2

Table of Contents:

Introduction ............................................................................................................................... 3

1. Financial impact on the host country ................................................................................. 3

2. FDI & Economic growth ...................................................................................................... 5

2.1 Impact of trade ............................................................................................................................. 6

3. FDI & Technology transfer : ................................................................................................ 8

4. Recommendation of MNE’s to improve domestic productivity ......................................... 9

5. Conclusion ......................................................................................................................... 11

Reference List: ......................................................................................................................... 12

3

Introduction

Globalisation has improved cross-border investment where a resident in one economy

invests in an enterprise resident in another economy with the objective of obtaining a

lasting interest. This is known as a foreign direct investment. OECD (2013) claims that this

type of investment creates direct, stable and long-lasting links between economies. It

encourages the transfer of technology and know-how between countries, and allows the

host economy to promote its products more widely in international markets. FDI is also an

additional source of funding for investment and, it can be an important vehicle for

development. During the recent years, the trend of Foreign Direct Investment in emerging

economies has been increasingly growing, for example in China it accounts for US$ 61 billion,

followed by Hong Kong (34), Brazil (18), Mexico (16) and Singapore for US$ 16 billion (Meyer,

2005).

This report aims to analyse how Foreign Direct Investment (FDI) affects emerging economies.

It will focus firstly on the financial impact that it has on the host country, then its

relationship with the economic growth of the domestic market with an insights on its impact

on exportations and outsourcing. Followed by an analysis on the relationship between FDI

and the domestic employment, and finally some recommendations will be explained on

different ways that multinational enterprises (MNE) could do to improve the productivity of

the emerging economy. To conclude a summary of the main literatures will be presented.

The rationale behind this research question is that, after some research I found that FDI is

the most popular way where MNE’s invest in emerging economies (Caves, 1971 ; Jackman,

1982; Meyer, 2005) so my interest was to understand whether there is any

positive/negative impact on the domestic economies.

1. Financial impact on the host country

In order to understand the type of financial impact that FDI can have on an economy, it is

important to identify if the development of financial system in a host country is a

requirement to the successful implementation of FDI. According to James (2008) analytical

4

framework that studies the impact of FDI on the economy of Thailand by controlling the

level of financial development, argues that the development of financial system is important

in stimulating economic growth, as well as an increase in the level of financial development,

followed by a financial liberalisation, will lead to higher output growth (Gurley & Shaw, 1955;

Goldsmith, 1969; Hicks, 1969). However this might not happen automatically, as it depends

on the absorptive capacity of the host country, such as the human capital, infrastructure,

trade system or the development of financial markets. The author argues that the provision

of different credit facilities enables entrepreneurs who lack internal funds to adopt new

technology, hire better skilled labours, and the fact of having developed domestic financial

markets can help foreign firms extend their financial activities easily. Thus, these methods

can help the host country exploit FDI more efficiently. Therefore the level of financial

development in the host country affects its ability to absorb the benefits of FDI (James,

2008). After collecting different empirical data and an econometric methodology, the author

concludes that there is a strong correlation between domestic financial development and

output expansion, however FDI exerts a negative influence on output in the long term.

While the results highlight that FDI has no direct positive effect on output, it has an indirect

effect in stimulating economic development in Thailand for example through financial sector

development. As a result James’s literature confirms that a developed domestic financial

system is a crucial prerequisite in order to have efficient and positive FDI.

Similarly Chee & Nair (2010) conducted a study to find out if financial sector development is

an important condition for FDI to improve economic growth in the region of Asia-Oceania,

and whether the impact is related on the stages of development of the countries. This

research was conducted on a sample of 44 Asia and Oceania countries for the period 1996-

2005. The authors argue that the positive growth impact of FDI is dependent on the extent

of financial sector development, as the impact of FDI on economic growth depends on

development of the financial sector. The study supports that financial sector development is

crucial for FDI to have positive effects on economic growth in the long term, and this is in

seven out of the nine countries examined such as the East Asian countries, UK, US and Japan.

On the other hand, Alfaro et al. (2006) studies mechanism that emphasises the role of local

financial markets in allowing FDI to promote growth, through for example through

5

backward linkages. This author argues that financial sector development influences the

extent to which FDI promotes higher economic growth in host countries via backward

linkages such as lower lending and borrowing rates. The financial sector development is able

to facilitate the flow of information between multinational enterprises and local companies.

The results of the study concluded that countries with highly developed financial sector

tend to have higher returns of FDI on economic growth. However other studies supported

that these hypothesis are not supported. Durham (2004) conducted a study that examines

the effects of FDI and equity foreign portfolio investment (EFPI) on economic growth in 80

countries from the period (1979-1998) and he pointed out that the complementary effect

between FDI and financial sector development was not statistically significant in economic

growth. In fact some data are consistent with the view that the effects of FDI and EFPI are

contingent on the ‘absorptive capacity’ of host countries, but following an analysis of the

simultaneity bias and financial variables such as the stock market, FDI and EFPI do not have

a positive impact on the economic growth. However leaving financial markets alone is not a

good way to encourage the economy, but the unconstrained capital flows do not necessarily

improve growth. Finally, some data suggests that cross-border investment is harmful to

development, under certain conditions (Durham, 2004).

