will continue subsidizing FDI. How should FDI incentives then be designed?

The most important argument against investment incentives focusing exclusively on foreign firms is based on the evidence that spillovers are not automatic, but depend crucially on the conditions for local firms.

The potential for spillovers is not likely to be realized unless local firms have the ability and motivation to learn from foreign MNCs and to invest in new technology.

Consequently, investment incentives aiming to increase the potential for spillovers may be inefficient unless they are complemented with measures to improve the local learning capability and to maintain a competitive local business environment.

This suggests first and foremost that the incentives should be rules-based and available on equal terms to all investors irrespective of industry and nationality of investor, rather than based on discretionary decisions. The motive for supporting foreign investors

including existing investors that may consider expanding their activities is to equalize social and private returns to investment. But there is a difference between social and private returns only if local firms are actually able to absorb some of the potential spillover benefits, and this does not occur automatically.

Hence, to justify FDI incentives, there is a reason to simultaneously subsidize local firms to strengthen their capacity to absorb foreign technology and skills. Moreover, the incentives should ideally not be of an ex ante type that is granted and paid out prior to the investment, but should instead promote those activities that create a potential for spillovers. In particular, these include education, training, and R&D activities, as well as linkages between foreign and local firms. An advantage of performance based incentives is that they may affect the entire stock of investments, rather than just the flow of new investment.

In addition to investment incentives of the type, governments should also consider their efforts to modernize infrastructure, raise the level of education and labor skills, and improve the overall business climate as parts of their investment promotion policy. As noted repeatedly above, these are important component of the economic fundamentals that determine the location of FDI. In addition to attracting FDI and facilitating the realization of spillovers, these policies will also promote growth and development of local industry.

Determinants of Foreign Direct Investment and Its Impact on Economic Growth It is widely recognized that foreign direct investment (FDI) produces economic benefits to the recipient countries by providing capital, foreign exchange, technology, competition and by enhancing access to foreign markets (e.g., Brooks and Sumulong, 2003; World Bank, 1999; Caves, 1974; Crespo and Fontura, 2007; Romer, 1993; UNCTAD, 1991). In 1991, for example, a total of 35 countries made almost 82 changes in their FDI policies to attract FDI (Ruffin, 1993). The scenario of FDI inflow to the developing countries is, however, not very encouraging.

Firstly, Developing countries are dominated by the developed countries in attracting FDI. According to UNCTAD (2007), in 2005 total FDI inflow in the world was 945.8 billion USD, of which developed countries received 590.3 billion USD which is 62.4 percent of the total FDI inflow in the world, whereas in the same year developing countries received FDI only 314.3 billion USD. It was only 38.6 percent of the total FDI inflow in the world. Thus, developing countries are dominated by the developed countries in attracting FDI. Secondly, among the developing countries, only a few countries, such as China, Indonesia, Egypt and Columbia are the most successful countries in attracting FDI, whereas majority of the developing countries apparently fail to attract FDI. According the UNCTAD (2007), in 2007 China, Indonesia, Egypt and Columbia received FDI in total 96.4 billion USD, which was nearly 31 percent of total FDI flowed to developing countries. Whereas some developing countries, such as Bolivia and Yemen faced the problem of negative FDI inflow (FDI outflow). Questions arise as to why FDI inflow is biased towards only to a few countries? What are the determinants of FDI inflow?

Finally, is there any relationship between FDI and economic growth?

A. Tends of FDI Inflow: FDI Mostly Flows towards the Developed Countries

Figure 1 presents the trends of total inflow of FDI in the world as well as in the developed and developing countries. The trends reflect that FDI mostly flows towards the developed countries.

Figure 1. Trends of FDI Inflow (in billion USD) during 1997 to 2005

Figure 1 shows that there is a one-to-one relationship between the trends of FDI inflow in the world and the developed countries. Both world FDI inflow and FDI inflow toward developed countries fluctuate in a similar pattern. For example, FDI inflow in the world and in developed countries hiked in 1999 and then started to decline in the same pattern. But after 2002, the inflow of FDI in the world, as well as in the developed countries again started to increase.

On the other hand, figure 1 shows that the trend of FDI inflow in the developing countries is almost constant and stagnant and uncorrelated with the world FDI inflow during the entire period under consideration.

In 2005, total inflow of FDI to the developed countries was more than 1200 billion USD, whereas in the same year in developing countries total inflow of FDI was even less than 400 billion USD. Thus, Figure 1 depicts that developing countries absolutely lag behind in competition with the developed countries in attracting FDI.

B. Lower-middle Income Developing Countries are more

Successful in

Attracting FDI. Developing countries are not only lagging behind in attracting FDI, but also the pattern of FDI inflow to the developing countries is highly uneven. A few developing countries enjoy massive FDI inflow, whereas other developing countries even face the problem of FDI outflow (negative FDI inflow).

An analysis of the UNCTAD (2007) report reveals that lower-middle income countries, that is developing countries with per capita GNI lies between US$ 755 to US$ 2995 are more likely to be successful in attracting FDI, but low-income countries that is developing countries with per capita GNI less than 755 USD are comparatively less likely to be successful in attracting FDI. Table 2 presents the uneven pattern of FDI inflow into the developing countries.

Table 2. Average Inflow of FDI into Sample Lowest 40 and Top 20 FDI Recipient Countries in 2005

In Table 2, sample 60 countries are divided into two groups based on the amount of FDI they have received in 2005. The first group consists of top 20 FDI recipient countries and the second group consists of 40 low FDI countries in 2005.

Among the top 20 FDI recipient countries, six countries were from Africa, 10 countries were from Asia and four countries were from Latin America. In 2005, these top 20 FDI recipient countries received a total of 129738 million (USD) FDI and on average each top

FDI recipient country received 6436.9 million USD as FDI. The performance in receiving FDI, however, varies across the continents.

The top performing six African countries on average received FDI less than 2500 million USD in 2005, whereas the top performing 10 Asian countries received on an average 9823.6 million USD in the same year. The top performing four Latin American countries, on the other hand received FDI on an average 3895.8 million USD in 2005. Thus, among the top performing countries inflow of FDI is uneven and the Asian countries are performing the best.

In 2005 among the 20 top FDI recipient countries, 16 countries were the lower-middle income countries and only four countries were the low-income countries. Thus, lowermiddle income developing countries tend to be more successful in attracting FDI and they are the dominant recipient of FDI. The four low-income but four among the top 20 FDI recipient countries in 2005 were Nigeria, Vietnam, India and Pakistan.

Table 2 also presents the average and total inflow of FDI into 40 low-income countries (whose per capita GNI are less than US$ 755). Among 40 low FDI recipient countries, 24 were from Africa, 10 were from Asia and six were from Latin America. Table 2 clearly shows that low income countries in general less successful in attracting FDI. In 2005, these 40 low FDI recipient countries received FDI only 5992 million USD in total with per country average FDI 149.8 million USD. Thus, the performance gap between top 20 FDI recipient countries and 40 low FDI recipient countries is very visible. The performance of the low recipient countries in terms of receiving FDI also varies across the continents. Table 2 shows that low FDI recipient Asian and Latin American countries on an average receive more FDI compared to the African countries.

Among 40 low FDI recipient countries, a total of 28 countries were the low-income countries and only 12 countries belonged to the lower-middle income group countries.

These low FDI recipient but lower-middle income countries were: Nicaragua, Angola, Georgia, Honduras, Sri Lanka, Bhutan, Bolivia, Paraguay, Guatemala, Iran, Namibia and El Salvador. Thus, in general low-income countries were the low FDI recipient countries in 2005.

Trend analyses of FDI inflow in the developed and developing world reveal two important issues. Firstly, the developing countries are in general not well performing in attracting FDI compared to the developed countries, and secondly, among the developing countries, lower-middle income countries are mostly successful in attracting FDI compared to the low-income countries.

Now the question arises as to why lower-middle income developing countries are more likely to be successful in attracting FDI compared to the low income developing countries? What determine the inflow of FDI? The next section compares the socioeconomic condition of top 20 and low 40 FDI recipient countries in 2005 with an attempt to answer the questions raised above.

C. A comparison of the Socio-Economic Condition between Top 20 and Low 40 FDI Recipient Countries in 2005 Table 3 presents the comparative socio-economic condition of the 20 top FDI recipient countries and 40 low FDI recipient countries in 2005.

To compare, five types of indicators have examined. These are: •

Market size and market potentials,

•

Openness to international market,

•

Total labor force and the contribution of industrial sector to the GDP,

•

Extent of corruption and business environment and

•

The communication facilities.

Market size and market potentials are compared by examining per capita GDP and annual GDP growth rate in 2005. Merchandise trade (export+ import) and export of goods and services (% GDP) are compared to measure the degree of openness to the international market. Total labor force and industrial value added (% GDP) are examined to compare the comparative availability of labor and industrial strength or contribution of industrial sector in the economy.

To compare the extent of corruption and business environment, a number of indicators are examined. These are corruption perception index (lower corruption means higher index and vice versa), cost of business start-up procedure (% GNI per capita), days required to start a business and days required to enforce a contract. To compare the communication facilities, the number of telephone and internet users (per 1000) in top 20 and low 40 FDI recipient countries in 2005 are also compared.

Table 3 shows that in 2005 the average per capita GDP in the top 20 FDI recipient countries was 1529.4 USD, whereas in 40 low FDI recipient countries it was only 651.5 USD. The annual average GDP growth rate in the top 20 FDI recipient countries was 7.4 percent in 2005, whereas in 40 low FDI recipient countries it was only 4.9 percent. The differences in GDP per capita and annual GDP growth rate between top and low FDI recipient countries are statistically highly significant and positive. Thus, the domestic market size and market potentiality of the top 20 FDI recipient countries were larger compared to the low FDI recipient countries.

Table 3. A Comparison of the Socio-Economic Condition between Top 20 and Low

40 FDI Recipient Countries in 2005.

The comparison of the degree of openness reveal that lower-middle income countries are more international market oriented compared to the low income countries.

Table 3 shows that in 2005, both trade (export + import) and export were higher in the top 20 FDI recipient countries compared to the 40 low FDI recipient countries. The differences in the averages of trade and export are also positive, though only the difference in the average export is statistically significant. Thus, the top 20 FDI recipient countries were more international market oriented compared to the 40 low FDI recipient countries in 2005.

The comparison of the size of the total labor force and the contribution of the industrial sector to GDP between top 20 and low 40 FDI recipient countries in 2005 shows that top 20 FDI recipient countries have on average more labor force and the contribution of industrial sector to GDP is higher compared to the 40 low FDI recipient countries in 2005, and the differences in the group of averages are statistically highly significant and positive.

To compare the business environment between top 20 and low 40 FDI recipient countries in 2005, corruption perception index (CPI), cost of business startup procedure (% of GNI), time required to start a business (days) and time required to enforce a contract (days) are compared. High CPI score, low business start-up cost and less time required to start a business and enforce a contract in the top 20 FDI recipient countries compared to the low 40 FDI recipient countries reveal that on average, the business environment in the top 20 FDI recipient countries is friendlier compared to the 40 low FDI recipient countries.

Finally, Table 3 also depicts a comparison of communication facilities between the top 20 FDI recipient countries and 40 FDI recipient countries in 2005. Table 3 shows that both telephone and internet users in the top 20 FDI recipient countries are higher compared to 40 low FDI recipient countries in 2005 and mean differences are highly statistically significant and positive.

Thus, modern communication facilities are also more available in the top FDI recipient countries compared to the low FDI recipient countries. The findings in Table 3 clearly support the hypotheses that countries with large GDP and higher annual GDP growth rate, business friendly environment and well equipped with modern communication facilities are mostly successful in attracting FDI.

4. Foreign Direct Investment for Development Foreign direct investment (FDI) is an integral part of an open and effective international economic system and a major catalyst to development. Yet, the benefits of FDI do not accrue automatically and evenly across countries, sectors and local communities.

National policies and the international investment architecture matter for attracting FDI to a larger number of developing countries and for reaping the full benefits of FDI for development. The challenges primarily address host countries, which need to establish a transparent, broad and effective enabling policy environment for investment and to build the human and institutional capacities to implement them.

A. Trends The magnitude of FDI flows continued to set records through the last decade, before falling back in 2001. In 2000, world total inflows reached 1.3 trillion US dollars (USD) – or four times the levels of five years earlier. More than 80% of the recipients of these inflows, and more than 90% of the initiators of the outflows, were located in “developed countries”. A breakdown of the outflows from OECD countries is provided in Table 4.

Table 4. OECD FDI Outflows by Region

The limited share of FDI that goes to developing countries is spread very unevenly, with two-thirds of total FDI flows from OECD members to non-OECD countries going to Asia and Latin America. Within regions there are some strong concentrations on a few countries, such as China and Singapore in the case of Asia. Even so, FDI inflows represent significant sums for many developing countries, several of them recording levels of FDI, relative to the size of the domestic economy, that overshadow the largest OECD economies (Figure 2).

Figure 2. Inward FDI stock, 2000 (share of GDP)

Moreover, the flow of FDI to developing countries worldwide currently overshadows official development assistance by a wide margin, further highlighting the need to

address the use of FDI as a tool for economic development. In recent years, an increasingly large share of FDI flows has been through mergers and acquisitions (M&As).

This partly reflects a flurry of transatlantic corporate takeovers, and partly the largescale privatization programmes that were implemented throughout much of the world in the 1990s.

B. FDI and Growth Beyond the initial macroeconomic stimulus from the actual investment, FDI influences growth by raising total factor productivity and, more generally, the efficiency of resource use in the recipient economy. This works through three channels: the linkages between FDI and foreign trade flows, the spillovers and other externalities vis-Ă -vis the host country business sector, and the direct impact on structural factors in the host economy.

Most empirical studies conclude that FDI contributes to both factor productivity and income growth in host countries, beyond what domestic investment normally would trigger. It is more difficult, however, to assess the magnitude of this impact, not least because large FDI inflows to developing countries often concur with unusually high growth rates triggered by unrelated factors.

Whether, as sometimes asserted, the positive effects of FDI are mitigated by a partial “crowding out� of domestic investment is far from clear. Some researchers have found evidence of crowding out, while others conclude that FDI may actually serve to increase domestic investment. Regardless, even where crowding out does take place, the net effect generally remains beneficial, not least as the replacement tends to result in the release of scarce domestic funds for other investment purposes.

In the least developed economies, FDI seems to have a somewhat smaller effect on growth, which has been attributed to the presence of “threshold externalities”.

Apparently, developing countries need to have reached a certain level of development in education, technology, infrastructure and health before being able to benefit from a foreign presence in their markets. Imperfect and underdeveloped financial markets may also prevent a country from reaping the full benefits of FDI. Weak financial intermediation hits domestic enterprises much harder than it does multinational enterprises (MNEs). In some cases it may lead to a scarcity of financial resources that precludes them from seizing the business opportunities arising from the foreign presence. Foreign investors’ participation in physical infrastructure and in the financial sectors (subject to adequate regulatory frameworks) can help on these two grounds.

I. Trade and Investment While the empirical evidence of FDI’s effects on host-country foreign trade differs significantly across countries and economic sectors, a consensus is nevertheless emerging that the FDI-trade linkage must be seen in a broader context than the direct impact of investment on imports and exports.

