Foreign Direct Investment (FDI) and MNCs

Multinational Corporations FDI is investment by firms based in one country (home country) in productive activities in another country (host country). MNC or TNC is a firm that undertakes FDI. (Corporation: a type of firm composed of a legal entity that is separate from the individuals who own it).

Importance of FDI for LDCs FDI is the most important source of resource flows to developing countries. In 2004, it accounted for 51% of these. For LDCs as a whole it is more important than ODA. For a number of LDCs ODA is still the main source of foreign finance.

FDI represents a small share of private investment in LDCs Total investment by local firms is greater than total investment by MNCs. In 2004, FDI was responsible for less than 20% of total private investment in LDCs. FDI is qualitatively very different from local investment: Economic and political power of MNCs Large size Superior technical and managerial expertise, know-how and technologies

Potential benefits and costs of MNCs for host developing countries MNCs can supplement insufficient foreign exchange earnings. Funds flowing into the LDC from abroad bring in foreign exchange. Activities of MNCs usually export oriented → ↑ in X earnings → positive impact in BoP. BUT: MNCs also engage in activities that result in foreign exchange outflows: Repatriation of profits Imports of raw materials Borrowing from parent corporation in home country

MNCs can supplement and improve upon local skills and technology. Technical and managerial expertise and new production technologies brought in by MNCs can be adopted by local workers and firms. → Improvements in physical and human capital. BUT: In practice, linkages between MNC and local economy are limited. Also, MNC often hire people from home country.

MNCs can supplement insufficient domestic savings and lead to increased investment. Inflows of foreign funds leading to new investments → formation of (new) physical capital. BUT: Inflows may not lead to new investment, as sometimes, rather than create new capital, MNCs buy existing capital: ‘cross-border mergers and acquisitions’ (M&As), of increasing importance in LDCs.

Investment and new capital formation using local resources (borrowing from local banks or issuing equity). This diverts the use of local savings from domestic to foreign investors → negative effects for local firms, as less savings are available.

MNCs can lead to greater tax revenues in the host country. BUT: MNCs enjoy many privileges that may lower the amount of tax paid. Transfer pricing, artificial accounting system that allows MNCs to lower their stated profits.

MNCs can help promote local industry. By purchasing locally produced goods and services as inputs, they support and promote development of local industrial activities → growth of exisiting local firms or establishment of new ones (‘backward linkages’). BUT: MNCs often import their needed inputs from abroad. Competition by MNCs forces local firms to shut down or does not permit new local firms to be established.

BUT: the impact will be limited if... MNCs can increase local employment and help lower UE in the host country By establishing productive facilities in the host country and hiring local workers Through the creation of backward linkages BUT: the impact will be limited if... MNCs create few backward linkages MNCs import capital-intensive technologies MNCs’ technologies make use of cheap local labour, but the possibility of the MNC relocating offsets the benefit for local labour force.

MNCs can lead to higher economic growth in the host country Through increased levels of investment, improved technology and increases in human capital Increased local investment through the creation of backward linkages. BUT, in addition to arguments above: MNCs and environmental degradation. They prefer to invest in countries with less environmental restrictions. MNCs are mainly responsible for the production of the bulk of industrial pollutants.

MNCs promote inappropriate consumption patterns in developing countries, where populations can less afford to spend their incomes on unnecessary goods. MNCs may divert government resources away towards building infrastructure to meet MNCs needs, in order to become attractive as a host country. MNCs may use their economic and political power to bring about policies that may work against economic development objectives.

Competition between LDCs to host MNCs and the ‘race to the bottom’. MNCs tend to invest in countries with weak labour protection laws and weak environmental regulations LDCs governments have a weak bargaining position, as MNCs may threaten with relocation. Competition between LDCs to host MNCs and the ‘race to the bottom’. Competition ≈ efforts to accomodate MNCs demands. Sacrifice of needed policies for economic development.

Examples: weak labour protection laws, weak environmental regulations; tax benefits that lower tax revenues; diversion of local resources for infrastructure that benefits the MNC. Also, excessive liberalization of the economy, including currency convertibility on the foreign account, which can be risky for the developing country.