La01.005 a study on the impact of foreign direct investment on economic development of lao p.d.r.

MINISTRY OF EDUCATION
LAOS NATIONAL UNIVERSITY
MINISTRY OF EDUCATION AND TRAINING
NATIONAL ECONOMICS UNIVERSITY
KHAMSEN SISAVONG
A STUDY ON THE IMPACT OF
FOREIGN DIRECT INVESTMENT ON
ECONOMIC DEVELOPMENT OF LAO P.D.R.
A thesis submitted to the National Economics University
in fulfillment of requirements for the degree of
Doctor of Philosophy in Economics
Hanoi, 2014
Viết thuê luận văn thạc sĩ, luận án tiến sĩ
Mail: luanvanaz@gmail.com
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DECLARATION
I hereby declare that this dissertation is my own work and effort. The
dissertation has not been submitted anywhere for any award. All the sources of
information used have been well acknowledged.
Date: Signature
KHAMSEN SISAVONG
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ACKNOWLEDGMENTS
The Vietnam – Lao Cooperative Program Doctor of Philosophy (PhD) between
NEU and NUOL is very important, necessary, valuable and beneficial to our nations
because this project allows Lao people to upgrade and enhance their level to Doctorate
Degree.
Therefore, I would like to acknowledge the leaders, Administrators, Professors
of the National Economics University of Vietnam and National University of Laos to
give me this excellence opportunities to achieve my dream of PhD.
I would like to express my gratitude to Prof. Dr. Tran Tho Dat, Assoc. Prof.Dr.
Nguyen Thanh Ha and other professors who were in the committees for evaluation of
my dissertation in the early stages of my PhD study.
I am deeply indebted to Assoc. Prof. Dr. Nguyen Thi Tuyet Mai, my
supervisor who gives me clear guidelines and contributing her advises to my
dissertation.
I am also grateful to Prof. Dr. Somkod Mangnormek, Governor of Xiengkhuang
Province, member of Central Committee Party, Prof. Dr Kikeo Khaikhamphithoun,
Head of National Accademic of Politic and Public Administration, member of Central
Committee Party, Prof. Dr. Thongsalith Mangnormek, Head of National Economic
Research, Prof. Dr. Bounpong Keonoradome, President of Savannakhet University
who encouraged and supported me to reach my goal of PhD.
My special thanks go to my family, Sengsavanh College’s staff and my friends.
They are always pleased to encourage and to assist me during my PhD research.
Without your supports I could not complete and realize my dream.
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CONTENTS
DECLARATION..........................................................................................................i
ACKNOWLEDGMENTS .......................................................................................... ii
ABBREVIATIONS .....................................................................................................v
LIST OF FIGURES .................................................................................................. vii
LIST OF TABLES................................................................................................... viii
CHAPTER 1. INTRODUCTION.................................................................................1
1.1 Research Background ............................................................................................1
1.2 Rationale for the Research.....................................................................................3
1.3 Research Objectives and Research Questions.......................................................4
1.4 Scope of the Study.................................................................................................6
1.5 Contributions of the Study.....................................................................................6
1.6 Dissertation Structure ............................................................................................8
CHAPTER 2. LITERATURE REVIEW ON THE IMPACT OF FDI ON
ECONOMIC DEVELOPMENT..................................................................................9
2.1. Definition and Indicators of Economic Development..........................................9
2.1.1 Definition of Economic Development...........................................................9
2.1.2 Indicators of Economic Development .........................................................10
2.1.3 Theoretical Economic Overview .................................................................11
2.2 FDI and its Impact on Economic Development ..................................................14
2.2.1 Definition and Determinants of FDI............................................................15
2.2.2 Impact of FDI on Economic Development..................................................30
CHAPTER 3. OVERVIEW OF ECONOMIC DEVELOPMENT AND FDI IN
LAOS51
3.1. Overview of Laos’ Economy..............................................................................51
3.1.1. Economic Growth.......................................................................................52
3.1.2 Economic Structural Changes......................................................................53
3.1.3 Financial Sector Growth ..............................................................................54
3.1.4 Banking Sector Development .....................................................................55
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3.1.5 Inflation has been effectively managed ......................................................55
3.1.7 Workforce and Employment Balance..........................................................56
3.1.8 Balancing the Sources of Funds for Development ......................................58
3.1.9 Balancing the State Budget..........................................................................60
3.1.10 Balancing Imports and Exports..................................................................61
3.1.11. Sectoral Development, Regional and International Economic Integration
...............................................................................................................................65
3.1.12 Infrastructure..............................................................................................88
3.2 Foreign Direct Investment in Laos ......................................................................90
CHAPTER 4. RESEARCH METHODOLOGY ......................................................95
4.1 Research Questions..............................................................................................95
4.2 Variables and Measures.......................................................................................95
4.3 Data Description ..................................................................................................97
CHAPTER 5. RESEARCH FINDINGS..................................................................107
5.1 FDI and GNI per Capita....................................................................................107
5.2 FDI and Financial Capital.................................................................................108
5.3 FDI and Level of Technology............................................................................111
5.4 FDI and Human Capital.....................................................................................112
5.5 FDI and Energy and Natural Resources ............................................................113
5.6 FDI and Transportation and Communication....................................................114
CHAPTER 6. CONCLUSIONS AND DISCUSSION............................................116
6.1 Conclusions........................................................................................................116
6.2 Implications of the Study...................................................................................117
6.3 Limitations of the Study and Future Research Direction ..................................121
REFERENCES ..........................................................................................................123
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ABBREVIATIONS
AFTA Asean Free Trade Area
AGOA
APTA
ASEAN
ATIGA
BIT
BOP
CAP
CEPEA
EAFTA
ECE
ECOWAS
EU
Africasn Growth and Opportunity Act
Asia Pacific Trade Agreement
Association of South East Asian Nations
Asean Trade in Goods Agreement
Bilateral Investment Treaty
Balance of Payments
Carribean African Pacific
Comprehensive Economic Partnership in East Asia
East Asia Free Trade Area
Economic Commission of Europe
Economic Organization of West African States
European Union
FDI Foreign Direct Investment
FPI
FY
Foreign Portfolio Investment
Financial Year
GDI
GDP
Gross Domsetic Income
Gross Domestic Product
GNI Gross National Income
IMF
IPRs
International Monetary Fund
Intellectual property rights
ISCED
ISIC
Lao PDR
International Standard Classification of Education
International Standard Industrial Classification
the Lao People’s Democratic Republic
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LDCs Least developed countries
MFs Multinational firms
MIGA
MNC
NEM
NIEs
Multilateral Investment Guarantee Agency
Multinational Corporation
New Economic Model
Newly Industrializing Economies
NTA
ODA
OECD
National Tourist Authority
Official Development Assistance
Organization for Economic Co-peration and Development
OLI
OLS
Ownership, Locational, Internalization
Ordinary Least Square
OPIC
PPP
Overseas Private Investment Corporation
Purchasing Power Parity
SAPTA
TDS
UN
South Asian Preferential Trade Agreement
Total Debt
United Nations
US the United States
VAT Value Added Tax
WTO World Trade Organization
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LIST OF FIGURES
Figure 1: Economic structure 2006 – 2010 ...................................................................54
Figure 2 Export and Imports from 2005-2009. .............................................................64
Figure 3 Average size of agricultural land per household.............................................66
Figure 4. Average share of value added in the industrial sector 2006-2010.................70
Figure 5. Structure of service sector 2006-2010 ...........................................................75
Figure 6 Foreign direct investment, net inflows (BoP, current US$) ...........................92
Figure 7. Distribution of FDI in Lao PDR (US$ m) .....................................................93
Figure 8. Share of accrual FDI by country (% of total, as of August 2009) .................93
Figure 9. Ten biggest foreign investors in Laos (1989 – 2012) ....................................94
Figure 10. Graph of Correlation between FDI and GNI per capita............................107
Figure 11. Graph of Correlation between FDI and long-term debt service on external
debt ..............................................................................................................................110
Figure 12 Graph of Correlation between FDI and level of technology .....................112
Figure 13. Graph of Correlation between FDI and School enrollment, tertiary ........113
Figure 14. Graph of Correlation between FDI and Natural Resources......................114
Figure 15. Graph of Correlation between FDI and Mobile cellular subscriptions.....115
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LIST OF TABLES
Table 1. Comparison between actual and targeted GDP growth rate in the Sixth Plan
(2006-2010) ...................................................................................................................52
Table 2. GDP per capita (plan vs. actual)......................................................................53
Table 3. Share of labour by sectors ...............................................................................58
Table 4. Private domestic and foreign investment from 2006-2010 (USD billion)......60
Table 5. Export structure of Lao PDR by commodities 2005-2009 (%).......................62
Table 6. Import structure of Lao PDR by commodities 2005-2009 (%).......................63
Table 7. Inter-Country Comparison on Opened Trade or Integration 2006-2010 ........86
Table 8. Export Market Structure with Main Trade Partners, 2008..............................87
Table 9. Foreign direct investment, net inflows............................................................98
Table 10. GNI per capita ...............................................................................................99
Table 11. Gross capital formation (annual % growth) ................................................100
Table 12. Financial capital ..........................................................................................101
Table 13. Industry, value added (% of GDP)..............................................................102
Table 14. Human capital..............................................................................................103
Table 15. Oil consumption per capita..........................................................................104
Table 16. Transportation and communication.............................................................105
Table 17. FDI and GNI per capita Coefficient of Correlation ....................................108
Table 18. FDI and Financial Capital Coefficient of Correlation.................................108
Table 19. FDI and Level of Technology Coefficient of Correlation...........................111
Table 20. FDI and Human Capital Coefficient of Correlation....................................112
Table 21. FDI and Energy and Natural Resources Coefficient of Correlation ...........113
Table 22. FDI and Transportation and Communication Coefficient of Correlation...114
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CHAPTER 1. INTRODUCTION
1.1 Research Background
Laos is a small landlocked country with an area of 236,800 square
kilometers. It shares its borders with Vietnam in the East, China in the North, and
Cambodia in the South, Thailand and Myanmar in the west. Two third of the
country is mountainous (northern part) thus its geographic circumstances constrain
both the quality and quantity of agriculture and cause difficulties to the
development of trade, social infrastructure and transportation and communication
links. However, the country has transformed from a landlocked to a land link and
cross road to other parts of the world.