The main trade-related benefit of FDI for developing countries lies in its long-term contribution to integrating the host economy more closely into the world economy in a process likely to include higher imports as well as exports. However, host-country authorities need to consider the short and medium-term impacts of FDI on foreign trade as well, particularly when faced with current-account pressures, and they sometimes have to face the question of whether some of the foreign-owned enterprises’ transactions with their mother companies could diminish foreign reserves.

As countries develop and approach industrialized nation status, inward FDI contributes to their further integration into the global economy by engendering and boosting foreign trade flows (the link between openness to trade and investment is illustrated by Figure 3).

Figure 3. The Openness to FDI and Trade

Apparently, several factors are at play. They include the development and strengthening of international networks of related enterprises and an increasing importance of foreign subsidiaries in MNEs’ strategies for distribution, sales and marketing. In both cases, this leads to an important policy conclusion, namely that a developing country’s ability to attract FDI is influenced significantly by the entrant’s subsequent access to engage in importing and exporting activities.

This, in turn, implies that would-be host countries should consider a policy of openness to international trade as central in their strategies to benefit from FDI, and that, by restricting imports from developing countries, home countries effectively curtail these countries’ ability to attract foreign direct investment. Host countries could consider a

strategy of attracting FDI through raising the size of the relevant market by pursuing policies of regional trade liberalization and integration.

Host countries’ ability to use FDI as a means to increase exports in the short and medium term depends on the context. The clearest examples of FDI boosting exports are found where inward investment helps host countries that had been financially constrained make use either of their resource endowment or their geographical location.

Targeted measures to harness the benefits of FDI for integrating host economies more closely into international trade flows, notably by establishing export-processing zones (EPZs), have attracted increasing attention. In many cases they have contributed to a raising of imports as well as exports of developing countries. However, it is not clear whether the benefits to the domestic economy justify drawbacks such as the cost to the public purse of maintaining EPZs or the risks of creating an uneven playing field between domestic and foreign enterprises and of triggering international bidding wars.

Recent studies do not support the presumption that lesser developed countries may use inward FDI as a substitute for imports. Rather, FDI tends to lead to an upsurge in imports, which is often gradually reduced as local companies acquire the skills to serve as subcontractors to the entrant MNEs. II. Technology Transfers Economic literature identifies technology transfers as perhaps the most important channel through which foreign corporate presence may produce positive externalities in the host developing economy. MNEs are the developed world’s most important source of corporate research and development (R&D) activity, and they generally possess a higher level of technology than is available in developing countries, so they have the potential to generate considerable technological spillovers.

Technology transfer and diffusion work via four interrelated channels: vertical linkages with suppliers or purchasers in the host countries; horizontal linkages with competing or complementary companies in the same industry; migration of skilled labor; and the internationalization of R&D. The evidence of positive spillovers is strongest and most consistent in the case of vertical linkages, in particular, the “backward” linkages with local suppliers in developing countries. MNEs generally are found to provide technical assistance, training and other information to raise the quality of the suppliers’ products. Many MNEs assist local suppliers in purchasing raw materials and intermediate goods and in modernizing or upgrading production facilities.

Reliable empirical evidence on horizontal spillovers is hard to obtain, because the entry of an MNE into a less-developed economy affects the local market structure in ways for which researchers cannot easily control. Some recent evidence appears to indicate that horizontal spillovers are more important between enterprises operating in unrelated sectors.

A proviso relates to the relevance of the technologies transferred. For technology transfer to generate externalities, the technologies need to be relevant to the hostcountry business sector beyond the company that receives them first. The technological level of the host country’s business sector is of great importance.

III.

Human Capital Enhancement

The major impact of FDI on human capital in developing countries appears to be indirect, occurring not principally through the efforts of MNEs, but rather from government policies seeking to attract FDI via enhanced human capital. Once individuals are employed by MNE subsidiaries, their human capital may be enhanced further through training and on-the-job learning. Those subsidiaries may also have a positive influence on human capital enhancement in other enterprises with which they develop

links, including suppliers. Such enhancement can have further effects as that labor moves to other firms and as some employees become entrepreneurs. Thus, the issue of human capital development is intimately related with other, broader development issues.

Investment in general education and other generic human capital is of the utmost importance in creating an enabling environment for FDI. Achieving a certain minimum level of educational attainment is paramount to a country’s ability both to attract FDI and to maximize the human capital spillovers from foreign enterprise presence.

The minimum level differs between industries and according to other characteristics of the host country’s enabling environment; education in itself is unlikely to make a country attractive to foreign direct investors. However, where a significant “knowledge gap” is allowed to persist between foreign entry and the rest of the host economy, no significant spillovers are likely.

Among the other important elements of the enabling environment are the host country’s labor market standards. By taking steps against discrimination and abuse, the authorities bolster employees’ opportunities to upgrade their human capital, and strengthen their incentives for doing so.

Also, a labor market where participants have access to a certain degree of security and social acceptance lends itself more readily to the flexibility that is key to the success of economic strategies based on human capital. It provides an environment in which MNEs based in OECD countries can more easily operate, applying their home country standards and contributing to human capital development. One strategy to further this goal is a wider adherence to the OECD Declaration on International Investment and Multinational Enterprises, which would further the acceptance of the principles laid down in the Guidelines for Multinational Enterprises.

While the benefits of MNE presence for human capital enhancement are commonly accepted, it is equally clear that their magnitude is significantly smaller than that of general (public) education.

The beneficial effects of training provided by FDI can supplement, but not replace, a generic increase in skill levels. The presence of MNEs may, however, provide a useful demonstration effect, as the demand for skilled labor by these enterprises provides host-country authorities with an early indication of what skills are in demand. The challenge for the authorities is to meet this demand in a timely manner while providing education that is of such general usefulness that it does not implicitly favor specific enterprises.

Empirical and anecdotal evidence indicates that, while considerable national and sectoral discrepancies persist, MNEs tend to provide more training and other upgrading of human capital than do domestic enterprises. However, evidence that the human capital thus created spills over to the rest of the host economy is much weaker. Policies to enhance labor-market flexibility and encourage entrepreneurship, among other strategies, could help buttress such spillovers.

Human capital levels and spillovers are closely interrelated with technology transfers. In particular, technologically advanced sectors and host countries are more likely to see human capital spillovers and, conversely, economies with a high human capital component lend themselves more easily to technology spillovers. The implication of this is that efforts to reap the benefits of technology and human capital spillovers could gain effectiveness when policies of technological and educational improvement are undertaken conjointly.

IV.

Competition

FDI and the presence of MNEs may exert a significant influence on competition in host country markets. However, since there is no commonly accepted way of measuring the degree of competition in a given market, few firm conclusions may be drawn from empirical evidence. The presence of foreign enterprises may greatly assist economic development by spurring domestic competition and thereby leading eventually to higher productivity, lower prices and more efficient resource allocation.

Conversely, the entry of MNEs also tends to raise the levels of concentration in hostcountry markets, which can hurt competition. This risk is exacerbated by any of several factors: if the host country constitutes a separate geographic market, the barriers to entry are high, the host country is small, the entrant has an important international market position, or the host-country competition law framework is weak or weakly enforced.

Market concentration worldwide has increased significantly since the early 1990s due to a wave of M&As that has reshaped the global corporate landscape. At the same time, a surge in the number of strategic alliances has changed the way in which formally independent corporate entities interact. Alliances are generally thought to limit direct competition while generating efficiency gains, but evidence of this is not firmly established. There has also been a wave of privatizations that has attracted considerable foreign direct investment (mainly in developing and emerging countries), and this, too, could have important effects on competition.

Empirical studies suggest that the effect of FDI on host-country concentration is, if anything, stronger in developing countries than in more mature economies. This could raise the concern that MNE entry into less-developed countries can be anti-competitive.

Moreover, while ample evidence shows MNE entry raising productivity levels among host-country incumbents in developed countries, the evidence from developing

countries is weaker. Where such spillovers are found, the magnitude and dispersion of their effects are linked positively to prevailing levels of competition.

However, the direct impact of rising concentration on competition, if any, appears to vary by sector and host country. There are relatively few industries where global concentration has reached levels causing real concern for competition, especially if relevant markets are global in scope.

While it is economically desirable that strongly performing foreign competitors be allowed to replace less productive domestic enterprises, policies to safeguard a healthy degree of competition must be in place. Arguably the best way of achieving this is by expanding the “relevant market� by increasing the host economy’s openness to international trade.

In addition, efficiency-enhancing national competition laws and enforcement agencies are advisable to minimize the anti-competitive effects of weaker firms exiting the market. When mergers are being reviewed and when possible abuses of dominance cases are being assessed, the accent should be on protecting competition rather than competitors. Modern competition policy focuses on efficiency and protecting consumers; any other approach may lead to competition policy being reduced to an industrial policy that may fail to deliver long-term benefits to consumers.

V.

Enterprise Development

FDI has the potential significantly to spur enterprise development in host countries. The direct impact on the targeted enterprise includes the achievement of synergies within the acquiring MNE, efforts to raise efficiency and reduce costs in the targeted enterprise, and the development of new activities.

In addition, efficiency gains may occur in unrelated enterprises through demonstration effects and other spillovers akin to those that lead to technology and human capital spillovers. Available evidence points to a significant improvement in economic efficiency in enterprises acquired by MNEs, albeit to degrees that vary by country and sector. The strongest evidence of improvement is found in industries with economies of scale. Here, the submersion of an individual enterprise into a larger corporate entity generally gives rise to important efficiency gains.

Foreign-orchestrated takeovers lead to changes in management and corporate governance. MNEs generally impose their own company policies, internal reporting systems and principles of information disclosure on acquired enterprises and a number of foreign managers normally come with the takeover. Insofar as foreign corporate practices are superior to the ones prevailing in the host economy, this may boost corporate efficiency, empirical studies have found.

An important special case relates to foreign participation in the privatization of government-owned enterprises. Experiences, many of them from the transition economies in East and Central Europe, have been largely positive; participation by MNEs in privatizations has consistently improved the efficiency of the acquired enterprises.

Some political controversies have, however, occurred because the efficiency gains were often associated with sizeable near-term job losses. Moreover, the value of FDI in connection with privatization in transition economies could partly reflect the fact that few domestic strategic investors have access to sufficient finance.

The privatization of utilities is often particularly sensitive, as these enterprises often enjoy monopolistic market power, at least within segments of the local economy. The first-best privatization strategy is arguably to link privatization with an opening of markets to greater competition. But where the privatized entity remains largely

unreconstructed prior to privatization, local authorities often resort to attracting foreign investors by promising them protection from competition for a designated period.

In this case there is a heightened need for strong, independent domestic regulatory oversight. Overall, the picture of the effects of FDI on enterprise restructuring that we can derive from recent experience may be too positive, because investors will have picked their targets among enterprises with a potential for achieving efficiency gains.

However, from a policy perspective, this makes little difference, as long as foreign investors differ from domestic investors in their ability or willingness to improve efficiency or realize new business opportunities. Authorities aiming to improve the economic efficiency of their domestic business sectors have incentives to encourage FDI as a vehicle for enterprise restructuring.

C. FDI and Environmental and Social Concerns FDI has the potential to bring social and environmental benefits to host economies through the dissemination of good practices and technologies within MNEs, and through their subsequent spillovers to domestic enterprises. There is a risk, however, that foreign-owned enterprises could use FDI to “export� production no longer approved in their home countries. 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.

The direct environmental impact of FDI is generally positive, at least where host-country environmental policies are adequate. There are, however, examples to the contrary, especially in particular industries and sectors. Most importantly, to reap the full environmental benefits of inward FDI, adequate local capacities are needed, as regards environmental practices and the broader technological capabilities of host-country enterprises.

Moreover, positive externalities have been observed where local imitation, employment turnover and supply-chain requirements led to more general environmental improvements in the host economy. There have been some instances, however, of MNEs moving equipment deemed environmentally unsuitable in the home country to their affiliates in developing countries. The use of such inferior technology will usually not be in the better interest of a company; this demonstrates the sort of environmental risk associated with FDI. Empirical studies have found little support for the assertion that policy makers’ efforts to attract FDI may lead to “pollution havens” or a “race to the bottom”. The possibility of a “regulatory chill”, however, is harder to refute for the lack of a counterfactual scenario. Empirical evidence of the social consequences of FDI is far from abundant.

Overall, however, it supports the notion that foreign investment may help reduce poverty and improve social conditions (Figure 4).

Figure 4. Poverty and inward FDI stock (in 60 developing countries)

The general effects of FDI on growth are essential. Studies have found that higher incomes in developing countries generally benefit the poorest segments of the population proportionately. The beneficial effects of FDI on poverty reduction are potentially stronger when FDI is employed as a tool to develop labor-intensive industries

– and where it is anchored in the adherence of MNEs to national labor law and internationally accepted labor standards.

There is little evidence that foreign corporate presence in developing countries leads to a general deterioration of basic social values, such as core labor standards. On the contrary, empirical studies have found a positive relationship between FDI and workers’ rights. Low labor standards may, in some cases, even act as a deterrent to FDI, due to investors’ concerns about their reputation elsewhere in the world and their fears of social unrest in the host country. Problems may, however, arise in specific contexts.

5. How Beneficial Is Foreign Direct Investment for Developing Countries?

Foreign direct investment (FDI) has proved to be resilient during financial crises. For instance, in East Asian countries, such investment was remarkably stable during the global financial crises of 1997-98. 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. The resilience of FDI during financial crises was also evident during the Mexican crisis of 1994-95 and the Latin American debt crisis of the 1980s. This resilience could lead many developing countries to favor FDI over other forms of capital flows, furthering a trend that has been in evidence for many years (Figure 5).

Figure 5. The Composition of capital inflows has shifted away from bank loans and toward FDI and portfolio Investment

A. The Case for Free Capital Flows Economists tend to favor the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several other advantages, as noted by Feldstein (2000). First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies. In addition to these advantages, which in principle apply to all kinds of private capital inflows, Feldstein (2000) and Razin and Sadka note that the gains to host countries from FDI can take several other forms: •

FDI allows the transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market.

•

Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country.

•

Profits generated by FDI contribute to corporate tax revenues in the host country.

Of course, countries often choose to forgo some of this revenue when they cut corporate tax rates in an attempt to attract FDI from other locations. For instance, the sharp decline in corporate tax revenues in some of the member countries of the Organization for Economic Cooperation and Development (OECD) may be the result of such competition. In principle, therefore, FDI should contribute to investment and growth in host countries through these various channels.

B. FDI versus Other Flows Despite the strong theoretical case for the advantages of free capital flows, the conventional wisdom now seems to be that many private capital flows pose countervailing risks. Hausmann and Fernรกndez-Arias (2000) suggest why many host countries, even when they are in favor of capital inflows, view international debt flows, especially of the short-term variety, as "bad cholesterol". In contrast, FDI is viewed as "good cholesterol" because it can confer the benefits enumerated earlier. An additional benefit is that FDI is thought to be "bolted down and cannot leave so easily at the first sign of trouble." Unlike short-term debt, direct investments in a country are immediately reprised in the event of a crisis.

C. Recent Evidence To what extent is there empirical support for such claims of the beneficial impact of FDI? A comprehensive study by Bosworth and Collins (1999) provides evidence on the effect of capital inflows on domestic investment for 58 developing countries during 1978-95.

The sample covers nearly all of Latin America and Asia, as well as many countries in Africa. The authors distinguish among three types of inflows: FDI, portfolio investment, and other financial flows (primarily bank loans).

