What is Foreign Direct Investment (FDI)?
. Introduction
Since the end of the Second World War one significant phenomenon in the world economy is the rapid growth of foreign direct investment (FDI) in the wake of the rapid expansion of multinational enterprises (MNEs). Although FDI growth slowed even dropped occasionally, it has been maintaining an overall growing trend. With the growth of FDI, there have been many significant changes in the world economy and politics, such as the growth and liberalization of international trade, the formation of regional trading groups, the rapid expansion of many industrialized countries, and the rise of newly industrialized countries, etc. FDI has been playing increasingly important role in international business and globalisation over years. In fact, FDI is now more important than trade as a vehicle for international business (Daniels and Radebaugh, 2001). During the growth of FDI, governments have been playing an important and interesting role. On one hand, there have been actions taken by the governments of host (receipt) and home (source) countries, such as providing incentives by modifying laws, policies, or even entire economic system, to encourage the flows of FDI. On the other hand, these countries have been placing constraints and regulations to restrict the flows, such measures include minimum export requirements, local content requirements and domestic participation requirement, etc. The extent and direction of these actions differ from countries; even for one country, they change over time. For example, China government has changed its attitudes and policies toward FDI from entire inhibition before 1980 to careful welcome, and then to encouragement but still with some restrictions which have become much less than before. Similar to China, in recent years, other countries have generally become increasingly receptive towards FDI.
The purpose of this essay is to discuss typical motivations of governments, both of host and of home countries, in attempting to influence FDI flows.
This paper is organized in the following way. First, the definition of FDI is presented. Then, government objectives are explained. Following these, the typical motivations of host and home governments towards FDI are respectively analysed and discussed. The incentives and restricts of host countries to FDI are also indicated. Finally, in conclusion, an overview is presented.
2. What is Foreign Direct Investment (FDI)?
According to IMF, FDI is defined as " investment that involves a long-term relationship reflecting a lasting interest of an entity resident in one economy (direct investor) in an entity resident in an economy other than that of the investor. The direct investor's purpose is to exert a significant degree of influence on the management of the enterprise resident in the other economy" (Dunning, 1993: 5). In terms of the definition, there are two distinctive features of FDI in comparison with portfolio investment, which is a pure transfer of capital and concerned with realizing immediate income or capital gains.
Firstly, FDI involves ownership (in part or whole) and control of a foreign operation, including decision-making, subsequent production, and marketing activities, etc. Secondly, FDI is usually accompanied by the transference of a bundle of capital, technology, and entrepreneurial skills across national boundaries.
Most FDI comes from multinational enterprises (MNEs). MNE is thus the dominant vehicle for FDI, while FDI is a means of fulfilling MNE's objectives (Daniels and Radebaugh, 2002).
MNE is "a company that takes a global approach to foreign markets and production" (Daniels & Radebaugh, 2002: 12). The principle objective of the MNE is to secure the least costly production of goods for world markets (Gilpin, 1987). There are three major operating objectives, as Daniels and Radebaugh (2002) point out, involving sales expansion, resource acquisition, and risk minimization. Therefore, FDI is generally an integral part of the global corporate strategy for MNEs operating in oligopolistic markets (Caves, 1982).
3. Governments objectives
The motives of governments toward FDI may be defined in terms of governments' objectives. Tayeb (2000) argues that governments' principal responsibility is the welfare and protection of their nations. For example, China Government aims at steadily improving people's standard of life, both in material and cultural respects. Governments are interested in a wide range of social goals, which involve economic and non-economic objectives. As Dunning (1993) suggests, economic objectives include economic growth, reasonably full employment or reduction in unemployment, currency stability, etc. Governments enact policies that will be consistent with their economic strategic plans for growth and development. Non-economic objectives, may be affected by economic policy, include a right distribution of income and wealth, sovereignty over decision taking, political and cultural identity.
