by Chakravarthi Raghavan
Geneva, 19 Oct 99 -- There are few cases of successful IFDI-led development and for most countries Inward Foreign Direct Investment (IFDI) should not figure as a central component of any development strategy, according to a research paper for the G-24, the group of 24 developing countries in the IMF/World Bank institutions.
The study by Prof. William Milberg, "Foreign Direct Investment and Development: Balancing Costs and Benefits", under the G-24 Research Programme (of which Canadian academic Prof. Gerry Helleiner was coordinator till end 1998) is in a forthcoming  volume in the UNCTAD series: International Monetary and Financial  Issues for the 1990s".
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Milberg, professor at the New School for Social Research, New York, notes that amidst the financial crisis, that began in July 1997 in East Asia and moved to the Russian Federation and then to Brazil, "there is now considerable doubt even among heads of the Bretton Woods Institutions, about the net benefits of financial liberalization for developing countries."
Some of the most respected economists (like Jagdish Bhagwati and  Paul Krugman) are now proposing the use of capital controls to limit the destabilising effects of volatile international financial flows.
In this environment, one could expect foreign direct investment (FDI) would increasingly be perceived as the main remaining  channel for a stabilising flow of capital from developed to developing countries.
Some of the protagonists (like then EC vice-president Sir Leon Brittan and the OECD in 1998) have advocated developing country liberalization of IFDI. In this view, IFDI promotes economic  growth and development, raises employment and wages, generates technological spillovers that raise productivity, provides export market access, and leads to improvement in the balance of payments.
The only major question, according to this view, is how best to go about attracting IFDI. And while the MAI negotiations at the OECD is stalled, according to UNCTAD's World Investment Report 1998, over 1500 bilateral investment agreements are in place.
[Since the paper was written, the OECD has decided not to continue the talks for the MAI. And, some like the EC and Japan are trying to promote it at the WTO, albeit less ambitiously, but in a framework aimed at getting the issue on to the WTO agenda, and expanding it later. The WIR itself has been using the growing number of bilateral agreements to suggest that developing countries want investment agreements and would be better off with a multilateral agreement.]  
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Milberg says that while the recent period has provided a healthy response to the dependency rhetoric of the 1960s and 1970s, "the analytical pendulum has swung too far in the other direction, with organizations such as the OECD extolling the virtues of capital account liberalization without fairly assessing its costs."
In a critical survey of the debate on net benefits of IFDI as a tool for economic development, Milberg says that "for most countries IFDI should not figure as a central component of any development strategy."
"Historically," he adds, "there are very few cases of successful industrialization in which IFDI has been a major driving force."
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There is potentially a large social cost to the competitive struggle to attract IFDI, and there is very mixed evidence on the degree to which the incentives offered as part of this competition may succeed in attracting foreign firms.
Says the study, "thus, while policies on IFDI should not be ignored, the policies most effective in 'attracting' IFDI are not those relating directly to the foreign sector but those that promote domestic economic growth through investment, infrastructure and human capital development - to raise absorptive capacity - and domestic competition.
"Finally, the IFDI-based development strategy suffers from a fallacy of composition: if all countries pursue the strategy simultaneously, global excess capacity is likely to develop that will only worsen developing countries' terms of trade."
The Milberg study brings out:

  • the hypothesized positive 'technological spillover' effects of IFDI (in host countries) have been difficult to verify empirically;
  • IFDI represents an insignificant share of gross capital formation in most developing countries;
  • Much developing country IFDI represents acquisition of existing assets as opposed to creation of new ones;
  • with the development of financial markets and their liberalization in developing countries, IFDI can easily be hedged, making it more similar to portfolio capital flows than ever before and thus giving it a potential for instability similar to that of those flows.