Bosworth and Collins find that an increase of a dollar in capital inflows is associated with an increase in domestic investment of about 50 cents. This result, however, masks significant differences among types of inflow. FDI appears to bring about a one-for-one increase in domestic investment; there is virtually no discernible relationship between portfolio inflows and investment (little or no impact); and the impact of loans falls

between those of the other two. These results hold both for the 58-country sample and for a subset of 18 emerging markets (Figure 6).

Figure 6. FDI has a stronger impact on domestic investment than do loans or portfolio investment

D. Reasons for Caution Despite the evidence presented in recent studies, other work indicates that developing countries should be cautious about taking too uncritical an attitude toward the benefits of FDI.

I. Is a High FDI Share a Sign of Weakness?

One striking feature of FDI flows is that their share in total inflows is higher in riskier countries, with risk measured either by countries’ credit ratings for sovereign (government) debt or by other indicators of country risks (Figure 7). There is also some evidence that its share is higher in countries where the quality of institutions is lower.

What can explain these seemingly paradoxical findings? One explanation is that FDI is more likely than other forms of capital flows to take place in countries with missing or inefficient markets. In such settings, foreign investors will prefer to operate directly instead of relying on local financial markets, suppliers, or legal arrangements. The policy implications of this view, according to Albuquerque (2000), are "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."

Figure 7. FDI’s share in total inflows is higher in countries with weaker credit ratings

Although it is very likely that FDI is higher, as a share of capital inflows, where domestic policies and institutions are weak, this cannot be regarded as a criticism of FDI per se.

Indeed, without it, the host countries could well be much poorer.

II. Fire sales, adverse selection, and leverage FDI is not only a transfer of ownership from domestic to foreign residents but also a mechanism that makes it possible for foreign investors to exercise management and control over host country firms—that is, it is a corporate governance mechanism. The transfer of control may not always benefit the host country because of the circumstances under which it occurs, problems of adverse selection, or excessive leverage. Even outside of such fire-sale situations, FDI may not necessarily benefit the host country. Through FDI, foreign investors gain crucial inside information about the productivity of the firms under their control. Excessive leverage can also limit the benefits of FDI. Typically, the domestic investment undertaken by FDI establishments is heavily leveraged owing to borrowing in the domestic credit market. As a result, the fraction of domestic investment actually financed by foreign savings through FDI flows may not be as large as it seems, and the size of the gains from FDI may be reduced by the domestic borrowing done by foreign-owned firms.

III. FDI Reversals

Recent work has also cast the evidence on the stability of FDI in a new light. Though it is true that the machines are "bolted down" and, hence, difficult to move out of the host country on short notice, financial transactions can sometimes accomplish a reversal of FDI. For instance, the foreign subsidiary can borrow against its collateral domestically and then lend the money back to the parent company

IV. Other Considerations There are some other cases in which FDI might not be beneficial to the recipient country-for instance, when such investment is geared toward serving domestic markets protected by high tariff or nontariff barriers. Under these circumstances, FDI may strengthen lobbying efforts to perpetuate the existing misallocation of resources.

6. The Social Impact of Foreign Direct Investment Multinational enterprises (MNEs) have become one of the key drivers of the world economy and their importance continues to grow around the world. The increased influence of OECD-based MNEs in developing countries is particularly striking. Today, developing countries account for almost one-third of the global stock of inward foreign direct investment (FDI), compared to slightly more than one fifth in 1990.

However, the activities of multinational enterprises abroad have also aroused much controversy and social concerns. For example, MNEs have been accused of practicing unfair competition when taking advantage of low wages and labor standards abroad. In some cases, MNEs have also been accused of violating human and labor rights in developing countries where governments fail to enforce such rights effectively. In many OECD countries, civil society has appealed to MNEs to ensure that internationallyrecognised labour norms are respected throughout their foreign operations.

A. How important is FDI for Developing Countries?

During the past 15 years, the importance of FDI in the world economy has increased rapidly. The total stock of FDI increased from 8% of world GDP in 1990 to 26% in 2006.

Although the bulk of FDI continues to take place between OECD countries, the increase in FDI has been particularly pronounced in developing countries, largely reflecting the integration of large emerging economies, the so-called BRICs (Brazil, Russia, India and China), into the world economy.

The increase of FDI into developing countries has been spectacular. The share of nonOECD countries in the global stock of inward FDI has risen from 22% in 1990 to 32% in 2005 (Figure 8).

Figure 8. Foreign Direct Investment in Non-OECD Countries has Risen Rapidly Inward FDI stocks in billions of US dollars at constant prices (2000), 1990-2005

1. Corresponds to the 30 OECD member countries.

Source: OECD Employment Outlook 2008, Paris.

China is by far the most important non-OECD country as a recipient of FDI, accounting for about one third of FDI in non-OECD countries in 2005. However, FDI inflows also tend to be sizable in many other emerging countries. Indeed, since the mid-1990s, inward FDI has become the main source of external finance for developing countries and is more than twice as large as official development aid.

Developing countries have also become increasingly active as foreign direct investors themselves. The share of non-OECD countries in the global stock of outward FDI has risen from 10% in 1990 to 17% in 2005.

The rise in outward FDI in emerging economies reflects predominantly the increase in FDI between non-OECD countries (South-South FDI). Outward FDI by emerging economies into the OECD remains relatively small, despite recurrent claims in the popular media that developing countries are acquiring strategic assets in OECD countries.

B. How Does FDI Affect Workers?

MNEs tend to have various advantages compared to purely domestic firms that allow them to compete successfully in foreign markets, despite the additional cost of having to coordinate activities across different countries. They may derive this advantage from their technological know-how, easier access to capital or modern management practices. The potential benefits of inward FDI depend on the extent to which local firms and workers can benefit from these assets.

One way that FDI can be beneficial for host economies is by creating high-quality jobs that are associated with higher pay and better working conditions. While there is no reason, in general, to expect MNEs to offer better jobs than their local counterparts, under certain circumstances, MNEs may find it in their interest to share their productivity advantage with their employees. For example, MNEs may wish to rely more

heavily on pay incentives to ensure quality and productivity, given the higher cost of monitoring production activities from abroad. MNEs may also offer above-market wages in an effort to reduce worker turnover and minimize the risk of their productivity advantage spilling over to competing firms.

FDI by OECD-based MNEs may also affect the quality of jobs available in domestic firms when there are knowledge spillovers from foreign to domestic firms. For example, domestic firms may learn from foreign firms by collaborating with them in the supply chain. Knowledge transfers may also result from worker mobility, when domestic firms recruit workers with experience in foreign firms.

Finally, increased product-market competition as a result of FDI may strengthen incentives among domestic firms to improve their efficiency. However, FDI does not necessarily have positive effects on the performance of local firms. Under certain circumstances, it may lead to the crowding out of local firms, reducing their ability to operate at an economically efficient scale.

C. Are Working Conditions in MNEs Better than in Local Firms?

According to the conventional wisdom, foreign MNEs offer better pay than their local counterparts and foreign-domestic pay differences are particularly important in the context of developing countries. The difference in pay offered by domestic firms and MNEs may reflect the greater technology gap between foreign MNEs and local firms in less developed countries. This view is based on a substantial body of research using information on cross-border takeovers to identify the effect of foreign ownership on average wages within firms.

Figure 9. Foreign Takeovers Raise Average Wages

1. Average effects over the first three years after the takeover.

Source: OECD Employment Outlook 2008, Paris.

Figure 9 presents new OECD evidence on the effects of foreign takeovers on average wages for two emerging economies (Brazil and Indonesia) and three OECD countries (Germany, Portugal and the United Kingdom). It shows that foreign takeovers raise average wages within firms in the short-term, particularly in emerging economies.

Wages are estimated to grow between 10% and 20% following foreign takeovers in Brazil and Indonesia, and between 0% and 10% in the three OECD countries. However, as these figures show the effect on average wages, it is impossible to tell how the change is distributed across the workforce and, particularly, whether the increase in average wages reflects wage gains for incumbent workers or instead changes in the skill composition of the workforce.

Figure 10. Foreign Ownership Matters particularly for New Hires

Source: OECD Employment Outlook 2008, Paris.

Figure 10 presents new OECD evidence on the effects of foreign ownership by focusing directly on individual workers. Foreign takeovers of domestic firms have a small positive effect on the wages of existing workers in Brazil, Germany and Portugal in the shortterm, ranging from 1% to 4% and no effect in the UK. The absence of a positive effect in the United Kingdom may reflect the relative flexibility of the UK labor market compared to the other countries, which makes it hard to sustain differences in pay for identical workers across firms. While the short-term impact of takeovers on incumbent workers is modest, the role of foreign ownership is more substantial for new hires. This is indicated by the relatively large wage gains of workers who move from domestic to foreign firms. They range from 6% in the United Kingdom to 8% in Germany, 14% in Portugal and 21% in Brazil.

In sum, the new evidence confirms that FDI may have a substantial positive effect on wages in foreign-owned firms in the host country, even when the focus is on the shortterm impact of cross-border mergers and acquisitions. And consistent with the conventional wisdom, the positive wage effects are more pronounced in emerging economies.

Furthermore, the positive impact of FDI resides primarily in better job opportunities for new employees, rather than better pay for workers who stay in firms that happen to change ownership. This may reflect more competitive conditions in the market for new hires that allow new employees to more widely share the productivity advantages of MNEs. The question whether MNEs also promote improvements in other aspects of workers’ employment conditions, such as training, working hours and job stability, is more complex and the existing evidence is scarce. Studies that have looked into this issue suggest that MNEs have a low propensity to export non-wage working conditions abroad.

New analysis by the OECD suggests that, in contrast to wages, non wage working conditions do not necessarily improve following a foreign takeover. Even when they do, it is not clear whether these effects derive from a centralized policy to maintain high labor standards or merely reflect the optimal responses by MNEs to local conditions.

D. How Does FDI Affect the Wider Economy?

In addition to having direct effects on workers employed by MNEs, FDI may also have indirect effects on workers’ employment conditions in domestic firms when there is knowledge spillovers associated with FDI. The effect on workers in domestic firms, however, is considerably weaker than the direct effect on employees of foreign affiliates of MNEs. It is true that FDI typically has a strong effect on average wages in local firms, but this largely reflects the competition among foreign and domestic firms for local workers. In

principle, FDI could also affect wages in local firms through its impact on the productivity in those firms.

Positive productivity-driven wage spillovers are likely to be more important when there are strong links between local firms and foreign MNEs, such as through the participation of local firms in the supply chain or through worker mobility.

New OECD evidence indicates that average wages are a little higher in local firms which participate in these supply chains or recruit managers with prior experience in MNEs, than in local firms with no apparent link to MNEs. However, there is little evidence to suggest that FDI leads to an expansion of the informal sector or non-compliance with labor standards. The effects of FDI on the performance of the labor market as a whole also depend on its effects on overall efficiency.

E. How Can Governments Ensure that FDI Boosts Development?

The positive effects of inward FDI for workers in host economies suggest that FDIfriendly policies could be a useful component of an integrated policy framework for development. When designing policies to promote FDI, policy-makers should take into account that these may not only affect the volume of inward FDI, but also its composition and, as a result, its corresponding benefits.

The OECD Policy Framework for Investment provides a useful starting point. For a start, removing specific regulatory obstacles to inward FDI could be important. Under certain circumstances, it may also be appropriate to provide specific incentives to potential foreign investors. However, such targeted policies should not become a substitute for policies aimed at improving the business environment more generally.

7. Foreign Direct Investment: A Lead Driver for Sustainable Development?

The most Heavily Indebted Poor Countries and low income countries of the world remain largely dependent on bilateral and multilateral aid for their development strategies. However, since 1990 total Overseas Development Assistance (ODA) has dropped by more than half. Much greater importance is now being placed on alternative sources of capital to finance national development (ECOSOC 2000) and Foreign Direct Investment (FDI) is now the largest source of foreign private capital reaching developing countries (Figure 11). Global flows of FDI have grown phenomenally over the last ten years. Total inflows rose by nearly four times, from US $174 billion in 1992 to US$ 644 billion in 1998. However, total flows to developing economies fell between 1997 and 1998 (UNCTAD 1999). Regionally, prospects look least good for Africa (Table 5.). Of the middle to low income countries, Asia has experienced the fastest rate of growth in FDI but also the greatest volatility (World Bank 1999).

Figure 11. Private Capital Flows to Developing Countries

The Secretary General’s report “Financial Resources and Mechanisms” to the eighth UN Commission on Sustainable Development indicates increased international dialogue about whether FDI is a significant source of development finance. For all its potential, there is far greater awareness of the complex nature of FDI and the possible negative impacts of rapid and large growth for least developed countries.

A. The Pros and Cons of FDI as a Source of Development Attraction of FDI is becoming increasingly important for developing countries. However this is often based on the implicit assumption that greater inflows of FDI will bring certain benefits to the country’s economy. FDI, like ODA or any other flow of capital, is simply that, a source of capital. However the impact of FDI is dependant on what form it takes.

Table 5. Regional Trends and Prospects for FDI Region Latin America & Caribbea n

Inflows Outflows Status and prospects Total Inflows (1998): US$ 71 Total Outflows (1998): FDI inflows have steadily billion.

US$ 15 billion risen since 1991 and this is expected to increase.

Key Receivers: Brazil, Chile, Key sources: Cayman However, current accounts Mexico, Argentina, Islands, Chile, Brazil, remain in deficit, and Key Sources: United States, Bermuda, Argentina. human, technical, financial Spain infrastructural Key Sectors: Services Receivers: Over 75% and (Business,electricity, finance), re- invested in the constraints continue to limit attraction of inflows.

Manufacturing (chemicals, region.

Domestic markets are still food/beverage/tobacco), largely geared to short term Mining. financing.

Asia & Total Inflows: US$ 85 Billion. Total Outflows: US$ Although financial crisis in Pacific 36 Billion.

1996/7 hit many Asian Key receivers: China, Korea, countries (especially Singapore, Thailand, Japan.

Key sources: Japan, Indonesia) others were Hong Kong (China), more resilient (Taiwan Key Sources: Australia, Japan, Korea (DPR), Taiwan Province, China, Hong Kong).

New Zealand.

Province.

Long run growth is predicted Key Sectors: Manufacturing (chemicals, wood), services Receivers: Over 50% of but the region may need to gain (transport, real estate). outflows are re- diversification invested in region, greater access to global economy.

China.

Central & Eastern Europe

Total Inflows: US$ 19 billion.

Key receivers: Poland, Czech Republic, Russia, Romania, Hungary Key Sources: Europe (Germany, Netherlands) Key Sectors: Mining, metals, food production & services.

Africa

Total Inflows: US$ 8 billion.

Key Receivers: Nigeria, Egypt, Tunisia, Algeria Key Sources: USA, Belgium, UK, France Key Sectors: Telecomm., food / beverage, tourism, mining/quarrying, textiles

North America

Total Inflows: billion.

US$

193

Key Sources: Mainly Europe (especially UK, Germany), Japan Key Sectors: Manufacturing (48%) and petroleum (30%)

Western Europe

Total Inflows: US$ 237 billion (1998).

Key receivers: Netherlands, France,Belgium, UK. Key Sources: United States,

Total Outflows: US$ 2 Resilient and increasing FDI billion. inflow to region especially compared to portfolio Key sources: Russia, investment and bank loans.

Hungary, Poland Small outward investors lack access to finance. The Receivers: Europe financial crisis in Russia reduced FDI inflows but longer term outlook is more positive.

