IMPACT OF FDI ON HOST ECONOMY

ABSTRACT

This project critically examines the negative effects that FDI poses to the host economy. The impact of FDI on the host economy can be understood with the help of The Standard Theory of International Trade and The Theory of Industrial Organisation. FDI has both positive and negative impacts on the host-country. FDI has an adverse effect on the host country’s economy, environment, domestic firms, political environment, labour market and trade balance. Through this project, it is concluded that the government policies should be such that they exploit the benefits of FDI completely in order to overrule its drawbacks.

INTRODUCTION

There is an increasing acknowledgment to recognize the forces of economic globalization which first requires looking at Foreign Direct Investment (FDI) by multinational corporations (MNCs): that is, when a firm based in one country locates or acquires production facilities in other countries. (Blonigen, 2006).

Over the past decade Foreign Direct Investment (FDI) has grown noticeably as a major form of international capital transfer. Between 1980 and 1990, world flows of FDI- defined as cross-border expenditures to acquire or expand corporate control of productive assets – have approximately grown three times (Froot, 1993). “FDI has turned out to be a major form of net international borrowing for Japan and the United States, the world’s largest international lender and borrower respectively” (Froot, 1993, pp. 1).

The most introspective effect of FDI has been seen in developing countries, wherein annual Foreign Direct Investment flows have increased from an average of less than $10 billion in the 1970’s to an annual average of $208 billion in 1999 (Source: UNCTAD). A large portion of global FDI is driven by mergers and acquisitions and internationalization of production in a range of industries (Graham and Spaulding, 2005).

Despite the noticeable importance of FDI and MNCs in the world economy, research on the factors that decide FDI patterns and the impact of MNCs on parent and host countries is in its early stages. The most significant general questions are: what factors determine where FDI occurs, and what impacts do those MNC operations have on the parent and host economies? This report mainly analyses the negative impact of FDI’s on host economies.

FORIEGN DIRECT INVESTMENT

“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”)” (OECD). In other words, it is a direct investment made by a corporation in a commercial venture in another country.

What separates FDI from portfolio investment is the control over the investment (Gillies, 2005). In case of FDI at least 10 percent of the voting rights must be held by the foreign investing company (Daniels et al., 2004). The difference between FDI and other ventures in foreign countries is mainly that the new venture operates completely outside the economy of the company’s home country.

The main motivators behind FDI are resource acquisition, sales expansion and risk minimisation. Besides this governments may also encourage FDIs due to various political motives (Daniels et al., 2004).

TYPES OF FDI

Foreign Direct Investment can be classified into three broad categories on the basis of direction, target or motives.

On the basis of direction FDI can be classified into Inward or Outward FDI. When foreign capital is invested in local resources, it is referred to as Inward FDI, on the other hand when investments are made by local firms in foreign resources it is referred to as Outward FDI. Outward FDI is also known as “direct investment abroad” and is always backed by government support in case of any risks.

On the basis of target FDI can be classified into Greenfield Investments, mergers and acquisition, horizontal and vertical FDI. Greenfield Investment refers to direct investment in new arenas or the development of existing amenities. This leads to creation of production capacity, employment opportunities, transfer of technology and expertise as well as linking of the host economy to the global marketplace.

Mergers and acquisition are a major kind of FDI whereby there is a transfer of existing resources from local businesses to foreign businesses. Cross border mergers take place when the management of resources and business operations is relocated from a local company to a foreign company, with the local organisation becoming an associate to the foreign organisation. Acquisitions take place when the foreign company takes over a domestic company, and establishes itself as the new owner of the domestic company.

Horizontal FDI refers to an investment made by a foreign company in the same industry in which it operates in its home country. Vertical FDI can be classified further into backward and forward vertical FDI. Backward Vertical FDI occurs when a domestic firm is provided input by a foreign firm in order to aid its production process whereas Forward Vertical FDI occurs when the output of a domestic firm is sold by an industry abroad it is known as forward vertical FDI.

Lastly on the basis of motives, FDI can be classified into four types. The first type is of FDI takes place when the various factors of production may not be available in the home country of the firm or be more efficient in the host country, thereby encouraging firms to make investments. This is known as Resource seeking FDI. The second type of FDI which can be used as a defensive strategy is Market-seeking FDI. These investments are made either to maintain existing markets or to penetrate into new markets. The third type is Efficiency Seeking FDI, where the firms hope to increase their competency by exploiting the advantages of economies of scale and also common ownership. The firms thus try to achieve the objective of profit maximization. the last type is Strategy -asset seeking FDI, which is a common tactic used by firms to stop their competitors from acquiring resources. Thus these are the various types of FDI.

