Foreign direct investment

Published by kind permission of the Author, 2012


Since the 19th century most African, Asian and South American countries have been under the control of more industrialised European states (‘mother country’) such as Great Britain, France, Belgium, Netherlands, Spain, Portugal etc. Exploitation and enslavement where utilised to accumulate wealth and gain political influence worldwide. Countries were invaded, new borders were ruthlessly created along longitudes and latitudes, regardless of settlement areas of the peoples, they were made property of another state from one day to another and forced to export their resources back to the mother country. Venezuela for example was an exporter of tea and coffee for the entire 19th century. Forcing them over decades to plant monocultures that were eventually exported, the colonial countries were left with a locked economy, having to import food from the mother country. This state of dependency was intended in order to maintain this cruel form of capitalism and prevent the colonial countries to transform their economy from agriculture to industrial.

Having this history in mind it is obvious that in the 21st century many critics are suspicious about foreign multi-national companies coming into the boundaries of developing countries and thus doubt the validity of their motives and are uncertain about their true intentions. Can and do foreign companies aid a country developing further and assist gaining prosperity and wealth? Or is foreign direct investment just an excuse to exploit labour, low taxes and lose government regulations to accumulate more profits?

This paper examines a few effects of FDI such as pollution, transfer of technology, GDP and balance of payments impacts, rules and regulations and employment. It discusses their advantages and disadvantages and illustrates the complexity of the debate with specific examples from Vietnam, Mexico, Ukraine, Nigeria and many more to clearly demonstrate benefits and drawbacks of FDI in developing host countries.

Foreign Direct Investment

If a domestic company acquires 10% or more of the shares of a foreign firm then this is called foreign direct investment (FDI). A company that engages in foreign direct investment thus operates in more than one country is called a multinational corporation (MNC).

FDI must be distinguished between direct investment and portfolio investment. The difference between the two lies in the intention of the investment. The first aims for control and influence, through loans, bonds, share purchases and change of management, whereas the latter is purely profit driven without any intervention in the existing structure and tradition. Further, only FDI has a long-term interest in the country thus counts as a true source of finance and aid development in the host country (Gad and Ellmers, 2007). This would explain the existence of ‘profit sharks’ which use portfolio investment to accrue revenue, have very limited interest in the country and may even harm the development and worsen poverty.

This is for example the case in Ukraine where a special agreement with Cyprus allows tax-free money movements between the two (NolteCY, 2009). It is therefore no surprise that in the Ukrainian state statistics Cyprus accounts for a quarter of inward FDI (State Statistic Service of Ukraine, 2012). Obviously this does not aid a country but only allows individuals to find an easy way around taxation. This paper is not concerned with this form of investment.


Credit rating agencies give many developing countries very low credit ratings, due to their level of political and economic situation, high debts, structure and performance of bank finance and capital markets (Mortimer, 2012). This makes it hard for these countries to obtain loans from banks, or only with huge interest rates (Standard & Poor, 2012; Moody’s, 2012). They do not have the financial means to finance development and fight poverty (Mikota, 2007).

Therefore, FDI is sometimes the only chance for a developing country to either obtain money for new projects or to save existing companies from bankruptcy thus gives those new prospects. An ideal example of the latter is the story of the Czech car manufacturer Škoda. Even after being nationalised, it was out-competed by west European countries, due to the lack of investment and weak innovation, and struggled to survive. Volkswagen bought Škoda in 1991, invested in products, modernisation, production, capacity and environmental protection. Since then Škoda sells increasingly more cars and has eager future plans (Škoda, 2011). This vividly shows how a change of management by a more experienced mother company can be beneficial.

This paper will now look more closely on specific effects of FDI on the host country.

Transfer of Technology

MNCs are the main opportunity for developing countries to obtain access to advanced technologies such as skills of managerial practice, know-how for inventory, quality control and standardisation, existing distribution network as well as relationships with suppliers, customers and investors, power and political influence (Borensztein et al., 1998; Hoekman et al., 2004; Gud and Ellmar, 2007).

On the one hand, evidence suggests that stimulation of technical progress ultimately adds to economic growth through technological spill overs which can happen in two ways (Borensztein et al., 1998; Hoekmanet al., 2004). The vertical spill over effect impacts the own supply chain and the horizontal spill over effect affects competitors. Evidence suggests that the first form is more common (Bockelmann, 2010). This seems legitimate as no successful MNC intends to give its competitors an advantage by consulting them how to improve their business. The spill over effect can have the form of copying, competition or mobility of labour (Bockelmann, 2010). The first one means the local company applies some of the MNC’s above mentioned technologies, which ultimately increases its own efficiency (Hoekman et al., 2004). The second one describes the pressures of competition which force a local company to put more effort in its own managerial practices, use its own resources more efficiently or search for more productive technology (Hoekman et al., 2004). For example the presences of MNCs in Mexico had a positive spill-over effect on local companies because they reported that their productivity levels increased in the period 1965-1982 (Blomstrom and Wolff, 1994).The third one means that MNCs train their employees and thus improve the skills of their workforce. Obviously MNCs tend to have a more advanced competence management thus train their employees more effectively than local firms do, which was found to be taking place in Kenya for example (Gerschenberg, 1987).