Total Outflows: US$ FDI has grown by 6 times in 0.5 billion. the last 10 years but only in a small number of countries Key sources: South and at a low level compared Africa, Liberia, Nigeria to international flows.

Problems of extortion and Receivers: Namibia, corruption indicate a vital Swaziland need for democratization, transparent regulation and improved rule of law to support inflows to the region.

Total Outflows: U$ A strong FDI competitor. The 110 billion. distribution of inflows to USA is uneven across states, Key sources: USA e.g. Hawaii has very high inflows (tourism). Although Receivers: Europe high FDI has little (54%) but also Latin contribution to employment America levels. Short run growth is Key Sectors: Services, predicted but in the medium as the dollar banks, manufacturing, term strengthens inflows may finance, insurance, drop.

Total Outflows: US$ Finland and Netherlands 406 billion have seen the highest growth rate of inflows.

Key sources: Germany, Other countries, such as UK, France.

Italy, have fallen in recent Receivers: Europe, years. The presence of the

Europe, Japan Key Sectors: Services (finance & trade related), manufacturing (petroleum, chemicals).

United States, Japan.

Key Sectors: Services , manufacturing (petroleum, chemicals)

Single European Currency hasn’t yet indicated noticeable benefit to members compared to nonmembers.

This includes the type of FDI, sector, scale, duration and location of business and secondary effects. A refocusing of perspective, from merely enhancing the availability of FDI, to the better application of FDI for sustainable objectives is crucial to push the debate forward. Various international fora and discussion have outlined a range of positive and negative aspects of FDI as a source of development for developing countries, some of which are discussed below.

I.

Stimulation of National Economy

FDI is thought to bring certain benefits to national economies. It can contribute to Gross Domestic Product (GDP), Gross Fixed Capital Formation and balance of payments. There have been empirical studies indicating a positive link between higher GDP and FDI inflows (OECD a.), however the link does not hold for all regions, e.g. over the last ten years FDI has increased in Central Europe whilst GDP has dropped. FDI can also contribute toward debt servicing repayments, stimulate export markets and produce foreign exchange revenue.

Subsidiaries of Trans-National Corporations (TNCs), which bring the vast portion of FDI, are estimated to produce around a third of total global exports. However, levels of FDI do not necessarily give any indication of the domestic gain (UNCTAD 1999). Corporate strategies e.g. protective tariffs and transfer pricing can reduce the level of corporate tax received by host governments. Also, importation of intermediate goods, management fees, royalties, profit repatriation, capital flight and interest repayments on loans can limit the economic gain to host economy. Therefore the impact of FDI will largely depend on the conditions of the host economy.

II.

Stability of FDI

FDI inflows can be less affected by change in national exchange rates as compared to other private sources (portfolio investments or loans). This is partly because currency devaluation means a drop in the relative cost of production and assets (capital, goods and services) for foreign companies and thereby increases the relative attraction of a “host� country.

However, if international flows of trade and investment fall globally and for lengthy periods, then stability is less certain. New inflows of FDI are especially affected by these global trends, because it is harder for a foreign company to de-invest or reverse from foreign affiliates as compared to portfolio investment. Companies are therefore more likely to be careful to ensure they will accrue benefits before making any new investments.

III.

Social Development

FDI, where it generates and expands businesses, can help stimulate employment, raise wages and replace declining market sectors. However, the benefits may only be felt by small portion of the population, e.g. where employment and training is given to more educated, typically wealthy elites or there is an urban emphasis, wage differentials (or dual economies) between income groups will be exacerbated (OECD a). Cultural and social impacts may occur with investment directed at non-traditional goods.

Within local economies, small scale and rural businesses of FDI host countries there is less capacity to attract foreign investment and bank credit/loans, and as a result certain domestic businesses may either be forced out of business or to use more informal sources of finance (ECOSOC 2000).

IV.

Infrastructure Development and Technology Transfer

Parent companies can support their foreign subsidiaries by ensuring adequate human resources and infrastructure are in place. In particular “Greenfield” investments into new business sectors can stimulate new infrastructure development and technologies to host economies. These developments can also result in social and environmental benefits, but only where they “spill over” into host communities and businesses (ECOSOC 2000).

However, this assumes that in-house investment (in R&D, production, management, personnel training) will result in improvements. Foreign technology/organizational techniques may actually be inappropriate to local needs, capital intensive and have a negative affect on local competitors, especially smaller business who are less able to make equivalent adaptions.

V.

“Crowding in” or “Crowding out”?

“Crowding in” occurs where FDI companies can stimulate growth in up/down stream domestic businesses within the national economies. Whilst “Crowding out” is a scenario where parent companies dominate local markets, stifling local competition and entrepreneurship. One reason for crowding out is “policy chilling” or “regulatory arbitrage” where government regulations, such as labor and environmental standards, are kept artificially low to attract foreign investors, this is because lower standards can reduce the short term operative costs for businesses in that country.

Exclusive production concessions and preferential treatment to TNCs by host governments can both restrict other foreign investors and encourage oligopolistic (quasi-monopoly) market structure (ECOSOC 2000, UNCTAD 1999). Empirical data for

these scenarios is variable, but crowding out is thought to be more common in specific sectors.

VI.

Scale and Pace of Investment

It may be difficult for some governments, particularly low income countries, to regulate and absorb rapid and large FDI inflows, with regard to regulating the negative impacts of large-scale production growth on social and environment factors (WWF 1999). Also a high proportion of FDI inflows in developing economies are commonly aimed at primary sectors, such as petroleum, mining, agriculture, paper-production, chemicals and utilities. Primary sectors are typically capital and resource intensive, with a greater threshold in economies of scale and therefore slower to produce positive economic “spill over” effects (OECD a).

VII.

Skewed Distribution

FDI inflows are still highly concentrated in certain countries and regions (Figure 12.).

TNCs are the largest source of FDI (about 95% of total inflows) and the majority of these are based in industrialised countries. The vast proportion of FDI flows go to other developed countries, especially the “Triad” of USA, UK, Japan, but also countries such as Germany, France, Canada, Netherlands.

Figure 12. Regional FDI inflows in 1998, as % of total global inflow US$ 644 billion

In 1998, 92% of total FDI outflows came from developed countries and 72% of the total inflows returned to these economies (UNCTAD 1999). Of the proportion that went to low-middle income countries, the highest percentage went to Asia and Latin America (42% and 38% respectively), 14% to Central Europe & East Asia, whilst only 6% was invested in Africa (World Bank 1999).

Over half of the FDI that does reach developing countries is concentrated in 5 countries.

This is also true transitional countries, for example in Eastern Europe 75 % of FDI inflows is directed toward 5 countries (WTO 1999, OECD b., ECOSOC 2000).

B. How Can FDI be better applied to Sustainable Development?

I. Accessibility and Stability of FDI If FDI is to take a greater role in building developing country economies, further assessment of the factors which influence and are influenced by FDI flows is necessary.

Foreign companies are thought to be attracted to recipient countries for a whole range of factors, e.g. political stability, market potential & accessibility, repatriation of profits, infrastructure, and ease of currency conversion.

Privatization and deregulation of markets are seen as central means to attract FDI, however this can leave the poorest or most indebted countries open to destabilizing market speculation (ECOSOC 2000). Whilst there is concern that increased regulation could deter new foreign investors, there is evidence, such as in Eastern Europe, that tighter regulation of corporate, environmental and labor standards has not affected FDI growth (ECOSOC 2000). Where low income and developing economies are successful in attracting FDI, they require considerable support to ensure that they can adapt to rapid and large inflows of FDI, and that these flows positively benefit domestic economic stability (WSSD 1995). This means developing strategies which encourage greater and

longer term domestic investment and saving, as well as higher returns on investment capital.

II. Socially Responsible Investment Ethical and socially responsible FDI can be encouraged through national, bilateral and international investment guidelines and regulation e.g. consumer rights, information provision, commercial probity, labor standards and corporate culture (UNCTAD 1999).

Several institutions have developed or are currently working on responsible practice.

The ILO has 180 conventions referring to social responsibility and it also has more specific “Tripartite Declaration of Principles” (1977), concerning TNCs and social policy.

UNCTAD has developed a “Code of Restrictive Business Practices”.

Eradication of poverty and reduction of gender inequality, where women make up nearly 70% of the worlds poorest, should be prioritized. Whilst governments may seek FDI for labor intensive sectors, those sectors which require greater skills are likely to require investment in domestic training and education. Intellectual property right agreements between host countries and foreign investors can also be strengthened to ensure domestic technology transfer and skills development are better incorporated (UNCTAD 1999).

III. Environmental Protection Greater efforts need to be made to assess the linkages between environmental impacts and FDI, although it may be difficult to isolate FDI impacts from other activities.

Authorities and businesses can apply Environmental Management Systems (EMS) to assess the potential impacts of FDI ventures, e.g. ISO 4001 which details techniques such as Life-Cycle-Analysis, Environmental Impact Assessments (EIA) and Environmental

Audits. These all require investment in inspection, monitoring, regulation and enforcement to ensure effective implementation. The resources required to effectively adopt these approaches are often lacking in many developing countries, suggesting a vital need for targeted international assistance (UNCTAD 1999).

Parent governments and businesses play a pivotal role in ensuring that the environmentally sustainable technology filters out into host countries (UNCTAD 1999).

In Agenda 21, WTO, GATT and TRIPS agreements governments are asked to take all practical steps to promote, facilitate and finance, as appropriate the transfer, diffusion, and access to environmental technology and know-how. Looking at specific sectors, tourism has been identified as a key source of FDI. At CSD 7 member states were urged to develop policies which encourage tourism, attract FDI but also adopt environmentally appropriate practices (ECOSOC 1999). “Corporate environmentalism” has potential for considerable enhancement internationally. For example, in the energy sector, parent companies can support subsidiary use of renewable energy.

Table 6. Examples of Key Institutional Roles and Responsibilities Institution Governmen

Examples of activities Governments should be committed to stimulate FDI in low income or heavily

t

indebted countries. Developing and developed country partnerships can promote stable, predictable, non-discriminatory and transparent systems of investment and regulation.

NGOs &

NGOs can help address the linkages between FDI and environment, welfare,

civil

poverty and inequality, because of their direct experience “on-the-ground”

society

e.g. micro-credit projects and consumer associations. They can contribute to

groups

the process of development, implementation and monitoring of business performance, strategies and benchmarks.

Industry

Parent companies can support more sustainable forms of technology transfer and skill sharing in subsidiaries to encourage self regulation of FDI. Standards for good practice and codes of conduct can enhance corporate transparency and accountability, and encourage equivalent levels of good

Internation

practice in both parent and host countries.

International development and finance institutions can mitigate some of the

al

risks of investment for small to medium enterprises and developing

Institutions

economies seeking to attract and stabilize FDI flows, through equity loan

Labor

expropriation of profits, and economic disturbances, such as war.

Unions can help monitor and call employers to account where companies fail

Unions

to meet core standards, regarding gender, age discrimination, working

finance and other insurance provisions to protect against currency transfer,

conditions. They can help develop guides to good practice e.g. International Confederation of Free Trade Unions has set out minimum labor standards Local

and a Framework for Multinational Investment.

They can undertake Sustainability Impact Assessments and regulate

Authorities

microeconomic and local conditions. This includes monitoring of benchmarks and business practice, EMS and transfer of environmentally sound

technology.

All these institutions need greater cooperation, coordination and more openly accountable processes to look at how international flows of FDI flows can be better directed toward the specific goals of sustainable development. Collectively, they need to ensure that finance, trade and investment strategies are mutually reinforcing toward sustainable ends. In relation to monitoring FDI, there is also a need to further develop and apply sustainability indicators to better assess the impacts of FDI for different regions and sectors (Table 7).

Table 7. Examples of Indicators for FDI and Sustainability Sources Type

Example of indicator

Economic Investment and Economic Productivity

Net Foreign Direct Investment (FDI) as % of GDP and of GFCP; Net change in foreign investment between the reporting country and the rest of the world; Ratio of aggregate Net Resource Transfers (long-term) to GNP (%).

R & D expenditure from FDI in local economy. % of FDI into Greenfield investments.

Other financial Ratio of Total Official Development Assistance (ODA) given Factors or received to Gross National Product (GNP) from Bilateral and multilateral sources. Ratio of total external debt to GNP (%), Ratio of total debt service to exports of goods and services, including worker's remittances %. Per capita domestic saving and investment.

Social Labor standards Adoption of ILO labor standards and indicators. % and employment in host economy created (directly/ indirectly) Employment

by FDI. Education Enrolment ratios by level of education, public/private expenditure on education/training, expected number of years of formal schooling Environ- Environ-mental Adoption of environmental management systems, ment Best environmental reporting, energy efficiency. Green Practice accounting e.g. “green" net national product (green NNP), genuine savings etc.

Environ-mental % of FDI into environmentally sensitive sectors. Ratio of Protection environmental protection expenditures to Gross Domestic Product (GDP) %. Degree of implementation of Multilateral Environmental agreements.

The question that remains to be answered is whether FDI can be better targeted toward the advancement of developing and heavily indebted countries, whilst ensuring the global security of coming generations.

The General Assembly Special Session “Financing for Development” (FfD) in 2001 considered how to mobilize domestic resources, international private financial flows, international financial cooperation, trade, debt, new financial mechanisms and governance, in the context of increasing globalization.

The CSD called for international cooperation over capital flight and profit repatriation, integration of environmental priorities into public policy and programmes, as well as the use of economic instruments and incentives to support long term private investment.

The FfD meeting is therefore a crucial opportunity to take a closer look at institutional processes and the linkages between FDI, trade and financial mechanisms, so that all of these can be better targeted toward meeting sustainable development targets.

The tenth CSD in 2002 is likely to provide a good opportunity to review the outcomes of these discussions and their implications. In this way the Earth Summit, later the same year, will serve as a platform for specific and coordinated international, regional and local programmes and initiatives geared toward making FDI a positive driver for a more sustainable future.

9. Growth and the Quality of Foreign Direct Investment: Is All FDI Equal Policy makers and academics often maintain that foreign direct investment (FDI) can be a source of important productivity externalities for the host countries. In addition to supplying capital, FDI can be a source of valuable technology and know-how and foster linkages with local firms that can help to jumpstart an economy. However, despite the strong conceptual case for a positive relationship between economic growth and FDI, the empirical evidence has been mixed.

While academics tend to treat FDI as a homogenous capital flow, policy makers, on the other hand, seem to believe that some FDI projects are better than others. National policies toward foreign direct investment (FDI) seek to attract some types of FDI and regulate other types in a pattern which seems to reflect a belief among policymakers that FDI projects differ greatly in terms of the national benefits to be derived from them. UNCTAD’s World Investment Report 2006 for instance describes “quality FDI” as “the kind that would significantly increase employment, enhance skills and boost the competitiveness of local enterprises.”

Policymakers from Dublin to Beijing have implemented complex FDI regimes with a view to influencing the nature of the FDI projects attracted to their shores. Sean Dorgan, Chief Executive of Ireland’s Industrial Development Agency, for example, claims that “the value of inward investment must now be judged on its nature and quality rather than in quantitative measures or job numbers alone.” Chinese officials have openly stated that the new challenge for the country is to attract more “high quality foreign direct investment.” However, this is difficult to establish because it is a function of many different country and project characteristics which are often hard to measure and the data quality is generally poor or available only at an aggregate level.

One explanation for the ambiguity of the evidence is that the growth effects of FDI may vary across industries. In particular, potential advantages derived from FDI might differ markedly across the primary, manufacturing and services sectors. More generally, there might also be differences among industries within a sector.