Government goals are dynamic. On one hand, the goals changes over time; on the other hand, there are trade-offs among the objectives. To the end, governments formulate and enact policies to fulfill these objectives. With the growing liberalization of the world macroeconomic environment and the movement towards closer economic interdependent between nations, a competitive perspective is becoming increasingly common in governmental policy-making. Governments enact policies to upgrade the competitiveness of their domestic resources and capabilities and to evolve a pattern of development which is consistent with their long-term dynamic comparative advantage (Dunning, 1972).
4. Motivations of host ...
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Government goals are dynamic. On one hand, the goals changes over time; on the other hand, there are trade-offs among the objectives. To the end, governments formulate and enact policies to fulfill these objectives. With the growing liberalization of the world macroeconomic environment and the movement towards closer economic interdependent between nations, a competitive perspective is becoming increasingly common in governmental policy-making. Governments enact policies to upgrade the competitiveness of their domestic resources and capabilities and to evolve a pattern of development which is consistent with their long-term dynamic comparative advantage (Dunning, 1972).
4. Motivations of host governments towards FDI
In terms of the objectives, the typical motivations of host government towards FDI may be categorized into economic growth, including technological transfer, managerial skills, and capital formation, employment, the balance of payment and trade, market structure and competition, social and cultural issues, sovereignty, and national security.
4.1 Economic growth
As mentioned above, FDI involves the transfer of a bundle of production factors, which usually have some competitive advantage over local firms. FDI thus may influence economic growth by raising total factor productivity or the efficiency in the usage of resources in host countries. Most empirical studies conclude that FDI generally does make a positive contribution to both factor productivity and national income in host countries, beyond what domestic investment normally would trigger (OECD, 2002). For example, the effect of FDI on China's continuingly rapid economic growth is significant. Some economists even argue that without FDI, China's growth might be negative. However, it doesn't mean that every foreign owned affiliate necessarily makes a positive contribution. For example, China exempts foreign invested enterprises from taxation, so it may be questioned whether the benefits outrun the costs. Moreover, there may be risk of crowding out domestic investment through FDI (OECD, 2002). Furthermore, as Behrman (1970) argued, FDI might result in economic development dependence, especially for those developing countries.
4.1.1 Technological transfer
FDI may provide considerable technological spillovers. Host countries want the advanced technologies that come with FDI by MNEs, which generally possess a higher level of technology than is available in host countries, especially in less developed countries (LDCs). For example, by technological transfer, China has made a significant leap forward and become the biggest manufacturing country in TV set, washing machine, and telephone. Now China is becoming increasingly important in the manufacturing industry of semi-conductor chips with the investment from Taiwan manufacturers. The degree of technological spillover depends on the nature of the investment. Firstly, the spillover will be typically greater if the foreign firm invests through a joint venture or a licensing arrangement. China has been favoring joint venture, especially in high-tech fields. Secondly, the spillover will be greater if the affiliate works with local suppliers of key components or inputs. For example, foreign auto plants in China have been required localization of components. Moreover, the spillover will be greater if the affiliate hire local people for key positions in the firm, and if the firm conducts R&D in the location. However, on one hand, Behrman (1970) argued that FDI might result in technological dependence because of the control of MNEs over the new technology advanced. On the other hand, Hood and Young (1979) pointed out that the technology obtained might be inappropriate to the host country and such that led to unemployment and destruction of innovation, and the technology received might be too expensive. They argued that technological dependence was not particularly important, rather, the appropriateness of the technology obtained, and the costs of the technology received, were more relevant because these factors would determine whether or not the recognized association between technology and economic growth was actually translated into net benefits at the host country level.
4.1.2 Managerial skills
Because FDI involves ownership and control of the affiliate operation, FDI may bring advanced managerial skills and entrepreneurial ability to host countries on a continuing basis. Firstly, these skills and ability may improve the balance of local economy. Secondly, as Hood and Young (1979) state, local personnel who are trained to occupy managerial, financial and technical posts in the affiliate may later leave the firm and help to stimulate indigenous entrepreneurship. On the other hand, local firms, especially smaller enterprises, might be choked off by the competition of the affiliates. Furthermore, for LDCs, the managerial skills may not give rise to positive contribution if they are little relevance to local normal ways of business operation. For example, in China, doing business relies heavily on personal relationship.