Laos is located in the center of energetic and prosperous region of South East
Asia and possesses a high potential of natural resources, raw material and
hydropower. The country is divided into three main regions: northern, central and
southern regions. The current total population of Laos is 6.9 million (2012) with
major of those live in valleys of the Mekong river and its tributaries. The population
density is about 27 per. Sq. meter. Vientiane is the capital and the largest city, and
its population is about 800,000 residents.
After becoming independent in 1975, Laos established control over the
economy through the centralized fiscal and socialist government until 1985 but
during that period, the government had seen that the performance of the economy
was unable to reach expected goals. Economic management was weak due to the
lack of skilled labor force. External assistance was provided but projects were not
completed at a satisfactory level. In 1986, the Lao government implemented the
New Economic Mechanism (NEM) to open the country and provided incentives for
developers and investors and moved from a centrally planned economy to a market
oriented economic model.
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The goals of the NEM were: Launching open market policies and the
introduction of market economy principles. The reform has attracted FDI projects in
the agricultural, industrial, hydropower electricity, mining and the service sectors.
These sectors of development have played an important role in the support of the
economic development in Lao P.D.R.
Laos has continuously pursued significant economic and institutional
reforms, aiming at improving social and economic wellbeing of its population by
consistently building itself a market oriented economy. Laos has achieved
remarkable economic growth and macroeconomic stability. It has witnessed a
significant rise in public and private investment.
These factors contributed to the annual average growth rate of over 6 percent
per annum from 1990 to 2009 and the annual average growth rate of about 8 percent
in 2012.
In order to promote and attract FDIs in Laos, the government has created
Special Economic Zones (SEZ) in compliance with the general investment policies
of the government. The government has implemented incentive policies to promote
both domestic and foreign investment in the special economic zone by shortening
the investment approval process in SEZ, facilitating business operations,
production, and services based on the mechanism of “smaller administration units
but wider society” or “one stamp mechanism” to generate a good environment for
investment.
FDI inflows in Laos have grown dramatically over the past decade and have
played an important role in the growth of the world economy as well as the ASEAN
Nations. In the developing world, FDI has become the most stable and largest
component of capital flows. As a result, FDI has become an important alternative in
the development finance process (Global Development Finance, 2005.)
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Laos is a small and still poor country. Therefore, the investment from foreign
countries in terms of FDI is needed because FDI plays an important role in job
creation, economic growth, capital inflow, technology transfer, human resource
development, and wealth in the host country. Thanks to the economic reform, the
number of FDI projects and the income on international trade have increased
significantly and have had a direct impact on national income as well as GDP
growth.
1.2 Rationale for the Research
It has been suggested that Foreign Direct Investment (FDI) inflows have
played an important role in promoting economic growth in developing countries,
especially in the Southeast Asian countries (Nguyen, 2008). They are the source of
large capital, knowledge, expertise, technology transfer, and international market
access. Since the 1990's, the global flows of FDI have grown phenomenally and
have become the largest source of foreign private capital to reach developing
countries like Laos.
The attraction of the FDI is becoming increasingly important for Laos to
bring certain benefits to the national economy like the contribution to the GDP, the
total investment, and the balance of payment for the host country. However, the
impact of FDI largely depends on the economic conditions. Domestic investment,
personal savings, the mode of entry (merger, acquisition, or new investment), the
industry sector involved, and the country's ability to regulate foreign investment are
all factors affecting the impact size of the FDI (Earth Summit, 2002).
FDI has a substantial influence on social and infrastructure development as
well as technology transfer. It helps in stimulating employment, raising wages, and
replacing declining market sectors, consequently having cultural and social impact
if the investment is directed toward non-traditional sophisticated product (Earth
Summit, 2002).
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Attracting FDI is the major concern and a desired outcome of Laos to catch
up and achieve economic growth. Since investors have certain requirements to
invest abroad, the host countries must posscess a standard macroeconomic
environment to attract those investors to bring their capital, technology, and
expertise. Hence, the role of the government in devising policies and building
economic infrastructure is a pre-determinant to attract FDI.
Location-specific attractiveness, political and economic stability, the
property and profit tax system, the market size and labor-force composition,
geographic proximity, the number of competitors, freedom of entry and exit from
domestic financial markets are all factors influencing the volume and the type of
capital inflows to Laos. In addition, energy and water resources, transportation and
telecommunication infrastructure are critical elements that have a great influence on
capital inflows and investments in the host countries.
Given the importance of FDI especially in developing countries like Laos,
theoretically as well as practically, there are however still inconclusive arguments
for and against the role of FDI inflows in enhancing economic development in a
country (cf., Nguyen, 2008). It has still been debate about whether FDI inflows are
beneficial or not to economic development, and what governments should do to
attract and use FDI inflows effectively (Kokko et al., 2003; Longani & Razin, 2001;
Masina, 2002; Nguyen, 2008). In addition, it has been suggested that the
relationship between FDI and economic growth may be country and period specific
(cf., Adegbite & Ayadi, 2010). Therefore, this study aims to explore the impact of
FDI inflows on some indicators of economic development in the context of Laos, a
developing country in Asia.
1.3 Research Objectives and Research Questions
This study seeks to analyse FDI inflows into Laos and to investigate their
impact on the economic development of Laos. It identified this impact by
responding to the country's characteristics and infrastructure as determinants for
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capital inflows, transfer of technology, augmentation of human capital, and other
spillover benefits.
The desired outcome of this research aims at confirming the linkage between
FDI inflows in Laos and the economic development indicators including GNI per
capita, financial capital, level of technology, human capital, energy and natural
resources, transportation and communication.
The major economic development theories and models such as The Stage
Theory of Rostow, the Harrod-Domar model of savings and productivity of
investment, the Lewis Model of Dual Economy, the Dependency Theory, and other
scholarly models in the field assisted in establishing the base theory for the
research.
The research problem revolves around the notion that Laos is incapable to
achieve economic growth. Natural resources, human capital, financial capital,
transportation and communication, level of technology, and leadership, are all
important elements of sustainable economic growth. They are the foundation for
any economic development stimulation. The scarcity of these resources will stall the
economy and make it difficult to make growth progression.
Research Questions
This research tried to answer the questions: 1) What are the relevant
literature and the theoretical background on FDI and its impact on economic
development? and 2) Does FDI have a significant contribution to economic
development of Laos?
With regard to the impact of FDI on economic development, the research
aims to answer the following specific questions:
• Does FDI have a significant role on the GNI per capita?
• Does FDI have a significant role on the Financial Capital?
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• Does FDI have a significant role on the country's level of technology of
Laos?
• Does FDI have a significant role on Human Capital of Laos?
• Does FDI have a significant role on the Energy and Natural Resources
availability of Laos?
• Does FDI have a significant role on the Transportation and
Telecommunication infrastructure of Laos?
1.4 Scope of the Study
This study focuses on the role of FDI on some indicators of economic
development in the context of Laos. Other aspects of development such as social
and environmental issues (i.e., poverty ratios of different sectors, education and
health care, environment pollution and damage) are not addressed in this
dissertation.
This study mainly employed the data to analyse the relationships between
FDI and Laos’ economic development indicators during the period 1990-2012. The
analyses of correlations were used to serve the objectives of this research.
1.5 Contributions of the Study
Investigation into the effects of FDI on the economies of host countries is
considered one of the two most important and most researched issues in
international business (Driffield & Love, 2007). This study aims to examine the
impact of FDI on several economic development indicators in the context of Laos.
The study is important to help Laos enjoy further economic development as well as
contributes to the literature of FDI and economic growth in the context of
developing countries.
