Reasons for the Increased Foreign Direct Investments

The factors that propel sustained economic development have not changed with  time. They include the generation and efficient allocation of capital and  labor,  application of technology and the creation of skills and institutions. These fact  determine how well each economy uses its endowments and adds to them. They  also affect how flexibly and dynamically each country responds to changing  economic conditions. However, the global context for development has changed  enormous the past decades. These changes affect not only the role of Foreign Direct Investment (FDI) in host countries, but also government policies on FDI. The following three are  of particular significance.

1. The Nature and Pace of Knowledge (Technological Knowledge Change)

The creation and diffusion of productive knowledge have become central to  growth and development. “Knowledge” includes not only technical knowledge  (research and development, design, process engineering), but also knowledge of  organisation, management and inter-firm and international relationships. Much  of this knowledge is tacit. Today, the resources devoted to such knowledge  exceed investment in tangible machinery and equipment in many of the world’s  most dynamic firms, and the costs of generating new knowledge are rising  constantly. The importance of knowledge is not limited to modern or high-tech  activities but pervades all sectors and industries, including traditional activities  in the primary sector (for instance, vegetable and flower exports), manufacturing  (such as textiles, clothing and footwear), and services (such as tourism and  banking). As a result, achieving development objectives is, more than ever, a  continuous learning process.

The sheer pace of technological change, in particular, is unprecedented arid is  accelerating. This means that enterprises that want to be competitive  internationally reed both the knowledge to use technologies efficiently and to  keep pace with developments. Innovators need to invest more in creating new  knowledge, but even followers need the capacity – difficult to acquire – to access  and use this new knowledge, or in fortuitous circumstances, to identify windows  of opportunity for technological caps. The skills required for this are changing  concomitantly, as are institutions and their relations with productive enterprises;  one development is the closer linking of science with technology-generation in  industry. An important result of this new “technological paradigm” is that  research-intensive activities are growing more rapidly than others in production  and trade; thus, sustained economic growth calls increasingly not just for the  application of new technology to existing activities, but also for a shift of  activities up the value-added chain.

The most profound technological changes today emanate from a merger of  communications and information processing technologies. While the telegraph,  telephone and computer were significant technological achievements; they pale  in comparison with emerging technologies based on the interface between  microprocessors arid telecommunications. These are generic technologies that  affect practically the whole range of economic and even social and cultural  activities. Information can now be transmitted across the globe at very low cost.

2. Shrinking Economic Spaces and Changing Competitive Conditions

Technical progress in transport and communications has caused economic space  to shrink dramatically. Countries now face much more intense and immediate  competition than ever before. This leads to a significant restructuring of their  comparative advantages ad activities. The nature of competition itself is  changing, with the rapid introduction of new products, shorter product cycles,  flexibility of response to demand, and customer interaction becoming more  important than traditional forms of competition based on lower costs. At the  enterprise level, this calls for new management and technical skills and  organisational forms. In many instances, it leads to flatter hierarchies and greater  use of networking and cooperation between related firms and also competing  firms (for instance, component suppliers now play a much more direct role in  new technology development). At the national level, it requires countries to be  more open to international flows of information, and to improve national  capabilities to absorb and use that information to develop new skills,  institutions and innovative capacities. Countries that can do that – either  generally or in niche markets – can move up the value-added ladder.

3. Changing Attitudes and Policy Regimes

Most developing and transition countries have moved to market-oriented and  private sector led economies. This shift reflects disillusionment with past  strategies and growing. Difficulties in pursuing them in the new technological  and competitive setting. The shrinking of economic space has itself rendered  elements of traditional strategies absolute while the flow of information has  made governments more aware of policies a performance in other countries.

Policy benchmarking in all areas is becoming more common which, in turn, puts  more pressure on countries to innovate in the policy arena. There is widespread  reduction and removal of trade barriers, deregulation of internal markets,  privatization  and liberalization of technology and investment flows at the  national level. At the international level, regulation has intensified and is being  harmonized. For instance, the TRIPS agreement of the Uruguay Round has  introduced a common more rigorous, system of intellectual property protection;  the TRIMs agreement established disciplines over certain performance  requirements; and quality requirements such as ISO standards are becoming  prerequisites for participating in international production and trade.