4.1.3 Capital formation
Many countries do not have much domestic capital necessary to provide adequate levels of investment and domestic savings. FDI may therefore be seen as a source of the capital needed. However, the actual inflow of FDI is often fairly small, with most finance coming from reinvested profits and local savings (OECD, 2002).
4.2 Employment
Usually, one of the main reasons a country likes to attract FDI is for the new jobs. As Hood & Young (1979) point out, by means of their very existence in host countries, FDI clearly makes some contributions to increase the level of employment. Also, the fact that the export-oriented affiliates of MNEs almost utilise cheap labour may reduce unemployment. For example, in China, foreign invested enterprises have been employing a lot of cheap rural redundant labour. FDI may also increase employment in domestic subcontractors. Furthermore, FDI may improve the quality of employment through formal and informal training. However, the effect of FDI on employment can be difficult to measure. For example, although the establishment of a new affiliate brings employment, the new affiliate might merely replace jobs held at domestic firms. The local employment might even decrease because the new affiliate could be more efficient than local firm in terms of its advantage. Moreover, the affiliate of MNEs can often attract higher quality employees provided with higher wages and better working conditions. Loss of those employees may weaken local entrepreneurial development.
4.3 The Balance of payment and trade
Governments want a healthy balance of payment. FDI has several individual effects on the balance of payment of a host country. As Root (1984) suggests, the benefits arise from the initial inflow of investment capital, the exports of the affiliate, and the replacement of imports by the affiliate's output (import substitution). These benefits will strengthen the host country's currency. The costs result from repatriated earnings and payment to other foreign factors of production, i.e. buying machinery, imports by the affiliate, and disinvestment (liquidation) of the affiliate. These costs will weaken the host country's currency. Thus, the net effect of FDI on the balance of payments and trade will depend on the benefits and costs mix.
In china, foreign investment generally makes positive contribution to the balance of payments and trade. Growing FDI has helped expand China's imports and exports. According to People Daily (, foreign invested enterprises have become the largest generator of imports and exports of China since 2001, accounting for more than half of the country's total import and export volume. Also, in recent years, China has been maintaining a healthy balance of international payments, which has been play a key role in keeping the stability of RMB, especially during the Asia Financial Crisis.
4.4 Market structure and Competition
FDI may greatly assist economic development by spurring domestic competition and thereby resulting eventually in higher productivity, lower price ad more efficient resource allocation (OECD, 2002). However, the entry of MNEs may raise the level of concentration in host markets, which can hurt competition.
4.5 Sovereignty issue
Many countries view the presence of MNEs as a threat to country's sovereignty. From their perspective, firstly, the MNE undertaking FDI is not only a business institution, but also a political institution that has sufficient decision-making power over key segments of the national economy from a headquarters located outside the national territory and beyond the jurisdictional reach of host government (Root, 1984). MNEs therefore can "thwarts the capability of the host government to achieve economic, social, and other goals in pursuit of the national interests" (Root, 1984:512). Secondly, the MNE identifies itself with the laws and policies of the home government. Finally, the MNE is an outsider, and intruder into the national community whose loyalty to the host country is questionable at best (Root, 1984).
However, with the trend of globalization being increasingly recognized, such view is less common now.
4.6 Social and cultural issues
The integration of FDI into a local economy often results in a deep social and cultural change. Movement of labour and links with domestic subcontractors enable transmission of business culture, which takes root from the society and culture of the home country. This may result in cultural clash. However, empirical evidence, though far from abundant, indicates that FDI may help reduce poverty and improve social conditions, especially of LDCs. Furthermore, there is little evidence that FDI leads to a general deterioration of basic values; on the contrary, empirical studies have found a positive contribution of FDI to workers' rights. On the other hand, in specific contexts, there might be cultural clash (OECD, 2002).