Most of the macro empirical work that has analyzed the effects of FDI on host economies, however, has not controlled for the sector in which FDI is involved, mostly due to data limitations. Indeed, it is found that when we control for industry characteristics and time effects, the relation between FDI and economic growth is no longer ambiguous but rather positive and significant. Result shows that an increase in

FDI flows from the 25th to the 75th percentile in the distribution of flows is associated with an increase of 13% in growth over the different industries’ sample means.

Industry level analysis also enables us to differentiate FDI according to its industryaverage characteristics. The macro literature has emphasized the dependence of productivity spillovers on the absorptive capacity of the local economy, with specific reference to human capital, financial development, and openness.

The importance of human capital presumably relates to the ability of a highly skilled domestic work force to adopt advanced technology. If the transfer of new technology and skills is one of the beneficial effects of FDI, we might expect the relationship between industry growth rate and FDI levels to be stronger in industries that are highly skill dependent.

It is argued that using countries’ own targets to subjectively distinguish between industries is appropriate because the national benefits of an FDI project are determined by the interaction of project and country characteristics. First, policymakers’ concepts of ‘quality FDI’ are likely to be based on a complex combination of different country characteristics such as human capital skills, financial dependence. Second, for any host country, the desirability of an industry will involve an interaction between the characteristics of the industry and the characteristics of the country.

It is tested whether the benefits of FDI are stronger in the industries to which governments accord special priority. Including only these targeted industries increases the significance of our results. It has been found in these selected industries that increasing FDI flows from the 25th to the 75th percentile in the distribution of flows occasions an increase of 73% in growth over the different industries’ sample means. Of course, these correlations might not imply causality.

An important concern in the FDI growth literature is that growth may itself spawn more FDI. Alternatively, some third variable might affect a country’s growth trajectory and, thereby, its attractiveness to foreign capital. In these cases, the coefficients on the estimates are likely to overstate the positive impact of foreign investment. As a result, one could find evidence of positive externalities from foreign investment where no externalities occur.

A. Foreign Direct Investment: Industry Data Figure 13: Foreign Direct Investment by Sector (1985-2000)

Source: OECD's International Direct Investment database.

Figure 13 breaks down national FDI statistics into seven sectors. The columns show the sum of inward FDI in constant 2000 U.S. dollars over the period 1985-2000. Finance, business, and real estate account for more than half, 53%, of FDI, manufacturing for 27%. The line in Figure 13 plots the ratio of FDI flows to total value added in the sector, which varies widely across industries from almost 15% in finance, business services, and real estate to less than 1% in agriculture.

B. Foreign Direct Investment and Industry Characteristics

Several recent studies have investigated how national characteristics might affect host countries’ capacity to benefit from FDI. These studies postulate that the size of spillovers from foreign firms depends on the so-called absorptive capacities of domestic firms, that is, their ability to respond successfully to new entrants, new technology, and new competition.

Domestic firms’ success is, to some extent, determined by local characteristics such as the domestic level of level of human capital and the development of local financial markets. Weaknesses in these areas might reduce the capacity of domestic industries to absorb new technologies and respond to the challenges and opportunities presented by foreign entrants.

Variation in absorptive capacities between countries (and industries within countries) is a promising line of research, offering, potentially, an appealing synthesis of the conflicting results that have emerged from the literature. FDI studies have documented the dependence of spillovers on various national characteristics, but not considered how this dependence varies across industries.

These national-level studies are subject to the objection that unobserved heterogeneity of countries could be correlated with the national characteristics being tested, thereby complicating interpretation of their interaction coefficients. Industry analysis is consequently an important cross check on the validity of interpretations of these studies’ results. Among other benefits, FDI is presumed to bring skills, technology, and capital to the host country.

10. FDI, Trade and Growth, a Casual Link?

A large body of literature exists on the direct and indirect effects of foreign direct investment (FDI), with a substantial number of studies concerned with the apparent relationship between foreign direct investment and trade. While some studies have

concluded that there is a substitution effect between inward direct investment and trade (Gopinath et al., 1999; Ramstetter, 1991; Svensson, 1996), other studies have concluded there is a complementary effect (Bayoumi and Lipworth, 1997; Blomström et al., 1988; Eaton and Tamura, 1994; Fontagné and Pajot, 1997; Marchant et al., 2002; Mekki, 2005; Pfaffermayr, 1996).

Similarly, the empirical evidence on the causal relationships between FDI investment and trade is equally contradictory, with results ranging from unidirectional causality, bidirectional causality, or even no causality between FDI and trade. Recently, PachecoLópez (2005) finds a two-way relationship between FDI and exports and FDI and imports in Mexico using a Granger causality test. Another study by Liu et al. (2001) concludes that there were interlinkages between FDI, exports, and imports in China. They suggest that a growth of imports results in a growth of FDI inflows.

In turn, the growth of FDI causes the growth of exports. Then, the growth of exports further leads to the growth of imports. Hence, synergy between the three variables (imports, FDI and exports) was observed in the Chinese economy. This is of particular interest for a country such as Indonesia that has attracted a high proportion of exportorientated inward investment, which is, theoretically at least also associated with an increase in imports, in the form of capital goods and components. While the relationships between imports, exports and FDI have been explored in the past, many studies tend to ignore growth effects. Both trade and FDI are also associated with growth, though the extent which these causal links feed through to the relationships between FDI and trade remain largely unexplored.

A. The Relationships between Trade, FDI and Growth.

I. Theories of Foreign Direct Investment and International Trade

The traditional Heckscher-Ohlin-Samuelson framework, suggests that international trade and FDI are substitutes assuming labor and capital can move freely between countries and no transportation costs apply. The implication is that international trade involves an indirect exchange of production factors between countries (Liu et al., 2001).

Mundell (1957) also holds that international mobility of factors of production, including FDI, may be a substitute for international trade if production functions are identical across countries.

Several more recent papers develop theories which argue that trade and foreign direct investment are substitutes. Horsmann and Markusen (1992) and Brainard (1993) posit that the decision for a firm to engage in horizontal FDI as opposed to engaging in exporting is a function of the relationship between proximity and concentration.

Helpman (1984) and Helpman and Krugman (1985) seek to explain the complementarity relationship between foreign direct investment and trade. Their theory is valid for vertical FDI in which a multinational enterprise has its headquarters located in the home country and several production sites located in the host country where cheaper costs of production and input resources are available. If the differences in factor endowments are significant between countries, the headquarters tend to export capital equipment and factor services, such as R&D, to the host country, and in return the host country exports input resources to the home country. A classical example for this type of FDI is direct investment in the mining industry.

The concept of trade and FDI being substitutes is also strongly embedded in the theory of FDI. Dunning’s (1988) eclectic paradigm theory implies that FDI and trade are substitutes, in that a firm moves from exporting to FDI when both transaction costs and manufacturing costs conditions dictate that this is rational for the firm. The analysis here is similar to that based on Vernon’s (1966) product life cycle theory, which suggests that there are two possible causal links between foreign direct investment and trade,

investment and trade. Initially, trade may lead to FDI in Vernon’s analysis, but over time foreign direct investment into a particular location changes in nature, from initially being motivated by the desire to capture new markets, (market seeking) to being attracted to locations with successful investments and infrastructure (efficiency seeking).

In a similar vein, Gray (1998) suggests that the relationship between FDI and trade is a function of motives of the firm to undertake FDI. If the motive is for market-seeking, FDI and trade tend to replace each other; therefore, substitution relationship occurs.

However, if the motive is for efficiency-seeking, the relationship between FDI and trade is complementary in that an increase in the amount of foreign direct investment leads to an increase in the level of trade.

The new trade theory identifies two major determinants of the FDI-trade relationship (Fontagné and Pajot, 2000). Firstly, the way a firm is organized is a key determinant. A vertically arranged firm which locates its production processes in different foreign affiliates will experience a complementary relationship between its foreign trade and investment, with each reinforcing the other.

A horizontally arranged firm will produce a given commodity at one location, probably close to the market if transport costs are relatively high and the minimum plant size is not too large. Secondly, economies of scale reduce the number of plants to achieve greater efficiency, yet at the same time transportation costs and trade barriers provide an incentive to increase the number of plants. If a firm has high fixed costs and each plant has limited fixed costs, a firm is provided an incentive to locate production close to its markets and FDI will substitute for trade if transport costs are a significant factor.

Many of these arguments are summed up by Pacheco-López (2005), who points out that there are two possible causal linkages between FDI and imports. Firstly, an increase in

imports in a country leads to a rise in FDI inflows to the same country. She argues that imports show the existence of a demand for a commodity. As a result, multinational enterprises might be attracted to carry out direct investment in the same country in order to produce the product domestically. Secondly, the presence of multinational enterprises in the host country stimulates an increase in imports through a rise in demands for imported supplies, such as raw materials and intermediate products, as well as capital goods from the home country.

II. Previous Empirical Evidence The bulk of empirical work so far has focused on the establishing the relationship between FDI and trade in the home country as opposed to the host country. However, work on China (Liu et al., 2001), Mexico (Alguacil et al., 2002途 Pacheco-L贸pez, 2005), and Turkey (Mekki, 2005) all focus on the host country. These studies take a range of methodological approaches, and find conflicting results concerning the relationships between trade and FDI. An increase in the quantity of inward FDI boosts exports in host countries through the accumulation of capital, introduction of new technology, and improvement in management and marketing strategies which are brought and practiced by the multinational enterprises. Thus, according to the UNCTAD, one of the key determinations of exports in a country is its inward direct investment. This is particularly true for the situation where the country is used as an exports platform or base by multinational firms.

However, other papers incorporating time series analysis suggest that there is a negative relationship between outward direct investment and exports from the investing countries. Blake and Pain (1994) for example suggest that net outward direct

investment resulted in the deterioration of exports, with net inward direct investment having a significant positive impact on UK exports.

III. Causal Links between FDI and Trade While there is a wealth of literature on the nature of the relationship between FDI and trade, there are relatively few which seek to explain the causal links between FDI and trade. For example, using a time series approach for Austrian quarterly data for outward FDI and trade from 1969 to 1990, Pfaffermayr (1994) surmises that there were significant bidirectional causalities between Austrian outward FDI and exports.

A later study by Bajo-Rubio and Montero-Muñoz (2000) using Spanish quarterly data between 1977 and 1998 finds that exports and outward FDI were cointegrated, and the relationship between both variables was positive and statistically significant.

The evidence of causal links between trade and FDI is limited, with much of the work in this area is based around Granger (1969) causality testing, see for example, Pfaffermayr (1994) or Bajo-Rubio and Montero-Muñoz (2000).

Pacheco-López (2005) based on Mexican data shows that the causality between FDI and exports occurs in both ways, in that exports encourage foreign direct investment to the country, and in turn, FDI inflows boosts the country’s exports. This result is consistent with the one concluded in the previous research by Alguacil et al. (2002).

However, the analysis of Fontagné and Pajot (2000), Markusen and Venables (1998), and Pain and Wakelin (1998) suggests that much of the time series analysis of the relationships between trade and FDI is over simplified.

A simple bivariate approach will ignore these development or growth effects – mechanisms suggested by theories of export led growth, or indeed import led growth

for example, tend to be ignored in many bivariate time series studies, leading to potentially misleading results.

11. Does Foreign Direct Investment Help Emerging Economies?

The gap between the world’s rich and poor countries largely comes down to the financial and physical assets that create wealth. Developed economies possess more of this capital than developing ones, and what they have usually incorporates more advanced technologies. The implication is clear: A key aspect of economic advancement lies in poorer nations’ capacity to acquire more capital and scale the technological ladder. Emerging economies undertake some capital formation on their own, but in this era of globalization, they increasingly rely on foreign capital.

Capital flows have proven effective in promoting growth and productivity in countries that have enough skilled workers and infrastructure. Some economists believe capital flows also help discipline governments’ macroeconomic policies.

Capital flows come in three primary forms: •

Portfolio equity investment, which involves buying company shares, usually stock markets, without gaining effective control.

•

Portfolio debt investment, which typically covers bonds and short- and long-term borrowing from banks and multilateral institutions, such as the World Bank.

•

Foreign direct investment (FDI), which involves forging long-term relationships with enterprises in foreign countries.

FDI can be made in several ways. First, and most likely, it may involve parent enterprises injecting equity capital by purchasing shares in foreign affiliates. Second, it may take the form of reinvesting the affiliate’s earnings. Third, it may entail short- or long-term

lending between parents and affiliates. To be categorized as a multinational enterprise for inclusion in FDI data, the parent must hold a minimum equity stake of 10 percent in the affiliate.

Establishing foreign affiliates usually entails starting new production facilities—so-called Greenfield investments—or acquiring control of existing entities through cross-border mergers and acquisitions. Recent years have seen a marked shift toward international mergers and acquisitions.

In developing nations, equity investments as a percentage of gross national income have been flat in recent years. Debt flows, however, have picked up since 2002 after plunging to zero in the previous two years. Meanwhile, FDI as a share of GDP has grown rapidly, becoming the largest source of capital moving from developed nations to developing ones (Figure 14).

Figure 14. FDI Dominates Developing Economies’ Capital Flows

From 1990 to 2005, developing economies’ share of total FDI inflows rose from 18 percent to 36 percent. In addition, the geographical composition of FDI flows has changed dramatically over the past four decades. Within developing economies, Latin America’s share of FDI has fallen from 52 percent in the 1970s to 33 percent since the 1990s. Asia’s share of inflows has risen from 25 percent to 60 percent during the same period.

Within Asia, China and India have gained FDI share relative to Southeast Asia. Today, these two emerging economic giants are the most attractive markets for FDI. China’s FDI shot up from $3.5 billion in 1990 to $60 billion in 2004, while India’s rose from a paltry $236 million to $5.3 billion. The shift reflects the two nations’ more open economic policies, as well as their sheer size and dynamic growth.

The rush to invest in places like China and India suggests that FDI will continue to be an increasingly important source of development finance. To better understand these capital inflows and their ripples, we need to examine their effect on key aspects of the receiving countries’ economic performance—stability, trade, savings, investment and growth.

A.

FDI’s Stability

For emerging economies, FDI has significant advantages over equity and debt capital flows. Foreign firms’ participation in domestic business encourages the transfer of advanced technologies to the host country, and it fosters human capital development by providing employee training. It also strengthens corporate institutions by exposing host countries to developed economies’ best business practices and corporate governance.

From a macroeconomic perspective, FDI is more stable than other types of capital flows (Figure 15). Equity and short-term debt in particular tend to be highly volatile and

speculative, and their role in igniting and deepening financial crises in the 1990s has been closely scrutinized.

FDI’s relative stability and long-term character make it the preferred source of foreign capital for many emerging economies. In fact, FDI has been so stable in tumultuous times that some economists have called it “good cholesterol” for emerging economies.

Figure 15. FDI More Stable than Equity and Short-Term Debt

The declining volatility of foreign capital flows has paid off in higher economic growth.

With FDI’s share of developing nations’ foreign investment rising, host countries have experienced less overall volatility in investment flows, as measured by their deviation from average rates of incoming capital. Comparing total capital flows with mean real GDP growth rates for emerging economies, we find that higher volatility coincided with lower economic performance from 1970 to 2004 (Figure 16).

Figure 16. Higher Capital Flow Volatility Means Slower GDP Growth

B.

