SANE Views

Vol.6 No.24, 05 July 2006

Suppose FDI doesn't work?

Margaret Legum

‘In the 1990’s foreign direct investment (FDI) came to be seen as a miracle drug- a jumpstart to economic growth and sustainable industrial development, especially in developing countries. Policies to attract FDI became the centerpiece of both national development strategies and supranational investment agreements.
‘ This paper examines …(the) evidence about the impacts of FDI in developing countries….We conclude that the purported benefits of FDI are exaggerated and its centrality in development strategies misplaced. Rather than attract FDI per se, development policies should aim to promote endogenous local capacities for sustainable production…..’

These are the conclusions of a longitudinal study by senior American economists, Kevin Gallagher and Lyuba Zarsky of Boston University, published this year by the Forum on Economic Reform.
http://www.undp-povertycentre.org/

It shows that the effects of FDI can be positive, neutral or negative; that they are generally negative for the poorest countries; and that positive effects happen only alongside interventionist government policies.

It is acknowledged by even the most conventional economists, that participation in the global market brings with it uncertainties and unpredictability that make life difficult for policy-makers – such things as fluctuating exchange rates and commodity prices and being affected by other emerging markets. But it is assumed that the benefits in terms of growth and low consumer prices outweigh the problems.

In that equation, attracting FDI ranks high. On the one hand, governments must jump through a lot of hoops to attract it. Not only must we provide obvious incentives like low corporate tax, ‘flexible’ wages, ease of hiring and firing, limited regulation, but also more subtle overall signals must be in place. Pro-poor policies, described as ‘populist’ and ‘unsustainable’ must be avoided, as must strong government, described as ‘interfering’; while budget balancing and limited social expenditure, seen as ‘prudent fiscal management’ is essential. Only one policy direction is tolerated by the market.

It is assumed that the benefits of attracting FDI make the sacrifices worthwhile. FDI is the prize for an open economy. It compensates for the frustrations of watching our own capital leave for greener pastures, seeing our skilled workers put out of jobs, and our own exporters and importers ride a switchback, since we have no control over the exchange rate. Attracting FDI is assumed to make it all worthwhile, because it gives us the competitive edge.

This extensive study shows that the purported advantages of FDI need to be re-examined.

First, investment by the major FDI players, being the transnational corporations (TNCs), mostly takes the form not of new productive capacity, but of mergers and acquisitions – buying foreign assets. These rose from 52% of the total in 1987 to 83% in 1999. Much of that was driven by the wave of privatizations that developing countries were exhorted to put into place in the ‘80s. It did little or nothing for growth, reduced employment and had no developmental impact.

Second, the strongest motivation for foreign investment is market size, not labour costs. Thus reducing wages, for which the TNCs lobby of course, is less important than developing a local market. The attraction of China - which absorbs nearly a third of total FDI for all developing countries, is principally based on the size of the market. So if we want new investment, strong home demand, not low wages, is the right policy

Third, there is little or no evidence that special investor protection measures, including tax holidays, has much effect on TNC decisions. Macroeconomic and political stability are important attracting factors; so a volatile exchange rate and fluctuating trade deficits discourage FDI. These cannot be controlled by governments committed to global openness.

Fourth, nearly three-quarters of FDI flows go from one developed country to another, showing that the efforts of developing countries to compete by reducing standards of living have been ineffective.

In the late ‘90s flows of aid outstripped flows of FDI in most of the poorest countries (55 out of 70). Even that small proportion of FDI going to developing countries fell sharply at the end of the ‘90s – from 39% ton 16%. Of that relatively small proportion, over 80% went into the top ten richer developing countries, including China. And among the 49 least developed countries, the four oil-rich nations received nearly half of FDI.

Fifth, the ‘efficiency spillover’ (meaning the assumed beneficial effect in poor countries of new technology and management skills) is shown to be small and limited to a few countries - 3 out of 11 - while 2 were shown to have been actually damaged. Whether that effect exists depends on whether there is a strong state in place that ‘nurtures domestic firms through effective market-friendly and performance-related subsidies.’ Without that, FDI can ‘crowd out’ domestic investment.

The report is very circumspect. What does become clear is that FDI is contributing hardly anything to development in the poorest countries. It can do so only if governments are active in developing what the report calls ‘endogenous local capacities for sustainable production.’ This is a Catch 22. Governments’ failure to do that arises from their fear that such activity in the market will be disapproved by the providers of FDI.

When poor governments grasp that FDI is doing nothing for development they will be free to choose active policies to promote their local market.