Need for FDI in developing countries

Impact of Foreign Direct Investment on Developing Countries

Many developing countries do not have the necessary resources at their disposal to develop some sectors and hence, they permit foreign capital to invest in these sectors. Of course, they also ensure that sectors like defense and other sectors that have national security implications are kept off the list of sectors in which foreign direct investment is allowed. For many countries, opening up of their economies results in benefits since they need the dollars as well as because they might not have the expertise to commence productive activities in these sectors. Finally, foreign direct investment can be used to pay for expensive imports and encourage exports as well. After all, every developing country (except those with large oil reserves) needs to pay for its oil imports in dollars and hence foreign direct investment helps to earn precious dollars.

Downsides of Foreign Direct Investment on Developing Countries

There are many downsides to allowing Foreign Direct Investment into the developing countries. However, the developing countries benefit because of inflow of dollars and much needed capital, which is not available domestically, there is scope for outflow of dollars as well since the foreign companies typically repatriate a part or whole of their profits back to their home countries. This is the reason why developing countries must think twice before allowing blanket foreign direct investment. To circumvent this, many developing countries typically restrict foreign direct investment into sectors that badly need capital and where the developing country does not have expertise. Further, the fact that many developing countries have capital controls on the capital account (which is to restrict wholesale repatriation of both profits and investment) and relax the current count where only profits and that too a percentage of it is repatriated.

Significance for developing countries

FDI has become an important source of private external finance for developing countries. It is different from other major types of external private capital flows in that it is motivated largely by the investors’ long-term prospects for making profits in production activities that they directly control. Foreign bank lending and portfolio investment, in contrast, are not invested in activities controlled by banks or portfolio investors, which are often motivated by short-term profit considerations that can be influenced by a variety of factors (interest rates, for example) and are prone to herd behavior. These differences are highlighted, for instance, by the pattern of bank lending and portfolio equity investment, on the one hand, and FDI, on the other, to the Asian countries stricken by financial turmoil in 1997: FDI flows in 1997 to the five most affected countries remained positive in all cases and declined only slightly for the group, whereas bank lending and portfolio equity investment flows declined sharply and even turned negative in 1997.

While FDI represents investment in production facilities, its significance for developing countries is much greater. Not only can FDI 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. The first to benefit are enterprises that are part of transnational systems (consisting of parent firms and affiliates) or that are directly linked to such systems through nonequity arrangements, but these assets can also be transferred to domestic firms and the wider economies of host countries if the environment is conducive. The greater the supply and distribution links between foreign affiliates and domestic firms, and the stronger the capabilities of domestic firms to capture spillovers (that is, indirect effects) from the presence of and competition from foreign firms, the more likely it is that the attributes of FDI that enhance productivity and competitiveness will spread. In these respects, as well as in inducing transnational corporations to locate their activities in a particular country in the first place, policies matter.

The Benefits of Foreign Investment

Hence, the fact that FDI is preferred more by developing countries become clear when one considers the deep and the longer-term nature of these flows. However, this does not mean that investments in equity and bond markets are not welcomed. This is because many developing countries run large current account deficits, which have to be financed with dollars. In other words, current account deficits are the difference between the imports and the exports that a country does and since many developing countries import more than they export, there needs to be a mechanism through which the deficit is financed. This is made possible by the investment in bonds and equities. On the other hand, FDI is suitable for generating jobs and creating conditions for future prosperity. Moreover, FDI comes with the added advantage of technology and knowledge transfer, which is beneficial to the developing countries. Therefore, as can be seen from this explanation, both FDI and hot money are attractive in terms of the usefulness they have to developing countries.

The Downsides of Foreign Investment

However, the downsides of these investments are that whenever there is a crisis like the recent economic crisis and the Asian financial crisis of 1997, there tends to be outward flows of foreign capital as panicky investors flee the developing countries markets lest they lose out in the process of the crisis eroding their investments. This is the key downside of foreign investment. Further, even FDI or capital investment can flee the developing countries if they have full capital account convertibility or the provision for the foreign companies to quickly convert their holdings in domestic currencies back to their home currency, which in many cases is the United States Dollar. Hence, the implications of FDI and Hot Money have to be clearly understood by policymakers before they commit themselves to opening up their economies. Indeed, as the experiences of China and India illustrate, the gradual opening up of the economy and the careful monitoring of flows of hot money are needed for developing countries to withstand currency shocks and liquidity crunches.