FDI and Trade

Many developing countries pursue FDI as a tool for export promotion, rather than production for the domestic economy. Typically, foreign investors build plants in nations where they can produce goods for export at lower costs. Another way FDI helps boost exports is through preferential access to markets in the parent enterprise’s home country.

Many developing countries pursue FDI as a tool for export promotion, rather than production for the domestic economy. Typically, foreign investors build plants in nations where they can produce goods for export at lower costs. Another way FDI helps boost exports is through preferential access to markets in the parent enterprise’s home country.

Multinational enterprises, the creatures of FDI, play a dominant role in world trade, accounting for two-thirds of all cross-border sales. Foreign affiliates were responsible for more than half China’s exports in 2001 and 21 percent of Brazil’s. They accounted for just 3 percent of India’s. At the country’s current rate of economic liberalization, however, foreign companies are likely to increase their share of India’s exports.

FDI can also provide a path for emerging economies to export the products developed economies usually sell—in effect, increasing their export sophistication. A new study by Dani Rodrik puts the export sophistication of China, a leading FDI recipient, at least three times higher than that of countries with similar per capita GDP. India, another FDI hot spot, also did well on this score. Some emerging economies are fast becoming attractive destinations for multinationals’ research and development centers, suggesting further gains for developing nations.

FDI is an important channel for delivery of services across borders—for emerging economies as well as developed ones. Services aren’t as widely traded as goods, making up only a fifth of world exports. That figure is expected to rise rapidly, however, as the Internet and other communications make more services tradable and facilitate the spread of outsourcing. In fact, FDI has grown faster in services than in goods in recent years.

In most developing nations, service industries have been closed to foreign investment.

As countries further open their economies, services can be expected to continue outpacing goods. The pattern of services FDI has also been changing. In 1990, finance cornered 57 percent of services FDI in developing economies. By 2002, its share had fallen to 22 percent as business services’ share rose from 5 percent to 40 percent.

As services become increasingly tradable, FDI in these industries can forge a strong link with exports of emerging economies. Multinationals operating in such services as banking, telecommunications and trade enhance the efficiency of homegrown providers in myriad ways, contributing to the export competitiveness of these economies’ service sectors. With both FDI and trade rising rapidly in services, FDI has an important role in promoting the sector’s globalization in other emerging economies.

C.

FDI, Savings and Investment

Foreign investment can ripple through receiving economies in many ways. It can finance current account deficits through its effect on investment or offset other financial transactions, such as increases in reserves or capital outflows.

The imported capital may simply result in additional consumption rather than investment. In principle, it needn’t always boost the country’s productive capital stock.

If foreign and homegrown companies vie for the same investment pie in the host country, FDI may simply offset, or crowd out, domestic investment.

Of course, FDI may represent a net capital gain or even “crowd in” domestic investment through a number of channels, such as transfers of technology and key expertise that doesn’t exist in host countries. India, for example, has opened up parts of its retail sector to foreign investment, although it limits outsiders to a maximum 49 percent stake. FDI is likely to spur domestic investment in India’s retail sector as existing players partner with such foreign giants as Wal-Mart to open stores.

We can test for crowding out by determining how a percentage point increase in the ratio of FDI inflows to GDP impacts domestic investment as a share of GDP. Using data from the World Bank, International Monetary Fund and other sources for 19 emerging economies, our model indicates the domestic investment rate rises in the first year following the FDI increase, with positive effects continuing beyond the second year (Figure 17). The 95 percent confidence bands, with upper and lower bounds, suggest the positive response could be as short as a year but may continue as long as two. The cumulative effect of an increase in FDI on domestic investment is positive in the long run.

Figure 17. Domestic Investment Responds Positively to FDI

Of course, this doesn’t account for the full range of capital inflows. Equity and debt investments may differ from FDI in the direction and magnitude of their impacts on investment. Because it’s more stable, FDI is likely to have a larger impact on domestic investment than equity flows do. Some forms of debt, particularly long-term borrowing from multilateral institutions like the World Bank, may be highly beneficial for domestic investment if used to fund extremely productive infrastructure projects in emerging economies.

Our model indicates that FDI has a significant effect on both investment and savings (Figure 18). A percentage point rise in the ratio of FDI to GDP leads to an increase of a half percentage point in domestic investment and three-fourths percentage point in domestic savings. The results suggest that FDI actually crowds in domestic investment and delivers a positive impact on savings. While FDI has strong positive effects on savings and investment, it has a small positive effect on the current account—the difference between domestic savings and investment.

Figure 18. FDI Has Positive Effect on Both Savings and Investment

In this model, FDI performs better than other types of foreign investment. Equity inflows show no discernible effect on investment or savings, possibly because they’re considerably more volatile than FDI and may represent largely speculative investment in financial markets. Debt, on the other hand, has a strong positive effect on investment, an indeterminate effect on savings and a significant negative impact on the current account.

The data support the notion that FDI should be the preferred form of foreign investment. It makes a net addition to developing nations’ productive resources, without causing deterioration to the current account. This suggests FDI will bolster the receiving country’s overall economic performance. The question is whether FDI’s desirable effects on savings and investment produce tangible effects on developing nations’ growth.

D.

FDI and Growth

Despite FDI’s potential to boost technology, productivity, investment and savings, economists have—somewhat surprisingly—struggled to find a strong causal link to economic growth. Some studies have detected a positive impact, but only if the country has a threshold level of human capital. This seems to confirm FDI’s important role in propelling growth in China and India, which have vast, untapped technical workforces.

China graduates 600,000 engineers every year; India produces 215,000.

A stumbling block to identifying FDI’s impact on growth lies in the fact that these investments can be the cause as well as the result of economic vitality because foreign capital beats a path to the world’s hottest developing-market economies.

Other problems make it difficult to disentangle FDI’s effect on GDP growth. For countries with high tariff and non tariff barriers, FDI may simply be the result of multinational corporations trying to access domestic markets because the export route has been closed. In this case, FDI may contribute to economic growth, but the impact will be reduced to the extent high tariffs stunt growth.

Countries also woo foreign investors with tax breaks and subsidies. Fiscal incentives are doubtlessly a good way to promote FDI. After all, tax havens are prominent FDI recipients. However, researchers have found that such policies aren’t effective ways to reap FDI’s economic benefits. Indeed, the policies may create distortions that significantly blunt FDI’s efficiency and productivity gains.

As we did with domestic investment, we can examine how a percentage point increase in the FDI-to-GDP ratio affects emerging economies’ performance (Figure 19). Although FDI doesn’t boost growth immediately, it delivers positive effects in the year after FDI increases. This suggests a significant link between FDI and GDP growth, one that develops over time because investment spending increases the nation’s productive capacity. Although the growth effect dies down, the cumulative effect on output is still positive in the long run.

Figure 19. FDI Spurs Economic Growth

.

In addition to spurring growth, FDI may have wage and productivity spillovers in the host country. If multinationals pay more than domestic firms, it may force the latter to raise wages. If foreign investors transfer technology to domestic firms, FDI would also help make workers more efficient.

E.

Is FDI Always Good?

FDI offers attractive benefits that include technology, investments, savings and growth.

But emerging economies should exercise caution. Counter to economic intuition, FDI may flow to riskier destinations. We can see that by plotting FDI’s share of a country’s total capital inflows against that nation’s composite risk rating for developing and emerging countries in December 2003 (Figure 20). The risk measure is obtained from the UNCTAD FDI Inward Potential Index database, which uses higher numbers to indicate lower risk.

Figure

20.

Riskier

Countries

Trend

to

Attract

Higher

FDI

The downward-sloping line indicates that FDI tends to make up a greater share of capital inflow in places investors might otherwise avoid. Most likely, such countries pay a premium for FDI through tax breaks and other incentives.

The relative advantages of FDI during crises are well documented. However, capital flight can’t be ruled out. In times of extreme financial crisis, FDI may be accompanied by distress sales of domestic assets, which could be harmful. Even in normal times, FDI can be reversed or diminished through domestic borrowing by affiliates of multinational corporations and repatriation of funds.

Too much FDI may not be beneficial. Through ownership and control of domestic companies, foreign firms learn more about the host country’s productivity, and they could over invest, at the expense of domestic producers.

There is a possibility that the most solid firms will be financed through FDI, leaving domestic investors stuck with low-productivity firms. Such “adverse selection” isn’t the best economic outcome.

Despite these pitfalls, FDI appears to help emerging economies develop. It complements the host country’s institutions and human capital. In many countries, however, barriers to FDI remain.

These barriers may range from limits on foreign ownership and control to outright bans on FDI in select sectors, such as services. Reducing them may well be a way to speed up economic development. FDI benefits investors, to be sure, but it also pays dividends to the countries that attract it.

F.

Does

Foreign

Direct

Investment

Promote

Development?

What is the impact of foreign direct investment (FDI) on development? The answer is important for the lives of millions—if not billions—of workers, families, and communities in the developing world. The answer is crucial for policymakers in developing and developed countries and in multilateral agencies. The answer is central to the debate about the costs and benefits of the globalization of industry across borders.

Yet determining exactly how FDI affects development has proven to be remarkably elusive. Investigating how FDI can contribute to, or detract from, the growth and welfare of developing countries is a challenge.

12. The Impact of Inward FDI on Host Countries: Why Such Different Answers?

A substantial body of literature has grown around the question of how inward foreign direct investment (FDI) affects host countries. On almost every aspect of this question there is a wide range of empirical results in academic literature with little sign of convergence. At the same time, policymakers seem to have made their own judgments that inward FDI is valuable to their countries. The United Nations Conference on Trade and Development (UNCTAD) publishes annual data on "changes in national regulations of FDI" and reports that from 1991 through 2002, over 1,500 changes making regulations more favorable and fewer than 100 making regulations less favorable to FDI were made.

There are many possible effects of FDI in ow on a host country. Since it is generally taken for granted that investing firms possess some technology superior to that of host country firms, higher-quality goods and services could be produced at either lower prices or in greater volume than previously available, resulting in higher consumer welfare. Another possible effect would be that inward investment adds to the host country capital stock, thereby raising output levels.

Although this issue has been explored, especially in earlier literature determining whether inward investment or aid supplements or displaces local investment, it is not specific to direct investment. Specific attention to direct investment has been devoted to the question of whether inward investments do involve superior technology and, if they do, whether it "spills over" to domestically owned firms rather than being retained entirely by the foreign owned firms. A related set of questions is whether the foreignowned firms pay higher wages for domestic labor, whether those higher wages raise the average wage level in the host country, and whether these higher wages spill over to

domestically

owned

firms. For both wages and productivity, the spillovers to

domestically owned firms or establishments could be either positive or negative. Wage spillovers could be negative if, for example, the foreign owned firms hired the best workers, at their going or higher wages, leaving only lower-quality workers at the domestically owned firms.

Productivity spillovers could be negative if foreign-owned firms took market shares from domestically owned firms, leaving the latter to produce at lower, less economical production levels. Survey articles have found inconclusive evidence in the literature regarding the most important effects of inward FDI, especially with respect to spillovers. Most work fails to find positive spillovers, with some even reporting negative spillovers.

With respect to effects on host country economic growth, Carkovic and Levine found no significant effect of FDI in ows over the entire 1960-95 period and only irregularly significant effects in five-year intervals. None of the variables found in other studies consistently determine the effect of FDI on growth, although some are significant in some combination of conditioning variables. For instance, Lipsey found it "safe to conclude that there is no universal relationship between the ratios of inward FDI ows to GDP and the rate of growth of a country".

A crucial feature of these surveys is that the summarized studies do not individually find that wage or productivity spillovers do not exist. Mostly, they find evidence for either positive or negative spillovers. However, future statistical studies could look at consumption effects. For example, has FDI growth in retailing reduced the price of food and other consumer goods? Has FDI growth in utilities reduced the price of telephone service or home heating and lighting? These possible effects of FDI are almost totally absent from the literature but should be studied.

The studies of wage spillovers are the beginning of these, which are not as numerous as those on productivity. There are several general issues that run through almost all the wage studies. One issue is that wage levels are calculated as total wages or total compensation per worker, but the only measure of skill is a division between production and non production or blue-collar and white-collar workers. Within those categories, almost no studies can distinguish between differences in skill or education level or between employees of foreign-owned and domestically owned plants from differences in wages for identical workers.

Similarly, they cannot distinguish between differential changes in skills between the two ownership groups and differential changes in wages for identical and unchanging workers in plants owned by the two ownership groups. A second issue is whether wage comparisons should take account of characteristics that are correlated with foreign ownership but not intrinsically related to it.

The question is whether these characteristics should be treated as controls and their influence eliminated or are they so bound up with foreign ownership that they should not be controlled for? As Aitken, Harrison, and Lipsey point out, a host country may not care whether higher employee wages in foreign-owned plants result from the fact that they are foreign owned or from the fact that they are large and use capital intensive technology and/or import-intensive technology. Size, capital intensity, and import intensity may all be elements of the foreign-owned firm's technology.

Empirical studies provide strong evidence of a wage premium in foreign owned firms.

Foreign firms pay higher employee wages in both developed and developing countries, after controlling for firm specific characteristics. It is of course possible that high employee wages in foreign-owned firms are caused, or at least biased, by foreign takeovers of high-wage domestic firms. In a recent study using a 25-year panel of

Foreign-owned firms did tend to acquire domestic plants with higher than average bluecollar wages for their industries, but the margins over the averages were far too small to account for the wage differential between domestically owned and foreign-owned plants. Thus, selectivity in take-overs could not account for the wage gap. Further evidence included the discovery that after a foreign takeover of a domestically owned plant, both blue-collar and white-collar wages rose strongly, in absolute terms and relative to their industries.

Takeovers of foreign-owned plants by domestic firms had the opposite effect on wages, illustrating that foreign takeovers, rather than takeovers in general, produced wage increases. Econometric analyses using the whole panel of establishments found large wage differences in favor of foreign firms at every level of industry and geographical detail, and the differentials remained large even when plant characteristics, such as size and the use of purchased inputs, were introduced into the wage equations. The finding that employee wages were higher in foreign-owned plants and became higher when domestically owned plants became foreign owned was not dependent on the use of cross-section rather than panel data.

Other subsequent studies have reported more evidence that wage spillovers occur.

Figlio and Blonigen concluded that the effect of a large new foreign investment in South Carolina on aggregate wage levels was so large that it could not have been solely the result of the high employee wages in the foreign-owned plants but must have involved spillovers to domestically owned plants. Their study differed from most others because it concentrated on geographical effects, rather than the effects within the industry of the investment.

In addition, assuming that an industry within an individual province represented a labor market still revealed that spillovers to domestically owned establishments occur. The combination of higher wages in foreign-owned plants and spillovers too domestically

owned plants meant that higher overall wages were associated with foreign ownership.

A study by Girma, Greenaway, and Wakelin using firm, rather than establishment, panel data for almost 4,000 firms in the United Kingdom from 1991 to 1996, also found some evidence of wage spillovers. On average, when spillovers were assumed to be identical across industries and firms, Girma, Greenaway, and Wakelin found no significant evidence for them. However, when the effects were permitted to vary across industries, wage spillovers were found and were higher in industries where the productivity gap between foreign and domestic firms was lower. One way this study differs from our earlier research is that it excludes firms that changed ownership, thereby eliminating one way in which foreign ownership affects wages.

The accumulation of studies since the earlier surveys seems to have put to rest the suspicion that the findings of wage spillovers were solely the result of ignoring firm differences in cross-section studies, since the spillovers did appear in panel studies.

