Developing countries have increasingly come to see FDI as a source of economic development and modernisation, income growth and employment. Countries have liberalised their FDI regimes and pursued other policies of attracting investment. They have addressed the issue of how to best pursue domestic policies to maximise the benefits of foreign presence in the domestic economy. This study attempts primarily to shed light on the second issue, by focusing on the overall effect of FDI on macroeconomic growth and other welfare enhancing processes, and on the channels through which these benefits take effect.

The report does not solely focus on the positive effects of FDI in developing countries. It also addresses concerns about potential drawbacks for the host economies, economic as well as non-economic. The potential drawbacks include the deterioration of the balance of payments as profits are repatriated, the lack of positive linkages with local communities, the environmental impact of FDI, especially in the extractive and heavy industries, the social consequences of an accelerated commercialisation in less developed countries, the effects on competition in national markets and the risk that host countries, especially small economies, may experience a loss of political sovereignty. Even some of the expected benefits may prove elusive, if, for example, the technologies or know-how transferred through FDI turn out to be ill-adapted to the host economy, depending on its current state of economic development.

On balance, the benefits of FDI exceed the costs. Benefits are, however, not homogenously distributed across sectors and countries. Clearly, for maximising the benefits of FDI, policies matter. Many challenges befall the host country authorities, who often need to improve economic structures, infrastructure and human capital, while at the same time putting in place environmental, social and competition safeguards. Home countries’ authorities do, however, share a responsibility for maximising the benefits of FDI for development, for example by pursuing policies of openness to trade and technology transfer that do not unduly hold back the activities of MNEs in developing economies. Corporate responsibility is also an issue, particularly where MNEs provide large sources of government revenue, or otherwise wield significant economic power relative to the host country authorities.

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Trends

The magnitude of FDI flows continued hitting new records in the course of the previous decade, before falling back in 2001. In 2000, world total inflows reached US$ 1.3 trillion -- or four times the levels that were recorded five years earlier. More than 80 per cent of the recipients of these inflows, and more than 90 per cent of the initiators of the outflows, were located in “developed countries”. Even the minority of FDI that does go to developing countries is spread very unevenly, with two-thirds of total OECD FDI flows to non-OECD countries going to Asia and Latin America. However, these FDI inflows do represent significant sums for many developing countries, several of them even recording FDI-to-GDP ratios in excess of 50 per cent. In most developing countries, the manufacturing sector is by far the largest recipient of FDI.

In recent years, an increasingly large share of the FDI flows has been through mergers and acquisitions. This partly reflects a flurry of transatlantic corporate takeovers, partly the large-scale privatisation programmes that were implemented throughout much of the world in the 1990s. However, in developing countries greenfield investment has remained overall the predominant mode of entry for direct investors.

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FDI and growth

The main part of the study focuses on the effects of FDI on macroeconomic growth, which is commonly considered as the most potent source of poverty relief, particularly in the poorest countries. Beyond the initial macroeconomic stimulus from the actual investment, FDI may influence growth by raising total factor productivity in the recipient economy. This works through two channels, namely (i) the spillovers and other externalities vis-à-vis the host country’s business sector, and (ii) the direct impact on structural factors in the host economy. The overall evidence of an effect of FDI on growth can be thus summarised:

- Most empirical studies conclude that FDI generally does make a positive contribution to both factor productivity and income growth in host countries. It is, however, more difficult to assess the magnitude of this impact -- not least since large FDI inflows to developing countries often concur with unusually high growth rates triggered by unrelated factors. As regards the question of whether FDI tends to crowd out domestic investment, thereby dampening its overall impact on growth, the evidence is generally mixed. Some studies find evidence of crowding out, while others conclude that FDI may actually serve to increase domestic investment.

