Making
Foreign Direct Investment
An Effective Tool for
Sustainable Development
Submitted to
Prof. Ahmad Kamal
for
“Globalization and Its Impact on the States”
Michiru Sugi
April 28, 2003
Table of Contents
Introduction………………………………………………………… Page 1
Figure 1 Private capital flows of developing countries
About the Foreign Direct Investment………………………….…… Page 1
Figure 2 World FDI Inflows and Outflows
Positive Aspects of FDI…………………………………….……… Page 4
Stimulation of National Economy
Stability Relative to Money Market
Tool for Social Development
Figure 3: GDP Growth and Poverty Reduction
Realities of FDI………………………………………………..…… Page 8
Rapid Increase yet Uneven Distribution
Adverse Impact on Social Development
Negative Effect on Environment
Figure 4: Regional FDI Inflows
What Should Be Done? …………………………………………… Page 11
Socially Responsible Investment
Environmental Protection
Conclusion………………………………………………………… Page 13
I. Introduction
Foreign direct investment (FDI) has been seen as a source of economic development, modernization, income growth and employment. It is widely believed that FDI brings into the recipient economy invaluable resources such as technology, management know-how, skilled labor, access to major markets and established brand names. These assets can play an important role in the modernization of the national economy and in the acceleration of economic growth. Thus FDI has been embraced by governments and regarded as playing a key role in the economic growth and development process.[1]
As the total Overseas Development Assistance (ODA) has declined significantly over the last decade[2] and most Heavily Indebted Countries and low income countries rely heavily on bilateral and multilateral aid, FDI’s importance in development financing is increasingly realized. Thus it is critical that the impact of FDI, both positive and negative, be examined at this time, and, any improvements be made. This paper intends to examine the current practices of FDI and make recommendations for improvements so that the contribution that FDI makes to development can be fully maximized.
II. about the Foreign Direct Investment
The importance of FDI for development has dramatically increased in recent years. FDI is now considered to be an instrument through which economies are being integrated at the level of production into the globalizing world economy by bringing a package of assets, including capital, technology, managerial capacities and skills, and access to foreign markets. [3]
As the ODA total declined significantly over the past decade and most low income countries remain dependent of such bilateral and multilateral aid, the foreign direct investment has become the largest source of foreign private capital reaching developing countries (Figure 1).[4]
Figure 1. Private capital flows of developing countries[5]
What does FDI entail? The Briefing Paper of the Earth Summit 2002 describes foreign direct investment (FDI) as follows:
“Foreign direct investment is a long term investment of a ‘parent’ enterprise from ‘home’ economy into a subsidiary, affiliate, or branch enterprise in a foreign ‘host’ economy. FDI flows include assets, property (e.g. parent company technology, branding, skills) and/or capital investment (greater than 10% of total share in a company), reinvested earnings (retained profits in an affiliate, or infra company loan/debt transaction (long term borrowing/lending) between firm and affiliate enterprises…”
FDI has increased quite rapidly over the last decade. Total inflows rose by nearly four times, from US$174 billion in 1992 to US$644 billion in 1998[6] (Figure 2). The number of transnational parent firms in 15 developed home countries increased from about 7,000 at the end of the 1960s to some 40,000 at the end of the 1990s, and the gross product associated with international production by transnational corporations is now about 10% of global gross domestic product (GDP), up from about 5% in 1982.[7]
Figure 2. World FDI inflows and outflows: value and annual growth rates,
1985-1998[8]
As the global FDI flows increased phenomenally, the FDI has become an important and largest source of foreign private capital reaching developing countries. Net FDI flows to developing countries had grown steadily through the 1990s to reach $126 billion in 1999, up from about $20 billion in 1990.[9]
The United Nations views foreign direct investment as “vital complements to national and international development efforts.”[10] In its Report of the International Conference on Financing for Development, the UN also states, “Foreign direct investment contributes toward financing sustained economic growth over the long term.”[11]
III. Positive aspects of FDI
As the Organization for Economic Co-operation and Development (OECD) states in its report, FDI can “[trigger] technology spillovers, [assist] human capital formation, [contribute] to international trade integration, [help] create a more competitive business environment and [enhance] enterprise development.”[12] The following segments describe in details the positive aspects of FDI:
1. Stimulation of National Economy
FDI is thought to bring certain benefits to national economies, and many developing countries consider FDI as an important channel for obtaining access to resources for development.[13] In the World Investment Report of 1999, UNCTAD states that FDI can bring a bundle of assets that can contribute to the development of host nations such as: (1) capital, (2) technology, (3) market access, skills and management techniques, and (4) environment.[14] UNCTAD explains those assets and benefits as follows:
a. Capital: FDI brings in investible financial resources to host countries. FDI inflows are more stable and easier to service than commercial debt or portfolio investment. In distinction to other sources of capital, foreign companies[15] typically invest in long-term projects.