Something else must account for the negative spillovers or lack of spillovers found in some developing countries. Aside from Indonesia, the positive spillovers have been found most frequently in developed countries. Even in the United Kingdom, large differences in productivity between foreign-owned and domestically owned firms reduced or eliminated spillovers. One possible cause for the negative results in some developing countries is that the gap between foreign-owned and domestically owned firms is too large for one group to influence the other.

Another possibility is that the labor markets in some developing countries are too segmented for wages in one group to influence the other. If we compare Mexico and Venezuela, two countries reported to show negative wage spillovers from foreign firms, with Indonesia, the United Kingdom, and the United States, for which positive spillovers were found, labor market conditions do seem different. An "employment laws index" produced by the World Bank, and based upon the work of Botero et al., had a range in

which a high number indicated very restrictive labor laws on hiring, firing, and conditions of employment. On the basis of this index, Mexico and Venezuela were ranked among the most restrictive countries, with index numbers of 77 and 75, respectively. The United Kingdom was rated at 28 and the United States at 22. Indonesia was in between at 57, not flexible by developed-country standards, but relatively flexible for a developing country.

Another topic not always considered is how the relevant labor market is defined. Most studies implicitly define a labor market as an industry at whatever level of detail industry is reported. Some define the market as an industry within the narrowest geographical area at which industry data are available. That may be appropriate for some countries or industries, but there may also be national labor markets within an industry, or local labor markets that straddle many industries.

These differences in defining the labor market may affect findings on spillovers.

Therefore, consideration of the industry and geographic construction of FDI measures is needed, and the conclusion might be different for wages from what it is for productivity.

For wages, the appropriate definition depends on the range of a labor market within which wages tend to be equalized, or at least within which one firm's wages inuence those in other firms.

The answers might be different in different countries or industries and at different times. In a recent study we tested the effect of different definitions of a labor market by using different industry and geographic classifications to examine the sensitivity of the results. They used FDI measures at two-three-, and five-digit industry levels and at both the national and province levels to examine the effect of foreign presence on the wages in locally owned Indonesian plants. The coefficients vary substantially, but they remain statistically significant in all specifications. The largest coefficients are for definitions of the relevant market as either national, at the two-digit industry level, or provincial, for all manufacturing industries combined.

However, there is concern that these coefficients may represent the foreign firms to move into either high wage geographical locations or high wage industries. Those possible biases are reduced by further geographical breakdown by province and by successively greater industry detail, culminating in breakdowns by five-digit industry and province. The coefficients are greatly reduced in size, but remain strongly significant, showing margins of a quarter for blue-collar and over a third for white-collar workers.

Why do studies of spillovers reach such diverse conclusions? With respect to wage spillovers, the use of cross-section or panel data does not seem to determine the result.

Aside from Indonesia, most of the evidence for wage spillovers comes from developed countries, particularly the United States and the United Kingdom. One hint that differences in labor market institutions might be important for the degree of wage spillovers is that two countries found to have valuable. Their exibility with respect to assumptions regarding timing and types of technology transfer suggests what statistical studies should look for and how the variables should be defined, especially if they encompass a wide range of both successful and unsuccessful ventures.

With respect to productivity spillovers, an accumulation of panel data studies has erased the previous unanimity of panel data results in showing negative or no spillovers. As with wages, firm-specific characteristics do not explain all the higher productivity found for domestic firms in industries where foreign-owned firms were important. The econometric method does not seem to be the crucial determinant of the result.

An explanation that seems plausible at this point is that countries and firms within countries might differ in their ability to benefit from the presence of foreign-owned firms and their superior technology. There might be countries or industries in which the domestically owned sector is too small or unable to learn from foreign-owned firms. In those cases, the domestic sector may be crowded out by competition from the more

efficient foreign owned firms.

The state of the domestically owned sector might depend not only on the stage of development of the economy, but also on the type of trade regime. A heavily protected domestically owned sector might be inefficient and lacking in entrepreneurship. It makes sense that the arrival of foreign firms with technology greatly superior to that of domestically owned firms should inict damage on at least some domestic firms.

The least efficient, perhaps often the smallest, might become unprofitable or be forced out of the industry. One might view that outcome as favorable for the host country as a whole if the average productivity of foreign owned and domestically owned firms together increased. Few studies take account of both the exit and the entrance of new firms, both of which are important for assessing the overall impact of inward FDI.

13. Analysis and Recommendation A. Analysis Foreign direct investment can play an important role in raising a country’s technological level, creating new employment, and promoting economic growth. Many countries are therefore actively trying to attract foreign investors in order to promote their economic development, particularly at times when the country’s domestic growth prospects appear weak.

After studying the Economies of Foreign Direct Investment Incentives in section 3, it is found that designing efficient incentive programs is complicated task, and the competition between host governments trying to attract FDI is likely to complicate the

task further, as it tends to shift profits and welfare from the host countries to foreign multinationals. A first-best solution for FDI incentive policy may therefore be multilateral policy coordination to set the rules of the game in the same way as GATT/WTO has defined the rules for international trade policy. In fact, countries participating in regional integration agreements that go beyond GATT/WTO rules most notably the European Union have realized the need to harmonize the use of investment incentives and introduced specific guidelines for their use.

The failure of OECD’s MAI initiative has, however, demonstrated that it will be difficult to achieve a broad multilateral solution in this area. Consequently, many countries will continue using FDI incentives as important policy tools. Spillovers of foreign technology and skills to local industry are not an automatic consequence of foreign investment. The potential spillover benefits are realized only if local firms have the ability and motivation to invest in absorbing foreign technologies and skills. To motivate subsidization of foreign investment, it is therefore necessary, at the same time, to support learning and investment in local firms as well.

Hence, rather than proposing narrowly defined FDI policies, good governance in the area of FDI policy is to consider the investment incentive packages as part of the country’s overall industrial policy, and make any incentives available on equal terms to all investors, foreign as well as local. The incentives should focus in particular on those activities that create the strongest potential for spillovers, including linkages between foreign and local firms, education, training, and R&D. It should also be noted that the country’s industrial policies in general are important determinants of FDI inflows and effects of FDI. By enhancing the local supply of human capital and modern infrastructure and by improving other fundamentals for economic growth, a country does not only become a

more attractive site for multinational firms, but there is increased likelihood that its private sector benefits from the foreign participation through spillover benefits.

Section 4 discussed about the Determinants of Foreign Direct Investment and Its Impact on Economic Growth in Developing Countries. By bridging the gap between domestic savings and investment and by enhancing knowledge spillover, FDI can play important role in industrial advancement and economic growth in the developing countries.

Although most of the developing countries have been taking measures to attract FDI, such as by offering incentive packages and liberalizing the trade regimes, only a few countries are successful in attracting a FDI. To find out the influential factors, the socioeconomic condition of the sample top and low FDI recipient countries is compared. The findings show that top FDI recipient countries in 2005 have large domestic market with high GDP growth rate. They are also well equipped with modern infrastructure, such as telephone and internet. Moreover, business environment in the top FDI recipient countries in 2005 is friendlier compared to other countries indicated by high score of corruption perception index and low business start-up costs.

A reduction in corruption and the expansion of infrastructural facilities can reduce transaction, information, communication and business start-up costs. It can contribute to the development of a business friendly environment, which might encourage inflow of FDI to the developing countries and also might contribute to attain rapid economic growth in the developing countries.

Foreign Direct Investment for Development is presented in section 5. The main policy conclusion that can be drawn from the section is that the economic benefits of FDI are real, but they do not accrue automatically. To reap the maximum benefits from foreign corporate presence a healthy enabling environment for business is paramount, which encourages domestic as well as foreign investment, provides incentives for innovation and improvements of skills and contributes to a competitive corporate climate.

In addition to the potential drawbacks of inward FDI, some micro-oriented problems could arise. For instance, while the overall impact of FDI on enterprise development and productivity is almost always positive, it generally also brings distributional changes and a need for industrial restructuring in the host economy. Changes give rise to adjustment costs and are resisted by social groups that do not expect to be among the beneficiaries.

Structural rigidities in the host economy exacerbate such costs, not least where labor markets are too slow to provide new opportunities for individuals touched by restructuring. Overall, the costs are best mitigated when appropriate practices are pursued

toward

flexibility,

coupled

with

macroeconomic

stability

and

the

implementation of adequate legal and regulatory frameworks. While the responsibility for this lies largely with host-country authorities, home countries, MNEs and international forums also have important roles to play.

In cases where domestic legal, competition and environmental frameworks are weak or weakly enforced, the presence of financially strong foreign enterprises may not be sufficient to assist economic development – although there are examples (notably in finance) where the entry of MNEs based in OECD member countries has contributed to an upgrading of industry standards. Where economic and legal structures create a healthy environment for business, the entry of strong foreign corporate contenders tends to stimulate the host-country business sector, whether through competition, vertical linkages or demonstration effects. FDI can be said to act as a catalyst for underlying strengths and weaknesses in the host countries’ corporate environments, possibly exacerbating the problems in “non-governance zones”, while eliciting the advantages in countries with a more benign business climate and better governance.

This reinforces the point made above about the need for host (and home) countries to work to improve regulatory and legal frameworks and other elements that help enable the business sector.

Finally, FDI – like official development aid – cannot be the main source for solving poor countries’ development problems. Likewise, while FDI may contribute significantly to human capital formation, the transfer of state-of-the-art technologies, enterprise restructuring and increased competition, it is the host country authorities that must undertake basic efforts to raise education levels, invest in infrastructure and improve the health of domestic business sectors. Domestic subsidiaries of MNEs have the potential to supplement such efforts, and foreign or international agencies may assist, for example through measures to build capacity. But the benign effects of FDI remain contingent upon timely and appropriate policy action by the relevant national authorities.

How Beneficial Is Foreign Direct Investment for Developing Countries is discussed in section 6 and from the study it can be stated that both economic theory and recent empirical evidence suggest that FDI has a beneficial impact on developing host countries. But recent work also points to some potential risks: it can be reversed through financial transactions; it can be excessive owing to adverse selection and fire sales; its benefits can be limited by leverage; and a high share of FDI in a country's total capital inflows may reflect its institutions' weakness rather than their strength. Though the empirical relevance of some of these sources of risk remains to be demonstrated, the potential risks do appear to make a case for taking a nuanced view of the likely effects of FDI. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.

After studying the Social Impact of Foreign Direct Investment in section 7, we can say that FDI-friendly policies in host countries can be usefully complemented by multilateral initiatives that seek to enhance the social benefits of inward FDI by promoting responsible business conduct amongst MNEs. The OECD Guidelines for Multinational Enterprises provide a good example of a government-backed initiative that aims to promote responsible business conduct. The Guidelines are most widely known for their system of National Contact Points (NCPs) through which disputes between relevant

stakeholders with respect to the implementation of the guidelines can be addressed.

Since its revision in 2000, more than 160 cases have been raised at the NCPs. Most of these have dealt with employment, labor and industrial-relations issues. The increasing share of these cases related to labor issues in non-OECD countries suggests that the OECD Guidelines are playing a growing role in the improvement of labor conditions worldwide.

There is also an important role for public initiatives that are specifically designed to raise labor practices in the supply chain. For example, by generating greater transparency in labor practices, improved public monitoring can strengthen the incentives for responsible business conduct among supplier firms. To enhance the attractiveness of their products to responsible buyers, technical assistance and credit facilities may be required to help supplier firms overcome obstacles to improved labor practices in the production process. The Better Work Program, a joint initiative launched by the International Finance Corporation (a member of the World Bank Group) and the International Labour Organization in 2006, is a promising initiative that attempts to raise working conditions in the workplaces of supply-chain factories through the enhanced public monitoring of labor practices and the provision of technical assistance and credit facilities to program participants.

Section 8 discussed about whether Foreign Direct Investment is a Lead Driver for Sustainable Development. Understanding what is needed to attract foreign direct investment is not difficult. The challenge is to create an environment and attitude that is attractive to foreign investors. In the short term this means creating a rational environment, which is not far removed in concept or execution from what the investor is used to. Familiarity reduces perceived risk. Reduced risk perception leads to a higher likelihood of investment. A competitive environment is not only about design (laws, rules, regulations). It is also about execution. Local public officials and civil servants must be coached on the importance of attracting and keeping foreign direct investment.

A competitive environment also promotes domestic investment. Without active evident domestic investment, cluster development and economic participation foreign investors will be unlikely to invest. Thus, it is the positive and consistent attitude of both the public and private sectors that are clear indicators to foreign investors regarding domestic investment and business opportunities.

Growth and the Quality of Foreign Direct Investment are discussed in section 9.

Understanding the effect of FDI on economic growth is important for a number of reasons. It has implications for the effect of rapidly growing investment flows on the process of economic development. It also informs foreign investment policy. In 1999 alone, there were 140 changes to state or national laws related to foreign direct investment. More than 90% of these changes liberalized foreign investment policy. One fifth introduced new incentives for foreign investors including tax concessions, financial incentives, import duty exceptions, and infrastructure and training subsidies (UNCTAD (2000)). Such policies however do not guarantee realization of the potential benefits of FDI that go beyond the “capital� FDI transfers to the host country.

If FDI does not exert a robust positive influence on growth, these pecuniary incentives and the active international competition for investment should be reconsidered. Local conditions in the recipient country can pose binding constraints on such spillovers. Our analysis, due to data limitation, has been restricted to OECD countries, which arguably have the local conditions to take advantage of FDI effects. More generally, studying the costs and benefits of FDI promotion are beyond the scope of this paper. More research on the consequences of FDI is warranted before advocating FDI promotion.

Section 10 argued about the casual link among the FDI, Trade and Growth. To analyze the section, it can be said that inward direct investment leads to increased trade concurs with the general theories of development, and is indicative of vertical foreign direct investment.

The decline in trade and investment barriers in mid 1980s as well as the abolition of foreign ownership restriction in mid 1994 resulted in massive FDI inflows to the country up to the onset of the economic crisis in mid 1997. These FDI inflows to Indonesia were particularly focused in three manufacturing industries: textile and textile products, chemicals, and fabricated metal and machinery. According to UNCTAD (1998), Indonesia was ranked among the top twelve recipients of FDI inflows among developing and transition economies.

After liberalization and deregulation in trade and foreign investment in 1985, new foreign firms entered mainly export-oriented and labor-intensive industries. Between 1990 and 1996, FDI contributed from 19 to 27 percent of total value added and from 20 to 35 percent of exports (Dhanani and Hasnain, 2002). An increase in inward FDI, therefore, had led to a rise in exports. The increasing reliance of foreign firms on suppliers outside the host country was evident in all industries with a significant foreign presence, suggesting that inward FDI does indeed generate imports.

The results of our causality testing are largely consistent with results reported for Mexico by Alguacil et al. (2002) and Pacheco-L贸pez (2005). FDI and exports were found to have bilateral causalities in Indonesia during the analyzed period, in that inward FDI is followed by an increase in exports and an increase in exports leads to a rise in FDI inflows. However, the results also imply that the relationships are rather more complicated than suggested by earlier work, in that the growth effects of FDI are important, both in explaining the nature of causality, but more importantly what the longrun effects of inward FDI into developing or transition economies may be.

