By Drishti Rai.
Economic growth aids in reducing poverty and unemployment, improving living standards and budget deficits. Whether FDI stimulates growth in developing countries or not is therefore important as government policy prescriptions can be made accordingly. This question, however, has been often contested. In this paper, we examine the FDI-growth relationship in three main regions: Sub-Saharan Africa, Latin America and developing Asia. We use empirical data from previous literature, but we add to the field by considering recent trends and contextual data. Upon examination, we find that FDI as a tool for stimulating economic growth in Latin America and Sub-Saharan Africa is often overstated. There are currently limitations that prohibit the full potential of benefits from FDI. However, in developing Asia, FDI is indeed an effective tool for stimulating economic growth. The implications of these finding are that future research look more deeply into the causes of such regional disparities and make policy recommendations for governments in these regions such that they can maximise on FDI benefits.
Recent trends in FDI
Although global FDI inflows fell by 16% overall from $1.47 trillion in 2013 to $1.23 trillion in 2014, FDI flows to developing economies increased by 2% to reach their highest level at $681 billion in 2014, accounting for 55% of global FDI inflows. In particular, Asian countries were subject to these FDI inflows, with levels increasing by 9% to $465 billion. Africa’s overall inflows remained flat at $54 billion, while those to Latin America and the Caribbean saw a 14% decline to $159 billion, a point I will later explore in more detail. Inflows to developed economies fell by 28% to $499 billion, decreasing in both Europe and North America. Outward FDI from developed countries however, increased by 23% in 2014, to $468 billion. In 2015, global flows of FDI rose by 38% to $1.76 trillion, the highest level since the 2008 financial crisis.
Regional Investment Trends
- FDI flows to Africa fell to $54 billion in 2015, a decrease of 7% over the previous year. An upturn into North Africa was more than offset by decreasing flows into Sub-Saharan Africa, especially to West and Central Africa. Low commodity prices depressed FDI inflows in natural-resource-based economies.
- FDI flows to Latin America and the Caribbean – excluding offshore financial centres – remained flat in 2015 at $168 billion. Slowing domestic demand and worsening terms of trade caused by falling commodity prices hampered FDI mainly in South America. In contrast, flows to Central America made gains in 2015 due to FDI in manufacturing.
- Develeping Asia saw FDI inflows increase by 16% to $541 billion, a new record. The significant growth was driven by the strong performance of East and South Asian economies.
A Regional Assessment
It is extremely difficult to conclude whether FDI leads to growth or not in general. In order to make this question more comprehensible and structured, we shall examine FDI and its effects on developing countries from different regions worldwide, namely: Sub-Saharan Africa, Asia and Latin America.
According to the African Development Bank, the continent holds 30% of the world’s known minerals and half of its uncultivated but arable land. Such investment opportunities explain why FDI projects in Sub-Saharan Africa have rapidly increased in recent decades: over 750 projects have been undertaken, creating over 100,000 jobs. Economic theory predicts that such a surge in investment must surely lead to an improvement in the region’s economic growth and development due to several reasons. Let us consider the benefits and drawbacks in reality.
One can make the case that high levels of FDI lead to improvements in infrastructure in Sub-Saharan Africa. As goods must be taken through neighbouring countries, whose quality of infrastructure they have no control over, landlocked countries tend to face higher transportation costs. Uganda, for instance, fails to access global markets due to such high transport costs. As a result, the railway construction in East Africa proves to be highly significant. Mombasa, Nairobi, Uganda, South Sudan and Rwanda will become connected, reducing transport costs in these interdependent nations, increasing growth and development potentials across the region.
However, most infrastructure improvements are not primarily aimed at improving development. After all, MNEs primary aim is profit maximisation through minimising the costs of factor inputs, and although there may arise positive externalities (that improve the overall economy) as a by-product, the benefits derived from FDI will not be as great as would be the case were the main goal to aid overall African development.
Another benefit of FDI in Sub-Saharan Africa is that FDI projects can increase the region’s productive capacities and potentials, whilst increasing their level of labour productivity. For instance, German firms have invested 400 billion Euros in ‘Desertec’, which aims to harvest solar energy for Europe, and Tanzania has been the recipient of a $1.7 billion investment from China, who is building satellite city. It is due to these supply-side improvements that, in theory, the international competitiveness of exporting firms improve, boosting the value of exports. Thus, in the long-run, it serves to improve the current account balance of payments.
