Fallacies about the theory of FDI: its conceptual and methodological pitfalls

There should be no open-door policy in developing countries towards foreign direct investment in general, the following article asserts, challenging the received wisdom on FDI and pointing to the imperative of harnessing domestic resources for development.

by Yash Tandon

The centrality of FDI in contemporary finance-for-development theory

There are certain simple propositions in economics that acquire the status of axiomatic truths, sometimes even the force of law. One of these, in our time, is the proposition that if a developing country (DC) seeks economic growth and welfare for its people, then the principal mechanism to do so is to try to attract foreign direct or private investment (FDI or FPI); and, furthermore, that in a globalized world, where capital is free to move where it will, the DC needs to offer competitive terms to attract FDI.

This simple proposition is often qualified with the addition, however, that FDI is not a sufficient factor for growth (for there are other factors that affect growth too) but is a necessary ingredient.  Another qualification that is sometimes added is that FDI can have both negative as well as positive consequences, but “on balance” the positive benefits outweigh the negative, and hence the policy strategy should be to maximize the positive effects and minimize the negative ones. 

The overall thrust of the argument is unmistakeable: a developing country is not going to get anywhere if, for some reason, FDI does not flow in.          

The agreed draft Monterrey Consensus of the international Conference on Financing for Development has this to say on FDI:

“18. Private international capital flows, particularly foreign direct investment, along with international financial stability, are vital complements to national and international development efforts. Foreign direct investment contributes toward financing sustained economic growth over the long term. It is especially important for its potential to transfer knowledge and technology, create jobs, boost overall productivity, enhance competitiveness and entrepreneurship, and ultimately eradicate poverty through economic growth and development. A central challenge, therefore, is to create the necessary domestic and international conditions to facilitate direct investment flows, conducive to achieving national development priorities, to developing countries, particularly Africa, least developed countries, small island developing states, and land-locked developing countries, and also to countries with economies in transition.

“19. To attract and enhance inflows of productive capital, countries need to continue their efforts to achieve a transparent, stable and predictable investment climate, with proper contract enforcement and respect for property rights, embedded in sound macroeconomic policies and institutions that allow businesses, both domestic and international, to operate efficiently and profitably and with maximum development impact. Special efforts are required in such priority areas as economic policy and regulatory frameworks for promoting and protecting investments, including the areas of human resource development, avoidance of double taxation, corporate governance, accounting standards, and the promotion of a competitive environment. Other mechanisms, such as public/private partnerships and investment agreements, can be important. We emphasize the need for strengthened, adequately resourced technical assistance and productive capacity building programmes, as requested by recipients.”

FDI, for the most part, is supply-driven

The case for FDI is usually presented in the literature as if it is demand-driven. Of course, any number of Third World leaders can be quoted as saying that they desire FDI. In the case of Africa, however, such desires are often accompanied by a less-than-optimistic view that no matter what they do, they have failed to attract FDI.  There is increasing scepticism about FDI among Third World countries. At the 4th Ministerial Conference of the World Trade Organization in Doha in November 2001, the Trade Ministers from the African Union, the least developed countries and the countries of the African, Caribbean and Pacific (ACP) group as well as several Asian Ministers had fought hard against paragraph 20 of the Ministerial Declaration that sought to initiate negotiations on a multilateral framework for investments. They finally gave in only because of enormous pressure on them from the developed countries. If FDI is such a good thing, why should the leaders of Africa and Asia not open their doors to negotiations on a free investment regime instead of fighting against it?

Increasingly, it is becoming evident that it is not so much the developing countries that desire FDI, but the representatives of the industrialized world - the transnational corporations (TNCs), the “experts” and the Investment division of the United Nations Conference on Trade and Development (UNCTAD) - that desire the DCs to desire FDI. In Thailand, for example, before the August 1997 crisis, the country came under enormous pressure from the IMF and donors to open its doors to FDI. Joseph Stiglitz compared the intervention of the IMF in Asia to the Holocaust.

The point is that it is in the interest of the industrialized countries to persuade the developing countries to take FDI as a “bundle”, for only through exporting the bundle as a non-negotiable package can they reap the full benefit of their comparative advantages in technology and management systems.  Increasingly, for example, the TNCs that are negotiating FDI transfers to countries like India and Brazil argue that in return for their latest technology (for example, the CFC-reducing refrigeration technology), they should have a stake in the ownership of the enterprises to which the technology is transferred. UNCTAD too has become a victim, or, to put it more kindly, a target, for pushing the case for FDI.  Vast amounts of money are injected into the system by Western donor agencies for workshops to persuade the Third World countries to open up their doors to FDI “for their own good”.  There are fundamental conceptual and statistical flaws that underlie UNCTAD’s annual World Investment Reports.

So where does the matter stand on FDI, especially in relation to Africa? 