However, while these results highlight the undoubted benefits of FDI, they also point to an increased dependence on foreign investors for future development, and the concentration of resources in the foreign owned sector. Comparisons with Mexico are apposite here. In the case of Mexico, a series of reforms led to a significant increase in

exports and imports in the country. However, as Pacheco-López (2005) asserts, if Mexico were to have a stable long-run economic growth, it is necessary for the government to better integrate the domestic industry and the export oriented sector aimed at strengthening local industries. Similarly, in the case of Indonesia, where foreign investments are also highly dependent on imported raw and/or intermediate inputs of production from international supply chains, it is thus important for the government to build an effective bridge between the domestic industry and the foreign export-oriented firms in order to make the most of the multinational presence in the country.

Sections 11 argued about whether Foreign Direct Investment Help Emerging Economies.

Despite some pitfalls, FDI appears to help emerging economies develop. It complements the host country’s institutions and human capital. In many countries, however, barriers to FDI remain. These barriers may range from limits on foreign ownership and control to outright ban on FDI in select sectors such as services. Reducing them may well be a way to speed up economic development.

The Impact of Inward FDI on Host Countries is presented in section 12. If country and industry differences are important to the impact of inward FDI on host countries, the main lesson might be that the search for universal relationships is futile. In that case, the question shifts from how inward FDI affects every host country and industry to which types of industries and host countries are affected, and what the impact is on each. It is in identifying the characteristics of firms, industries, and countries that promote the transfer of technology that case studies can be most implausible.

B. Policy Recommendations for FDI

Policies matter for reaping the full benefits of FDI. Foreign investors are influenced by three broad groups of factors: the expected profitability of individual projects; the ease with which subsidiaries’ operations in a given country can be integrated in the investor’s global strategies; and the overall quality of the host country’s enabling environment.

Some important parameters that may limit expected profitability (e.g. local market size and geographical location) are largely outside the influence of policy makers. Moreover, in many cases the profitability of individual investment projects in developing countries may be at least as high as elsewhere. Conversely, developed economies retain clear advantages in the second and third factors mentioned above, which should induce less advanced economies to undertake policy action to catch up. Important factors such as the host country’s infrastructure, its integration into the world trade systems and the availability of relevant national competences are all priority areas.

I. The challenges facing host country authorities Sound host-country policies toward attracting FDI and benefiting from foreign corporate presence are largely equivalent to policies for mobilizing domestic resources for productive investment. As stated in the Monterrey Declaration, domestic resources in most cases provide the foundation for self-sustaining development. An enabling domestic business environment is vital not only to mobilize domestic resources but to attract and effectively use international investment.

As the experience of OECD members and other countries has shown, the measures available to host-country authorities fall into three categories: improvements of the general macroeconomic and institutional frameworks; creation of a regulatory environment that is conducive to inward FDI; and upgrading of infrastructure, technology and human competences to the level where the full potential benefits of foreign corporate presence can be realized. The first of these points establishes the fact that every aspect of host countries’ economic and governance practices affects the

investment climate. The overall goal for policy makers must, therefore, be to strive for the greatest possible macroeconomic stability and institutional predictability. More concretely (and while macroeconomic and financial enabling environments have not been the focus of the main report), the following recommendations are widely supported: •

Pursue sound macroeconomic policies geared to sustained high economic growth and employment, price stability and sustainable external accounts.

•

Promote medium-term fiscal discipline, efficient and socially just tax systems, and prudent public-sector debt management.

•

Strengthen domestic financial systems, in order to make domestic financial resources available to supplement and complement foreign investment. A priority area is the development of capital markets and financial instruments to promote savings and provide long-term credit efficiently. This will help alleviate funding constraints in general and allow local enterprise development to benefit those business opportunities arising from foreign corporate activities. This process will entail a progressive implementation of multilaterally agreed financial standards.

The broader enabling environment for FDI is generally identical with best practices for creating a dynamic and competitive domestic business environment. The principles of transparency (both as regards host country regulatory action and business sector practices) and nondiscrimination are instrumental in attracting foreign enterprises and in benefiting from their presence in the domestic economy. FDI is unlikely unless investors have a reasonable understanding of the environment in which they will be operating. Moreover, a lack of transparency may lead to illicit and other unethical practices, which generally weaken the host country’s business environment. In this context, host-country authorities should undertake the following measures:

•

Strengthen their efforts to consolidate the rule of law and good governance, including by stepping up efforts against corruption and enhancing policy and regulatory frameworks (e.g. as regards competition, financial reporting and intellectual property protection) to foster a dynamic and well-functioning business sector. Such policies will benefit the climate for FDI through their effect on transparency. By bringing a larger share of the informal economy into the open, they will also have important secondary effects on countries’ ability to attract investment.

•

Work toward increased openness to foreign trade, so the domestic enterprise sector can participate fully in the global economy. This approach should be undertaken jointly with efforts to increase business-sector competition. A combined approach would allow a greater domestic and international openness to business to go hand-in-hand with safeguards against the negative effects of a rise in concentration. Moreover, the successful elimination of global and regional trade barriers makes participating countries more attractive for FDI, owing to the concomitant expansion of the “relevant” market.

•

Enshrine the principle of non-discrimination in national legislation and implement procedures to enforce it through all levels of government and public administration. Given the importance of competition for resource allocation and sustained economic growth, it is essential that foreign entrants should be able compete without government prejudice, and that incumbent enterprises are not unduly disadvantaged vis-à-vis foreign-owned ones.

To reap the maximum benefits from corporate presence in a national economy, domestic competences, technologies and infrastructure need to be sufficiently well developed to allow nationals to take full advantage of the spillovers that foreign-owned enterprises generate. Host-country authorities should therefore – with due regard to

the balance between costs and expected benefits, and the state of development of the domestic economy – undertake measures to the following effect: •

Put in place, and raise the quality of, relevant physical and technological infrastructure. The presence of such infrastructure is instrumental in attracting MNEs, in allowing national enterprises to integrate the technological spin-offs from foreign-owned enterprises in their production processes, and in facilitating their diffusion through the host economy. Allowing foreign investment in infrastructure sectors and leveraging such investment by means of ODA may assist in these efforts.

•

Given the importance of basic, widespread education for development, raise the basic level of education of national workforces. The provision of specialized skills beyond basic education should build on existing competences in the host economy, rather than target the short-term or specific needs of individual foreign-owned enterprises. A healthy workforce population is also needed, which requires basic public health infrastructure (e.g. clean water).

•

Implement internationally agreed. Efforts to reduce child labor, eliminate workplace discrimination and remove impediments to collective bargaining are important in their own right. They also serve as tools to upgrade the skills and raise the motivation of the labor force and facilitate linkages with MNEs operating on higher standards. Additionally, a comparatively sound environmental and social framework becomes increasingly important for countries seeking to attract international investments operating on high standards.

•

Consider carefully the effects of imposing performance requirements on foreign investors. Rather than justifying performance requirements as a necessary counterweight to generous FDI incentives, countries may wish to reassess the

incentive schemes themselves. Moreover, it should be recognized that such requirements may work against efforts to attract higher quality FDI.

II. The challenges facing home-country authorities While host-country authorities should bear the brunt of the policy adjustments needed to reap the benefits of FDI for development, the home countries of MNEs – and the developed world more generally – should review the ways in which their national policies affect developing countries. Thus, the benefits of FDI that flow from increased international trade integration and diffusion of technology, as mentioned in this report, are influenced significantly by the policies of developed countries.

Further trade liberalization would contribute substantially to worldwide economic development, benefiting both developed and developing countries. In the FDI context, the trade policies of developed (home) countries gain a further dimension, insofar as an important share of FDI is contingent upon subsequent trade between related enterprises. Trade barriers and subsidies aimed at limiting imports into developed countries currently impose costs on developing countries (the magnitude of which arguably exceeds aid flows). The authorities in developed countries could enhance developing countries’ ability to attract foreign investment by working to reduce and eventually eliminate these barriers and subsidies.

Home-country governments need to assess the effects that their technology policies may have on the transfer of technologies to the host economy. Authorities can contribute to a positive outcome by encouraging MNEs to consider the technological needs of host countries. The OECD Guidelines for Multinational Enterprises, which adhering countries are committed to promote, stipulate that enterprises should adopt practices that “permit the transfer and rapid diffusion of technologies and know-how, with due regard to the protection of intellectual property rights.

While recognizing that developed and developing countries generally do not compete for the same investment projects, developed countries should remain attentive to the potential impacts of their measures of subsidizing inward direct investment on developing countries’ ability to attract FDI. Another area of action relates to improving the synergies between FDI flows and ODA. While ODA has been, in certain least-developed countries, the only substitute for inadequate FDI, there is evidence that carefully targeted development assistance may assist in leveraging FDI flows and creating a virtuous circle of increasing savings and investment. ODA can be used to buttress or develop institutions and policies in developing countries. This helps create a favorable environment for domestic savings, and for domestic and foreign investment and growth.

Some donor and recipient countries are already working along these lines. ODA funds can be used to support those areas considered important to investors in determining investment decisions, notably by helping host countries achieve some of the measures outlined in the previous section. Efforts to improve physical infrastructure, human capital and health in developing countries are all cases in point.

III.

The role of multinational enterprises

The private sector (notably foreign investors) plays a vital role in generating economic growth, and contributing to achieving sustainable development goals. Therefore, the way private enterprises behave and are governed is important in maximizing the benefits of FDI for economic development. OECD countries have launched several initiatives to promote responsible corporate behavior. Among these are the OECD Guidelines for Multinational Enterprises.

Along with provisions for national treatment and other elements of the OECD Declaration on International Investment and Multinational Enterprises, voluntary

principles and standards for responsible business conduct are provided by the Guidelines for Multinational Enterprises, recommended by 36 OECD and non-OECD governments to MNEs operating in and from their countries. These recommendations can be read as an approach to the Development Agenda now facing the international community in areas such as technology transfer, human capital management practices, transparency and competition. Moreover, companies should refrain from seeking exemptions from national environmental, labour and health standards.

IV.

The importance of international co-operation

International co-operation, whether under the auspices of international organizations or bilaterally, may assist and reinforce the FDI-related efforts of host countries, home countries and multinational enterprises. The added value of co-operation in the context of home countries, or developed countries more broadly, lies in the fact that the fields for policy action suggested above cannot easily be pursued by countries acting alone.

Embarking on the vast array of policy measures proposed above for host countries is beyond the capabilities of many poorer nations. This creates a scope for other countries and organizations to help via measures aimed at technical assistance and capacity building.

Against the background of the Doha and Monterrey Declarations, which identify capacity building as a priority area for international co-operation, international organizations and relevant national agencies should carefully assess the need for activities in the field of international investment – particularly FDI. Increased capacitybuilding measures would focus on assisting developing countries to develop stronger competences in the following fields: general supply-side challenges; formulation and implementation of broad-based policies toward FDI; and the specific architecture for negotiating and implementing international treaties and agreements related to foreign investment.

The OECD has a key responsibility to act as a forum for sharing Members’ experience with capacity building and with investment instruments of co-operation. The OECD’s distinctive methodology relies on a peer-review process based on long-tested benchmarking for FDI policies, recommendations from governments with diverse perspectives and cultures, and the monitoring of process. The success of such an approach will depend on the mechanisms for co-ordinating the use of resources for capacity building and technical assistance. The challenges are so great that no single institution can respond adequately to the needs of developing countries. This implies a need for greater co-operation among investment and aid agencies and for institutional support to field representatives of aid agencies to engage in a broader range of investment capacity-building activities. Such enhanced responses presuppose that international organizations give investment capacity building a very high priority at both headquarters and the field level.

14. Summary and Conclusions Foreign direct investment reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘‘direct investor’’) in an entity resident in an economy other than that of the investor (‘‘direct investment enterprise’’). FDI can play a significant role in raising a country’s technological level, creating new employment, and promoting economic growth. Many countries are therefore actively trying to attract foreign investors in order to promote their economic development, particularly at times when the country’s domestic growth prospects appear weak.

Based on empirical findings, it is suggested that developing countries should try making the more business friendly environment and ensuring create business friendly environment, developing countries, in the long run need to develop some necessary institutions to reduce the extent of corruption and to control the factors that increase both visible and invisible business start-up costs.

Developing countries, emerging economies and countries in transition have come increasingly to see FDI as a source of economic development and modernization, income growth and employment. Countries have liberalized their FDI regimes and pursued other policies to attract investment. They have addressed the issue of how best to pursue domestic policies to maximize the benefits of foreign presence in the domestic economy.

The overall benefits of FDI for developing country economies are well documented.

Given the appropriate host-country policies and a basic level of development, a preponderance of studies shows that FDI triggers technology spillovers, assists human capital formation, contributes to international trade integration, helps create a more competitive business environment and enhances enterprise development. All of these contribute to higher economic growth, which is the most potent tool for alleviating poverty in developing countries. Moreover, beyond the strictly economic benefits, FDI may help improve environmental and social conditions in the host country by, for example, transferring “cleaner” technologies and leading to more socially responsible corporate policies.

While many of the drawbacks, referred to as “costs”, arguably reflect shortcomings in the domestic policies of host countries, important challenges may nevertheless arise when these shortcomings cannot easily be addressed. Potential drawbacks include a deterioration of the balance of payments as profits are repatriated (albeit often offset

by incoming FDI), a lack of positive linkages with local communities, the potentially harmful environmental impact of FDI, especially in the extractive and heavy industries, social disruptions of accelerated commercialization in less developed countries, and the effects on competition in national markets. Moreover, some host country authorities perceive an increasing dependence on internationally operating enterprises as representing a loss of political sovereignty. Even some expected benefits may prove elusive if, for example, the host economy, in its current state of economic development, is not able to take advantage of the technologies or know-how transferred through FDI. The net benefits from FDI do not accrue automatically, and their magnitude differs according to host country and context. The factors that hold back the full benefits of FDI in some developing countries include the level of general education and health, the technological level of host-country enterprises, insufficient openness to trade, weak competition and inadequate regulatory frameworks. Conversely, a level of technological, educational and infrastructure achievement in a developing country does, other things being equal, equip it better to benefit from a foreign presence in its markets.

Yet even countries at levels of economic development that do not lend themselves to positive externalities from foreign presence may benefit from inward FDI through the limited access to international funding. By easing financial restraint, FDI enables host countries to achieve the higher growth rates that generally emanate from a faster pace of gross fixed capital formation. The eventual economic effect of FDI on economies with little other recourse to finance depends crucially on the policies pursued by hostcountry authorities. The sectoral composition of an economy can also make a difference. While the service sectors of many developing countries may be underdeveloped and hence unable to attract large inflows of FDI, extractive industries in countries with abundant natural resources can be developed beneficially with the aid of foreign investors.

With average inward FDI stocks representing around 15 % of gross domestic capital formation in developing countries, foreign investment acts as a valuable supplement to domestically provided fixed capital rather than a primary source of finance. Countries incapable of raising funds for investment locally are unlikely beneficiaries of FDI. Since we are living in an increasingly interdependent global economy, part of the development dilemma is how can foreign direct investment (FDI) be harnessed to assist and facilitate local economic development. FDI is becoming an increasingly important issue when considering that the level of overseas development assistance has dropped by more than 50% since 1990. Additionally, FDI is playing an increasingly large role in global economic growth rates. Thus, foreign direct investment is being increasingly seen as a rational financial development alternative.

Attracting FDI is dependent upon the existence of a successful private sector and by creating a business climate, which offers businesses a familiar and competitive environment to operate from and comparable to what can be found in countries which have been successful in attracting FDI. The business climate is an important issue because ICT is one of the only international sectors in which any nation can develop the appropriate resources and compete. No single nation has a monopoly on skilled, educated and creative people.

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