How to Enjoy the Benefits of Foreign Direct Investment

Developing countries need to think carefully about the economic environment they provide for the operations of foreign firms. Foreign direct investment (FDI) is no panacea for the problems of development, but if it is provided with a neutral trade regime favouring neither export-oriented nor domestically focused industries, it can be an effective catalyst for economic growth. That is the conclusion of an article by V N Balasubramanyam, Mohammed Salisu and David Sapsford in a recent issue of the Economic Journal. They show that countries such as the East Asian tigers, Kenya and Chile have benefited to a much larger extent from FDI than countries which have pursued import substitution policies, such as Indonesia and the Philippines, Morocco and Nigeria, and Peru and Uruguay.

Balasubramanyam and his colleagues note that in recent years, opinion on the role of FDI in the growth process appears to have shifted from doubt, suspicion and pessimism to near euphoria. But excitement has not been matched by research designed to establish the pre-conditions for the effective utilization of FDI. The mere presence of foreign firms, often enticed by attractive incentive packages including tax concessions and protection from import competition, will not necessarily engender growth. Indeed, such enticements may attract foreign firms and fill their coffers but do little for employment, incomes and technological change in the host countries.

Balasubramanyam et al test a hypothesis put forward by Jagdish Bhagwati. This focuses on
countries with a neutral trade regime in which artificial incentives, such as subsidies and tariffs,
favour neither export nor home market oriented industries. It suggests that they are able to utilize FDI much more effectively in the growth process than countries that favour one or other of the two sets of industries. The research presented in this paper not only confirms the hypothesis but also provides a set of reasons for its validity based on recent developments in what is known as the new growth economics:

  • Foreign firms are able to conduct and plan their business in countries that pursue a neutral trade regime with confidence and ease. This is because they don''t rely on artificial incentives that may encourage them towards a sector that may not possess the sort of resources and markets they need. What''s more, such incentives may be transient, subject to the whims of bureaucrats.
  • In a neutral regime, foreign firms'' resource allocation decisions, their choice of products
    and processes and the length of their commitment are all guided by market forces and the intrinsic abilities and endowments of the economy.
  • A liberal regime of trade and investment that allows for competition from both domestic
    and foreign sources promotes innovation, learning by doing and the formation of skills.
    Indeed, these are all ingredients that foreign firms are known to contribute to the growth
    process. They are also the mainsprings of growth identified by the new growth economics.
  • Foreign firms are able to do all this effectively in an economic environment that emphasizes competition and the necessity to seek and utilize available resources and talent. Such an environment also promotes the diffusion of skills and technology throughout the economy.

''Foreign Direct Investment and Growth in EP and IS Countries'' by VN

Balasubramanyan, M Salisu and David Sapsford is published in a recent issue of the Economic Journal.

VN Balasubramanyan

Professor of Development Economics at Lancaster University