Term Paper
International Finance
Impact of Foreign Direct Investment on developing
countries
Kaustubh Andhorikar
18-S-004
MMS II, JBIMS
Abstract
Foreign direct investment (FDI) and trade are often seen as important catalysts for economic growth in
the developing countries. FDI is an important vehicle of technology transfer from developed countries to
developing countries. FDI also stimulates domestic investment and facilitates improvements in human
capital and institutions in the host countries. International trade is also known to be an instrument of
economic growth. Trade facilitates more efficient production of goods and services by shifting
production to countries that have comparative advantage in producing them.
This paper examines the impact of FDI on economic growth in developing countries. It also includes
studies of different countries and how FDI has affected economic growth in these countries along with
other criterion.
Introduction:
Foreign direct investment (FDI) and trade are often seen as important catalysts for economic growth in
the developing countries. FDI is an important vehicle of technology transfer from developed countries to
developing countries. FDI also stimulates domestic investment and facilitates improvements in human
capital and institutions in the host countries. International trade is also known to be an instrument of
economic growth (Frankel and Romer). Trade facilitates more efficient production of goods and services
by shifting production to countries that have comparative advantage in producing them. Even though
past studies show that FDI and trade have a positive impact on economic growth, the size of such impact
may vary across countries depending on the level of human capital, domestic investment, infrastructure,
macroeconomic stability, and trade policies. The literature continues to debate the role of FDI and trade
in economic growth as well as the importance of economic and institutional developments in fostering
FDI and trade. This lack of consensus limits our understanding of the role of FDI and trade policies in
economic growth processes and restricts our ability to develop policies to promote economic growth.
Impact of Foreign Direct Investment on Developing Countries
Many developing countries do not have the necessary resources at their disposal to develop some
sectors and hence, they permit foreign capital to invest in these sectors. Of course, they also ensure that
sectors like defense and other sectors that have national security implications are kept off the list of
sectors in which foreign direct investment is allowed. For many countries, opening up of their
economies results in benefits since they need the dollars as well as because they might not have the
expertise to commence productive activities in these sectors. Finally, foreign direct investment can be
used to pay for expensive imports and encourage exports as well. After all, every developing country
(except those with large oil reserves) needs to pay for its oil imports in dollars and hence foreign direct
investment helps to earn precious dollars.
Downsides of Foreign Direct Investment on Developing Countries
There are many downsides to allowing Foreign Direct Investment into the developing countries.
However, the developing countries benefit because of inflow of dollars and much needed capital, which
is not available domestically, there is scope for outflow of dollars as well since the foreign companies
typically repatriate a part or whole of their profits back to their home countries. This is the reason why
developing countries must think twice before allowing blanket foreign direct investment. To circumvent
this, many developing countries typically restrict foreign direct investment into sectors that badly need
capital and where the developing country does not have expertise. Further, the fact that many
developing countries have capital controls on the capital account (which is to restrict wholesale
repatriation of both profits and investment) and relax the current count where only profits and that too
a percentage of it is repatriated.
Impact of FDI on India:
FDI and Economic Growth The historical background of FDI in India can be traced back with the
establishment of East India Company of Britain. British capital came to India during the colonial era of
Britain in India. After Second World War, Japanese companies entered Indian market and enhanced
their trade with India, yet U.K. remained the most dominant investor in India. Further, after
Independence issues relating to foreign capital, operations of MNCs, gained attention of the policy
makers. Keeping in mind the national interests the policy makers designed the FDI policy which aims FDI
as a medium for acquiring advanced technology and to mobilize foreign exchange resources. With time
and as per economic and political regimes there have been changes in the FDI policy too. The industrial
policy of 1965, allowed MNCs to venture through technical collaboration in India. Therefore, the
government adopted a liberal attitude by allowing more frequent equity. In the critical face of Indian
economy the government of India with the help of World Bank and IMF introduced the macro-economic
stabilization and structural adjustment program. As a result of these reforms India open its door to FDI
inflows and adopted a more liberal foreign policy in order to restore the confidence of foreign investors.