4.7 National Security and other national interests
Host governments, even American government, may block FDI for national security reasons. For example, if foreign companies were able to purchase military suppliers, they might gain military secrets. In addition, there are other industries that host governments will not allow foreign companies to own. Examples include telecommunications, culturally sensitive industries, and airlines.
5. Host government's policies towards FDI
Due to increasingly recognized benefits of FDI to economic growth, host countries provide incentives to attract FDI, while with restrictions on the affiliates' activities.
5.1 Incentives
Some typical incentives include:
. Duty-free import of materials (until the goods are sold locally).
2. Tax concessions (income and property).
3. Infrastructure improvements: roads, water, electricity, telecommunications, and schools, etc.
4. Subsidies: subsidized financing, subsidized land, environmental subsidies, worker training.
5. Most governments set up foreign (or free) trade zones (FTZs) or export processing zones that provide some of the incentives listed above. A notable example is China's special economic zones.
5.2 Restrictions
Some typical restrictions involve:
. Developing countries often require that foreign investors obtain approval before investing.
2. There are trade-related investment measures. These rules govern the trading activity of foreign affiliates. They can include minimum export requirements, local content requirements, as well as stipulations on export ratios.
3. Governments often place limits on foreign equity participation. These limits force foreign firms to find a domestic partner.
4. Limits are also placed on income repatriation. China strictly restricts income repatriation.
6. Motivations of Home Governments towards FDI
Different angle from host countries, the typical motivations of home countries involve the balance of payment and trade, employment, tax, secure key raw materials, market position, tool of diplomacy, and national security.
6.1 The balance of payment and trade
Same as host countries, home countries need a healthy balance of payment as well, while the multiple effects of outward direct investment also involve some individual effects which result respectively in benefits and costs. As Root (1984) states, the positive effects include income received from FDI, receipts from royalties and fees, associated exports, and foreign borrowings by home investors. The negative effects involve FDI outflow, interest payment on foreign borrowings, displaced exports, and imports. The net effect of FDI outflow, though difficult to measure, depends on the motivation and behavior of investing company and on the willingness and capability of foreign affiliate to take advantage of investment opportunities in their own country (Root, 1984).
On the other hand, the effect of the balance of payment on economic growth is becoming doubtful. In the past 10 years, as the biggest adverse balance of payments country in the world, American economy grew strongly. While Japan, the biggest balance of payments surplus country, fell into continuing economic recession.
6.2 Employment
Organized labor and other critics in home countries argue that FDI outflow exports jobs by production from foreign affiliate and transferring technology abroad. They also argue that outsourcing production lead to wages decline in the home country. Their arguments may be true. However, in fact, there are various possibilities exist in the effects of FDI outflow on employment. As Hood and Young (1979) argues, first, production displacement effect may result in employment losses to the extent that MNEs service foreign markets by production abroad rather than exports from the parent company. Second, export stimulus effect lead to positive contribution to domestic employment arising from foreign affiliates' demands for home country exports of capital equipment, intermediate goods, complementary products, etc. Third, home office and supporting firm effects may give rise to further stimuli to non-production employment in the home country by the centralization of management functions at the parent company. Furthermore, the operation of foreign affiliates may result in increased demands in the home country for legal and public relation services, management and engineering consultants, etc. Thus, the net employment effect is difficult to measure. However, empirical research indicates that restrictions on FDI outflow would not increase employment and indeed might decrease it, contradicting the view of labor that FDI exports jobs. In an investigation of nine industries, Stobaugh estimated the net employment effect of U.S. FDI to be positive in six industries and zero in other three industries (Root, 1984).
6.3 Tax
On one hand, home government can raise domestic income and welfare by establishing an optimum tax of FDI earnings. On the other hand, as Root (1984) pointed out, some or all of the income of a MNE might fall between tax jurisdictions and thereby result in tax avoidance. Moreover, "the fact that host countries frequently offer tax holidays and other fiscal incentives is seen as a further means of escaping domestic taxes" (Hood and Young, 1979: 295).