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FDI has been suggested as a determinant of economic development in both
developed and developing countries. Its important role in promoting economic
growth and bringing many benefits to the economy is especially emphasized in the
context of developing countries. However, the literature also provides mix findings
pertaining to the effects of FDI, and there has been suggested that the link between
FDI and economic development may be country and period specific. Therefore, it is
important and meaningful to examine the impact of FDI inflows on economic
development in Laos, a developing country which has received very modest
research attention to date.
By focusing on six main research questions pertaining to the relationships
between FDI inflows and various indicators of economic development, the research
has contributed to both theoretical and practical sides. From theoretical perspective,
the research helps to enrich the knowledge about the important topic pertaining to
FDI’s impacts on economic development in general and in the context of a
developing country in particular. From practical perspective, the research findings
provide significant implications to policy makers in Laos.
The issue of FDI and its important role is more important for developing
countries and the countries in transition like Laos because they lack capital, know
how, and managerial skills. Understanding the role of FDI would help making good
policies to attract more FDI for the purpose of economic development. Therefore,
the results of this dissertation are expected to provide significant implications for
policy makers. The results can be applied in the area of attracting the FDI flows.
The dissertation can also provide recommendations for a better business conditions
for investment and doing business.
Briefly, the findings of this study help to enrich the knowledge about the
important topic pertaining to FDI’s impacts on economic development in general
and in the context of a developing country in particular. The study also provides
implications to policy makers.
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1.6 Dissertation Structure
This dissertation includes six main chapters. The brief content of each
chapter is presented in the following.
CHAPTER 1. INTRODUCTION
Chapter 1 briefly introduces the research background, research motivations,
the objectives, and the structure of the dissertation.
ECONOMIC DEVELOPMENT
This chapter reviews the literature on economic development, FDI and
focuses on the impact of FDI on economic development.
CHAPTER 3. OVERVIEW OF ECONOMIC DEVELOPMENT AND FDI
IN LAOS
Chapter 3 focuses on providing an overview of the state of FDI in Lao
P.D.R., Lao government policies and Laos’ economic growth since 1990.
CHAPTER 4. RESEARCH METHODOLOGY
This chapter outlines the research methodology and data sources used to
answer the research questions.
CHAPTER 5. RESEARCH FINDINGS
This chapter presents the key findings on the relationships between FDI
inflows and various indicators of economic development in Laos over the period
1990-2012.
CHAPTER 6. CONCLUSIONS AND DISCUSSION
The final chapter summarizes the research findings, provides implications,
and discusses limitations of the study and offers suggestions for future research.
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ECONOMIC DEVELOPMENT
2.1. Definition and Indicators of Economic Development
2.1.1 Definition of Economic Development
Economic Development is the progress in an economy and is a measure of
the welfare of humans in a society. It usually refers to the adoption of new
technologies, transition from agriculture-based economy to industry - based
economy, and general improvement in living standards (Businessdictionnary.com).
Similarly, the International Economic Development Council defines economic
development as an “activity that seeks to improve the economic well-being and
quality of life for a community, by creating and/or retaining jobs…”
(smallbusiness.chron.com).
Economic development is a normative concept. It means that it applies in the
context of people's sense of morality (right and wrong, good and bad). The
definition of economic development given by Todaro (1994) is an increase in living
standards, improvement in self-esteem needs and freedom from oppression as well
as a greater choice. The most accurate method of measuring development is the
Human Development Index which takes into account the literacy rates and life
expectancy which affect productivity and could lead to economic growth. It also
leads to the creation of more opportunities in the sectors of education, healthcare,
employment and the conservation of the environment. It implies an increase in the
per capita income of every citizen (Todaro, 1994).
Economic development can also be referred to as the quantitative and
qualitative changes in an existing economy. Economic development involves
development of human capital, increasing the literacy ratio, improve important
infrastructure, improvement of health and safety and others areas that aims at
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increasing the general welfare of the citizens. The terms economic development and
economic growth are used interchangeably but there is a big difference between the
two. Economic growth can be viewed as a sub category of economic development.
Economic development refers to government policy to increase the economic, social
welfare and ensure a stable political environment. Economic growth on the other
hand refers to the general increase in the country products and services output
(source: whatiseconomics.org).
2.1.2 Indicators of Economic Development
According to United Nations Human Development Report (2001) and report
research of bbc.co.uk, some key indicators of economic development are presented
as follows.
- GDP per capita (Gross Domestic Product- the value of all the finished
goods and services produced within a country’s borders in a specific time period).
- Human Development Indicators (life expectancy, Infant mortality rate,
Poverty, Access to basic services, Risk of disease)
- Literacy rates (Access to education )
- Measures of poverty
- Demographic indicators
- Unemployment
- Government spending priorities
- Gender equality
- Infrastructure development
In literature, previous studies have examined various aspects of economic
development such as economic growth, GDP per capita, transportation (road
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access), information network, industry establishment, techonology, financial capital
flow, foreign trade, and human capital (e.g., Adegbite & Ayadi, 2010; Kotrajaras et
al., 2011; Mengistu & Adams, 2007; Phimphanthavong, 2012; Prasad & Sharma,
2012).
In this study, the author examines the impact of FDI on economic
development in Laos, focusing on some economic development indicators
including:
- Gross National Income (GNI) per capita
The GNI per capita is the dollar value of a country’s final income in a year,
divided by its population. It reflects the average income of a country’s citizens.
Knowing a country’s GNI per capita is a good first step toward understanding the
country’s economic strengths and needs, as well as the general standard of
living enjoyed by the average citizen (Wikipedia).
- Financial Capital
- Level of technology
- Human Capital
- Energy and Natural resources
- Transportation and Communication
2.1.3 Theoretical Economic Overview
Rostow (1960) argued that all countries passed through the same historical
stages of economic development and underdeveloped countries were at an early
stage compared to the advanced world (e.g., Europe and North America). He
identified societies in their economic status as passing through one of five stages:
the traditional society, the preconditions for take-off, the take-off, the drive to
maturity, and the age of high mass- consumption.
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Lewis' Dual Economy model (1954) was based on the assumption that many
LDCs had dual economies with both a traditional agricultural 'informal' sector and a
modern industrial 'formal' sector. The traditional agricultural sector was described
with low income, low productivity, low saving, and high unemployment rate. The
industrial sector on the other hand was technologically advanced, with high
investment level operating in urban environment. According to this model, surplus
labor in the traditional agricultural sector should migrate to the modern sector where
the high rising marginal product is. Migrating surplus labor would have no effect on
agricultural productivity since marginal productivity of the rural workers is close
to zero.
In his 1954 paper on Economic Development with Unlimited Supplies of
Labour, Lewis argued that the modern sector would have larger savings,
accumulation of capital, and investment, and consequently economic growth.
Capital accumulation comes from the higher wages in the modern sector compared
to the rural sector. The underdeveloped countries have a larger population than
capital and natural resources, employing workers with insignificant productivity,
zero or even negative (Fields, 2004).
According to the traditional model of economic development and its
proponents like the Harrod-Domar growth model, the absence of the high level of
savings in underdeveloped countries contended that the stimulus for economic
growth could only be achieved from an outside capital provided by MFs through
foreign direct investment (FDI) since they have the capabilities and the resources to
provide that capital and transfer modern technology to the underdeveloped nations.
Harrod-Domar model suggested that the economy's rate of growth depends on the
level of saving and the productivity of investment; that is, the capital output ratio.
The model was developed to help analyze the business cycle. However, it was later
adapted to explain economic growth. It argues that the main ingredient of economic
growth is to expand the level of investment both in terms of fixed capital and human
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capital. To do this, policies are needed to encourage saving and/or generate
technological advances that enable firms to produce more output with less capital or
lower their capital output ratio (Pool & Stamos, 1990).
Opposing the traditional model, the equity structuralist model stated that
underdevelopment could only be explained in a historical context. The state of
underdevelopment was the result of colonization that allowed a small minority to
own and control the majority of the land, the primary raw materials, and the
illegitimate political power (Pool & Stamos, 1990).
Dependency theory (Pool & Stamos, 1990) on the other hand, has explained
the underdevelopment based on the Marxian analysis. It argues that the MFs have a
negative impact on developing nations and market structure, challenging both the
traditional and the structural models. Because of the MFs power of economy of
scale and barriers to entry (technology and capital resources), they are an obstacle to
competition from the local firms in the host countries.
The Dependency theory has presented the practice of transfer pricing
(overpricing imports and under pricing exports) by the MFs to gain benefits at the
expense of the developing countries. Additionally, developing countries were
targeted by MFs to transfer their economic surplus to the developed world by
extracting and controlling raw materials, and accessing cheap labor markets.
In his classic 1956 work, Solow proposed that the study of economic growth
should begin by assuming a standard neoclassical production function with
decreasing returns to capital. He suggested that the rate of saving and population
growth could determine the steady state of per capita income. Since these variables
vary across nations, they reach different levels of GDP per capita. Therefore, when
the rate of saving is high, the richer the country is, and when the population growth
is high, the poorer the country is (Mankiw et al., 1992).