In terms of evaluation, however, there has been a lack of improvement to the human development index (HDI) in Sub-Saharan African economies. Although FDI has increased over time (as a percentage of GDP), many countries in Sub-Saharan Africa, including the Democratic Republic of Congo, Liberia, Niger, and Chad, still suffer from poor health (infant mortality rates) and poor infrastructure (measured by the number of internet users per 100). The goal of these projects, who garner so much FDI attention, is to maximise profits. Although the continent has an abundance of potential in the energy sector, most investments in energy go towards exporting projects. Consequently, only a minority of countries even manage to supply electricity to over half of their populations.
On the other hand, a benefit of FDI is that it increases government revenue, which can be used to enhance development and increase growth through investing in total areas which have not benefited from FDI, thereby reducing inequality. As the level of FDI increases, corporation tax receipts increase as corporate profits increase from successful FDI projects and household incomes for those employed. This should also be advantageous in terms of long-run growth: FDI lowers the need for governments to borrow, so the private sector is able to engage in more projects that would otherwise be the responsibility of the government who may be unable to afford it. This ‘crowing-in effect’ should free up government money, previously allocated to debt servicing, for developing and growth stimulating projects.
Yet there exists a risk of overdependence from governments and firms on FDI as the predominant means of financing. Capital is becoming ever-more mobile over time, and with the existence of footloose capital, coupled with high dependency on FDI, economies become less diverse and more susceptible to any changes. For example, if capital flight occurs, then this can lead to an economic catastrophe. This is made worse by the fact that although capital mobility is high, labour mobility in Sub-Saharan Africa is particularly low, which means that this can lead to detrimental hysteresis effects, should investment wane in the long-run.
In terms of advantages, FDI can cause human capital spill-overs, a supply-side advantage. For example, IBM’s research centre in Nairobi aims to strengthen local enterprise and innovation, developing ‘cognitive computing technologies that can be applied to address issues in public health, education and agriculture.’ With a similar sentiment, Tullow Oil trains engineers and employs local citizens, improving the level of welfare in the area.
Furthermore, numerous American universities are being established in multiple African countries, focusing on a variety of issues, including water resources management, natural resources, and energy-solar power. Such investment in human capital leads to improved skills in the labour force, improving productive capabilities, adding value to exports. For example, Nigeria has been able to shift away from primary products dependency as a result of human capital spill-overs from FDI. Knowledge transfer has facilitated rapidly emerging industries such as Telecommunications and Pharmaceuticals. There has also been a surge in consumer expenditure, rising from $860 billion in 2008 to $1.4 trillion in 2020 (McKinsey Global Institute). Hence, people are being alleviated from poverty. The World Bank states that 13% of the population in Africa fall under the stable middle class, but by 2060, this has been forecasted to reach 42% of the predicted population. This embodies the long-run growth and development as a result of, or aided by, FDI and improved human capital.
However, by implementing government policies in order to attract FDI, particularly through low wages and deregulation, this may harm development and erode human capital. For example, a UN paper explains that ‘those working in export processing zones (set up to encourage FDI)… suffer poor working conditions and health risks, as well as low pay.’ This damages human capital as working environments discourage workers from being productive, leading to lower labour productivity that hinders economic growth.
In addition to this, it is also the case that FDI in these rapidly growing businesses has not led to a proportionate amount of job creation. In the technology, media, and communications sectors, for example, despite being the largest recipients of FDI (20% of all African FDI), this has resulted in only 7.5% of the overall jobs created. Similarly, financial services (15% of FDI) have only created 2.7% of the new jobs. This may be due to the use of migrant workers: for example, China provides 90% of the finance required to build a new railway line in East Africa, but this investment was tied to the sole use of Chinese workers, limiting the benefits of FDI to the domestic economy.
In terms of empirical studies and their findings, Kamara (2013) found that infrastructure and human capital actually have negative effects on the FDI-growth relationship. Although these could be due to overlooked variables in the implemented model in the study, another explanation for the negative effects of human capital include the fact that most of the FDI in Sub-Saharan Africa go to highly capital intensive areas that hire less domestic labour.