- In the least developed economies, FDI seems to have a markedly less benign effect on growth, which has been attributed to the presence of “threshold externalities”. Apparently, developing countries need to have reached a certain level of development in educational and infrastructure levels before being able to benefit from a foreign presence in their markets. An additional factor that may prevent a country from reaping the full benefits of FDI is imperfect and underdeveloped financial markets. Weak financial intermediation hits domestic enterprises harder then MNEs, and may in some cases lead to a scarcity of financial resources that effectively precludes them from seizing the business opportunities that arise from the foreign presence. Foreign investors’ participation in the infrastructure and financial sectors can help on these two grounds.

The extent of technology transfer through the presence of MNEs is a crucial point, not least since multinational enterprises are among the world’s most important players in creating and developing technology. Since many cutting edge technologies are not taken to the market, developing countries have increasingly come to view investment as one of the most important means to acquire knowledge and upgrade their domestic production base, as well as to improve the environment. Current empirical evidence would appear to support the following generalisations:

- The most frequent channel for technology benefits to the host economy from FDI works via the vertical linkages that MNEs create. MNEs attempt to minimise the value of explicit and implicit transfers toward their host country business partners, but they are rarely able to wholly avoid them. Backward linkages (with suppliers) are found to contribute to the technological level of suppliers though MNEs’ demand for quality improvements, which in many cases even induces foreign-owned enterprises to train their subcontractors and suppliers. Forward linkages (with clients) are particularly important where MNE presence makes a higher quality of input goods available to the host country business sector. An additional route for technology transfers are horizontal linkages, whereby competing host country enterprises learn via demonstration or direct competition. Also, recent studies have concluded that labour migration (trained employees shifting employment from MNEs to domestic companies, or setting up their own enterprise) is important.

- There are significant differences between host countries’ ability to benefit from technology transfers from various kinds of FDI. In particular, if the relative difference between the technological level of host country enterprises and MNEs (the “technology gap”) is large technology transfer is usually impeded. In addition to the relative levels of technology, an absolute minimum of human capital is found to be crucial if domestic enterprises are to be able to appropriate foreign technology. These findings are observationally equivalent with the externalities thresholds identified in the economic growth chapter.

- On downside, concerns have been voiced that the technologies transferred by MNEs, being usually enterprise specific, are often ill-suited to the host economy at large. An even graver concern, particularly to emerging economies, is the risk that the takeover of a national technology-intensive enterprise by a foreign competitor could actually lead to a technology transfer out of the host economy.

An aspect of FDI that affects social concerns alongside with purely economic objectives is the potential for human capital enhancement. The major impact of FDI on human capital appears to have occurred not principally through the efforts of individual MNEs, but rather from government policies seeking to attract FDI via enhanced human capital. Once individuals are employed by MNE subsidiaries, their human capital may be further enhanced through training and on the job learning. Those subsidiaries may also have a positive role on human capital enhancement in other enterprises with which they develop links, including suppliers. To the extent that human capital is thereby enhanced, this can have further knock-on effects both as that labour moves to other firms and to the extent that it leads to employees becoming entrepreneurs. Thus, the issue of human capital development is intimately related with other, broader development issues. Nevertheless, the following general points can be made:

- Human capital enhancement may be related in various ways to the issue of the transfer of technical knowledge. In some Asian economies there has been a rather low level of transfer of both technical knowledge and management techniques, and also of training in general, as the majority of FDI inflows has been in low to medium technology industry that does not require much skill. Even in the high technology sectors, the wide technology gap has inhibited the ability of the local employees to learn, either because the gap is so great that it is hard to bridge, or because the perceived gap simply deters MNEs from attempting to bridge it.

- The most important point for policy makers lies in the interaction between for human capital development and technology diffusion. Policies to further the latter will inevitably involve action by government and other public agencies to enhance human capital, as requirements and opportunities become apparent. Also, technological diffusion will increase the incentives for companies to take a stronger interest in human capital enhancement. Finally, such policies could serve to attract, in particular, FDI into relatively high value added areas.