b. Technology: Foreign companies can bring modern technologies, some of them not available in the absence of FDI, and they can raise the efficiency with which existing technologies are used. They can adapt technologies to local conditions, drawing upon their experience in other developing countries. They may, in some cases, set up local research and development (R&D) facilities. They can upgrade technologies as innovations emerge and consumption patterns change. They can stimulate technical efficiency and technical change in local firms, suppliers, clients and competitors, by providing assistance, by acting as role models and by intensifying competition.
c. Market access: Foreign investments can provide access to export markets, both for goods that are already produced in host countries, helping them switch from domestic to international markets; and for new activities that exploit a host economy’s comparative advantages. The growth of exports itself offers benefits in terms of technological learning, realization of scale economies, competitive stimulus and market intelligence.
d. Skills and management techniques: Foreign investments employ and have world-wide access to individuals with advanced skills and knowledge and can transfer such skills and knowledge to their foreign affiliates by bringing in experts and by setting up state-of-the-art training facilities. Improved and adaptable skills and new organizational practices and management techniques can yield competitive benefits for firms as well as help sustain employment as economic and technological conditions change.
e. Environment: Foreign companies are in the lead in developing clean technologies and modern environmental management systems. They can use them in countries in which they operate. Spillovers of technologies and management methods can potentially enhance environmental management in local firms within the industries that host foreign affiliates.
2. Stability Relative to Money Market
FDI is considered a more favorable and stable form of investment than other private sources, such as portfolio investments or loans, because it is typically for a long-term and can be less affected by change in national exchange rates. For example, the risks of global financial markets became evident at the wake of the financial turmoil in East Asia in 1997-99. In the 1990s, net capital flows to Indonesia, the Republic of Korea, Malaysia, the Philippines and Thailand rocketed, reaching $93 billion in 1996.[16] As turmoil hit market after market, these flows reversed overnight – with an outflow of $12 billion in 1997.[17] In contrast, in 1998, despite the difficult economic situations in Asia and other parts of the world, the FDI inflows “increased by 39% globally” marking the highest rate since 1987.[18] Moreover, while FDI flows to developing countries have grown steadily, portfolio investment flows and bank flows have shown volatility. According to the Commission on Sustainable Development of the United Nations Economic Social Council, net portfolio investment in developing countries “reached a peak of $90 billion in 1994 and then fell to almost nothing in 1998 before recovering somewhat in 1999.”[19] Other private flows to developing countries, such as bank lending, have fluctuated from net inflows of about $70 billion in 1991, to net outflows of $36 billion in 1994, inflows of $80 billion in 1995 and outflows of $77 billion in 1999.[20] However it must be noted that, if international flows of trade and investment fall globally and for a long period of time, stability is less certain. For example, FDI growth continued in some Asian countries, such as Korea and Thailand, during the 1996-97 financial crisis, it fell in Indonesia. This example suggests that investment sensitivity varies from country to country.