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Mankiw et al. (1992) said that Solow's model was successful in predicting
the effects of saving and population growth on economic development but did not
predict the magnitude of that effect. Therefore, they augmented Solow's model by
including accumulation of human as well as physical capital to the formula of
economic growth. They concluded that for a given rate of human capital
accumulation, higher saving or lower population growth leads to higher level of
income and thus a higher level of human capital. Hence, accumulation of physical
capital and population growth has greater impacts on income when accumulation of
population growth rates. This would imply that omitting human capital
accumulation biases the estimated coefficient on saving and population growth.
Heady (1979) indicated that the real problem in the least developed countries
is the imbalance between the accumulation of capital and the production level.
These countries face a necessity to increase the exports level of their raw materials
of which their prices constantly fall, while imports of industrialized materials,
technology, and other finishes products of which the prices rise up. Consequently,
per capita income gap between the developed nations and LDCs is always
increasing, in addition to the relative increase of population growth.
2.2 FDI and its Impact on Economic Development
In literature, there are various FDI theories including production cycle theory
of Vernon, strategic behaviors, industrial organization, internalization eclectic
paradigm, complement theory of FDI, the theory of internationalization of FDI (OLI
paradigm), the resource based theory, the business network theory, the theory of
new economic geography, diversified FDI and risk diversification model, policy
determinants of FDI, etc. It is important to have critical points of view towards the
theories relating to FDI. This chapter focuses on some main issues related to FDI
theories and FDI’s impact on various aspects of economic development. However,
the first section will present definition of FDI and the reasons for FDI.
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2.2.1 Definition and Determinants of FDI
2.2.1.1 Definition of FDI and reasons for FDI inflows to developing countries
Definition of FDI
FDI has been defined by OECD (2012) and OECD International Direct
Investment Statistics (database), that are presented as follows.
FDI is defined as cross-border investment by a resident entity in one
economy with the objective of obtaining a lasting interest in an enterprise resident
in another economy. The lasting interest implies the existence of a long-term
relationship between the direct investor and the enterprise and a significant degree
of influence by the direct investor on the management of the enterprise. Ownership
of at least 10% of the voting power, representing the influence by the investor, is the
basic criterion used.
Inward stocks at a given point in time refer to all direct investments by non-
residents in the reporting economy, while outward stocks are the investments of the
reporting economy abroad. Corresponding flows relate to investment during a
period of time. Negative flows generally indicate disinvestments or the impact of
substantial reimbursements of inter-company loans.
The FDI index gauges the restrictiveness of a country's FDI rules through
four types of restrictions including foreign equity limitations, screening or approval
mechanisms, restriction on key foreign employment, and operational restrictions.
The OECD FDI regulatory restrictiveness indexes presented here
demonstrate that the service sector tends to have higher FDI restrictions across
countries, followed by primary sectors. The manufacturing sector remains the most
opened economic sector.
In the same line, according to investopedia.com, FDI refers to an investment
made by a company or entity based in one country, into a company or entity based
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in another country. FDI differs substantially from indirect investment such as
portfolio flows, wherein overseas institutions invest in equities listed on a nation's
stock exchange. Entities making direct investments typically have a significant
degree of influence and control over the company into which the investment is
made. Open economies with skilled workforce and good growth prospects tend to
attract larger amount of FDI than closed, highly regulated economies.
When analyzing FDI, it is important to differentiate it from Foreign Portfolio
Investment (FPI). FPI is passive, non-fixes holdings of foreign stocks, bonds, or
other financial assets. Investors look for profit from the rate of return on their
investment and no management control is assumed. It is noted that the most
accepted definition of FDI is the one given by the International Monetary Fund
(IMF). IMF defines FDI as the acquisition of at least 10% of the ordinary shares or
voting power in an enterprise by nonresident investors, and direct investment
involves a lasting interest in the management of an enterprise and includes
reinvestment of profits (cf., Agrawal & Khan, 2011). Therefore, the distinguishing
feature between FDI and FPI is that FDI has some form of control over operation
and influence over decision, but with control comes risk and commitment. Risk is
something which multinational enterprises (MNEs) prepared to take. MNEs can be
defined as “companies headquatered in one country but having some upstream
and/or downstream operations in other countries” (Lee & Rugman, 2009; p. 62). So,
those organizations which conduct FDI in other countries can be classified as
MNEs.
Reasons for FDI inflows to developing countries
Yoonbai (2000) examined the reasons behind the flow of FDI in countries
like Korea, Malaysia, Chile, and Mexico. The research found that this flow was
influenced by two factors on a global level: recessions faced by many industrialized
economies and the global interest rate drop. Internal factors like (a) country-specific
productivity shocks, (b) demand shocks, (c) inflation shocks,(d) monetary shocks,
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(e) credit worthiness because of macroeconomic stabilization, (f) widespread
liberalization of financial market, and (g) a successful resolution of debt problems
were found relatively less important.
A study by Ito and Rose (2002) explaining the nature of international
competition among MFs in the tire industry and the determinants of an MFs
decision to establish a subsidiary in a foreign country showed that the number of
competitors, the host country characteristics, and the foreign experience of the firm
defined the pattern and location of the firm investment. Oligopolistic reaction and
FDI theories with binomiallogit and logistic regression models were used in the
study. The data sample included eight major tire firms; (Bridgestone, Continental,
Dunlop, Firestone, General, Goodrich, Goodyear, Michelin, Pirelli, and Uniroyal),
and a total of 939 observations for the years 1982, 1987, and 1992. It was also
found that factors associated with FDI decision are (a) location-specific
attractiveness, (b) political and economic stability, (c) low corporate tax, (d) large
market size, (e) geographic proximity, (f) size of the foreign market, (g) number of
competitors, and (h) anticipation of profit.
An earlier cross-country data analysis using representative countries from
Asia and Latin America (Calvo, Leiderman, and Reinhart, 1996) also outlined the
causes of the capital inflows to developing countries in the 1990s, and the
macroeconomic effects on them because of this inflow. The concluded causes were
(a) the sustained decline in the world interest rate which motivated the investors to
the high-investment yields and improving economic prospects of Asia and Latin
America's economies, (b) the 1990s recessions in the U.S., Japan, and many
countries in Europe made the profit opportunities in developing countries appear
more attractive, (c) the trend toward international diversification of investments in
major financial centers and toward growing integration of world capital markets, (d)
the significant progress that many heavily indebted 12 countries made toward
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improving relations with external creditors as well as adopting sound monetary and
fiscal policies with trade liberalization.
The Earth Summit (2002) indicated that the most heavily indebted and
low- income countries are mostly dependent on bilateral and multilateral financial
aid to carry on their development strategies. However, since the 1990s the global
flow of FDI has grown phenomenally and has become the largest source of
foreign private capital to reach developing countries.
Albuquerque (2003) examined the volatility of the FDI inflows to developing
countries compared to other forms of financial inflows. Research showed that there
was substantial evidence that FDI flows are less volatile than other forms of
financial flows to developing countries, for example, the Latin America debt crises
in 1980. The FDI collapsed but other forms of capital inflows fall was seven times
greater. Mexico's debt crisis in 1994 is another example, where FDI fell in 1996
by 27%, while other forms fell by 89% for portfolio equity and by 45% for debt
flows.
The level and relative importance of FDI has fluctuated over time, and was
high in the early parts of the 20th century, low in the middle part and growing high
towards the end. Recently, there has been increase in FDI to developing countries,
though concentrated in a few regions and countries. Inward FDI to developing
countries has always been concentrated in a handful of countries, in part reflecting
their economic wealth, but also reflecting the ability of countries to create the
conditions to ensure efficiency and strategic asset for FDI needs including good
quality of human resource and technological capabilities.
There has been a marked shift towards liberalization of FDI regime, and FDI
is regarded more favorably. No longer can it be assumed that FDI is mainly
negative (as it may have been a dominant perception in the 1970s ). Appropriate
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policies benefit from FDI include building up local human resource and
technological capacities to capture productivity spillovers.
Renewed confidence in the positive benefits of FDI has led many countries
that were restricting FDI in the 1990s and 1980s to be more open towards FDI in
1990s (Safarian, 1999) and beyond. Governments are liberalizing FDI regimes as
they associate FDI with positive effects for economic development in their countries
(e.g., Lall, 2000s). Much of potential for economic development was not realized 3-
4 decades ago because many countries have severe restrictions toward foreign
ownership, and many of quality local capabilities were not in place. This is
gradually changing. Almost all countries now actively welcome FDI.
They have liberalized their investment regime, but at different points in time.
South – East Asian economies: in 1960s, Hongkong {China}, Singapore, Malaysia
were first, while other Asian countries (Republic of Korea, China and India) and
Latin America countries began to liberalize in 1980s and 1990s (even the Republic
of Korea, which had previously restricted FDI and imported technology through
licensing, decided after the Asian crisis in 1997 to open more to FDI for the capital
and technology it could bring). Many African countries followed only in 1990s.
Countries now actively try to attract FDI and have established FDI promotion
agencies for this, thereby aiming to change an FDI screening task into true FDI
promotion. The proliferation of other tools included incentives, expert processing
zones, Science parks, etc. Restrictions on FDI on the other hand have declined as
competition for FDI increased: there has been a decrease in the inclined as
performance requirements (UNCTAD, 2003).