However, Kamara (2013) does find that financial development and domestic institutions have a positive impact on the FDI-growth relationship in Sub-Saharan Africa, falling in line with the likes of Borenzstein, Alfaro, Durham, Hermes and Lensik. However, Kamara’s findings contrast with Borensztein, for example, who finds that human capital plays a role in boosting the growth effects of FDI in developing countries. The study explores the channels through which FDI promotes growth in Sub-Saharan Africa, identifying four important host country factors before examining each: human capital, institutions, infrastructure and financial development, all of which, in theory and in a lot of previous literature, have been shown to have a direct positive effect on growth.
Another study by Juma (2012) examines the data from 43 countries between 1980 and 2009, concluding that increased FDI inflows are generally associated with higher growth in Sub-Saharan African countries: they show that a percentage point increase in FDI as a share of GDP is associated with a subsequent increase in annual GDP growth of between 0.30 and 0.71 percentage points.
2. Latin America
Following the economic and political instabilities of the 1980s as well as the deregulation of the 1990s, Latin America has come a long way. However, FDI inflows into Latin America and the Caribbean have stagnated. For the fourth year running, the region recorded negligible increases in FDI inflows in 2015. This is problematic, in particular, for South American economies that specialise in primary goods, especially oil and minerals. This productive specialisation, alongside the collapse in world commodity prices, has had a substantially negative impact on FDI. As a result, inflows of foreign direction investment (FDI) into Latin America and the Caribbean declined by 9.1% between 2014 and 2015, dropping to US$ 179.1 billion, the lowest level since 2010. This performance reflected the drop in investment in natural resource sectors, especially mining and hydrocarbons, and the slowing of economic growth, particularly in Brazil.
According to the Foreign Direct Investment in Latin America and the Caribbean report of 2016, due to the fall in mineral prices, FDI into Chile and Colombia fell by 8%, reaching $20.5 billion and 26% to $12.1 billion, respectively. In Brazil, FDI decreased by 23% to $75 billion, although it continued to be the top recipient in the region. Corruption scandals, political instability and lower demand for commodities are the factors plaguing the Brazilian economy. Meanwhile, FDI in the Caribbean declined 17% to $5.9 billion.
This highlights one of the drawbacks of FDI in the Latin American region: according to the economic complexity index (ECI), taking into account income per capita in the region, Latin American nations are one of the least diversified in the world – this is particularly the case with Chile. Palma (2015) found that since 2002, when commodity prices began to increase, US$1 trillion had left the region by 2015, in the form of profit repatriation by MNEs. With Chile specifically, between 2002 and 2014, profit repatriation by FDI was six times higher than that of the 33-year period that preceded (1980-2002).
The amount of FDI withdrawn from Chile as profit repatriation between 2002 and 2014 was ‘larger than the stock of the entire retirement account savings of all Chilean workers (about 10 million people) … -about $190 billion vs $160 billion, respectively.’ In response to overdependence, the UN agency has urged regional countries to reverse this trend by diversifying their economies and boosting innovation, warning that FDI could decline as much as 8% this year.
On the other hand, following the plummeting prices of natural resources, the importance of the services sector is rising. In Brazil, Colombia and Mexico, FDI in services now accounts for 49% of total FDI, and in Central America, this figure reaches 65%. Among the services of greatest interest to foreign investors in the most recent period were telecommunications and renewable energy. There are three specific aspects of services that merit particular attention. First, the renewable energy sector is growing strongly and gaining importance in the region. Second, the telecommunications sector is one in which foreign firms are dominant and investment needs are great. For example, reaching almost $30.3 billion, on the other hand, FDI in Mexico increased by 18% in 2015 – one of the highest levels reached in seven years. This was mainly due to the telecommunications and manufacturing sectors, particularly automotive. Finally, the retail trade sub-sector is interesting for its high growth rate and the significant participation of trans-Latin firms.
However, although this seems positive in outcome, growth is still stagnant overall, and Lund’s (2010) empirical research finds that FDI in the manufacturing sector leads to economic growth, whereas service sector FDI has no causal relationship with growth. Perhaps it may be the case that FDI into services provides less advanced technology, access to export markets or linkages to local enterprises in the same way that FDI in manufacturing does. After all, several services are more monopolistic in nature than the manufacturing sector, making them more prone to any exploitation of market power held by MNEs which could depress aggregate demand through higher prices in the domestic economy. WIR (2004) has also found that FDI in the financial services sector can increase foreign exchange volatility, possibly leading to contagion effects from other countries’ markets. As such, Palma (2015) finds that businesses in emerging markets from the developing world are far more susceptible to vicissitudes in international finance than their counterparts in the western world.