IMPACT OF FDI ON HOST ECONOMY

There are two approaches in economic theory which contribute to studying the effects of Foreign Direct Investment on host countries.

One is the standard theory of international trade by Macdougall (1960). This theory is a “partial equilibrium comparative-static approach intended to examine how marginal increments in investment from abroad are distributed” (Blomstrom, 1997, p.1). The main assumption of this model is that there is an increase in the marginal productivity of labour and a decrease in the marginal productivity of capital.

The other theory was proposed by Hymmer (1960) and is called the theory of industrial organisation. The main question of the theory is why firms make investments in other countries in order to manufacture the similar goods they manufacture at home. The answer to this question has been rightly devised by Kindleberger, 1969, p.13), who says, “for direct investment to thrive there must be some imperfection in markets for goods or factors, including among the latter technology, or some interference in competition by government or by firms, which separates markets”. Thus firms of home countries must have some asset which is going to be lucrative for its associate in the home country (Blomstrom, 1997).

Foreign Direct Investment has both positive and negative effects on the host economy.

POSITIVE EFFECTS OF FDI ON HOST ECONOMY

FDIs have a number of positive impacts on the host country. It encourages economic development by increasing the productivity and exports of the host countries. There are four channels which help in increasing the productivity of host country, namely imitation, skill acquisition, competition and exports (Gorg & Greenaway, 2004).

The local firms in the host countries benefit by the indirect technology transfer that takes place between the MNC and the domestic companies. Local firms can compete more successfully in the export markets by copying the superior technology or management techniques used by the multinationals (Blomstrom, 1991).

Domestic firms become more exposed to the foreign markets and subsequently their knowledge of the international markets increases. The Managers and other qualified employees of the domestic firms acquire the superior managerial and technical skills, which increases their efficiency.

Multinationals increase the existing market competition, instigating the local firms to become more efficient by investing in physical or human capital. They help to increase industrial efficiency and improve resource allocation in host countries by entering markets which had many entry barriers. Thus by entering these monopolistic markets they increase competition and force the local firms to become more proficient. This is how, domestic firms are provoked by multinationals and other overseas firms to improve their performance and productivity.

Multinationals also influence the local suppliers of intermediate products to become more efficient with delivery speed, quality and reliability of the products so as to meet the high standards of the overseas company.

It is seen that FDI has a positive impact on labour market. If the productivity of domestic firms increases by copying the multinationals production style which is based on increased labour productivity, then the domestic firms will not hesitate from paying higher wages to the labour (Lipsey & Sjoholm, 2010). Multinationals also increase the standard of the host country’s labour market by providing the labourers with training and making them qualified enough to handle complicated machinery and increasing their productivity.

Lastly FDI affects the economy of the host country positively by increasing their revenues in the form of taxes, strengthening the exchange rate of the country and instigating the government to make policies which would attract more MNCs towards it.

NEGATIVE IMPACT OF FDI ON HOST ECONOMY

As seen above FDI has a number of positive effects on the host economy but these effects do not come free of cost. FDI brings along with it a number of negative effects which prove harmful to the country in various ways. Extend of the negative effects of FDI depends on the characteristics of the multinational companies, the host country and the policies of the host country.

Some of the negative effects have been highlighted below:

ENVIRONMENTAL DEGRADATION

With increasing competition all over the world, companies are shifting their production base to developing countries where they can carry out the production of goods that are pollutant to the environment. These countries have flexible environmental regulations and are less stringent with their enforcements. Thus by carrying out production in such countries they are able to get a competitive edge over companies which carry out production elsewhere. Lowered trade obstacles are leading to a shift of polluting industries from countries with austere environmental regulations to countries with moderate environmental regulations. This leads to an increase in pollution in countries with lenient environmental policies because they refuse to tighten them in order to gain a stronger position over others in international trade. Trade may modify the environmental outcomes through a number of different channels. The scale effect is one such channel that has harmful implications to the environment. This is because when multinationals set up manufacturing facilities or outsource these to other local businesses, it leads to an increase in output which in turn leads to an increase in pollution (Liang, 2006).