2.2.1.2 Determinants of FDI
It has been considered that imperfections in market throughout the world
create the desire to invest in other countries, and therefore, firms conducting FDI
are opportunists who are continually looking for possibilities to explore. Firms are
motivated to engage in FDI for a number of reasons. Wall and Rees (2004) have
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identified three main factors including 1) supply factors, which include reduced
production cost, more favorable location, lower distribution costs, better availability
of natural resources and access to technology; 2) demand factors, which include
better marketing power through a presence on the ground, protection of a brand
name through a better monitoring and closer proximity to business customers; and
3) political factors, which are the benefits of avoiding set trade barriers as well as
tax and economic incentives from host governments. The presence of just one of
the aforementioned reasons supports the decision to engage in FDI rather that
pursuing an alternate means of serving a foreign market, such as exporting,
licensing or franchising.
Firms who choose to invest abroad are commonly more competitive than
their peers, who remain satisfied with a domestic market. Not all firms choose FDI,
as it is inherently risky due to the degree of unknown when operating in a foreign
market. However, increased risks mean greater incentives, and those firms who
manage to become more successful of a result of their FDI activities receive large
reward (United Nations, 2006).
There have been a number of theories and approaches that help explain the
motivations of FDI and identify FDI’s determinants. The following will present
some of these.
Internalization
Internalization was conceptualized by Ronals Coase (1937), who found that
FDI and associated internalization take place when transaction costs, i.e. the cost of
negotiating, enforcing and overseeing a contract, are high and in such cases firms
internally can be suitable substitute for market. Alternatively, when these costs are
low, this positively supports the case for working in partnership with other firms,
being parts of the market, and using mutually beneficial licensing and franchising
agreements. The firm is left to decide whether it is more cost effective to own and
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run a facility oversea (internalize) or it is better to establish a contract with a foreign
firm to run, license or franchise on their behalf (Wall & Rees, 2004). The
internalization theory developed from the imperfections in the market.
Internalization can be seen as a form of vertical integration, where the firms takes
ownership of duties and/or goods that it formerly relied on a third party to provide.
Hood & Young (1979) argue that it is not just the ownership of a firm’s specific
asset that gives it its advantages, which is the process of being able to internalize
the asset, rather than selling it, which gives the MNE its overriding advantage.
Overall, knowledge provides a firm with a monopoly advantage and only through
discriminatory pricing, instead of licensing for example, can MNEs capitalize fully.
Transactions with other firms consume time, and additional costs can be
incurred during searching periods and in uncontrollable events. Therefore, replacing
these market inherent obstacles with internal processes can reduce insecurity. The
internalization argument provides reasons why firms prefer FDI in some
circumstance to importing and exporting, and why they may refrain from licensing
or franchising (Moosa, 2002). The internalization argument does not appear to have
any theoretical foundations, and Rugman (1986) supports this by stating that due to
its generality, internalization can be seen as more of an approach than a theory.
Also, with internalization, centralization is promoted. This may not be beneficial in
all firms, especially those that are innovative (ibid).
The costs of internalization need to be taken into consideration: more
accounting and ownership of information is required; the costs of communication
increase; and the dislike of MNEs in some host countries cause political
discrimination that could affect the firm adversely. All of these costs need to be
justified (Hood & Young, 1979). MNEs have to consider the full picture when
making future FDI decisions and as Grosse (1985) put it, MNEs are complex and
that the internalization principle features are a small part of a larger picture in the
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FDI decision making process. Nevertheless, FDI evidence across many countries is
in general supports of the hypothesis of firm’s preference for FDI (Moosa, 2002).
Eclectic paradigm
The eclectic paradigm, constructed by Dunning (1981) proposes three
determinants of FDI of which each relates to advantages of conducting direct
investment as a preference to other methods of serving foreign customers (Bende –
Nabende, 1999). The three variables of the eclectic paradigm are ownership,
location, and internalization (OLI), and these act like a three legged stools, of which
each leg is equally as important as the other (Dunning, 2000). Dunning asserts that
firms will become involved in FDI when all three factors are present.
Ownership advantage (O): A unique advantage must be present which can
counter the disadvantage of competing with firms on their home grounds. A firm
can gain this by having one of three forms of assets. Two main advantages arise
from having one of the aforementioned: First, a firm will have more effective
production and marketing, and second, a firm will have an international,
competitive advantage due to having a string ownership advantage over the local
firms (Bende- Nebende, 1999; Griffin & Putsay, 2002).
Location advantage (L): There must be increase in profitability from
exploiting a firm’s ownership advantage in a different location rather than in its
domestic market, and this may come in the form of economic, market, cultural, or
prospect benefit (Wall & Rees, 2004 ). The advantages of the location can either be
used to directly serve the foreign market or as a convenient base from which to
export. The location advantage needs to be considered in relation to the current state
the host country as well as the foreseenable development path of the home country
(Bende – Nebende, 1999).
Internalization advantages (I): There must be increasing benefits from having
full control over the foreign business rather than using an independent local firm to
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carry out those duties. There are a rang of situations where internalization can be
beneficial, from circumstances where local firms cannot be trusted either for
tarnishing the brand of a firm or being incapable of performing the required duties,
through to being overpriced (Griffin & Pustay, 2002). With internalization, firms
have the opportunity to fully exploit the ownership advantages. Firm advantages
commonly revolve around their knowledge of making a product or provide a
service, and internalization provides opportunity to keep that particular information
secure, as this could be the core of their competitiveness (Czinkota, Ronkainen and
Moffett, 2005).
The three elements of Dunning’s eclectic theory have been assembled using
the supports of other theories, namely Sermon’s product life cycle, Hymen’s
ownership advantage, and internalization by Coase. When combined, they bring
together separate areas, which allow them to provides greater and more detailed
criteria to judge the suitability of FDI. Therefore, eclectic paradigm has three times
the power of each of the theories which make it up. Dunning (1997) also suggests
four type of seeking behavior that stimulate firms to engage in FDI. These include
resource seeking to attain physical or human resources, market seeking to use or get
close to a foreign market, efficiency seeking to gain access to more efficient labor
or technology, and strategic assets seeking to acquire resources and capabilities that
help to capitalize on competencies or to prevent an asset being lost to a competitor.
Traditionally, FDI was motivated by lower cost of production overseas with the
view of exporting to serve other markets rather than serving domestic market, but
reasons for investing abroad vary tremendously. More recently, FDI has been
undertaking to serve domestic markets, and this is particularly evident in developing
countries (IMF, 2003).
The eclectic paradigm does justify the who, where and how of FDI, but
unlike the product life cycle theory, the eclectic paradigm is incapable of indicating
exactly when a firm should invest overseas. If its plans are delayed, a firm may find
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itself beaten by other investors because local partners are scarce or natural resources
are limited. Also, if the country has a small market, the firms who move first could
saturate the market and confrontation could result in reduced profitability for a
firm. Timing is an important consideration. When firms move into developing
countries and fail to consider, it could mean that a firm invests after the optimum
time (Ramasamy, 2003). Foreign investment does not happen instantly, but once
the commitment has been made it may be irreversible. After investment, and while
waiting for operations to commence, a firm’s golden benefits of a market may slide
away. This could cause a knock-on effect and result in delays in entering the next
market, as all of this affect the firm negatively when compared to proactive
competition.
Complement Theory of FDI
The complement theory, as synthesis of the Heckscher-Ohlin model, the
Rybczinski theorem, Linder’s hypothesis, and the Vernon product cycle hypothesis,
was developed by Kojima in the late 1970s. Kojima’ thesis offers an alternative
hypothesis to Mundell’s substitution Theory (Ozawa, 1979). He argued that FDI
originates from the comparatively disadvantaged industries of the home country,
which are potentially comparatively more advanced industries in the host country,
depending on the different stages of economic development in home and host
countries.
Kojima’s approach predicts that export-oriented FDI occurs when the source
country invests in those industries which have a comparative advantage in the host
country. FDI is considered as the transfer of superior production function to replace
inferior ones in the host country (Kojima, 1975).
Thus, Kojima derived the result that export-oriented FDI is welfare
improving and trade creating since it can promote both host countries’ and source
countries’ export, in particular, Japanese export business to market distortion
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created by government policies in the developing countries (Tsurnmi, 1979).
Obviously, besides Asia, this can be extended to other transition countries.
The Resource-Based Theory
Summarizing multiple MNCs’ incentives, Behrman (1972) proposed and
developed a typical FDI. This classification is based on industrial organization
theory and corporate governance. According to Behrman, MNCs are always seeking
one of four types of results: resources, markets, efficiency (global Sourcing FDI),
and strategic assets. However, because ownership and internalization advantages are
supply-side factors, they are not considered by Behrman. The resource-based theory
of the firm (Bamey, 1991; Grant, 1991; and Davidow, 1986) creates a methodical
basis for MNC investment strategy to achieve competitive advantage by
understanding the external forces that strongly effect an organization (Lindelof and
Lofsten, 2004).
