Does FDI promote sustainable economic growth?

Submitted by:

Sahil S Raut

National Institute of Industrial Engineering, Mumbai

Introduction:

Globalisation of economies has allowed free flow of capital into countries where an investor

believes he or she could obtain the highest returns for a given amount of risk. This flow of

capital in turn leads to transfer of technology, knowledge and expertise. One such form of

capital flow i.e FDI plays a very dynamic role in the development of host economies.

Policymakers across countries have had mixed reactions to FDI, while some view it negatively

there is a general perception where FDI is expected to generate positive effects towards the

economy.

A firm invests in a foreign country only when it sees an opportunity where it can use its

capabilities as a competitive advantage over domestic firms. These capabilities can be in form

of higher efficiency, advanced technology, greater innovation and superior skills.

The purpose of this study is two-fold. Firstly, the paper will list certain pre-conditions which

highlight the absorptive capacity of a Foreign Direct Investment by the host country. A

favourable tick mark, will improve chances of a positive effect to the economy. Secondly, the

below paper will present indicators that reflect the performance of FDI in a country. These

indicators will be based on the following four factors Productivity, Technology, Innovation

and Skills. The context of this dissertation, including the examples quoted, is from the point of

view of developing nations, therefore the basic assumption is that there is inflow of FDI into a

particular developing nation.

A lot of study has already been conducted, which presents a mixed picture in terms of

effectiveness of FDI. Examination of East Asian Economies suggest little evidence that inflows

in foreign direct investment cause technical or efficiency change (Ng, 2006) . Moreover, it has

been argued that FDI in Greenfield projects would typically improve likelihood of productivity

increase than FDI through joint ventures or M&A sales (JAVORCIK & SPATAREANU,

2003). Also, (Blomstrm & Kokko, 2002) have suggested that a certain level of human capital

is necessary for significant spillover effects from FDI into host countries. Positive spillovers

of FDI also depend on the sector where the investment has been made, (Alfaro, 2003) pointing

out that FDI inflows into different sectors of an economy can have different impacts. Inflows

in the primary sector have a negative effect, while on the other hand FDI in manufacturing has

shown a positive relationship.

Therefore, to evaluate the performance of an economy as an effect of FDI, it is critical to

develop an understanding of these pre requisite factors which are necessary to cause a positive

effect. On the other hand, a country is less likely to react positively to FDI, if it doesnt have

this foundation.

Prerequisites that define Absorptive capacity:

1. Level of human capital

For developing countries, it is less costly to grow using technology adapted from the developed

world, than use technology generated endogenously. Moreover, a country that is

technologically inferior has that opportunity to grow at a much faster rate, reaching

productivity levels of some of the developed nations quickly. However, this also depends on

the absorption capacity of human capital and their ability to reverse engineer technology for

their advantage. It is therefore necessary to have improvements in education and human capital,

which can adapt foreign technology thereby leading to long run economic growth.

(Blomstrm & Kokko, 2002) have shown that FDI has a positive overall effect on economic

growth, although the magnitude of this effect depends on the stock of human capital available

in the host economy. However, the nature of the interaction of FDI with human capital is such

that for countries with very low levels of human capital the direct effect of FDI is negative.

Comparison of South Korea and Indonesia in the period of 1981-1999:

(Data from World Bank)

Human Capital or Schooling is measured in terms of % enrolment in secondary education. The

entire set of data was obtained from the World Bank portal. The FDI (% GDP) has been more

or less the same for both the economies in the given time period of 1981 to 1999

0

20

40

60

80

100

120

-15

-10

-5

0

5

10

15

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Comparing level of Human Capital

Growth Indonesia Growth South Korea Schooling Indonesia Schooling South Korea

In the above figure, we can observe that, Korea which has a higher level of human capital, has

a greater impact of FDI on its economy than Indonesia, whose level of human capital is

comparatively lower.

2. Types of FDI : Greenfield Project Investments

FDI typically comes to a host nation in form of - Greenfield project investments and Mergers

& Acquisitions. Greenfield FDI is characterised by fresh investment that may involve setting

up a new firm or facility in the host country. On the contrary, M&A involves FDI in an existing

firm, providing decision making power to a foreign investor.

Findings by (Harms & Mon, 2012) suggest that -

Greenfield projects predominantly drives the growth due to FDI.

However, M&A sales have no significant effect on growth.

Comparison of FDI through Greenfield vs M&A (UNCTAD, 2000)

Factor Greenfield M&A

Investment Direct addition to host country

production facilities

Provides funds for local activities.

However, if the funds are used for

productive investment is

questionable

Technology

&

Innovation

More likely to introduce new

technologies

May or may not introduce new

technology

Employment Generates more skilled jobs No immediate creation of new jobs.