MARKET STRUCTURE

FDI has a negative impact on the market structure as well. As the multinationals enter the market, it leads to the increase of concentration levels within the economy which in turn hampers market control. Therefore risk is prevalent. FDI’s tend to assemble in exceedingly concentrated industries. The relationship between presence of foreign organisations in the host countries and the concentration within the economy is indebted to the nature of multinational ownership benefits rather than to anti-competitive activities. In small economies, proficient exploitation of modern advanced technology leads to concentrated market structures. If such economies have lenient trade administration then the risk of anti-competitive activities is diminished to a great extent (Lall, 2000). However it is evident that successful competition strategies are very important as multinationals have the capability to simply control an industry in a host economy.

TECHNOLOGY

FDI’s open the doors for the host country to access new technology but this technology is controlled and possessed only by the MNEs. MNCs generally invest in capital-intensive technologies and have strict proprietary rights which prevent its spill over to local firms.

The technology bought in by the MNC may not be favourable to conditions of the host country. For example if the host country is a labour-intensive country and the technology used by the multinational is capital-intensive then gradually it will have a negative effect on the host economy. Once the domestic firms start imitating the foreign firm and start using the same technology used by them, labourers will lose out on their jobs. Thus this would lead to unemployment problems which will negatively affect the economy of the host country. A country attracts FDI so that the national economy grows by creating new job opportunities but in this case it would work in the opposite direction. Pollution-intensive technology may also be exported from countries where they are banned.

COMPETITION

FDIs have an adverse affect on competition and hamper the prevailing market equilibrium. In developing countries, the domestic firms may not be able to cope up with the competition put up by the MNCs. Thus they would lose out on business.

Some multinationals acquire monopoly status in highly profitable sectors. With their monopolistic power they wipe out all competitors from the market. New enterprises are not willing to enter these markets because of the huge capital and risks involved. Thus these multinationals are able to demand unreasonable prices form the customers, leaving them with no other choice but to pay excessively higher charges due to the limited choices available. These monopolistic companies do not even invest in new technologies to bring down their costs since they are already enjoying the luxury of irrational prices.

PRODUCTIVITY

Atiken and Harrison (1999) and Konings (2001), have suggested that MNCs decrease the productivity of local organisations through competition effects. MNCs are able to carry out productions at lower costs since they bring along some proprietary knowledge which is firm specific. In addition they have superior managerial and marketing skills, reduced production costs, bulk purchases, etc which helps them reduce their marginal costs. Therefore, the demand for goods produced by MNC’s increases, which in turn reduces the demand for locally produced goods. This ultimately leads to a decrease in domestic production increasing the average costs.

With the establishment of multinationals, the demand for foreign inputs increases in comparison to local inputs which hinder the domestic firm from producing to its optimum capacity. Thus the domestic firms are not able to take advantage of economies of scale.

Domestic firms may not be quick enough to grasp knowledge from the foreign firms, losing out on competition in the short run (Gorg & Greenaway, 2004).

MNCs usually offer higher wages to domestic workers, thereby attracting all the skilled ones, leaving behind only the semi or unskilled labour for the local firms. It is a common trend amongst MNCs to offer higher wages in comparison to the domestic firms in developed as well as developing countries.

LABOURERS

The workers in the host countries may not be comfortable with some of the foreign policies adopted by MNCs.

One of the most attractive features for FDI in a host country is cheap labour. They take advantage of the cheap labour by producing labour intensive goods and thereby decreasing their costs of goods. With the establishment of labour intensive technology by MNCs, a country becomes highly dependent on them for its employment. Now multinationals are always trying to reduce their costs, so if they are able to find places with cheaper labour, they shift their base to that country. Thus there is always a fear of unemployment due to FDI withdrawal.

GOVERNMENT POLICIES

The government of the host country may face problems due to the establishment of FDIs. The government has less control over the operations of the foreign company that is functioning as the wholly owned subsidiary of an overseas company. Taking advantage of this, the MNC may not abide by the economic policies of the host country. They hamper the various environmental, governance and social regulations laid down by the government of the host country.
With FDI there is risk that confidential information of the host country could be leaked out to rest of the world. It has been seen that due to FDIs the defence of a country has witnessed various risks.

It is also noticed that multinationals are very reluctant to pay taxes of the host country. MNCs exploit the tax structure of the country by taking advantage of the lenient tax regulations of the host country and lack of enforcement by the government (Velde, 2001).

Another huge problem faced by host countries is that of transfer pricing which is a financial accounting device used by MNCs to maximise profits. Transfer pricing refers to the price charged by one associate of a company to another associate of the same company. Transfer pricing relates to all transactions that take place within a company including raw materials, management fees, royalties, finished products, etc. Transfer pricing is an illegal way of making huge profits for the MNCs. Transfer prices can be fabricated, thus different from the price that unrelated firms would have to pay. Thus by using transfer prices as a weapon, MNCs manipulate their books of entry and acquire huge amounts of profits without an actual change in their physical capital.