In terms of empirical studies that have been conducted, Lund (2010) used data from 1980 to 2003 for Argentina, Brazil, Chile, Colombia and Mexico, finding out that actually, only two countries showed FDI to GDP causality (in the short run, Brazil, and in the short and long-run, Mexico). In fact, he found that increased GDP led to increased FDI in Colombia, Chile and Mexico. Additionally, the study by Porzecanski and Gallgher (2007) showed that only a few nations in the region were recipients of FDI, but even amongst those who were, the expected benefits towards development and growth did not materialise.
Moreover, focusing on 18 Latin American countries, Bengoa and Sanchez-Robles (2003) attempted to discover the relationship amongst economic freedom, FDI and economic growth utilising panel data between the years of 1970 and 1999. They explored that FDI is positively correlated with economic growth in the recipient countries. Nevertheless, the hosting country needs sufficient human capital, economic stability and market liberalization to benefit from long-term capital flows (Bengoa and Sanchez-Robles, 2003).
Rjoub et al (2016) investigate the FDI-growth relationship in seven Latin American countries (Brazil, Nicaragua, Mexico, Colombia, Chile, Peru and Argentina) with fixed effect panel estimation. The results indicate that FDI does have a lagged positive impact on economic growth. This is furthered by trade openness through fewer barriers to trade. This encourages production in host nations, promoting specialisation amongst regions. However, the study found a negative impact of human capital on economic growth, contrasting, amongst others in the literature review, Bengoa and Sanchez-Robles, who state human capital as a necessity for taking advantage of FDI. Kottaridi and Stengos, (2010) suggest that human capital and its absorptive capacities for new technologies and skills is not necessarily paramount for economic growth since the two variables seem to have a non-linear relationship that linear regression models are unsuitable for.
Before the late 1980s, developing Asia lacked the capital needed to fulfil the investment requirements needed to sustain growth. The limited development of domestic financial and capital markets also meant that long-term capital could not be supplied to domestic firms. As a result, Asian governments actively promoted inward FDI. However, since the 60% appreciation of the Japanese yen after the Plaza Accord in 1985, developing Asia has been rapidly growing.
The Plaza Accord was arguably the most important contributor to the rise of Japanese FDI in the late 1980s for several reasons. First of all, the appreciation of the Yen made labour more expensive in Japan, reducing exports. Japanese firms started transferring many operations, therefore, to other Asian economies with lower production costs. Secondly, the yen’s appreciation meant that Japanese firms became wealthier in terms of increased collateral and liquidity, and were hence able to finance their investment more cheaply relative to their foreign competitors (Urata and Kawai, 2000).
Despite the economic stagnation of the 1997 financial crisis, the rise in Japanese FDI brought about several benefits to Asian economies. Agarwal (2000) showed that FDI inflows in South Asia led to greater domestic investment and faster economic growth, particularly during the late 1980s and early 1990s.The IMF (2012) found that for every 1% increase in Japanese FDI to an emerging Asian economy between the periods 1985-2011, growth in the country increased by 058-0.69%. According to the IMF, this is much more than the increase in growth caused by FDI from other countries. One reason for this, as Kojima (1973) noted, is the technology transfer and learning in developing Asia. Lim and Kimura (2010) discussed how, once economies in Asia host a critical mass of FDI, this in turn leads to technology spill-overs. To echo this, Lee and Shin (2012) presented regression evidence indicating that FDI led to substantial technology spill-overs, concluding that FDI inflows lead to large welfare gains in countries like China, Indonesia, Malaysia, the Philippines, and Thailand.
A key factor that enables Asian economies to sustain high growth rates is foreign demand for manufactured goods. The type of FDI (the ‘traditional Japanese type’ as states by Huang, 2012) mentioned above was designed to take advantage of lower production costs, before the final goods were exported to developed countries in Europe and North America. In accordance with this, Asian economic growth has often been export-led. The low production costs in developing Asia mean that they possess a comparative advantage in labour, attracting multinational corporations from developed countries. Although FDI initially focused on labour-intensive industries such as textiles and food processing, over time, high value added industries have benefited from FDI, for example, the electronic components and automobiles industries.
Bosworth, Collins, and Virmani (2006) found that augmenting FDI in India will likely stimulate the country’s economic growth. Bergman (2006) demonstrated that FDI in the pharmaceutical industry in India rendered positive spill-over effects, such as greater competition and improved industrial management skills in that industry.
