Costs and Benefits of Foreign Direct Investment (FDI)

Many governments can be considered pragmatic nationalists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here we explore the benefits and costs of FDI, first from the perspective of a host country and then from a perspective of the home country.

Host Country Effects: Benefits

There are three main benefits of inward FDI for a host country: the resource-transfer effect, the employment effect, and the balance of payments effect.

  1. Resource transfer effects: Foreign direct investment can make a positive contribution to the host country’s economy by supplying capital, technology, and management resources that would otherwise not be available. If such factors are scarce in a country, the FDI may boost that country’s economic growth rate. Many of the MNEs by virtue of their size and financial strength, have access to financial resources not available in the host country firms. These funds may be available from internal company resources, or, because of their reputation, large MNEs may find it easier to borrow money from the capital markets than host country firm would.
  2. Employment Effects: The beneficial employment effect claimed for FDI is that it brings jobs to the host countries that would otherwise not be created there. Direct effects arise when a foreign MNE directly employs host country’s citizen
  3. Balance of Payment: The effect FDI has on a country’s balance of payment accounts is an important policy issue for most host countries. A country’s balance of payment accounts keeps track of both its payment to and its receipt from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. The current account tracks the export and imports of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling assets to foreigners. For instance, the persistent US current account deficit of the 1980s and 1990s was financed by a steady sale of US assets (stocks, bonds, real estate, and the whole corporations) to foreigners. Because national governments dislike seeing the assets of their country fall into foreign hands, they prefer a current account surplus. FDI can help a country achieve this goal in two ways.
    1. FDI is a substitute for imports of goods and services, it improves the current account of the host’s countries/balance of payments. Much of the FDI by Japanese automobile companies in the US and UK, for instance, substitutes fore imports from Japan. Thus, the current account of the US balance of payments has improved somewhat because many Japanese companies are now supplying the US market from production facilities in the US, as opposed deficit in Japan. For insomuch as this has reduced the need to finance a current account deficit by asset sales to foreigners, the US has benefited.
    2. Potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

Host Country Effects: Costs

Three main costs of inward FDI that give rise to concern in host countries are: the possible adverse effects of FDI on competition within the host nation, adverse effects on the balance of payments and the perceived loss of national sovereignty and autonomy.

  1. Adverse effect on competition — Host governments sometimes worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organizations. As such, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous out of business and allow the firm to monopolize the market. Once the market was monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own that can compete with the subsidiaries of foreign MNEs.
  2. Adverse Effect on the Balance of Payment — The possible adverse effects of FDI on a host country’s balance of payment position are twofold.
    1. To offset the initial capital inflow that comes with FDI must be the subsequent outflow of income as the foreign subsidiary repatriates earnings to its parent company. Such outflows show up as a debit on the current account of the balance of payments.
    2. When a foreign subsidiary imports a substantial number of its inputs from abroad, which also results in a debit on the current account of the host’s country’s balance of payments. One of the criticisms leveled against Japanese-owned auto assembly operations in the US, for instance, was that they imported many components parts from Japan, reducing the favorable impact of this FDI on the current account of the US balance of payment position. The Japanese auto companies responded by pledging to purchase 75% of their component parts from US-based manufacturers (but not necessarily US-owned manufacturers).
  3. National Sovereignty and Autonomy– many host countries worry that FDI is accompanied by loss of economic independence. Key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. Over thirty years ago this concern was expressed by several European countries, who feared that FDI by US MNEs was threatening their national sovereignty. The same concerns are now surfacing in the US with regard to European and Japanese FDI.

Home Country Effects: Benefits

There are also costs and benefits to the home (or source) country. Does the US economy benefit or lose from investments by having its firms invest in foreign markets? Some even go a step further to argue that FDI is not in the interest of the home country and therefore should be restricted. Others also argue that the benefits far outweigh the costs and that any restrictions would be contrary to national interests. For us to understand why people take these positions, it becomes imperative for us to look at the benefits and costs of FDI to the home (source) country.

The benefits of FDI to the home country arise from three sources.

  1. The current account of the home country’s balance of payments benefits from the inward flow of foreign earnings. FDI can also improve the current account of the home country’s balance of payments if the foreign subsidiary creates demands for the home country exports of capital equipment; intermediate goods, complementary products, and the like.
  2. Benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home country exports of capital equipment, intermediate goods, complementary products, and so on.
  3. The third point is that benefits arise when the home country MNE learns valuable skills from its exposure to foreign markets that can be transferred back to the home country. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country’s economic growth rate. For instance, one reason General Motors and Ford invested in Japanese automobile companies (GM owns part of Isuzu, and Ford owns part of Mazda) was to learn about those Japanese companies apparent superior management techniques and production processes. If GM and Ford can transfer this know-how back to US operations, the result may be a net gain for US economy.

Home Country Effects: Costs

Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center around the balance of payments and employment effects of outward FDI. The home country’s trade position (its current account) may deteriorate if the purpose of the foreign investment is to serve the home market from low cost production location. For instance, when a US textile company shuts its plants in South Carolina and moves production to Central America, imports into the US rose and trade position deteriorated. The current account of the balance of payments also suffers if the FDI is a substitute for direct exports. Thus, in so far as Toyota’s assembly operations in the US are intended to substitute for direct exports from Japan, the current account position of Japan will deteriorate.

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