Impact of FDI on the Economy of Host Countries

In last decades the importance of Foreign Direct Investments (FDI) has increased significantly due to globalization process, which offers huge opportunities for mostly developing countries to reach faster economic growth through trade and investment. FDI assists foreign investors in utilizing their assets and resources more efficiently as well as host countries in acquisition of better technologies and getting involved in international production and trade networks (Athukorala, 2003).

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Developing countries have started to see FDI as a source of economic development and modernisation, income growth and employment. These nations have liberalised their investment regimes and followed other policies to attract more FDI. They have attempted to find the ways of pursuing those domestic policies that will allow them to drive maximum benefits from multinational enterprise presence in the domestic economy (OECD, 2002).
The aim of this study is to analyze the impact of FDI on the economy of host countries. The first part of the work will be addressed to the relationship between foreign investments and the economic growth of the host nations. The study will answer the question why some countries benefit from FDI more than other countries, and what these governments should realize in order to maximize their benefits from the presence of foreign firms.
The following parts will be devoted to more certain issues, such as positive and negative effects of FDI in the host countries. Since there is a broad literature on the positive impacts of foreign investments, the main focus in this work is emphasized on the negative impacts. The study shows that although MNEs bring many benefits to host countries and the governments are trying to attract more and more investments, the negative effects of FDI in the economy of host countries should not be neglected. Any indifference to these issues may result in negative spillover effects, balance of payment deficits, dual economy, pollution and etc.
Brief information about the negative impacts of FDI, especially, Dutch Disease effects, on the economy of Azerbaijan is also given at the end of the study in order to bring a practical example. This part is also provided with charts for more visual description of the effects.
FDI and Economic Growth
Global economic events of past decades driven by technological progresses, regional integration and realignment of economic policies and systems have changed the perception of host country governments of how FDI can contribute to their economic and social purposes. They became more interested in the role of FDI in their countries to understand its benefits and costs, and to reveal what should be done by national administrations to insure that benefits of FDI inflows to their economic and social needs will be maximized (Dunning, 1995).
Theory on FDI and growth relationship
In theory there are contradictory views about the growth effects of FDI. The main rationale behind the special incentives to attract FDI is the belief that they produce externalities in the form of technology transfers and spillovers (Carkovic and Levine, 2002). Romer (1993) argues that FDI can ease the transfer of technological and business know-how to less developed countries and enhance the productivity of all firms in the host country.
However, some theories state that foreign investments will damage resource allocation and slow the economic growth due to trade, price, financial and other distortions in less developed countries (Boyd and Smith, 1992). Despite these contradictory theories, some models suggest that FDI will promote the economic development under particular policy conditions (Carkovic and Levine, 2002).
Factors of FDI influence
The extent to which the foreign investment can contribute to the economic growth depends on a variety of factors. One of them is the host country characteristics, called “absorptive capacity”, – a capability of the host economy to benefit from technological spillovers from the more industrialized nations and the ability to accumulate and best utilize technology and knowledge (Narula and Portelli, 2005). The main determinant of the “absorptive capacity” is the quality of institutions, particularly, the rule of law and the property rights protection.
Trade openness, which is a measure of the competition level in the local country, also positively influences the level of FDI contribution to growth. Countries with more open trade policy have less market distortions, high level of efficiency and competition which enhance the spillover effects of FDI (Balasubramanyam et al., 1996). A test between FDI and output growth in 24 countries in 1971-1985 years conducted by Nair-Reichert and Weinhold (2001) also reveals that the degree of country’s trade openness had a huge impact on the efficiency of FDI in the host country.
The level of technological sophistication and human capital stock in the host country is also one of the main factors of FDI impact on growth. It has been found that FDI raised the growth in those countries that reached a minimum threshold level of technological sophistication or the stock of human capital (Borensztein et al., 1998; Xu, 2000) The technology gap between MNE and domestic firms in the host countries is the main attribute for the emergence of technology spillovers. A high technology gap along with a low competition reduces the spillover effects to the host country (Kokko et al, 1996).
Other determinants include economic power, industry, type of FDI, and regional integration, industry specialization, market size, R&D, geographical location, FDI policy of host country and etc (OECD, 2002).
Maximization of FDI benefits
In order to reap the benefits of FDI governments of host countries need to implement some policies, such as improvements of the general macroeconomic and institutional frameworks; creation of a regulatory environment that is conducive to FDI inflows; and upgrading of infrastructure, technology and human competences to the level where the full potential benefits of foreign corporate presence can be gained (OECD, 2002).
International co-operation might assist and reinforce the investment-related efforts of host countries since the policy actions recommended above cannot easily be pursued by governments – especially by poor countries – acting alone (OECD, 2002).