Possible generation of employment

in the long run

Labour

productivity

Immediate boost in labour

productivity

Long-run boost in labour

productivity

3. Sectoral dependence

The potential of FDI to generate positive productivity effects depend on the sector where the

investment has been made. These sectors are classified into Primary, Manufacturing and

Services. (UNCTAD, World Investment Report, 2001) suggests that linkages between local

suppliers and foreign affiliates is limited in the primary sector. On the other hand, the

manufacturing sector is quite evolved presenting greater spillover effects of foreign investment.

The reach of a manufacturing firm is much broader, which includes strong backward and

forward linkages. Comparing manufacturing to services, typically FDI in services is in form of

setting up an outsourcing facility, thereby maintaining strong linkages only with parent

company in the home country. However, it may seem that there would be spillovers in form of

increased wages, employee training and technological know how.

Studies conducted by (Alfaro, 2003) suggest

Little support for positive FDI spillovers in the primary sector

A strong positive effect of FDI in manufacturing on growth

An ambiguous impact of FDI in the services sector

Point to consider: (Binh, 2014) found out a negative causal relationship between FDI and Total

Factor Productivity Growth in the period of 1996-2009. At the same time, it was found that

this negative relationship was on account of higher natural resource extraction. An evidence

from (Binh, 2014) suggests that for countries with no natural resource exports, 3% higher FDI

causes 0.3-0.5% faster TFPG. However, in countries with 10% natural resource exports reduces

the TFP growth by almost 1% for the same level of FDI

Indicators to measure impact:

The relationship between FDI inflows and growth has been found to be fairly ambiguous.

However, policy makers should look to consider the above three factors Level of Human

Capital, Greenfield investment and Sector, while coming up with policies tailored to a

countrys unique need. Although, the record of FDI in primary sector is abysmal, there can

always be regulations framed that reduces this negative relationship.

Hence further, the study will now focus on economic indicators that are affected by a Foreign

Direct Investment which impact a countrys growth potential-

1. Total Factor Productivity

The growth rate of total factor productivity is the amount by which output would increase as a

result of improvements in methods of production, with all inputs unchanged. (Dornbusch,

Fischer, & Starz, 2008). This indicator will help us analyse the technological and productivity

spillovers related to Foreign Direct Investment. As superior technology flows in through FDI,

diffusion takes place, wherein domestic firms starts improving their methods of production, in

turn becoming more efficient. As a result, cumulatively the countrys output grows, with

resources remaining the same, caused due to higher productivity.

Empirical results by (Baltabaev, 2012) have shown that increase in share of FDI Stock

(foreign capital + retained earnings) in GDP increases by 10% to 15%, then the TFP would

grow around 0.8% due to the mentioned share alone. (WOO, 2009) has also reported 1%

point increase in the share of FDI flow in GDP would lead to an additional 0.2% increase in

annual TFP growth

Source: World Bank & United Nations Industrial Development Organization - World

Productivity Database

Although, FDI Stock would have been a better indicator (Baltabaev, 2012), showing a higher

correlation with TFP, the above chart also gives an indication of how TFP has progressively

increased alongwith FDI Inflows for South Korea. (Please note FDI data was unavailable from

year 1961 to 1975)

2. Output elasticity

Another indicator that can be used to study impact of FDI is the output elasticity (percentage

change of output divided by the percentage change of an input). Generally as FDI improves

productivity, the output elasticity should increase as well

3. Wage Spillovers

Foreign firms that invest in form of FDI, typically offer higher wages in the host nations. This

is especially true if the host nation is a developing country. As wages for those working in such

firms are significantly greater, domestic companies also increase their wages in order to stop

employee movement. This increase in domestic wages converging to those offered by foreign

firms is called wage spillovers.Study of empirical findings by (Hale & Long, 2008) indicate

upward pressure of FDI on wages in China. However, this is limited to market for skilled

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0

0.5

1

1.5

2

2.5

1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

FDI INFLOWS & TFP - SOUTH KOREA

FDI (% of GDP) TFP_K06_US

Wages offered by firms with

FDI Inflows

Wages offered by Domestic

firms

High

Time

Converges

labour. Since such personnel is scarce in developing nations like China, foreign and domestic

firms compete, thereby increasing overall wages. (Ono & Odaki, 2004) have also estimated

that a one percentage increase in foreign ownership share of equity raises wages by 0.3 percent

in Japan.

