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".

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

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

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.]

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

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."

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

* 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

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

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

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
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