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.

8 Responses to “Foreign Direct Investment and Economic Development”

  1. Marie Duggan says:

    If speculative flows were banned, or heavily curtailed, it would be possible to put regulations on FDI to benefit developing nations. However, with speculative flows such an easy and attractive option, I fear it pressures developing nations (and small towns in the US, too) to simply race to the bottom in to offer tax breaks and other nasty incentives to get the FDI.

  2. Kevin Gallagher says:

    I think the debate has shifted from “is FDI good for development” to “how might FDI be good for development.” Indeed, some of UNCTAD’s work has helped steer the debate in that manner. Their previous work has shown that FDI crowded out domestic investment in Latin America but has been associated with crowding in investment in Asia. Why? Because East Asian nations have a complementary set of industrial and innovation policies to “capture” the potential spillovers from FDI: what was once Compaq becomes Acer. Latin America discarded its policies to get the most out of FDI, and now attracts foreigners to drill holes in the ground. For a comprehensive look at FDI and development in Latin America see:

  3. I think UNCTAD’s WIR has been overly optimistic about how good can FDI actually be for development. Also, there are geo-political reasons for why in Asia FDI has a more positive role than in Latin America. China has an independence of action, that Mexico does not.

  4. Rick Rowden says:

    From my understanding, Kevin Gallagher’s point is exactly correct, and alot of his research has been good on this. It would be interesting to see what would happen if other developing countries beyond East Asia began to shrug off the advice of the Washington Consensus and (re)establish the kinds of rules on entry for FDI that could ensure more domestic spillovers to domestic firms and workforces in the areas of technology transfer and workforce skills upgrading. The Washington Consensus also promised other developing countries that if they cut back on labor, envoronmental and capital control regulations, and cut their domestic public investment in public health and education and infrastructure (to comply with tight fiscal and monetary targets), that these factors would make their economies even more attractive to FDI. Yet, other research has suggested that on balance, greenfield FDI generally flows to countries with healthy and skilled workforces and with good infrastructure. Arguably the governments of East Asia made much bigger public investments in health, education and infrastructure than did others who adhered more strictly to Washington Consensus approach. So there may also be lessons here about not just the need for regulations to ensure spillover benefits to domestic frms from FDI, but about how important it is for governments to scale-up public investment in the health and education of their workforces and in infrastructure.

  5. I would go further, not just in health and education and infrastructure. I think there are good reasons for direct government investment in areas connected to production. They saved GM, why not make a public (with private partnerships, if it makes people happy) effort to produce a zero emissions car. The same is true in developing countries. The Brazilian government, through Petrobras, is going to invest a lot in trying to get the oil from the sea. You would be surprised at the positive spillover effects on the Brazilian industry.

  6. Anis Chowdhury says:

    The claim that, “outflows of remittances have increased consistently” is contrary to what the figure shows in the case of Brazil. While I am sympathetic to the policy conclusion, I think one needs better empirical foundation than what the author has presented. It is extremely dangerous to propose policies in a strong langauage based on this kind of weak evidence.

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