Foreign Direct Investment and Economic Development

Matías Vernengo

In the 1960s Foreign Direct Investment (FDI) and Transnational Corporations (TNCs) were seen, at least by progressives, as an obstruction in the process of economic development.  The ultimate critique was that not much of the technological development introduced by foreign firms diffused to other parts of the economy, and that profit remittances would become a burden on the balance of payments accounts.  Hence, TNCs were seen as signs of the exploitation of the South by the North.  It did not help that companies, like International Telephone and Telegraph (ITT) in Chile during the Allende government, were plotting to bring down democratically elected governments.  Everything about foreign capital was bad.

By the 1990s, after a lost decade and the victory of the Washington Consensus Decalogue, foreign capital and TNCs were seen as central for economic development.  FDI created jobs, increased productivity, and macroeconomic problems associated to the balance of payments accounts were seen as secondary, since export performance, within the context of an export-led development strategy, would reduce the possibilities of crises.  Everything about foreign capital was good.

A more pragmatic approach would admit that foreign capital, while not always deleterious, is also not a panacea.  And even though several strands of the Washington Consensus have been under attack, the benign view of FDI and TNCs has prevailed in most economic debates basically unchallenged.  This is also true of UNCTAD’s World Investment Report, an institution that has otherwise promoted a view of trade and development that is critical of the main tenets of the neoliberal agenda.  In fact, since the first report (WIR, 1991), the general position adopted was that developing countries had to adopt pro-business market-friendly policies, in order to attract capital inflows, which would prove to be the engine of growth.

While the international financial crises that culminated with the Great Recession of 2007-09, have definitely shown that capital account liberalization (in particular short-term speculative flows) is dangerous, and that capital controls, accumulation of foreign reserves, and intervention in foreign exchange markets are all necessary to prevent crises (e.g. Trade and Development Report, 2008), the same has not led to a significant revision about the role of FDI.

In the case of Latin America, a region were the role of foreign capital seems to have curtailed the development of indigenous corporations (contrary to the Asian experience), the macroeconomic effects of FDI on the long-term sustainability of the balance of payments should be part of the main preoccupations for policy makers and analysts.  This should lead, also, to a more intense effort to understand the distinction between greenfield FDI, which corresponds to the installation of new capacity, and mergers and acquisition (M&A), on the one hand, and the distinction between flows that are often classified as FDI, but correspond to short-term speculative flows.

For example, among the highest recipients of FDI inflows in Latin America, besides Brazil, Chile and Mexico, are the British Virgin Islands and the Cayman Islands (WRI, 2011, p. 58; Table A), Offshore Financial Centers (OFCs) and tax havens for TNCs. It is hardly believable that these flows represent in any sense long-term investment in the region.  Further, a significant part of the increase in inflows to the region has been associated to M&A by Asian firms, of which a high percentage is Chinese capital, in the energy sector.

The FDI flows are associated to the Chinese development strategy, and their increasing energetic needs.  It is not clear that these inflows would lead to technological progress, a more skilled labor force, higher levels of investment, higher exports or economic growth.  This wave of FDI comes on top of the wave of the 1990s, which was associated with the process of privatization, and led fundamentally to an increase in profit remittances.

The graph above illustrates the point by showing the net flows of FDI and profit remittances as a share of GDP in the Brazilian case.  While the FDI flows grew and become more volatile, the outflows of remittances have increased consistently.  Brazil has exchanged short-term volatile flows with uncertain effects on productivity and exports for persistent capital outflows.

This suggests that the regulation of long-term capital, to guarantee that firms re-invest profits in the host country, spend part of the proceeds to fund Research and Development (R&D) and train the labor force, and higher taxes to transfer money to public investment for infrastructure, should be part of a more balanced view about the role of FDI.