One problematic aspect about the debate on FDI is that there is a confusing array of definitions of FDI or, worse, no definition at all, only a presumption that FDI (irrespective of what it means) must be attracted to stimulate growth.  In one rare attempt, the Economist defined FDI as a package, a “bundle”. The point about FDI is that it is far more than mere “capital”: it is a uniquely potent bundle of capital, contacts, and managerial and technological knowledge. It is the cutting edge of globalization (The Economist, 24 February 2001). This definition of FDI does raise a question: if FDI is indeed a “bundle”, can it be unbundled?  Can it be unpackaged?  Can a developing country say to the bearer of FDI: “We’ll have your technology, but we’d rather depend on our own savings as capital, and we will provide the management ourselves”?  Or is it in the very nature of FDI that it comes as a “bundle” - take it or leave it?

FDI is falsely marketed to the developing countries as a solution to their underdevelopment.  There is no necessary correlation between FDI and growth, nor between growth and development.  Development itself is a complex phenomenon. Its reduction to an economic phenomenon has been one of the most egregious faults of neoliberal economics. And further narrowing-down of the narrow economic doctrine into “FDI as a source of development” is reductionism pushed to its absurdity.

What developing countries may (or may not) need is capital, especially capital that is embodied in technology.  They do not need FDI. Why?  Because FDI is really a bundle of assets in the service of TNCs in their perpetual quest for profits, markets and sources of raw materials. FDI is a means for foreign owners of capital to acquire assets in the host country.

In terms of policy, this implies that the developing countries need to be very careful so as not to accept FDI anyhow.  They must try to unpackage and unbundle FDI and negotiate with the supplier of FDI what they want out of it and what they would rather depend on their own resources.  And like in all negotiations in business, it is a special skill acquired through experience, and often through bitter lessons.

There is no “good” or “bad” FDI outside of national policy.  In other words, it is only in relation to national policy that FDI can be described as good or bad.  All FDI is inherently problematic.  Such investments do not come as a matter of charity; they come to make profits, to make use of local resources, to take advantage of cheap or skilled labour, or to capture the local market against other foreign competitors, indeed even against local enterprises. Foreign direct investors do not transfer technology for the love of it; they do so, if they do it at all, in order to control production and the market.

Hence, there should be no “open-door” policy towards FDI in general. It must be allowed in as and when required by national consensus between the government, the local private sector, the workers and small farmers, and other organs of civil society. The FDI must operate under certain nationally determined conditions (for example, limited access to domestic savings) and must conform to certain performance requirements (for example, effective transfer of technology or managerial know-how).

Contrary to received wisdom, Africa does not suffer from a “low savings rate”, leaving an “investment gap” that then has to be “filled in” by FDI. On the contrary, Africa’s savings rate is high.  However, those savings are not described as “savings” in the dominant economic literature.  They are described, by some archaic accounting convention, as dividends, interest on loans, debt payments, etc.  These then are externalized, and when they come back, in another guise, they are described as “fresh investments” or “FDI”. 

Empirically speaking, instead of capital flowing into Africa, there is a net, indeed massive, outflow of capital.  These take different forms, but data on these are hard to come by because there is no institution in the world that is commissioned and funded to carry out an empirical investigation of this kind. Unless the savings are retained within Africa for domestic capital accumulation, Africa will forever be seeking capital from outside and thus remain a permanent hostage to the conditions imposed by international capital.  These conditions, under the IMF and World Bank regime, are increasingly becoming political as well as economic. And so, in addition to becoming an economic hostage to the dictates of international capital, Africa is in danger of also losing its political independence.  This is the real meaning of capital-led globalization.

There does not appear to be a concerted effort by African countries to address this very serious issue.  It would require a major overhaul of the entire system of central banking conceptual and management structures to do anything serious and sustainable in this critical area.  Most central banking infrastructure in Africa is by now completely infiltrated by IMF-trained and “conditioned” experts (in some cases by direct placement of people from Washington). These officially cannot be relied upon to protect the national economy from attacks by FDI or speculative capital (which has been the main reason for, for example, the devaluation of the South African rand by more than 40% during 2001).  African central bank officials and even most ministers of finance are caught up with the mindset of the IMF paradigms for Africa’s “development”.  They are made to believe that even externalization of funds is “good” for Africa, even as, ironically, they are looking for FDI to “fill the gap” between savings and investments!

Most African countries are now in such dire balance-of-payments crises that it is not the “sequencing” of inflows with which they are most concerned, but the “sequencing” of outflows of capital.  This includes outflow in the form of debt servicing, dividends, payments for needed imports, pensions for former colonial servants, holiday allowances for the elite class, etc.  Hence, the first task of political leadership in Africa is to “sequence” the outflow of capital by first and foremost refusing to pay for all illegitimate debts incurred by Africa.  It must then critically look at all the various ways in which capital exits from the continent (including corruption of officials and externalization of capital by devices such as “transfer pricing”), and so, in the long run, put a check on the massive outflow of capital from Africa.                                               

Yash Tandon is the Director of the Southern and Eastern African Trade Information and Negotiations Initiative (SEATINI). The above article, which first appeared in the SEATINI Bulletin (Vol. 5, No. 2, 31 January 2002), is condensed from a paper presented at the 4th Conference of International Economists, February 2002, Havana, Cuba, on the theme of “Globalization and Development Problems.”

From TWE No. 275 (15-28 February 2002)