3. Tool for Social development
The Human Development Report of 1999 states that foreign investments, along with increased trade, new technologies, can “[fuel] economic growth and human advance.” It adds, “All this offers enormous potential to eradiate poverty in the 21st century.”[21] Although these is no clear evidence to statistically prove the correlation between the growth of GDP per capita and poverty reduction, the World Bank asserts that, for every percentage point increase in overall per capita growth, poor people’s incomes increase at the same rate (Figure 3).[22]
Figure 3. GDP Growth and Poverty Reduction.
Even though FDI flows are small in many of the least developed countries compared with those to other counties, they are very important in relation to domestic investment. For some developing countries, particularly middle-income countries, private financial flows are the largest source of external finance for sustainable development.[23]
IV. Realities of fdi
Although FDI can make the positive impact as described in the previous section, there are also some realities that are preventing FDI to be an effective tool for sustainable development. Some challenges of FDI are explained as follows:
1. Rapid Increase yet Uneven Distribution
Despite the rapid increase in FDI and its importance to the developing countries, the global flows of FDI are concentrated in certain regions of the world. The vast proportion of FDI flows go to developed countries, especially the “Triad” of USA, UK, and Japan.[24] In 1998, 92% of total FDI outflows came from developed countries and 72% of the total inflows returned to these economies. (Table 1)[25] Regionally, prospects look least good for Africa. Of the proportion that went to low-middle income countries, the highest percentage went to Asia and Latin America (42% and 38% respectively), 14% to Central Europe & East Asia, while only 6% was invested in Africa (Figure 4)[26] Over half of the FDI that does reach developing countries is concentrated in 5 countries.[27]
Figure 4. Regional FDI Inflows
In addition, FDI, where it generates and expands businesses, can theoretically help stimulate employment and raise wages. However, the benefits may only be felt by small portion of the population. For example in China, which is a prominent recipient of FDI, disparities are widening between the export-oriented regions and the interior. According to the Human Development Report issued by UNDP, the human poverty index is just under 20% in the export-oriented regions whereas it is more than 50% in the inland province.
Table 1. OECD FDI Outflows by Region
2. Adverse impact on social development
Despite the positive impact that FDI can possibly bring to the host nations, there are also some adverse impacts of a foreign business presence in developing countries. As the multinational corporations seek a market in pursuit of profit maximization, they may exploit local resources, such as child labor. The International Labour Organization (ILO), a UN specialized agency which seeks the promotion of social justice and internationally recognized human and labor rights, reports that there were 211 million children ages 5 to 14 at work in economic activity in the world as of 2000, and about 73 million working children are less than 10 years old.[28] Many of these children laborers are utilized by multinational corporations. Despite the multilateral efforts to eliminate the use of child labor, the disturbing practice continues. According to the soccer ball industry research, conducted in late 1997, up to 20% of the balls brought to the U.S. continued to be stitched by children under the age of 14.[29] These children, instead of going to school to receive basic education, work at factories for an extremely low wage.
With regard to the relationship between FDI and human capital enhancement, OECD states:
“Investment in general education and other generic human capital is of the utmost importance in creating an enabling environment for FDI. Achieving a certain minimum level of educational attainment is paramount to a country’s ability both to attract FDI and to maximize the human capital spillovers from foreign enterprise presence.”
Thus it is imperative that an attention is paid to human capital development in developing countries so that they are able to enjoy the full benefit from a foreign presence in their markets.[30]
3. Negative effects on environment
Globalized economy, fueled by practices such as FDI, places negative effects on environment. According to WWF, some developing countries, particularly the low income nations, are “forced to maintain a more intensive and damaging use of their natural resource base” in order to “maintain current levels of foreign currency”.[31] In addition, some host nations of FDI deliberately keep their environmental standards low to attract foreign investors because lower standards can reduce the short term operative costs for businesses in that country.[32] OECD provides examples of such a case in its report presented at the OECD Global Forum on International Investment Conference. In Zambia, foreign investors have been exempted from environmental liabilities resulting from activity in the past and received permission of delayed compliance with environmental standards.[33] In Ghana, foreign investors are placing pressure on the government to allow exploration and mining in its forest reserves.[34] While some low-income countries may artificially lower their environmental standards, others may not simply have the capacity to regulate and absorb rapid and large FDI inflows. At the same time, low income economies may not have the capacity to mitigate environmental damages or take protective measures, which will incur significant costs.