4. Domestic Investment Crowding in or Crowding out?

FDI can have two types of effects on domestic investments

Crowding in : Opportunities are created for domestic investment

Crowding out : Domestic investors move out of industry

It has been observed that the crowding in or crowding out effect varies from country to country

depending on its domestic policy:

FDI in under-developed countries has a higher chance of causing a crowding out effect

on domestic investment (Ndikumana & Verick, 2008)

In a study by (Hanif & Jalaluddin, 2014) only South Korea, Thailand & Pakistan have

crowd in effect. On the contrary, China, Indonesia, Phillipines, Sri Lanka and Malaysia

show a neutral effect of inward FDI

Source: World Bank

Ever since liberalisation in 1991, there has been a slight correlation between the domestic

investment and FDI inflows. Most importantly, a crowding out effect, where domestic

investment reduces has not been observed. Furthermore, (Sunny & Sawant, 2012) have

deduced based on empirical studies that India shows a slight crowding in effect

Although it is possible to grow in the short & medium term, like China, exhibiting a crowding

out or neutral phenomenon, but in the long term it is desirable for an economy to show a

crowding in effect for sustainable growth

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

0

5

10

15

20

25

30

35

40

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

GCP vs FDI Inflows - IndiaGross capital formation (% of GDP) Foreign direct investment, net inflows (% of GDP)

5. Innovation

For growth in the long run, innovation is critical. Once the technological gap is bridged between

developing and developed nations, it is innovation and R&D that leads a country in a mode of

steady long term growth. FDI, tends to bring in new technology, thereby encouraging local

researchers to innovate. Supply side linkages leads to knowledge spillovers, with firm

beginning to adopt best practices and methodologies that are technologically advanced.

The following chart indicates how firms with 10% or more foreign ownership based in India

fare in terms of innovation and technology:

Subgroup

Level

% firms with

an

internationall

y-recognized

quality

certification

% firms

using

technology

licensed

from

foreign

companies*

% of

firms

having

their

own

Web

site

% of firms

using e-mail

to interact

with

clients/supp

liers

% of firms

with an annual

financial

statement

reviewed by

external

auditors

Domestic 21.7 4.7 30.2 55.9 59.1

10% or more

foreign

ownership

57.5 32.5 74.4 95.0 97.6

Source: World Bank Enterprise Surveys, Innovation & Technology, India, 2006

Inorder to ensure that firms with foreign ownership share their superior capabilities, it

necessary to have robust policies that

Develop inward and backward linkages in the economy

Ease movement of human resources within companies

To perfect laws regarding intellectual property rights

Conclusion:

The relation of FDI to economic growth is inconclusive. However, there are certain conditions

where it is possible to positively influence the economy through FDI. These conditions depend

on certain factors such as Level of human capital, Greenfield Investment and the sector where

investment has been made. Although, it is possible to generalise these factors, the solutions for

positive results are highly country specific. Therefore, it is crucial that advisors and policy

makers evaluate each FDI proposal on a case by case basis. This is where a sound FDI policy

tailored according to a countrys need can act as lever to catapult it to an era of sustainable long

term growth

References

Alfaro, L. (2003). Foreign Direct Investment and Grow. Harvard Business School.

Baltabaev, B. (2012). FDI and Total Factor Productivity growth: New Macro Evidence.

Binh, Q. M. (2014). Bad FDI? Resource Extraction and Technology Transfer.

Blomstrm, M., & Kokko, A. (2002). FDI AND HUMAN CAPITAL: A Research Agenda. OECD

DEVELOPMENT CENTRE.

Dornbusch, R., Fischer, S., & Starz, R. (2008). Macroeconomics. McGraw Hill Publication.

Hale, G., & Long, C. (2008). Did Foreign Direct Investment Put an Upward Pressure on Wages in

China? . FEDERAL RESERVE BANK OF SAN FRANCISCO .

Hanif, A., & Jalaluddin, S. (2014). FDI and Domestic Investment in Malaysia.

Harms, P., & Mon, P.-G. (2012). Good and bad FDI: The growth effects of greenfield investment

and mergers and acquisitions in developing countries.

JAVORCIK, B. S., & SPATAREANU, M. (2003). To Share or Not to Share : Does local

participation matter for spillovers from Foriegn Direct Investment. World Bank Policy

Research Working Paper.

Ndikumana, L., & Verick, S. (2008). The Linkages between FDI and Domestic Investment:

Unravelling the Developmental Impact of Foreign Investment in Sub-Saharan Africa.

Ng, T. H. (2006). Foreign Direct Investment and Productivity: Evidence from East Asian Economies.

UNITED NATIONS INDUSTRIAL DEVELOPMENT ORGANIZATION.

Ono, H., & Odaki, K. (2004). Foreign Ownership and the Structure of Wages in Japan .

Sunny, D., & Sawant, A. (2012). Crowding-in and Crowding-out impacts of FDI on Domestic

Investment : An Indo-China analysis.

UNCTAD. (2000). FDI and Development: Does Mode of Entry Matter?

UNCTAD. (2001). World Investment Report.

Vahter, P. (2004). The effect of foriegn direct investment on labour productivity. Tartu University

Press.

WOO, J. (2009). PRODUCTIVITY GROWTH AND TECHNOLOGICAL DIFFUSION THROUGH

FOREIGN DIRECT INVESTMENT. Economic Inquiry.