6.4 Secure key raw materials
At the point of the significance of securing key raw materials, i.e. petroleum, governments and MNEs hold identical views. For example, the control of petroleum guaranteed security of supply and preference for American customers in times of shortage (Krasner, 1978). This control also was exercised to moderate price increases during critical period such as the Korean and Vietnam wars.
6.5 Market position
FDI is considered a major instrument through which the home country could maintain or increase its relative position in world market (Gilpin, 1987). For example, FDI outflow is regarded as a means to maintain America's dominant world economic position in other expanding economies, such as those of West Europe and Japan. Meanwhile, home countries want R&D, finance, and managerial control to remain in home economy. On the other hand, it is argued that the transfer of highly advanced technology may erode the home country's competitive advantage and meanwhile improve the host country's competency.
6.6 Tool of diplomacy
Gilpin (1987) stated that home governments might use FDI to induce or coerce other governments to do their bidding. There are many instances of attempting by the U.S. and other governments to enlist MNEs in the conduct of foreign policy. For example, President Regan attempted to use denial of American technology to the Soviet Union as a tool of political and economic warfare in the case of Soviet-Western Europe gas pipeline agreement (Gilpin, 1987).
6.7 National security
Similar to host countries, home countries especially the U.S., prohibit FDI for national security reasons. Though America is the biggest weapon exporter in the world, outward FDI of military industry is banned.
7. Conclusion
As a means of fulfilling companies' global objectives, mostly MNEs', FDI has two special features. The first one is the power of control in a foreign enterprise. The second one is the transference of a bundle of capital, technology, and managerial skills across national boundaries. In terms of the two features, FDI may influence the fulfillment of governments' economic and social objectives, which involve economic development, social fairness, sovereignty, and political and cultural identity.
On one hand, host countries view FDI as catalyst of economic growth, as provider of capital, technology, and managerial skills, as creator of jobs and wealth, as supplier of foreign currency, and as stimulators of entrepreneurship. Meanwhile, these countries recognize the negative impacts brought with these benefits, such as development and technology dependence, decreases in competitiveness of domestic markets, etc. On the other hand, host countries concern FDI with loss of sovereignty, damage of national security, and deterioration of basic social and cultural values.
For home countries, on one hand, they see FDI as a challenge to employment and the balance of payment. On the other hand, they use FDI as an instrument of securing key raw materials, of maintaining market position, and as a tool of diplomacy.
Generally, governments enact policies towards FDI to maximize its benefits and simultaneously minimize its costs, so that increase the net benefits attained.
FDI essentially serves MNEs' global strategies; FDI flows are determined by the MNEs themselves after all. What the MNEs concern is whether there is an 'appropriate' environment, where the MNE can make use of its competitive advantages. For governments, this means that they should not only consider their own interests, but also the MNE's. By doing this, both sides may benefit from FDI. Otherwise, costs may rise.
8. Bibliography
John H. Dunning (1993) Multinational enterprises and the global economy Wokingham: Addison-Wesley
Franklin R. Root (1984) International trade and investment 5th Ed Cincinnati: South-Western
OECD (2002) Foreign direct investment for development: maximizing benefits, minimizing costs Paris: OECD
Jack N. Behrman (1970) National interests and the multinational enterprise: tension among the North Atlantic Countries Englewood Cliffs: Prentice-Hall
Robert Gilpin (1987) The Political Economy of International Relations Princeton: Princeton University Press
Neil Hood & Stephen Young (1979) The economics of Multinational Enterprise London: Longman
Monir H. Tayeb (2000) International Business: Theories, Policies and Practices Essex: Prentice Hall
John H. Dunning (1972) International investment: selected readings Harmondsworth: Penguin
http://english.peopledaily.com.cn (16th April, 2003)