There are some mechanisms to assess the environmental impacts, such as Environmental Management Systems, however, UNCTAD notes that the resources required to effectively adopt these approaches are often lacking in many developing countries.
V. What Should Be Done?
FDI may help stimulate national economies of the host nations. However, in order to make FDI a more effective tool in helping low income countries and possibly eradiate poverty, attentions should be paid not only to its impact on the economic development but also on the social development.
1. Business - Socially Responsible Investment
Multinational corporations, who play in the global marketplace and benefit from the global economy and resource pools, should take responsibility for the social and economic impact of their operations, as well as for the people in the communities in which they operate. It is now widely known that if corporations are socially responsible, that contributes to brand reputation and financial performance.[35] Thus, multinational corporations should take a more proactive measure to help local societies. They should work with local and national government in the host nation to ensure that their governmental regulations, such as labor and environmental standards are in compliance with the global standards. Also, multinational corporations can provide funding to programs that address social issues such as poverty reduction and access to basic education. By becoming socially responsible, multinational corporations can effectively market themselves as good corporate citizens, thus building a positive reputation. Furthermore, if the host nations develop economically and socially, they will ultimately turn out to be a valuable resource pool, as well as a potential market.
2. Government
Several studies show that the effects of FDI on development often depend on the initial conditions prevailing in the recipient countries, on the investment strategies corporations and on host government policies.[36] Thus appropriate government policies can greatly enhance the contribution that FDI makes to development, and the government of nations, who wish to attract FDI, should implement such policies. For example, host governments can encourage better investment strategies with incentives, such as business awards and regulatory mechanisms. Although privatization and deregulation of markets are misleadingly believed as critical means to attract FDI, such policies can “leave the poorest or most indebted countries open to destabilizing market speculation.”[37] Since foreign companies view stability of host nations as one of the critical criteria upon seeking investment sites, legislation of host nations should support matters such as better investment security for local markets, fair competition, and corporate responsibility. There is a concern that an increased regulation of corporate, labor and environmental standards discourage new foreign investments, however, according to ECOSOC, there is evidence that the tighter regulation has not affected FDI flows in East Europe.[38] In order for a nation to maximize the benefit, government action should focus on fostering, channeling and complementing FDI.
3. International Institutions/UN
In order to fill the void of the efforts made by businesses and governments, the international institutions (the United Nations System) should promote and facilitate cooperation among the key players of FDI and investigate how international flows of FDI can be better directed toward the specific goals of sustainable development.
As noted in a previous section, some developing countries may not have sufficient resources to assess the environmental impact of FDI, thus, the international institutions should assess and monitor FDI and its impact, particularly within developing countries, where such assistance is greatly needed. It should also monitor and ensure codes of conduct so that finance, trade and investment strategies are mutually reinforcing toward sustainable development.
In its efforts to facilitate the cooperation among the FDI players, UN should further promote the Global Compact[39]. The Compact is an innovative initiative to bring business, government, civil society and international institutions together and to place a greater accountability on companies for their actions. However, the most current member corporations are from developing countries, thus more efforts should be made in encouraging the corporations from developed countries, the major contributors of FDI, to join the Compact to make it more effective.
VI. Conclusion
Globalization is often viewed as simply doing business on a global scale. However, it requires corporations to take a step further as a corporate citizen in the global society. Multinational corporations, as they benefit from the global economy and resource pools, should be responsible for the social and economic impact of their operations, as well as for the people in the community in which they operate. At the same time, the international institutions and governments of FDI host nations should carefully examine the current FDI practices and its various impacts so that the positive influence it can bring is fully maximized.
Reference
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