  • IFDI has tended to lag behind GNP growth in most developing countries, and not lead to growth process;
  • the competitive struggle among national governments (and sometimes regional governments within countries) to attract IFDI has in general not succeeded in attracting FDI but may have reduced social standards, including the repression of labour compensation, a reduction of labour and environmental standards and a diminished ability of the state to tax corporate profits and regulate capital generally;
  • and contrary to economic theory, IFDI has contributed to  growing wage inequality in some developing countries, more than offsetting any equalizing effects; and
  • IFDI has an ambiguous effect on the host country balance-of- payments, since the increasing vertical disintegration of production has meant more imports for each dollar of exports at the same time as outflows of profits, interest, dividends, royalties and management fees have been rising.

Milburg points out that according to economic theory, capital will flow from where its return on investment is lowest (ie where capital is most abundant) to where its return is highest (ie where it is most scarce), increasing world output and global efficiency of resource.
But contrary to this prediction, FDI has been increasingly  concentrated among developed countries. At the same time, the heightened international mobility of capital, resulting from declining costs of communication and transportation and  development and liberalization of financial markets, has also meant that the international division of labour depends less on comparative advantage and more on firm decisions about location of production.
And location decisions may deviate from those predicted by comparative advantage for a number of reasons. Firms may put national characteristics ahead of relative cost consideration.
To the extent that heightened capital mobility has coincided with growing global excess capacity, trade liberalization may not bring about the price adjustment necessary to convert a relative productivity advantage to an advantage in terms of absolute money costs. And when currency values do not respond to trade imbalances in the expected fashion, then the price adjustment implied by the theory of comparative advantage may also be inoperative.
While the bulk of FDI still takes place among developed countries, developing countries have slowly increased their share of FDI from 29 to 37 percent from 1992 to 1997. And the stock of world FDI located in developing countries rose from 23 to 30 percent between 1980 and 1996. But the FDI expansion has not spread evenly. And the increase in developing country share of world FDI stock is almost entirely to IFDI in China.
Milburg notes that the globalization of production is typically illustrated with reference to the dramatic increase in world trade relative to world GDP - and the oft-cited reasons include dramatic reduction in cost of international transportation and communication, the technological revolution in telecommunications and the continued liberalization of international trade.
But most of the global increase in trade has been in intermediate goods and "much of the global integration of production has been within firms." Intra-firm trade now represents 30-50 percent of trade volume of the major industrialized countries.
The international integration of production by TNCs has important implications for labour markets in both developed and developing countries.
The symmetry of economic theory - following on the Stolper-Samuelson theorem - would indicate that rising wage inequality in industrialized countries will be matched by falling wage inequality in developing countries.
There is now considerable evidence that over the past 10-15 years many developing countries have experienced a similar rise in the relative wages of skilled workers.
A study of nine countries (Argentina, Chile, Colombia, Costa Rica, Malaysia, Mexico, the Philippines, Taiwan province of China and Uruguay) found that after netting out labour supply changes, trade liberalization was associated with a rising wage differential between skilled and unskilled workers.
The simultaneous liberalization of markets and international integration of production by firms, according to Milberg, have a number of implications for developing countries.
Important activities of TNCs remain concentrated in home countries. Most significantly, most of the R & D and the decision about allocation of retained earnings.
With a network of affiliates, TNCs may shift production locations in response to changes in costs, including in exchange rates. In fact, the increase in global exchange rate volatility is sometimes cited as a cause of local diversification of costs and revenues.
With the location of components of the production process determined centrally, "countries may get caught in a 'low-level equilibrium trap' - that is specializing in low-value-added components of the overall process without the ability to move up to higher-value-added areas of production."
The 'trap' occurs because low wages are simply not sufficient to offset low and slow-growing productivity.
Another feature of rapid growth of FDI to developing countries in the 1990s is the "boom" in international mergers and acquisitions (M&A) - with developing country cross-border M&A sales increasing more than five-fold between 1990 and 1997, to over $90 billion.
More than 90% of these M&A investments were in South-East Asia and Latin America. In some cases privatization has accounted for a large share of FDI inward flows.
As for technological spill-overs of IFDI, namely beneficial  effects both within and across industries, Milberg says that these are difficult to measure, but when case studies have been  done, the results have been mixed. (SUNS4533)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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