Foreign investors play a significant role in begetting economic growth and contributing to achievement of sustainable development goals. Consequently, the way MNEs behave and are ruled is important in maximization of the FDI benefits for economic development. Foreign affiliates must enhance technology transfer, improve human capital management practices, and provide transparency and competition. They should also refrain from seeking exemptions from national environmental, labour and health standards (OECD, 2002).
Positive effects of FDI
Trade effects
FDI influences economic growth by increasing total factor productivity and the efficiency of resource use in the host country. It increases the capital stock of the host country and thus raises the output levels. The main trade-related benefit of FDI is that it contributes to the integration of host countries into the global economy by engendering and boosting foreign trade flows as well as the establishment of transnational distribution networks. This, in turn, implies that host countries will pursue a policy of openness to international trade to benefit from FDI (OECD, 2002).
Human capital contribution
FDI’s contribution to human capital in host countries is significant. MNEs increase workplaces, thereby reduce the unemployment in the host country. They usually provide higher wages and working conditions due to their higher productivity which is explained by greater technological know-how and modern management skills that enables them to compete effectively in foreign markets. The transfer of technological and managerial know-how through affiliates also gives rise to direct benefits and increases competitiveness in host countries. For example, domestic employees can move from foreign to domestic firms. Local firms might increase their productivity through learning from foreign firms by collaboration. (OECD, 2008). The presence of MNEs may also cause a useful demonstration effect, forcing the government to invest in education more, as the demand for skilled labour by these firms is very high (OECD, 2002).
Spillover effects
MNE’s usually possess a higher level of technology, especially “clean”, which is the main factor of their higher productivity. One of the positive effects of FDI is that it generates significant technological spillovers in the host countries. MNE’s usually provide technical assistance, training and other information to increase the quality of the suppliers’ products (OECD, 2002).
Local firms might increase their productivity as a result of gaining access to modern, improved, or cheaper intermediate inputs produced by MNE in upstream sectors. Sales of these inputs by MNE might be accompanies by provision of complementary services which might not be available through imports (Javorcik, 2004). Local sub-contractors can also benefit from MNE’s international contacts, thus gaining more access to foreign markets. FDI can also increase research and development initiatives of local companies (Dunning, 1995).
Competition level
FDI exerts a significant influence on the competition level in the host country. The presence of MNEs assists the economic development by stimulating the domestic competition and thereby leading to higher productivity, innovation, lower prices and more efficient resource allocation (OECD, 2002).
Management and governance practises
FDI through acquisition of local firms result in the changes in management and corporate governance. MNEs generally impose their own company policies, internal reporting systems and principles of information disclosure. This effect improves the business environment and develops the corporate efficiency. Moreover, different cases show that foreign investments also create a more transparent environment in the host country as MNEs encourage more open government policy, raise corporate transparency and assist in the fight against corruption. (OECD, 2002).
Since foreign investments provide needed resources to developing nations such as capital, technology, managerial skills, entrepreneurial ability, brands, and access to markets, they are important for these economies to industrialize, develop, and create jobs reducing the poverty level in their countries. Therefore, most developing economies recognize the potential value of investments and have liberalized their investment regimes and conducted investment promotion activities to attract FDI from developed countries (Athukorala, 2003).
Negative effects of FDI
Crowding out effect of FDI
FDI can have both crowding in and crowding out effects in host country economy. The main negative effect of crowding out effect is the monopoly power over the market gained by MNEs. Empirical evidence in that regard is mixed. Econometric test by Agosin and Mayer (2000) covering 39 countries for a long period (1970-1996) demonstrated that crowding out and crowding in was detected in 10 economies, but in 19 the effect was neutral. Crowding out effect did not exist in Asia, but it was quite obvious in Latin America. Another study of 83 economies over the period of 1980-1999 found no impact of FDI on host country for 31, crowding out for 29 and crowding in for 23 countries (Kumar and Pradhan, 2002).
This diversity might be due to the fact that various economies attract different types of FDI. Countries that attract mostly domestic market-seeking investments will experience crowding out as the establishment of foreign subsidiaries results in tough competition with domestic firms. But for export-oriented investment, it might be less so (Bhalla and Ramu, 2005).
MNE with lower marginal costs increases production relative to its domestic competitor, when imperfectly competitive firms of the host country face fixed costs of production. In this environment, foreign firms that produce for the domestic market draw demand from local firms, causing them to reduce the production. The productivity of local firms falls as their fixed costs are spread over a smaller market which forces them to back up their average cost curves. When the productivity decrease from this demand effect is large enough, total domestic productivity can diminish even if the MNE transfers technology or its firm-specific asset to local firms (Aitken and Harrison, 1999).