Accordingly, MNCs aim to possess resources that are rare, unique, and
limited to beat their competitors. The resource-based theory has been developed to
explain how organizations achieve sustainable competitive advantage (Caldeira and
Ward, 2003). Accordingly, firms must look for unique attributes that may provide
superior performance (Barney, 1991; Caldeira & Ward, 2003). This theory focuses
more on the advantages associated with the complexity of managing multiplicity of
activities and functions in a volatile but innovated global economy (Dunning, 2000).
The finding of Tondel (2000) supports a hypothesis of market-seeking and resource-
seeking investments prevailing in Central and Eastern Europe and former Soviet
republics. Kudina and Jakubiak (2008) also find that market-seeking orientation has
the most positive effect on investment performance, followed by skilled labor and
cheap input orientation countries.
Resmini (2000) argues that a statistically significant position between FDI
and market size, wage differential, the stage of the transition process and the
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openness of the economy. However, MNCs emerging in the transition economies
with the government as main stakeholder are limited in the natural-resource –
seeking activity of foreign investors. This situation especially contains
characteristics of rent – seeking countries (Filippov, 2008). The rent-seeking
empires of the oligarchs become monopolist on the domestic resources market. As a
result, foreign investors should seek labor and efficiency and form horizontal FDI
patterns. This may partially explain the predominance of horizontal FDI pattern in
transition economies.
The Theory of New Economic Geography
According to the theory of new economic geography (Krugman, 1991,
1999), the ‘home market effects’ interprets agglomeration as the outcome of the
interaction of increasing returns, trade costs and factor price differences. If trade is
largely shaped by economies or sales, as Krunman’s theory argues, then those
economic regions with most production will be more profitable and will therefore
attract even more production and FDI. In other words, instead of spreading evenly
around the world, production will tend to concentrate in a few countries, regions or
cities, which will become densely populated but will also have higher levels of
income.
In line with Krungman and Vendables (1994), Damijan and Kostve (2008)
find very strong evidence that in most of the transition countries analyzed, trade
liberalization has caused a declined and divergence in relative regional wages, but
the relative wages then adjusted toward the stock mainly through economic
geography factors. For instance, in Central and Eastern European countries,
important inter-regional relocation of manufacturing activity have taken place after
trade liberalization with the EU, and inward FDI mostly to the capital and border
regions has help to the foster these adjustment processes. However, since economic
integration with EU provides important opportunities for individual regions, it can
also have severe polarization effects. In fact, such a polarization can be observed in
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all transition countries. For example, Ledyaeva, and Linden (2006) note that the
central region of Russia has a rather high value of accumulated FDI per capita
compared with other regions. In fact, it accumulated almost 40 percent of total FDI
stocks in Russia and has the highest FDI per capita.
According to Pan – European Institute estimate (Pan – European Institute
report, 2004 ), out of the 20 Russia receiving the most FDI; 11 of them have cities
of more than a million inhabitants. Hence, big city advantages like high levels of
business infrasture and large market size are important factors of inward FDI.
Ledyaeva and Mishuna (2006) analyze FDI distribution in Russian regions and
show that only a fraction of aggregated profit in a particular region is robustly
related to regional distribution of investment in Russia, which is unfavorable and
only high profit can compensate for the risks and attract investors.
Suggesting regional homogeneity of FDI factors for transaction economies,
Deichmannetal (2003) examine the extent to which none-spatial determinants of
FDI are affected by spatial proximity. Thus, within the group of transition factors,
we can also distinguish some regional subgroups according to historical, economic
and cultural conditions.
Diversified FDI and risk diversified model
A large stream of empirical contributions have analyzed the role of risk
factors on explaining FDI patterns and MNCs, incentive to invest abroad (Miller
and Pras, 1980; and Caves, 1996). Faeth (2009) noted that while horizontal and
vertical patterns of FDI can be explained well by the transaction- cost approach and
knowledge – capital model, diversified FDI, which is growing in importance,
cannot be explained, as it is considered a minor factors of MNCs’ desire to spread
investment risk. Firms’ risk aversion, which has been considered a minor factor of
FDI, is gradually emerging as one of the main determinants of FDI. Rugman’s
diversification to hypotheses has been widely supported by empirical evidence. In
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contrast to horizontal and vertical patterns, conglomerates arise as a response to
high risk business environments. Kopites was the first to describe this form of MNC
in 1979. Bettis (1981) suggested that firm achieved better performance because of
openness to the possibility of differentiation and segmentation based on identified
risk factors.
Policy determinants of FDI
The earliest study by Bond Samuelson (1986), Black and Hoyt (1986),
Haufler and Wooton (1999), and Haland and Wooton (1999) argued that there are
strong links between MNC strategy and government policy in the host countries.
Empirical studies show that an MNC’s decision to invest can be influenced by
factors such as information asymmetry, structure of the host economy, market size,
market evolution, openness, the level of infrastructure and the level of
political, economical and financial risk (e.g. see Resmini, 2000).
Altomonte (1998) obtained evidence by including variables measuring the
Institutional and economic uncertainty under which the investment is made. In the
context of institutional and risk factors, we can identify a dual role of
government in transition countries. The government is not only interested in
attracting FDI but can also provide large support for domestic MNCs, being a key
stakeholder in them. This phenomenon has been explored in a wide empirical
literature (Brouthers & Bamossy, 1997; Cass, 2007; Drahokoupil, 2008).
Deicmann, studying the origins of FDI in Poland (2004) and in the
Czech Republic (2010) finds that origin effects and government promotion
abroad play an implicit contradictions that complicate FDI into transition
economies. Using political leverage (an administrative resource like close ties to
the government or lobbying in Parliament) and domestic media leverage, emerging
MNCs protect and promote their business, but also successfully compete with
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foreign companies within the host market and regional markets (Khanna & Yafeh,
2008).
Changes in the determinants of FDI.
The way that FDI affects growth and development depends, for an important
part, on the type and volume of FDI. Thus, when understanding the impact of FDI,
it is importance to understand what attracts FDI, how this has changed over time,
and what these changes in determinants and type of FDI mean for differential
growth prospects. The main determinants of inward FDI can be divided in to several
categories, and relate to:
- General policy factors (e.g. political stability, privatization)
- Specific FDI policies (incentives, performance requirements, investment
promotion, international trade and investment treaties)
- Macro economic factors (human resources, marketing size and growth)
- Firm specific factors (e.g., technology): For instant, ICT development have
had a profound impact on the way companies structure their international activities.
Most importantly, it has facilitated a more competitive environment for any given
activity.
There have been treads in all of these factors over the past decades and
between them. They can explain large parts of why FDI has gone more to some
countries and regions than others. There has also been changes in their relative
importance. The main point is that, and we will also see later, factors that have
become increasingly important in attracting FDI (building up appropriate and good
quality, local capabilities are also increasingly important in marketing FDI work for
economic development).
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2.2.2 Impact of FDI on Economic Development
FDI has been considered to be one of the most important drivers in
upgrading the country-specific resources as well as the firm-specific capabilities of
host countries. FDI’s contributions to the development of host countries can be
implemented through several channels such as transferring financial resources
directly to the FDI recipient countries, technological and managerial spillovers to
local firms of the host countries, and/or helping host countries join the global
trading, investment and technology networks of foreign MNEs. The importance of
FDI to the development of host countries has recently increased due to the role
‘flagship’ of MNEs, who are considered the main FDI implementors (cf., Lee &
Rugman, 2009).
In the following sections, first the author review previous studies on the
impact of FDI on economic growth and some other aspects of economic
development, mainly in the context of developing countries. After that, a review of
the studies on the impact of FDI on economic development through human capital
and technology is provided. Finally, the author presents FDI and its spillover
effects.
2.2.2.1 Impact of FDI on economic growth and other economic development
aspects
New growth theorists, Levine and Renelt (1992) have identified investment,
including FDI as one of the main determinants of economic growth (Adegbite &
Ayadi, 2010. According to UNDCTAD (1999), much have been written about
relationship between FDI and development. The author reviews the main impact
areas and suggest there have been major changes within these, with an emphasis on
FDI relates to economic growth (we do not deal separately with equality and
poverty). There are several areas through which FDI affects development
(UNCTAD, 1999), including: Employment and incomes, capital formation, market
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access, structure of skills, technology and skills, fiscal revenues, political, cultural,
and social issues.
FDI affects economic growth through all of the above channels. FDI can
raise economic growth by increasing the amount of factors or production (by
increasing capital or employment, directly in local suppliers and competitors), in the
traditional growth accounting context, or increasing efficiency by which these
factors are using (by using superior technology, or locating in high productivity
areas, or through productivity spillovers), as expressed in the literature in
endogenous growth (e.g. Aghion and Howitt, 1988) where FDI represents the port
through which new ideas are gained. In the long-run, FDI induced productivity to
local capabilities, while FDI induced building up of factors may only raise growth
temporarily (e.g. by establishing a garment assembly factory).