Profit transferring is a way of avoiding or saving taxes by MNCs through illegal ways. If the MNCs pay lesser taxes in the home country of their foreign affiliates in comparison to their host countries, then in order to increase profits, MNCs manipulate their book of accounts. They will inflate their expenditure on import of materials from their foreign partners or subsidiaries, this will show higher profits in the books of accounts of the foreign affiliates and less profit in the MNC’s account in the host country. Thus evading taxes and at the same time they will artificially transfer profits to the home country.

CROWDING OUT OF DOMESTIC INVESTMENTS

FDI crowds out domestic investments by creating a monopolistic environment. This can be explained in two ways. Firstly MNCs raise funds locally in the domestic market, increasing the demand for money and in turn increasing the interest rates, which crowds out domestic investments. Secondly when MNCs enter a new country, they bring with them huge investments which increases the overall money flow of the country. This increases the aggregate demand, leading to an increase in prices, i.e. inflation, which will then increase expenses, reduce savings and ultimately force people to borrow money, leading to higher interest rates. Thus is this way the local investments are crowded out (Borensztein et al., 1997).

Foreign firms have better advertising powers, ability to dominate the market and predatory pricing to prevent entry.

INFRASTRUCTURE CONSTRAINTS

Multinationals come in the way of a country’s infrastructure development. It is seen that multinationals are always attracted towards the more favourable regions of a country. Now with the establishment of multinationals in these regions, more efforts are put towards the betterment of these regions. As a result the rural and poor regions are ignored and they continue to remain underdeveloped.

COUNTRY’S TRADE BALANCE

FDI has an adverse effect on the Balance of Payment of the host country (De Mellow, 1997). Financial inflows raise the exchange rates, making it unfavourable for exports. When MNCs enter a country, they bring along foreign exchange and thus increase their supply, which strengthens the host-country currency, making the domestic products more expensive in the international markets, and as a result of this the total exports of the host country reduces. Thus there is a decrease in the net exports (Total Exports- Total Imports) of the country. Hence the BOP may become unfavourable.

The capital and current account are also hampered. When the MNC enters the host country, it might have previous raw material suppliers, or intermediary product suppliers, from whom it continues to buy its secondary material; this would lead to an increase in the import of the country making the BOP unfavourable. Secondly MNCs transfer their profits, management fees, royalty fees, etc back to their home country, hampering the capital account of the country.

ECONOMY

Multinationals usually tend to exist in close proximity to each other. It is seen that MNCs have a tendency to concentrate in the certain sectors taking advantage of the location, labour and resources. Thus the economy becomes extremely reliant on the MNC. A withdrawal of MNC from such areas could seriously hamper the economy and this is seen as a very severe problem in the backward areas.

RECOMMENDATIONS & CONCLUSION

This research paper was carried out to analyse the negative effects of FDI on the host economy and we have come to a conclusion that even though FDI helps in the development and growth of various countries all over the world, these benefits do not come free of charge. FDI can have several harmful effects on the host country. To overcome these harmful effects some recommendations gave been proposed

• To overcome the negative impact of environmental hazards, the host countries can use a variety of channels. One such channel is the technique effect where the local firms of the host country could learn from MNEs who often use superior technology or these firms may also exit from the market if the foreign firms seize the market share as well as labour supply. Therefore directness to trade will help in improving the quality of the environment. Another channel is the income effect whereby the local electorate may demand better environment standards as well as more strict regulations which are more enforceable by the government when the multinationals increase the income in the economy by creating jobs and thus increasing employment (Liang,2006).
• To overcome the competitive barriers in developing countries, the domestic firms could use various protective corporate agreements. They could either combine local firms or begin cooperative ventures with the foreign firms.
• Government of the host company should become more stringent with their policies. They should adopt policies which encourage proper social and environmental principles by the foreign companies. Multinationals should be penalised if they do not adhere by the policies of the country
• Measures should be taken to curb consumer and labour exploitation and at the same time competition should be created in the labour and product market, removing all entry barriers from the domestic markets.
• Encourage education, train labourers and promote infrastructure to increase the local capacity to absorb and disseminate the superior new traditions pioneered by overseas companies.

By taking a few precautionary measures and by amending the government policies, the harmful effects of FDI can be avoided. Thus, these policies should be such that they are able to maximise the benefits of FDI and curtail their negative effects.

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