In general, crowding out might take place due to two reasons: 1) when domestic firms disappear because of higher efficiency and better product quality of foreign subsidiaries, and 2) when they are wiped out because these foreign affiliates have better access to financial resources and/or engage in anticompetitive practices. In the first case, the net impact on welfare is positive as firms with higher efficiency and better product quality contribute to the economic development of the host country. But in the second case, there is welfare loss and governments intervene through different channels in order to help the local firms. For example, they might establish or subsidize financing for domestic small and medium firms (Bhalla and Ramu, 2005).
Negative wage spillovers
Wage spillovers of the FDI are considered to be mostly positive as workers of MNEs can leave their workplace and become entrepreneurs in future, which will increase the competitiveness of domestic firms. However, it might cause negative consequences as well, especially, if MNEs hire the best workers due to their high wages and thereby leave lower-quality workers at the domestic firms (Lipsey and Sjoholm, 2004). In response to that domestic firms can increase or copy MNEs’ wages artificially to prevent their high-quality employees from changing the workplace in favour of foreign firms. But this action can lead to competitiveness decrease of them as MNEs have productivity advantages over the domestic firms.
Gorg and Greenaway (2001) reviewed six studies on wage spillovers and reported that three panel studies of those studies found negative spillovers, while two cross-sections studied showed positive ones. One possible reason of the negative results in some developing countries is that the gap between MNE and domestic firms is very large for one party to influence another. Moreover, the labour markets in some developing economies are too segmented for wages in one party to influence another (Lipsey and Sjoholm, 2004).
Profit repatriation
When MNEs make investments in foreign countries their main objective is to maximize their profit. Some advantageous characteristics of these countries, such as cheap labour force, natural resource abundance or high quality expertise, allow MNEs to enhance their economic performance. MNEs regularly repatriate their profits from investment to the account of their parent companies in the form of dividends or royalties transferred to shareholders as well as the simple transfer of accrued profits. It also helps them avoid larger taxes by using transfer prices. However, this profit repatriation results in huge capital outflows from the host country to the home country and negatively affects the balance of payment of the former. Thus the host countries often set limits on the amount of profits that MNEs can repatriate in order not to have balance of payment deficits or reduced foreign exchange reserves. Such policy can induce these MNEs to invest profits in different projects within the host country (Billet, 1991).
But there is also a possibility that such limitations might discourage MNEs from investing in these countries, which will move FDI to the countries with less profit repatriation limitations. For example, a survey of chief executive officers from 193 American MNEs revealed that nearly 70% of them viewed profit repatriation as a main factor positively motivating the FDI behaviour of them (Kobrin et al). One of the biggest FDI receivers in the world, India, permits 100% profit repatriation for foreign investors in most sectors (NRI Repatriation).
Dual economy effect
FDI, especially, made in the developing countries can lead them to have a dual economy, which has one developed sector mostly owned by foreign firms and underdeveloped sector owned by domestic firms. Since the country’s economy becomes overly dependent on the developed sector, its economic structure changes. Often this developed sector is the capital-intensive, while another one is labour-intensive. Therefore, dual economy effect hampers the economic development of countries as most of their citizens are located in the non-developed labour-intensive sector. This effect is visible in most oil-rich countries, where foreign investments made in the oil and gas sector resulted in the resource boom and left the agriculture and manufacturing sectors underdeveloped. That negative effect of FDI can lead to Dutch Disease effect in natural resource abundance countries.
Dutch Disease model postulates that a resource boom, mostly after the huge investments in the sector, diverts country’s resources away from activities that are more conducive to growth in long run. First symptom of this phenomenon is an appreciation of the country’s exchange rate caused by resource boom, which in turn causes a contraction in the manufacturing exports (Bulte et al, 2003). The booming resource sector draws capital and labours away from manufacturing, leading its costs to rise (Neary and van Wijnbergen, 1986). The result is that the competitiveness of country’s non-tradable commodities rise, while that of tradable – manufacturing commodities falls in the world markets, reducing the potential for export-led growth of manufactures in the long run. Since manufacturing sector is regarded as the main “engine of growth”, its decline causes consequently a growth decline in country’s economy in the long run (Sachs and Warner, 1999). One possible solution to the problem is a diversification of the economy by investing in different sectors.
Balance of payment effect
Empirical studies reveal that a bidirectional relationship exists between foreign investments and imports. An increase in FDI inflows from the home country will result in an increase in imports in the host country from the home country. It can be due the fact that the MNE purchases inputs from its traditional suppliers or increased inflation rate speeded up by foreign capitals in the home country. As more investment flows in, the host country economy becomes more and more dependent on the production technology of MNE’s home country. The host country will have to import more inputs and intermediate goods from the MNE’s home country, which might constrain the development in the domestic industry. If these investments are not export-oriented, the host country can suffer from trade deficits (Chaisrisawatsuk S. and Chaisrisawatsuk W, 2007).