Further, under the new foreign investment policy Government of India constituted FIPB (Foreign
Investment Promotion Board) whose main function was to invite and facilitate foreign investment and
access to international quality goods and services the Indian Government has used many steps to attract
more FDI. The highest amount of FDI was received in the year 2011-2012, amounting to Rs.
173947crore. The highest growth rate of FDI inflow is in the year 2006-07 i.e., 186.9622 percent. The
table also shows that FDI as a percentage of GDP was less than one until 2005-06 after then it is
increasing year after year.
The above table shows the FDI inflow and GDP in India from the year 1991-92 to 2011-2012(postliberalization period). The table states that India had showed a large amount of FDI inflow. It showed
that FDI inflow has been increased by more than 210 times during the study period because the FDI
Inflow has been increased from Rs. 409 crore in 1991-92 to Rs. 173947 crore in 20011-2012. Due to
technological up gradation, access to global managerial skills and practices, optimal utilization of human
and natural resources, making Indian industry internationally competitive, opening up export markets,
providing backward forward linkages and access to international quality goods and services the Indian
Government has used many steps to attract more FDI. The highest amount of FDI was received in the
year 2011-2012, amounting to Rs. 173947crore. The highest growth rate of FDI inflow is in the year
2006-07 i.e., 186.9622 percent. The table also shows that FDI as a percentage of GDP was less than one
until 2005-06 after then it is increasing year after year.
Impact of FDI on China
China has been successful in mobilizing inward Foreign Direct Investment (FDI). Attracted by the
country’s investment opportunities and by its sheer size and growing domestic market, China received
about 20 percent of all FDI to developing countries over the last 10 years and over $100 billion in
2008. In terms of share of GDP and investment, FDI accounted for some 2.5 percent of GDP on average
over the last five years. While this may appear to be low it can be easily explained by the overall size of
the economy: China is the third largest economy of the world, just behind Japan and the United States
of America.
Inbound FDI has played an important role in China’s economic development and export
success. According to the Ministry of Commerce (MOFCOM), foreign invested enterprises account for
over half of China's exports and imports; they provide for 30% of Chinese industrial output, and
generate 22% of industrial profits while employing only 10% of labor – because of their high
productivity. Evidence on technology spillovers is more limited, but industries with higher FDI seem to
have higher productivity increases than other industries, suggesting a positive effect. Importantly,
foreign investment has catalyzed China’s economic reform. Together, these contributions have
supported China in maintaining a record-high 10 percent growth rate during most of the 1980-2010
period.
FDI policies in China have evolved alongside economic development and strengthened institutional
capacity. A gradual and prudent approach has been taken in the process of liberalization. When market
institutions were not fully in place in 1980s and 1990s, China experimented with opening up to foreign
investment in selected coastal cities and in special economic zones/industrial parks with a focus on
attracting export-oriented manufacturing FDI. Corresponding to China’s shift of its development goal
from an emphasis on GDP growth towards a more harmonious balanced development, China made a
radical commitment to services liberalization in its accession to WTO. This has triggered a shift of FDI
to service industries. By 2009, FDI in services increased 3 times from that in 2000, while manufacturing
FDI in China increased 81 percent. Regional production networks in East Asia grew substantially in the
past few years and were largely aligned with China as their center. The results have been
extraordinary. Thousands of multinational corporations have invested in China. The latest UNCTAD
report on World Investment Perceptions lists China in first place among the top 15 investment locations.
Hong Kong SAR and Taiwan, China have traditionally been the most important sources of FDI, but the
presence of investors from Japan, the USA, and Europe has grown over the years.
China has been quite open for FDI in almost all manufacturing and most service industries. But China has
been circumspect in its gradual approach to liberalization to synchronize it with the development of
institutional capacity. Arguably, this has served China well to weather the financial crisis. Looking into
the near future there may be a case for further liberalization of backbone services such as finance and
telecommunication.
China’s highly decentralized FDI approval and policy implementation creates opportunities for healthy
competition for FDI among local authorities but can also become cause of excessive red tape and
corruption. In such a decentralized environment transparency of regulation and open communication
between Government and business community is of special importance. To this end, local governments
are increasingly seeking to ensure the administrative and operational efficiency of the approval
process. The most common practice is setting up “one-stop” facilities, which aim at allowing investors
to conduct all procedures in one place.