On the other hand the drawback of technological transfer is that the host country must be ready for it in order to able to absorb the technology. Substantial evidence suggests a strong correlation between human capital and increase in economic growth though FDI (Nelson and Phelps, 1966; Benhabib and Spiegel, 1994; Boresztein, 1998). This means, only if the educational level of a country is above a certain benchmark then the growth rate benefits from the MNCs. For example if a county imports new software, then the people in the host country need to have a certain standard of education in order to use this technology. Not only the education level needs to be sufficiently high, also the financial markets need to be sufficiently developed so that the host country benefits from the FDI (Alfaro et al., 2003).

A perfect example to make this dilemma of the technological transfer clearer is the soap industry in Kenya which can be seen as a benefit and a drawback of FDI at the same time. MNCs used machinery to produce soap, thus, the local companies faced difficulties selling their handmade soap. Only those which had the capital to improve production through machinery could stay in business (Blomstrom and Kokko, 1997). The benefit is that competition induced the aim for higher efficiency, the drawback, however, is that weak local companies are forced to shut down.


The dilemma with employment is that it mostly depends on the intention of the MNC. As earlier mentioned portfolio investments tend to be ‘footloose’, meaning the MNC usually only has a very short-term and profit-related interest. Of course this can create very volatile levels of employment in the host country. MNC with sustainable investments, however, are far more likely to have a long-term and stable impact on employment. How can FDI affect the host country’s employment level?

On the one hand, when FDI comes as a supplement to existing investment, called “greenfield” plants, it can boost demand for labour in expanding industries (Jenkins, 2006). For example, the Danish Carlsberg successfully entered Vietnam through Joint Venture in 1993 (Nguyen et al., 2004). In combination with the spill over effect and linkages to the local firms this demand has an even more complex impact on employment outside the MNC itself (Jenkins, 2006). Evidence suggests that MNC generally pay their employees more, which obviously increases the wage level, which increases consumption and hence boosts the economy (Jenkins, 2006).

On the other hand, MNCs can add to regional unemployment for various reasons too. For example if the FDI takes place in form of an acquisition then there are not necessarily new jobs created like the ABB joint venture in Vietnam (Nguyen et al., 2004). It makes sense, that the impact on employment is low if only the management changes. Again, new management means new strategy which can have a positive effect like the example of Škoda showed but it can also mean that the management decides to apply a downsizing strategy that reduces employment levels. From a more complex perspective, MNCs can also affect local companies. Some local firms may be unable to compete with the MNC, due to high wage levels or imported goods that replace their own production, and thus are pushed out of the market (Jenkins, 2006). Some countries created special economic zones such as Malaysia, Pakistan and Myanmar. Attracting FDI in very sporadic places can of course fuel regional imbalances of employment and wage levels leading to social class creation and other social conflicts that harm the country’s growth.

GDP and Balance of Payments

Some developing countries transform from a centrally-planned economy to a market-based economy and therefore eventually need to open up to the world economy and liberalize its trade regulations and allow foreign investment to enter the country. Does this liberalisation aid the host country’s growth and Balance of Payments (BOP)?

On the one hand Vietnam for example underwent such a transformation in the 1990s and two major side effects were the economic growth and decrease of poverty (Jenkins, 2006). Vietnam benefitted from FDI as it improved its balance of payments through increasingly more investment into the export-orientated sectors (Athukorala, 2002b). Firstly it attracted domestic-orientated FDI projects between 1987 and the early 1990s and then gradually gained more export-related projects in the middle of the 1990s until by 2000 most FDI projects were of the latter nature.

On the other hand, sudden high levels of FDI may not have a sustainable nature and the inflows may stop after a couple of years again. This happened in Vietnam in the end of the 1990s and Freeman and Nestor (2002) point quite rightly out that these ‘euphoric’ prospects were simply disappointed after some time.


Aliyu (2005) lists various reasons for weak environmental regulations in developing countries: demand for environmental quality increases with wealth in the country; high levels of corruption; little financial means, low manpower and equipment to cover costs for controlling and enforcement; and urbanisation and developing infrastructure accompany the evolving manufacturing industry. Do MNCs exploit these low environmental regulations in order to make reckless profits?

On the one hand, evidence suggests a relationship between FDI and local environmental standards (Xing, 2002; Aliyu, 2005). The “pollution haven hypothesis” indicates that developing countries are forced to deliberately lower their environmental regulations in order to attract more MNCs (Aliyu, 2005). Extreme critics even suggest that MNCs in general harm the environment as the nature of trade burdens the environment (Lofdalh, 2002).