Those countries whose local capabilities have been enhanced because of FDI
(e.g. in Singapore and island, where local suppliers have become global exporters)
have also been able to benefits most from FDI in the long- term. However, those
countries that attracted FDI in the apparel sector because of trade policy distortions
(due to the multi Fiber Arrangement quotas which governed world trade in textiles
and clothing until 2005) without building up local capabilities or linkages, may have
derives fewer long – term benefits from FDI. For instance, there are now fears that
investors in Lesotho would withdraw, at a time that much apparel capacity is
relocated to China.
It has been argued that FDI enhances long run economic growth via
technological progress, capital accumulation and human capital augmentation (Chee
& Nair, 2010). Gao (2005) investigated the interrelationship between FDI and
growth. Using a two-country model in which FDI and growth are endogenous, he
found that both FDI and growth respond endogenously because of the change in the
world economic integration.
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Zhang (2001) studied the link between FDI inflows and economic growth
in developing countries. Using a sample of 11 countries in Asia and Latin America
with estimation and cointegration tests, the research found that, depending on
countries' characteristics, FDI can be growth-enhancing when they have liberalized
economies, sufficient human capital derived from education system
improvements, export-oriented policy, and macroeconomic stability.
Balasubramanyam et al. (1996) examined the role, which FDI plays in the
growth process in countries characterized by different trade policy regimes. Using
regression analysis on determinants of growth rate of real GDP on cross-section
data relating to a sample of 46 developing countries, research suggested that the
beneficial effect of FDI in terms of enhancing economic growth is stronger in
those countries that pursue an export promoting policies than it is in those
countries adapting an import substituting policies.
In the context of developing countries, it has been suggested that FDI can
bring benefit if the countries have the capabilities to absorb advanced
techonologies. A recent study by Agrawal and Khan (2011) has showed that FDI
has significant impact on economic growth in China and India. Specifically, they
found that 1% increased in FDI would results in 0.07% increase in GDP of China
and 0.02 increased in GDP of India. So, FDI can have different affects on economic
growth in different countries.
Similarly, a study by Kotrajaras et al. (2011) have examined the impact of
FDI on economic growth in groups of 15 East Asian countries classified by level of
economic development. The results suggested that the impacts of FDI depend on
complementary factors, particularly each host country’s economic conditions such
as levels of financial market development, institutional development, better
governance, and appropriate macroeconomic policies.
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In India FDI is considered to play an important role in the development of
the Indian economy. In many ways, FDI has enabled India to achieve a certain
degree of financial stability, growth and development (Prasad & Sharma, 2012).
The sudy by Adegbite and Ayadi (2010) investigates the relationship
between FDI flows and economic growth in Nigeria. The study became necessary
because as never before, the civilian governments since 1999 have employed
several strategies to ensure increased flow of FDI into Nigeria because of its
perceived benefits as lauded in the theoretical literature as the panacea for economic
underdevelopment. The study utilized simple OLS regression analysis and
conducted various econometrics tests on the model so as to obtain the best linear
unbiased estimators. The study confirmed the beneficial role of FDI in growth.
However, the role of FDI on growth could be limited by human capital. The study
concluded that indeed, FDI promotes economic growth, and hence the need for
more infrastructural development, ensuring sound macroeconomic environment as
well as ensuring human capital development is essential to boosting FDI
productivity and flow into the country.
The research by Mengistu & Adams (2007) has examined the dynamic
relationship between FDI, domestic investment, institutional environment, and
economic growth in developing countries. The results indicate that the two most
important determinants of economic growth over the study period were FDI and
institutional infrastructure. The study also found that FDI’s effect on economic
growth was more through its efficiency effects than through its augmentation of
domestic investment. Accordingly, developing countries need to focus on policies
that promote institutional development and become attractive destinations for FDI
to sectors that lead to increasing returns to domestic investment and production.
In a comparative analysis, Nataliya Ass and Matthias Beck (2005) observe
that a negative relation between FDI and “Trade Balance” which is much stronger
for the Central Asian countries, co-exists with a positive relationship between FDI
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and “Export per capita” for this region. This appears to indicate that resource
centered FDI is likely to increase per capita export. However, these gains are wiped
out by excessive public and private spending which negatively affects the country’s
overall trade balance.
The relationship between FDI and some other economic indicators provide
further evidence. Thus, EU accession countries are the only group for which FDI is
negatively correlated with inflation. By contrast, in all post Soviet states, FDI
inflows are not associated with the reduction of the rated of inflation. Moreover, in
case of the post soviet European states (Belarus, Moldova, Russia and Ukraine) FDI
shows a strong positive relationship with “debt per capita”, while for all other
groups this relationship is weakly negative. This indicates thast this region attracts
riskier and lower quality debt- increasing investment.
The opposite situation can be observed for ‘unemployment’. The EU
accession countries are the only group for which unemployment reveals strong
enough (in comparison to all other cases) positive relationship with FDI vis-avia
post Soviet countries where FDI is negatively related with unemployment. This
finding, through contradictory to the original argument on lower FDI quality in
post- Soviet states, indicates that EU accession countries are now attracting FDI
which is not contributing to the increase of employment in the region. The inference
can be made that, after reaching a certain level of development by transition
countries, FDI changes its quality from being unemployment reducing to not
contributing to the increase in employment. Negative relationship between
unemployment and FDI in case of post-Soviet European countries, in turn, can be
explained by the high levels of underreporting figures on unemployment in these
states.
In their regional study on the Arab World Economic Development and
Growth over the past four decades, Sala-i-Martin and Artadi (2003) have related
the lack or the slow economic growth in that region to the inefficient public
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investment, which requires heavy tax revenues but has minimal positive impact
on the national productivity due to the wrong sector choice, or the intention to
attain just political or private gain. In addition, the negative rate of growth in the
Arab World can be tied to several other factors: The Inefficient financial sector
and its negative role played in the productive investments, the excessive reliance
on public investment, the political instability represented by the wars, violence,
and social conflicts, the excessive government intervention and complex
overregulation for business licensing, which creates environment for bribery and
high level of corruption, the lack of transparency, and the inadequate, unqualified
human capital.
Based on Frederick Mmieh, Nana Owusu-Frimpong research paper on “State
Policies and the Challenges in Attracting Foreing Direct Investment: Areview of the
Ghana Experience” (Septemeber, October 2004), effects of FDI are at the center of
a continuing controversy in the economic transformation of Ghana. Many Ghanaian
economists believe that the impact of such investment is positive, since it brings to
the country a package of capital, foreign exchange, technology, managerial
expertise, skills, and other inputs typically in short supply locally. It is also being
argued that while FDI and participation in the global market might bring about a
higher growth rate, it is often at the expense of economic stability, employment,
income distribution, and even political freedom, with minimal technological
transfer. In the 1970s and 1980s, Ghana became heavily indebted and, finding it
difficult to raise new foreign loans to mobilize domestic resources, FDI looked
increasingly attractive, not as an additional source of capital but for the technology
and market access such investment brings.
This study takes the view that without FDI the country would not have been
able to achieve the progress it has made so far, resulting in a modest increase in FDI
flows into the country. This article, however, recognizes that countries such as
Nigeria and Angola are able to attract higher returns of FDI in the extractive
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industries to compensate for political instability, even though they abandoned the
reform program in the early 1990s. It is acknowledged in this study that as long as
foreign business organizations are confident of being able to operate profitably in a
business environment without undue riskto their capital and personnel they will
continue to invest. Evidence demonstrates that under the SAP, the deterioration of
the economy has at least halted, and a modest growth rate of around 4% has
transpired evidence of a remarkable recovery” (Debrah, 2002). The SAP’s limited
success also includes the lowering of inflation, promotion of an environment of
financial stability, elimination of licensing requirement, opening of previously
closed sectors, removal of tariff barriers that prohibit FDI inflows, abolishing
exchange controls, and reducing opportunities for the foreign exchange black
market. In spite of the limited degree of success of the SAP, there are still problems
that impede the attraction of high value-added FDI into Ghana. Some of these
problems include bribery and corruption, which are deeply rooted in the political,
socioeconomic systems, thus confirming the findings of Wei (1998) and Van
Vuuren (2002) on the subject. This article suggests that it might be worthwhile for
the government to embark on a nationwide campaign to tackle this endemic
problem head-on among people in positions of authority.
Alfaro et al. (2004) investigated the impact of the financial market
development on the FDI attraction to achieve economic development using cross-
country data between 1975 and 1995 for multiple developing and developed
countries. Empirical analysis through growth regressions showed that the role of the
FDI in economic growth alone is ambiguous. The research suggested that the
development of strong financial market could increase an economy's ability to
absorb and efficiently manage FDI capital inflow and take advantage of potential
FDI benefits.
FDI has been considered to have a substantial influence on social and
infrastructure development as well as technology transfer. It helps in stimulating
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employment, raising wages, and replacing declining market sectors, consequently
having cultural and social impact if the investment is directed toward non-
traditional sophisticated products (Earth Summit, 2002).