After discussed whether the development of the financial sector is a condition to efficient

FDI, many authors discussed the financial impact of FDI. De Mello (1997) argued that FDI

enhances long run economic growth, capital accumulation, and financial development. The

development of the financial sector plays an important role in further enhancing the

contributions of FDI on the economy. In addition, the impact on the economy and on the

financial sector is complementary, however the growth impact of FDI and financial sector

development is most important for least developed countries, while being equally important

for developing and developed economies (Chee & Nair, 2010).

2. FDI & Economic growth

Theoretically, it is easy to argue that FDI impact positively the host economy. However, the

results of different studies provide mixed views (Meyer, 2005).

6

Recently, many foreign investors seek local markets and export platforms due to different

advantages in the domestic market, such as low labour wages, prosperous economic

conditions etc. In the host economy, local companies benefit potentially from the FDI in

different ways: labour employment, improved supply bases, transfer of infrastructure and

technology. However, the impact of FDI varies depending if the local stakeholders will take

advantage of the potential benefits of FDI – as discussed before as ‘the absorptive capacity’.

In the other hand, the local government has to provide competitive conditions that will

encourage local entrepreneurship, and avoid market power from foreign investment firm

(Meyer, 2005).

Meyer (2005) examines the impact of FDI in emerging economies through different

literature, and on a macroeconomic level, he claims that FDI offer positive outcomes but yet

affect indirectly local employment, capital and gross domestic investment.

FDI play an important role in providing capital flows, and tends to be less volatile than other

forms of capital inflow (United Nations, 1999), but at a later stage it is repatriated through

profit remittance, which finally makes the host country pays for the costs of capital. For the

gross domestic investment, Meyer (2005) claims that even though the capital inflow may

increase the exchange rate, which might affects the costs of international borrowing; both

effects can lead to crowding out of local investment. However Johnson (2005) argues that

inflows of capital could improve the rate of economic growth but the most important effect

comes from spillovers of technology. MNE operations in the host country can result in

technology spillovers from FDI, which enables them to improve their productivity as they

generate a positive externality that should allow the host country to enhance its long-run

growth rate.

2.1 Impact of trade

The effects of FDI spread on different levels of trade, from imports, exports, production,

employment, and general welfare of the country that finally impacts the whole growth of

economy. Mehra (2013) conducted a study with the regression tool and multiple regression

analysis to find out the impact of FDI on employment and gross domestic product in India.

She claims that there are many arguments verifying that inflows of FDI improves flows of

7

trade and economic growth potential, and consequently enhances employment for the local

market. It is true that FDI provides technological advances that increases the Gross

Domestic Product (GDP) but it also improve employment opportunities that widen the

scope for the domestic market (Mehra,2013). Similarly Craigwell (2006) studied the impact

of FDI on the Caribbean region, confirmed that an increase in FDI leads to an increased

employment rate. From his empirical results, it is estimated that FDI has the greatest impact

during the first year, which is improved after the consideration of trade policies and

financial development, that in a healthy environment positive returns of FDI are generated.

In contrast, another literature by Rizvi and Nishat (2009) analysing the impact of FDI on

employment in India, China and Pakistan, argues that expecting FDI to create direct impacts

on employment is not enough, but suggests that in addition to FDI enhancement policies,

other measures should be taken to boost employment growth.

According to Fontagne (1999) that studies the relationship between FDI and international

trade, found out from his empirical results that until the mid-1980s, international trade

generated direct investment. After this period, the cause-and-effect relationship seems to

have been reversed, with direct investment heavily influencing trade. The study was

conducted in 14 countries demonstrating that each dollar of outward FDI produces about

two dollars’ worth of additional exports. The evidence indicates that foreign investment

abroad stimulates the growth of exports from investing countries and, consequently this

investment is considered complementary to trade.

Theoretically there are two different types of FDI, depending on the way the MNE organises

its international business, either horizontally or vertically. FDI horizontal, is associated with

bilateral flows of investments between developed economies. The parents company

reproduce the whole process of production in different countries. Vertical FDI occurs when

the home company fragments the production process across different countries. Vertical

investments are mostly present in FDI flows from developed to less developed economies

and refers to less sophisticated stages of production (Magalhaes & Africano, 2007).

According to Balasubramanyam et al (1996) analyses the effects of FDI on economic growth

in 46 developing economies through cross-section data, finds out that FDI has a positive

8

impact of economic growth using an export promoting strategy but not in countries where

import substitution strategy is implemented in the host country. However De Mello (1997)

finds a weak positive impact of FDI on the economy despite using time series and panel data

fixed effects estimations in a sample of 32 developed and developing countries.

Finally the difficulty in analysing the positive impact of FDI on economic growth provides a

strong incentive for further empirical studies. However based on the previous literatures,

most authors claims that technology spillovers provide the strongest potential for FDI to

boost the economy (Johnson, 2005) which will be discussed in the following part.