On the other hand, strong evidence suggests that the level of pollution depends on the state of economic development. Grossman and Krueger (1995) visualised this behaviour with the “Environmental Kuznets Curve”, which implies that both, pre- and post-industrial economies, have low levels of pollution whereas industrial economies show high levels. This suggests that if FDI in a developing country aids the transition from a developing to an industrialised country, then higher levels of pollution occur due to the nature of transformation rather than because of reckless MNCs exploiting lax environmental regulations. Ignoring the USA this is a reasonable hypothesis, as many highly industrialised countries such as Germany, Sweden and Spain are very environmental friendly, whereas newly industrialised countries such as China and India still need to do their homework on their eco friendliness (Bryan, 2012; Madaan, 2009). Eskeland and Harrison (1997) challenge this hypothesis and instead report that MNCs with advanced pollution norms were actually better for the host countries in Latin America. They back this up with the idea that local companies lack experience with environmental standards in production, thus would start from scratch with eco friendliness. This also seems legitimate as MNCs have a reputation to maintain as well as a high standard of performance in order to maintain their credit worthiness among various investment banks in their home country. Headlines in newspaper like it happened to Shell and its catastrophe in the Gulf of Mexico will harm their business and it seems therefore unreasonable to be the normal practice.

Laws and Regulations

On the one side, evidence suggests that MNCs are more likely to enter the market of developing countries if certain basic conditions, such as stable and sustainable rules of laws and low levels of corruption, are given (Fabayo et al., 2011). It is no surprise that MNCs abandon their projects and leave the host country if tax regulations are volatile, if rulings are not transparent enough, or if funds are lost to corruption.

An example of the latter would be the government auction of the largest steel mill in Ukraine. It was initially sold for $800 million but the deal was annulled after court ruled it cannot be sold to former politicians. The auction was repeated and sold for $4.8 billion, saving the Ukrainian government $4 billion (BBC, 2005a; BBC, 2005b). This vividly shows, that governments effectively lose money due to corruptive business deals and so do companies which is why they avoid corruptive countries.

In theory this would mean a developing country would improve its investment climate and reduce risk and uncertainty to attract more MNCs to trust and thus penetrate the market. However, in reality especially the high levels of corruption in the government bodies, which are extremely hard to overcome, prevent that the country’s interests are represented rather than the ones of oligarchs, as the previous scandal in Ukraine, among many more, illustrates. Thefts like this are the reason for poor international credit rankings which lead to low trust in the market, which reduces investments and ultimately hinders the promotion of growth. Genuine MNCs generally avoid corruption because the anti-corruption codex in America for example forbids corruptive business deals and obviously a MNC would not want to harm its own reputation and rather invest in safer places.

For example Nigeria has the problem of high levels of corruption that drive foreign companies away and the lack of FDI hinders the country to gain economic growth (Fabayo et al. 2011). Kazakhstan only recently tackled corruption with laws such as the “Convention against Corruption” (2008) and the “Anti-Money laundering international Treaty” (2011) to improve its reputation (Mack et al., 2011). The introduction of these laws and increased enforcement boosted Kazakhstan up 40 places within two years in the 2010 Corruption Perception Index 2010 (Transparency International, 2010). This shows that the prospect of FDI, thus growth, can be an incentive for developing countries to enhance their body of law and tackle fraud which will ultimately aids them to become a newly industrialised country.

On the other side, even if basic conditions are given it does not necessarily mean that MNC will invest in the country. For example Ukraine was very important to the former Soviet Union (SU) from an agricultural as well as an industrial perspective, especially its aircraft sector. After the collapse of the SU, Ukraine started to struggle and now counts as a developing country. Even though it can offer a moderate level of infrastructure, a variety of educational institutions, has the third highest number of graduates in higher education (UNESCO, 2009), a geographical advantage, is reasonably democratic, has moderate freedom of press, has relatively low levels of wages, has natural resources and is part of the WTO, Ukraine still only receives less than 1% all FDI in all developing countries (UNCDAT, 2010). This shows how important it is for a developing country to fight corruption in order to be attractive for MNCs to invest in the country.


As this paper shows the question whether or not FDI will ultimately aid the developing host country to transform to a more industrialised state and to fight poverty is based on a very complex debate and this paper will not provide the reader with a right or wrong answer.

It can, however, conclude the following: As Gad and Ellmers (2007) rightly pointed out, no matter in which country FDI takes place, irrespective of the MNCs true intentions and despite a possibly positive impact on either employment, technological advancement, balance of payments, the environment or on rules and regulations, FDI will always be accused of polarising various factors, creating so called ‘modernisation islands’. This may include higher than average levels of wages, infrastructure, factors of production, such as capital and skilled labour force, or value creation. Evaluating this behaviour is difficult as it seems legitimate that a transformation in its nature is accompanied by restructuring existing conditions. In a way, polarisation will obviously occur and cannot be avoided.

One could say as a final statement that how much a developing host country benefits from FDI depends on the MNC’s intentions and how they use their power in this country, taking into account that the actions of MNC’s are more and more monitored by increasingly more influential organisations and institutions world wide, such as the WTO or the OECD.

Copyright by Vicky Hannebauer


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