Across South Asia, India’s dominance in FDI in South Asia is in large part due to the size of its economy, the largest in the region. However, India’s policy reforms geared toward liberalization also played an important part in India’s dominance of FDI. After its independence in 1947, India adopted a socialist planned economy. Inefficiency was a problem in all sectors, making it a high-cost economy. Regulations on imports and FDI were strict, and the domestic market was virtually closed. In the late l980s, however, the Government gradually liberalized the economy and lifted restrictions on FDI. Consequently, India achieved high economic growth in 1988 and 1989. In July 1991, the New Industrial Policy was announced. Under this policy, foreign investment was approved without conditions, formalities for granting import licenses were simplified, and private companies were permitted to enter fields that previously had been dominated by government-owned companies. India changed itself from a closed economy to an open economy. Movement toward liberalization in terms of FDI promotion is now common to all countries in South Asia. In 2015, total FDI inflows to South Asia increased by about 22 per cent to $50 billion – surpassing FDI into West Asia. India became the fourth largest recipient of FDI in developing Asia and the tenth largest in the world, with inflows reaching $44 billion. New liberalization steps enacted since the inauguration of the new Government have contributed to attracting FDI from all quarters.
In China, FDI has proven to be a successful tool for economic growth, predominantly through three main ways: China has effectively mobilised FDI inflows, China’s export success is largely attributed to FDI, and FDI policies have evolved and strengthened institutional capacity.
According to the Ministry of Commerce (MOFCOM), foreign invested enterprises comprise for more than half of China’s trading, summing 30% of Chinese industrial output, and generating 22% of industrial profits and employing 10% of their labour. There is high productivity in the nation and s a result, it can be concluded that FDI leads to growth.
FDI policies in China have strengthened institutional capacity. China radically liberalised the services sector in its accession to the World Trade Organisation (WTO) and this triggered a shift of FDI towards the service sector. By 2009 FDI in services increased 3 times from than in 2000. Regional production networks in East Asia grew substantially in the early 2000s and as a result, thousands of MNEs have invested into China. The nation’s highly decentralised FDI approval and policy implementation creates opportunities for healthy competition for FDI.
Having looked at the empirical data, FDI appears to be effective in aiding economic growth in developing Asia. However, in recent years, rising wages and production costs, particularly in the coastal region, have put an end to the significant edge that China once held in manufacturing in general and labour-intensive production in particular. Now, in most South Asian countries, including India, the services sector hosts more FDI than any other sector.
Sub-Saharan Africa has seen an increase in investment into human capital, namely through the establishment of American universities, and research and training centres. These supply-side policies should increase productive capacities, yet there has been a lack of improvement to the human development index in this region. However, consumer expenditure has risen and people are being alleviated from poverty. The World Bank states that 13% of the population in Africa fall under the stable middle class, but by 2060, this has been forecasted to reach 42% of the predicted population. This embodies the long-run growth and development aided by FDI.
In conclusion, the extent to which economic growth is stimulated in Sub-Saharan Africa as a result of FDI depends poignantly on the use of the FDI and the government’s economic climate. The IMF states that, in order to reap the full benefits of FDI, African governments must ‘de-risk the situation’ by ‘providing better regulatory frameworks, financial stability and security’. For example, African government could introduce reforms such as formal property rights.
In Latin America, the economic climate poses limitations on the potential positive effects of FDI: according to the economic complexity index (ECI), taking into account income per capita in the region, Latin American nations are one of the least diversified in the world, specialising in primary goods and natural resources. After the global plummeting of these prices, the services sector has gradually grown. However, growth is still stagnant overall, perhaps due to Lund’s theory that in the manufacturing sector, FDI leads to growth, whereas in the service sector, FDI does not. This is potentially explained with the idea that services provide less advanced technology and access to export markets or linkages to local enterprises. FDI is not highly successful in Latin America. Porzecanski and Gallgher (2007) showed that the expected benefits towards development and growth did not materialise.
In response to over-dependence, the UN agency has urged regional countries to reverse this trend by diversifying their economies and boosting innovation, warning that FDI could decline as much as 8% this year.
In Asia, however, FDI has led to significant economic growth. Lee and Shin (2012) presented regression evidence indicating that FDI led to substantial technology spill-overs, concluding that FDI inflows lead to large welfare gains in countries like China, Indonesia, Malaysia, the Philippines, and Thailand.