Is Foreign Direct Investment a Panacea?

 

Kavaljit Singh

 

The UN Conference on Trade and Development, popularly known as UNCTAD, every year releases the “World Investment Report.” The focus of World Investment Report 2004, released in September 2004, is on the services, with a special analysis of off shoring service activities. Over the years, World Investment Report has become one of the strong proponents of the liberalization of foreign investment, particularly foreign direct investment (FDI), in the developing world. In the light of growing consensus among academic and policy circles on the desirability of FDI, the time has come to debunk some of the popular myths associated with it. 

 

  1. FDI is not a panacea. There is no country in the world which has developed solely on the basis of FDI flows. At best FDI can supplement domestic savings and investments, it cannot replace domestic savings. On the contrary, we find that a number of countries (for instance, Japan, South Korea, Taiwan and China) registered higher growth without liberalizing their foreign investment regimes.

 

  1. What is good for a TNC may not be good for a host country like India and Malaysia. 

 

  1. FDI flows have also changed in the last few decades. Two decades ago, bulk of FDI flows were related with greenfield investment (the establishment of new industrial and service units. Bulk of FDI flows are now associated with cross-border mergers and acquisitions, their benefits in terms of technology transfers and employment generation have been diluted. So what happens is TNCs acquire already created local assets rather than creating new productive assets.

 

  1. The benefits of FDI would also depend on the sector in which the investment is taking place. If the FDI flows are going into exploitation of natural resources, (as in Africa and Latin America), then the benefits in terms of transfer of technology, knowledge and skills would be negligible.
  2. In the last one decade, the composition of FDI to developing countries has changed. The share of manufacturing activity in total FDI inflows has declined in the 1990s while the share of services has increased. This can have serious negative consequences because services such as telecom, energy and finance are non-tradable. Thus, investment in these sectors is not going to generate foreign exchange through export or import substituting activity. On the contrary, it would involve substantial foreign exchange outflows over time in the form of imports of inputs, royalty payments and repatriation of profits.

 

  1. This brings me to the other myth which is being propagated that FDI is good because it is non-debt creating capital. It is true that FDI does not involve direct repayment of debt and interest, but it is also true that it has substantial foreign exchange costs. Capital can move out of the country on account of remittance of profits, royalty payments, technical fees. We also know that TNCs indulge in ‘transfer pricing’ (overinvoicing and underinvoicing) to save taxes. Brazil has witnessed a huge jump in foreign exchange outflows in the form of profits, royalties ($37 million in 1993 to $7 billion in 1998).

 

  1. If FDI is not related to exports, it can have serious implications on foreign exchange. In India, a recent study by our Central Bank found that over 300 TNCs operating in India are net negative foreign exchange earners. That is they spend more foreign exchange than they earn. What is important is that more than 3/4th of these outflows were related to import of raw materials and technology. So foreign investment does not only mean more money coming in, but also means money moving out.

 

  1. Then there are empirical studies which have found out that FDI can crowd out not only local firms but also local products, technologies, and business practices in the host countries.

 

  1. In particular, there are studies which shows that entry of foreign banks is not always beneficial. The entry of foreign banks does not mean more access to credit. On the contrary, many studies have found that real credit has declined with the increased entry of foreign banks in several CEE countries. No doubt, foreign banks give better services, but they have a tendency to serve the needs of big TNCs and big domestic corporations in host countries. They generally neglect SMEs. In countries like India, Germany, US, where SMEs constitute the backbone of economy and are the engines of economic growth, it can have disastrous consequences for economic growth.
  2. Even FDI is not stable as it used to be a few decades ago. Recent evidence in Chile and Brazil shows that as a financial crisis approaches, TNCs indulge in large-scale hedging activities to protect their businesses from foreign exchange risks. This hedging by TNCs generates additional pressure on currencies.

 

  1. The rate of profit on FDI is higher than interest rates on commercial loans. In the late 1990s, average rates of returns on FDI in developing countries were between 16-18 per cent. While in the case of poor SSA countries where investment risks are relatively higher, the rates were between 24-30 per cent per year.

 

  1. Finally, it has been observed that FDI flows are procyclical, they fall when you need them most, as witnessed during the Mexican and Southeast Asian financial crisis.

 

Source: Asia-Europe Dialogue Project (www.ased.org)