Infrastructure development constraint
FDI constrains basic infrastructure development by diverting resources from public investment in infrastructure. Since FDI is attracted mostly to wealthy parts of the host country, the infrastructure in these regions will require a greater effort to be improved, especially depriving the poorer regions and the rural regions (Yamin and Sinkovics, 2009).
Environmental issues
A large volume of FDI is concentrated in natural resource sectors of developing and less developed countries. Most of these countries have a less strict or non-existent regulatory regime. Sometimes countries deliberately attempt to exempt or loosen their regulatory requirements to attract FDI. However, while these countries can benefit from positive effects of investment, the negative effects of FDI on host country’s ecosystems and environment might bring disaster in the long run (Gray, 2002).
The solution to these problems is to raise host country capacity to regulate and construct international environmental standards. NGO’s and other civil society groups from home and host countries can also play a significant role in the improvement of government regulations and increase of MNE’s responsibility on environmental issues (Mabey and McNally, 1998).
Other possible negative impacts
FDI can cause political, social and cultural unrest and divisiveness in the host countries by introduction of unaccepChart values, which include advertising, business customs, labour practices and etc, and by direct interference of the MNEs in the political regime or electoral process in the host country (Dunning, 1995). For example, some least developed countries with the economy overly dependent on powerful multinational enterprises are threatened of loosing political sovereignty (OECD, 2002).
Case Study: Dutch Disease effects in Azerbaijan
Azerbaijan had had a moderately developing economy with a consistent annual GDP growth above 10% until 2005. However, after a large amount of FDI’s in energy sector, the economic situation critically changed and grew significantly in 2005-2009 years due (Chart 1. GDP of Azerbaijan. Chart 2. GDP growth). Its oil and gas revenues fuelled the economy and promoted a rapid rise in living standards. But despite this prosperity, some negative impacts of immense foreign investments, especially, Dutch Disease effects, became visible over time.
Large capital inflows and revenues soon demonstrated its impact on high inflation level (Chart 3. Inflation rate) and the national currency of Azerbaijan – AZN has appreciated against USD Dollar and Pound Sterling, while its value against Euro has been volatile during 2006-2010 years (Chart 4. Currency Exchange). As exports increased, the country started to run balance of payment surplus (Chart 5. Balance of Payment).
The competitiveness of non-tradable commodities have risen during this period in Azerbaijan. Especially, oil boom fuelled banking sector, real estate and construction. However, the growth rate of tradable sectors of Azerbaijan was little (Going Dutch). Main non-oil exports of the country agriculture and metals sector have not seen a significant growth, meaning country’s competitiveness is not growing. In fact the country became dependent on oil sector, as it accounts for 90% of exports and 60% of GDP contribution (Chart 6. GDP composition by sector). Current forecasts predict that the oil boom of Azerbaijan will be relatively short-lived and oil production will begin to decrease in 2012, which will have a colossal negative impact on the economy (Going Dutch) .
Dutch Disease effects have a significant impact on the poverty rate of the country. Although living standards have largely improved, a high level of poverty persists, especially, in rural areas. About 42% of the rural population live below the poverty line, and 13% of poor people live in extreme poverty (Rural poverty in Azerbaijan). Despite the large GDP contribution of industry sector, mainly oil and gas sector, laborforce represented by this sector is the least – by 12%. However, agriculture with the biggest laborforce occupation accounts for 6% in GDP contribution (Chart 7. Laborforce occupation by sector.). This implies that main laborforce of the country is located in less competitive and less efficient sector, and the economy must be diversified and competitiveness of manufacturing products, owned by domestic firms, must be increased to minimize the high level of poverty.
Conclusion
Although there are contradictory thoughts about the impact of FDI on the economic growth, it is broadly believed that investments positively contribute to the economic development of host countries. However, countries do not benefit from the investments at the same level. Foreign investments are not advantageous or disadvantageous by themselves. Their contribution depends on the policy and behaviour of host country governments and MNEs.
The same foreign investment may bring lots of benefits to one country, while it might be quite harmful for the other. Therefore, it does not mean that if you get more FDI, your economy will boost. For example, Azerbaijan’s economy grew significantly due to foreign investments, but if the government does not diversify the economy and take measures against the negative effects of FDI, its economy will be worsened in long term. The inflation is increasing, non-oil sector is hardly growing, and the economy is becoming more and more dependent on the oil and gas sector, owned mostly by foreign firms.
The study implies that an appropriate policy and gradually improved “absorptive capacity” of governments will minimize the negative effects of FDI and allow these economies to reap the benefits of investments at the maximum.