The Political Economy of
Foreign Direct Investment
Ram Mudambi
IMBA BA 951
Spring 2005
© Ram Mudambi, Temple University, 2005
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MACRO
Why is FDI growing more rapidly
than world trade or output?
World political and
economic change
Wider acceptance
of MNC operations
Improved logistics
Most international
trade is intra-firm
Movement of operations to the
most efficient location
© Ram Mudambi, Temple University, 2005
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MICRO
Why is FDI growing more rapidly
than world trade or output?
Growing power of regional
economic blocs
EU, NAFTA, Mercosur, etc.
Strategy of extra-bloc
firms to become ‘domestic’
‘Tariff-jumping’ FDI
© Ram Mudambi, Temple University, 2005
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The Spectrum of Political
Ideology Toward FDI
Radical
View
Pragmatic
Nationalism
© Ram Mudambi, Temple University, 2005
Free
Market
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Radical View
Marxist view is that MNE’s enslave less
developed countries.
Instrument of domination
not development.
Popular from WWII to the 1980s.
Practiced by Eastern Europe, India, China, 3rd
World Countries.
Ended with the collapse of Communism.
Bad performance by those countries vs those
with freer market approach
© Ram Mudambi, Temple University, 2005
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Free Market View
Sees FDI as way to disperse production and
flow of goods and services in the most
efficient manner.
Supported by Smith and Ricardo and ‘market
imperfection’ explanations of FDI.
However, all countries impose some
restrictions on FDI.
© Ram Mudambi, Temple University, 2005
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Pragmatic View
Lies somewhere between
radical and free market
views.
Governments should
maximize national benefits
and minimize costs of FDI.
© Ram Mudambi, Temple University, 2005
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Ideology and FDI
Ideology
Characteristics
Marxist roots
Radical
Views FDI as an
imperialist tool
Classical economic
roots
Free Market
FDI as a tool for
efficient location of
operations
Pragmatic
Nationalism
FDI has both
benefits and costs
© Ram Mudambi, Temple University, 2005
Host-Government
Policy Implications
Prohibit FDI
Nationalize MNC
subsidiaries
No restrictions on
FDI
Court targeted
MNCs
Tailor incentives
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What do the data tell us? – 1
MNC economic interests are
overwhelmingly concentrated in the triad –
North America, Europe and Japan/East Asia
There is no evidence that triad governments
are subject to ‘control’ by MNCs
Competitive pressures cause MNCs to cancel each
other out
Activities outside the triad are too
insignificant to justify expense of political
activities
E.g., a recent CIMA study found that most MNCs
followed ‘whiter than white’ accounting practices
© Ram Mudambi, Temple University, 2005
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What do the data tell us? – 2
Globalization refers to FDI, not financial flows
FDI flows are extremely stable
MNC strategies tend to be regional, rather than
global, reflecting regional trading blocs
Fears of global homogenization are over-rated
EU, NAFTA, Mercosur, APEC
MNCs tend to be “flagship firms” – serve as
hubs of extensive business networks/clusters
© Ram Mudambi, Temple University, 2005
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Benefits of FDI to Host Countries
Resource-transfer effects
Capital, technology, management
Employment effects
Balance-of-payments effects
Economic growth
© Ram Mudambi, Temple University, 2005
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FDI and resource-transfer effects
HOST
Inflow of capital
Subsidiary
HOME
Parent
Spillover
of
technology
and
management
practices
© Ram Mudambi, Temple University, 2005
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FDI and employment effects
HOST
Subsidiary
Direct
local
jobs
created
Jobs created
in local
supplier &
ancillary
network
Jobs lost in local
firms that are
driven out of
business
Jobs created due to increased
income generation
© Ram Mudambi, Temple University, 2005
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FDI and balance of payments
Taxes, tariffs
and other
HOST
payments
to the govt. Subsidiary
(+)
Local
output
replaces
imports
Subsidiary
(+)
exports
(+)
Inflow of capital
(+)
HOME
Parent
Repatriated
profits (-)
3rd Country
© Ram Mudambi, Temple University, 2005
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Economic Growth
Increased:
 productivity growth,
product and process innovation,
and greater economic growth,
Stemming from increased competition of
MNE’s investments.
© Ram Mudambi, Temple University, 2005
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How Do Countries Encourage
FDI?*
Risk insurance.(Home)
Elimination of double taxation. (Home)
Tax incentives.(Host)
Low interest rates. (Host)
Grants for land and training of workforce
(Host)
Stable government and stable policies (Host)
*See http://sbm.temple.edu/~rmudambi/Publications/Mudambi%20IJEB.pdf
© Ram Mudambi, Temple University, 2005
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How Do Countries Discourage
FDI?
Limit capital outflows. (Home)
Manipulate tax code to encourage domestic
investment. (Home)
Political restrictions on investing in certain
countries. (Home)
Ownership restraints. (Host)
Performance requirements. (Host)
© Ram Mudambi, Temple University, 2005
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Determinants of Bargaining
Power
Bargaining Power of Firm
High
Low
Firms time horizon
Long
Short
Comparable alternatives open to
firm
Many
Few
Value placed by host
government on investment
High
Low
© Ram Mudambi, Temple University, 2005
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