FDI are always involved in research and development that bring new
products and manufacturing techniques that would benefit and augment the local
industry. Additionally, technology spillover can occur from the labor turnover from
foreign to domestic firm. Additionally, the FDI spillover of technology and its
significant financing capability should be the desired outcome of attracting foreign
investors to achieve economic growth. FDI can also create linkage for local market
for supplying needed inputs, which will enable local firms to achieve economy of
scale (Alfaro et al., 2004).
Mody and Murshid (2005) examined the relationship between long-term
capital inflows and domestic investment for 60 developing countries from 1979 to
1999. Regressions on data showed a declined impact of the foreign capital,
including portfolio and FDI flows, on the local investments. The reason for this
decline was due to either (a) the capital was not the binding solution for the desired
development, or (b) the inability of some economies to absorb the capital inflows.
Results also suggested that proper market policies and investment environment are
the keys to enhance the capital inflows- investment relationship. Capital control for
example, can intensify this relationship by directing capital inflows to specific
investment projects or restricting domestic capital outflows.
Rodriguez-Clare (1996) investigated how MFs affect underdeveloped
countries through the generation of backward and forward linkages (Backward
linkages refer to technology transfer through supply chains from downstream
multinationals to local suppliers, while Forward linkages exist when increased
production by upstream firms provides positive pecuniary externalities to
downstream firms). Using a two-country model, the research found that MFs can
generate a positive linkage in the host country when the demand for intermediate
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inputs increases as a result of (a) the production of complex goods, (b) the
increase of communication cost between the production plant in the host country
and MFs headquarter, and (c) the difference in culture, social, and legal system.
The linkage coefficient is higher when the host market is more developed.
FDI is often seen as an important catalyst for the economic transformation of
the ECE transition economies. Its importance is seen to be not only in providing
finance for the acquisition of new plants and equipment, but also in the transfer of
technology and organizational forms from relatively more technologically advanced
economies. FDI can also result in positive “spillovers” to the local economy through
linkages with local suppliers, competition, imitation and training. It can also result,
however, in negative spillovers if it forces domestic enterprises to close down
because they cannot obtain the necessary financing for upgrading their technology.
Moreover, it is possible that spillovers to the rest of the economy may not occur at
all if there are institutional obstacles or deficiencies in the absorptive capacity of
domestic enterprises (Djankov & Hoekman, 1993).
The National Bureau of Economic Research, Working paper no 5057,
Borensztein et al. (1998)’s research results suggest that FDI is in fact an important
vehicle for the transfer of technology, contributing to growth in larger measure than
domestic investment. Moreover, they find that there is a strong complementary
effect between FDI and human capital, that is, the contribution of FDI to economic
growth is enhanced by its interaction with the level of human capital in the host
country. However, their empirical results imply that FDI is more productive than
domestic investment only when the host country has a minimum threshold stock of
human capital. In their research paper, they also investigated the effect of FDI and
domestic investment, namely, whether there is evidence that the inflow of foreign
capital “crowds out” domestic investment. In principle, this effect could have either
sign: by competing in product and financial markets, MNS’s may displace domestic
firms; in contrast, FDI may favour the expansion of domestic firms by
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complementarity in production or by increasing their productivity through advanced
technology spill over effects.
While the explosion of FDI flows is unmistakable, the growth effects remain
unclear. Theories provide conflicting predictions concerning the growth effects of
FDI. The economic rationale for offering special incentives to attract FDI frequently
derives from the belief that foreign investment produces externalities in the form of
technology transfers and spillovers (Romer, 1993).
FDI may boost the productivity of all firms, not just those receiving foreign
capital. Thus, transfer of technology through FDI may have substantial spillover
effects for the entire economy (Maria Carkovic, Ross Levine, 1994). Other
researchers argue that FDI is only growth enhancing in countries with low
educational attainment (Maria Carkovic, Ross Levine, 1994).
FDI remains significantly and positively linked with growth when
controlling for inflation or government size. However, FDI becomes insignificant
once we control for trade openness, the black market premium, or financial
development (Maria Carkovic, Ross Levine, 1994).
In the transition economies, Hungary and Estonia showed early signs of FDI-
led growth. In Hungary, there were significant inflows of FDI in the early 1990s,
before GDP started to recover (from the transition recession) in 1994. The output of
FIEs was already expanding in 1992-1993 while that of domestic firms continued to
decline (it was only later that the FIEs dominated economic performance). In
Estonia, too, relatively large FDI inflows preceded the economic upturn in 1995. A
similar pattern may be observed somewhat later in Latvia. In both cases, the
governments’ strategies involved an early infusion of FDI through the sale of
strategic state assets. On the other hand, in Poland an economic recovery (starting in
1992) preceded the surge in FDI by several years. Due to its size, location, etc.,
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Poland was from the very beginning of the transition considered one of the most
attractive countries for foreign investment.
However, despite this and its early favourable economic performance,
foreign direct investors essentially held off until 1996, when the country’s large
external debt was reduced in agreements with London and Paris Club creditors.
Subsequently, FDI inflows and high rates of economic growth appear to have joined
in a virtuous circle (as has probably also been the case in Hungary and the Baltic
states). The fact that in Croatia, Slovakia and Slovenia there were extended periods
of fairly rapid growth without attracting much FDI is explained by domestic
policies (as already noted). The experiences of Croatia and Slovakia underline the
fact that FDI will only begin to flow after a commitment has been made to reform
(including a privatization programme) and investor friendly policies are in place.
Over the past decades, there have been several major shifts in relation to the
impacts of FDI. First, in parallel to shifts in the nature and composition of FDI, the
time and direction of impacts have changed. Secondly, the literature on the macro
effects of FDI has evolved and become more sophisticated over time. Thirdly,
governments have increasingly involved. They can influence the types and direction
of impact through appropriate mix of policies, and they have increasingly made use
of such policies. At the same time, some policies used in the past are now regulated
in various international treaties.
2.2.2.2 Impact of FDI on economic development through human capital
The human capital stock has a very significant value in the process of
economic development. It is required to acquire new skills and benefit from the
technology diffusion. Labor has to be sufficiently educated and trained to absorb
technology and to be an infrastructure for FDI investment in the host countries. In
modem economies, human capital is the prime engine of economic growth, while
during the industrial revolution physical capital was the focus.
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Becker et al. (1990) indicated that human capital is the economic growth
backbone that goes hand in hand with technology and science acquisition. They
emphasized that investing in human capital would lead to a rise in production in
the future, opposing the notion by other scholars that with population growth
resources would diminish (Aguirre, 2002)
The FDI possess more advanced knowledge, pioneering as lower-cost
new product producers. However, human capital stock in developing countries
becomes a prerequisite to take advantage of and absorb such advanced technologies
to achieve economic growth. FDI in tum should work on stimulating technological
progress for the developing countries, rather than increasing the total capital
accumulation (Borensztein et al., 1998).
Labor has to be sufficiently well educated and trained, and domestic non-
reproducible inputs have to satisfy minimal quality standards, to justify investment
and technology transfers into the host country. The latter leads to human capital
augmentation in the presence of FDI, given that the host country has passed the
development threshold needed for the existence of basic labor skills and
infrastructure (Blomstrom et al., 1994; Borensztein et al., 1998).
Galor (2004) argued that human capital has become the prime engine of
economic development, replacing the physical capital and altering the qualitative
impact of income inequality on economic development. In the beginning of the
Industrial Revolution, the physical capital was the focus since development relied
on the people with higher saving rates. This shift and replacement was due to the
import of capital and technology.
Saving is a crucial factor in economic growth. As society pays attention to
the birth of children, investment in each child along with long-term physical capital
provides human capital abundance. Consequently, the rate of return on human
capital investment becomes high compared to the rate of return on the number of
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children. Countries with limited human capital usually have large families with less
investment in each child, while those with abundant human capital have smaller
number of children with a higher human and physical capital (Becker et al., 1990).
Rosenzweig (1990) confirms Becker's research in that high-income countries
have been characterized by low fertility and high level of human capital, while low-
income countries have high fertility and low level of human capital. The countries
that have experienced high rates of per capita income growth in the last four
decades have also experienced relatively rapid declines in fertility and increases in
human capital levels.
Analyzing the role of decisions about the human capital accumulation in
determining the rate of growth, Stoket (1991) concluded that international trade
affects growth by influencing the incentives for schooling or other investments in
human capital.
Investment in research and development (R&D) and human capital is also
essential to produce higher quality goods. It was found that the growth per capita in
countries like Japan, Korea, and Hong Kong was associated with the rapid
expansion in the volume of exports, investment in education, and the composite of
output (Stoket,1991).
2.2.2.3 Impact of FDI on economic development through technology
Technology was defined by many scholars as the increase in the output
using a fixed amount of labor and capital. Literature on technology relationship
with economic growth had focused primarily on diffusion and transfer of know how
and processes from technologically advanced FDI to developing countries, and as
an infrastructure to attract FDI. Education and R&D are two main elements of the
technology infrastructure.
Bartel et al. (2005) studied the relationship between technological change in
the world today and it effect on outsourcing. They indicated that the revolution in
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La01.005 a study on the impact of foreign direct investment on economic development of lao p.d.r.

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