The World Bank Group recently published its Investing Across Borders 2010 report. The report is a new
study comparing regulation of inbound foreign direct investment across four topics for 87 countries. It
presents indicators only on countries’ laws, regulations, and practices affecting how foreign companies
invest across sectors, start businesses, access industrial land, and arbitrate commercial disputes. As such
its scope is intentionally limited. It does not cover all circumstances relevant for foreign investors. As
stated in the report, for example, in addition to assessing the legal and regulatory framework, it is well
established that investors value the economic size of the host country, its domestic market and
proximity to important foreign markets, the potential for innovation, and the level and quality of
government services; and an educated and skilled workforce. From the host country’s point of view, the
risk of negative externalities from foreign investments, such as environmental and social damage
(especially if the poor are the ones affected) needs to be balanced with the opportunity of positive
externalities that such investments can yield. The Country profiles of the report need to be read with
that context in mind.
The challenge for China now is to attract the right kind of FDI as it strives to rebalance its economy,
improve the environment, and move up the value chain. As a result, recent FDI strategies have taken a
more selective approach, to attract environmentally sustainable, energy efficient, and technologically
advanced industries. As befits its economic global rank China is providing a level playing field for all
firms, domestic or foreign alike.
China has been quite open for FDI in almost all manufacturing and most service industries. But China has
been circumspect in its gradual approach to liberalization to synchronize it with the development of
institutional capacity. Arguably, this has served China well to weather the financial crisis. Looking into
the near future there may be a case for further liberalization of backbone services such as finance and
telecommunication.
China’s highly decentralized FDI approval and policy implementation creates opportunities for healthy
competition for FDI among local authorities but can also become cause of excessive red tape and
corruption. In such a decentralized environment transparency of regulation and open communication
between Government and business community is of special importance. To this end, local governments
are increasingly seeking to ensure the administrative and operational efficiency of the approval
process. The most common practice is setting up “one-stop” facilities, which aim at allowing investors
to conduct all procedures in one place.
Impact of FDI on Argentina
Although the programme of structural reforms and price stabilization has contributed to a better
environment for foreign direct investment (FDI) in Argentina in the 1990s, FDI flows are mainly
explained by the incentives established in specific policies regulating the privatization of public services
and in the automotive regime. The growth in internal demand has been the main locational advantage
inducing recent FDI into Argentina. In this context, the impact of trade liberalization, entry of new firms
and the requirements of the specific policies in force have encouraged firms to apply their human and
physical resources in a more efficient way. Thus, in contrast to what happened in the era of import
substituting industrialization, recent investments have been not only internal market but also efficiency
seeking. However, most FDI has a significant import content and, except in the automobile industry, has
not led to export growth. Furthermore, resource enhancement activities have been far less important
than efficiency seeking investments and no significant strategic asset seeking investments have yet been
made in the country.
Foreign Direct Investment plays an imperative role in generating sustainable development in an
economy. It is considered to be a great source of employment generation, modernization, equity
promotion, poverty alleviation, technology transfer and economic development. It can boost the
economy through greater research, productivity and innovation (OECD, 2002). The Argentine
government has always opened its arms to foreign investment, offering a favorable climate to their
progress and development. However, there are several factors that constrain the FDI from reaching
Argentina. These include bureaucratic mechanisms, corruption, excessive taxation, instability of the
domestic currency, inflexible labor laws, extreme regulations and poor infrastructure. The government
needs to address all such issues for FDI to prosper. Paul O’ Neill (Ex US Treasury Secretary) rightly stated,
“No one wants to spend time and capital fighting a system that is unfriendly to success…”
FDI in Argentina has been quite unpredictable which engages hatred among potential investors. The
Argentinean-US Bilateral Investment Treaty (BIT) in 1991 led to a favorable impact, causing FDI to
accelerate from 1991-99(after a lot of uncertainty). However, it plummeted again in 2001-02 undergoing
the worst implosion in the global economic slowdown. After that, it began to rise slowly and steadily
until 2008 when it dropped from $8.9 billion to $4.9billion in 2009, rising again to $6.2billion in 2010,
causing greater volatility.
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https://www.ripublication.com/gjbmit/gjbmitv4n1_03.pdf
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