Perhaps nowhere is the policy change more striking than in the changing attitude  o governments to TNCs. Why have governments changed their attitudes to  TNCs? There are several reasons for the change in attitudes towards TNCs.  Governments recognize that TNCs can  provide a package of external resources that can contribute to development. There  is also now an increasing number of TNCs from developing countries, reflected  in the fact that the share of developing countries in FDI outflows has increased  from about two per cent at beginning of the 1980s to approximately 15 per  cent of a much higher total in the mid, 1990s; their home governments want  access for their firms to foreign markets and locations. At the same time, many  governments have improved their administrative capabilities and feel more  comfortable in dealing with TNCs. Efficient FDI screening has been difficult  even for countries with sophisticated bureaucracies, given the need to relate it to  changing country and sectoral advantages, changing firm strategies and competition, and political pressures from other countries. On the aggregate level  external financing has shifted from official to private sources, especially towards  FDI. Finally, the  liberalization  of FDI (and trade) policy is often part of the  conditionality in IMF and World Bank adjustment programmes, and is  promoted by many leading aid donors.

Reflecting this change of attitude, FDI is now not just permitted – it is avidly  sought governments and, indeed, many sub-national public sector entities at all  levels, from provinces to individual communities. Apart from active promotion  (which has led to the establishment of investment promotion agencies in a great  number of counties, having their disposal an array of incentives), policy  liberalization  is the principal tool.  Liberalization  has been extended to such  service industries as telecommunication, transportation and power generation  and distribution, previously closed to foreign investors. Many developing  countries and economies in transition have concluded bilateral treaties to protect  FDI and avoid double taxation. A number of regional schemes (notably the  European Union, NAFTA, ASEAN and MERCOSUR) have reduced barriers to  FDI or are in the process of doing so, facilitating intra-regional investment trade  flows. At the multilateral level, the General Agreement on Trade in Services (GATS) has  contributed to the  liberalization  of FDI in services, and the TRIMs Agreement  has contributed to the use of certain performance requirements. The FDI global regime that  has emerged after these changes, though uneven, is much more friendly towards  foreign investors than in the past.

Significance of Foreign Direct Investment on Developing Countries

It has been increasingly recognized that growing foreign direct investment inflows can contribute to economic development and promise a variety of potential benefits to poor country recipients. Due to the potential role foreign direct investment can play in accelerating growth and economic transformation, many developing countries seek such investment to accelerate their development efforts. Consequently, foreign direct investment has become an important source of private external finance for developing countries.

Reasons for the Increased Foreign Direct Investments

The foreign direct investment can increase growth in two ways. The investment increases total investment by attracting higher levels of domestic investment. Also, through interaction of the more advanced technology with the host country’s human capital, foreign direct investment is more productive than domestic investment.

Indeed, the most significant channel through which foreign direct investment contributes to productivity growth is perhaps increased access to technology, through market transactions such as joint ventures, licensing, and goods trade.

While foreign direct investment represents investment in production facilities, its significance for developing countries is much greater. Not only can foreign direct investment add to investible resources and capital formation, but, perhaps more important, it is also a means of transferring production technology, skills, innovative capacity, and organizational and managerial practices between locations, as well as of accessing international marketing networks. In addition, the foreign direct investment can improve overall growth by promoting competition in the domestic input market.

In particular,  the foreign investment  could increase competition in the host-country industry, and hence force local firms to become more productive by adopting more efficient methods or by investing in human and/or physical capital. Multinational firms large size, advanced technology, and advertising expertise often enable them to invest in industries in which barriers to entry, such as large capital requirements coupled with trade restrictions, reduce the access of potential local competitors.

Multinational corporations can promote the transfer of technology, with possible spillovers to the rest of the host economy or domestic firms. Technology spillover is a channel through which capital account liberalization can have a positive impact. These spillovers are most clear in the case of foreign direct investment, especially through foreign firms incorporating new technologies in their subsidiaries. As new technologies are generally developed and adapted by firms in industrial countries, foreign direct investment may be the most efficient way for developing economies to gain access to them. In addition, this knowledge may become more widely available in the country over time, as employees with experience in the techniques used in foreign companies switch to other firms.

Furthermore, foreign direct investment can help boost host country exports. Multinational enterprises may help developing host countries process and export locally produced raw materials, using their marketing skills, superior technology, and general know-how. They facilitate the export of local production through their distribution networks, and they often account for a significant share of host country exports.

External Links:

  • Foreign Direct Investment  in Developing Countries  (IMF)
  • How Beneficial Is Foreign Direct Investment for Developing Countries?  (IMF)

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