- In the field of employment, the presence of MNEs have the potential, but not the certitude, to raise labour standards a par t of the way toward the levels prevailing in the investors’ home countries. Also, while the overall employment effects of FDI are not always clear, a higher share of employment by MNEs in developing countries often lifts members of the labour force out of the informal and into the formal economy.

The relationship between FDI and corporate sector competition is a complex one. Clearly, the entry of foreign competitors in itself acts to a spur to competition, particularly in economies where competition policies are weakly enforced and market incumbents assert undue influence on pricing. On the downside, however, a higher incidence of M&A and strategic alliances, higher concentration ratios and, in some cases, higher entry and barriers have raised host country concerns about their domestic competitive environment. The recent literature lends itself to the following findings:

- Evidence abounds of a positive initial impact of FDI on competition. Where competitive local markets already exist, additional competition brought about by the entry of an MNE generally encourages local firms to enhance their quality and increase their productivity. Where local markets are weak or dominated by monopolistic incumbents, FDI has in many cases helped create a competitive environment -- inter alia because of their greater ability to overcome access barriers -- and it has helped nurture the creation of national markets. Moreover, the entry of one MNE is often followed by others, particularly in sectors which are, at the international level, characterised by a degree of oligopoly.

- However, the benefits of MNE entry via competition presuppose that domestic enterprises are sufficiently healthy to face the foreign competitors (or, alternatively, that the host market is large enough to accommodate several MNEs). In some well-documented instances, a few MNE entrants have crowded out all the domestic competitors. While this need not be a problem if the host markets are fully contestable, developing countries’ experience show that it can be a significant problem in practice, and the development of an adequate competition law framework is necessary. There may also be a need to accompany competition policies by policies to enhance the competitiveness of domestic sectors (e.g. eliminating obstacles to business development such as excessive regulation).

- Finally, the successful introduction of competition may have a negative short-term effect on the host countries’ employment rates, but in the longer term this trend should be reversed by the stronger economic growth stemming from more competitive markets. This accentuates a general need for labour market flexibility, and it may present national authorities with difficult policy choices.

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FDI and trade

The consensus views on the linkages between FDI and foreign trade have changed somewhat over the latest decade. Most importantly, imports, exports and allocation decisions by MNEs form integral parts of an increasingly international production of goods and services. The fact that a sharply higher share of industrial input goods are imported illustrates the point that MNEs increasingly rely on the trading of raw materials and input goods within international networks of related enterprises. For the more advanced developing countries, this implies that the traditional focus on FDI as a source of boosting their export base or substituting for imports is to some extent being replaced by the greater challenge of integrating the domestic economies into the evolving patterns of international production sharing. Hence, in order for developing countries to benefit fully from FDI, the trade regimes pursued in host as well as in home countries must be sufficiently accommodating. However, many developing countries faced with chronically unsustainable current accounts still look to increased MNE activity in the domestic economy as a possible medium-term solution. The empirical evidence suggests the following:

- No firm conclusions can be made as regards a general impact from FDI to exports, inter alia due to the heterogeneity of FDI as regards sectors and motivations of investors, but FDI motivated by an access to resources, whether human or natural, in the host economy is likely to produce a direct effect on exports. In the longer run, any kind of FDI is likely to raise exports, through its effects on host country productivity and international competitiveness that emanate from technology transfers, human capital upgrading and competition. Developing countries have attempted to selectively harnessing FDI for exports by means of targeted measures such as export processing zones. While some “success stories” have emerged, the general applicability of such policies remains contested.

- Over time the nature of the linkage between FDI and imports appears to have changed somewhat. Traditionally, the question of whether or not FDI may serve to substitute for goods imports has attracted much attention, but an increasing body of literature finds evidence of complementarity between investment and import. This reflects an increasing importance of “vertical” FDI (investment aiming to exploit scale economies through vertically integrated production relationships) making MNE subsidiaries increasingly dependent on imported inputs, which serves as a further indication of the integrational forces mentioned above.

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