3. FDI & Technology transfer :

According to Glass & Saggi (2002), traditionally MNE have a superior technology comparing

to the local firms, where workers acquire knowledge from that superior technology. As a

result FDI is considered one of most important channels where technology can be

transferred, and later on by developing production facilities, this technology can also be

transferred to local firms. Glass & Saggi (2002) argues that the best way to transfer

technology successfully from MNE to local firms is through labour mobility as knowledge is

shared to different stakeholders. However since labour and employment factor has already

been discussed above, the focus will be on technology spillovers.

Lee & Tan (2006) studied the intensity of international technology transfer in some ASEAN

economies through import of machinery and FDI, and claims that empirical results showed

that knowledge spillovers regarding FDI channels has mixed results. For instance

Borensztein et al. (1998) studied FDI flows from OECD countries in 69 developing countries

and found that FDI had a positive effect on income growth only for the countries that

reached a minimum human capital threshold. However for Indonesia (Sjoholm, 1997),

Mexico (Blomstrom & Persson, 1983; Kokko, 1994), United States (Branstetter, 2000) found

that MNEs had positive effects on local productivity; however, studies for Morocco (Haddad

& Harrison,1993) and Venezuela (Aitken & Harrison, 1999) concluded that there was no

evidence that MNEs had a positive effect on the productivity growth of local firms.

9

Lee & Tan (2006) claims that there is not enough empirical evidence for the ASEAN

countries to study how beneficial FDI is for technology spillovers. Past literatures about this

topic, although abundant, are inconclusive. However the old and existing policies in ASEAN

countries contributed to the growth of their economies, through attracting the inflow of FDI

and enhancing technology transfer. The rapid economic growth was driven by exports, but

foreign firms did not encourage sustainable development. Most of the time, local

competencies were not developed sufficiently in the export sectors as it was dominated by

MNEs, which led the host country to be vulnerable to changes. The competition for

investment increased mainly from other countries (Lee & Tan, 2006).

In the contrast to that, van Pottelsberghe de la Potterie and Lichtenberg (2001) conducted a

research study about research and development and productivity in 16 OECD countries,

stating that FDI inflows does not affect the host country productivity through international

research and development spillovers, but creates significant technology spillovers. As a

result, they conclude that FDI transfers knowledge in only one direction (Bitzera & Kerekesb,

2008).

On the other hand, Bitzera & Kerekesb (2008) studied the relationship between FDI and

technology transfer in 17 OECD countries, argues that it is inward FDI that acts as a channel

for knowledge spillovers. Comparing to van Pottelsberghe de la Potterie and Lichtenberg

(2001) there is no empirical evidence found for positive technology sourcing effects, related

to FDI. Finally the authors results proves that the output elasticity of outward-FDI-weighted

foreign research and development capital is negative for non-G7 countries.

From the previous literatures discussed, it is possible to conclude that technology spillovers

have different effects on the FDI depending on the development of the economy of each

country as well as the different economic and social factors and its relationship with the

MNEs.

4. Recommendation of MNE’s to improve domestic productivity

Other than providing capital investment, trade, technology inflows and domestic

employment, MNE can improve the productivity of the host economy in different ways.

10

Different literatures claims that one factor can have different results depending on the

country and the economic situation, so the recommendations will be based on the actions

the MNE should take in order to make a positive impact on the host economy without

relating it to a specific country. The successful development of an economy depends on the

engagement and interaction of MNE with their environment globally. Slaughter (2009)

suggests that MNE should provide their products/services to local consumers instead of

focusing mainly on the home market where the parent company remain. Since the MNE are

dedicated to provide mainly lower cost, higher quality products, they could also engage in

selling their products/services locally in order to boost the demand and create a sort of

competition with the local producers that will boost the economy. In addition the author

claims that the engagement of MNE should be mainly by taking the opportunity and

supporting the operations in the host market as they enhance the productivity and average

standard living of the host country.

In addition, Mujih (2012) suggests that MNE should try to develop corporate social

responsibility (CSR) actions to help the domestic economy. Unfortunately most of the MNE

tend to just focus on the need to survive in a different economy and satisfy the economic

necessities. Indeed the perception of CSR in the home country vary from the actions taken

in the host country, for example in the home country (mostly developed countries) tend to

focus on sustainability and environmental issues whereas host countries (generally third

world countries) might not take these concepts as a priority but will focus more on the

socio-economic challenges that the country face. However understanding the new market

requirements and implementing CSR activities according to the market demand with

emphasise the relationship between the MNC and the host economy, improve the brand

image of the company and avoid the worst examples of labour exploitation and moreover

improve the productivity of the economy. Pimpa et al (2015) illustrates the example of

Thailand from his literature recommending that MNEs can contribute to the local economy

by alleviating poverty and improving social conditions. The corporate initiatives should

however be directly related to their core business, and with the help of local authorities

they should focus on key social and economic issues such as health promotion, labour, and

infrastructure development as they are linked with poverty alleviations strategies. Key CSR

11

activities from MNCs may focus on social and economic development of the local

community. Finally Pimpa et al (2015) claim that key issues such as poverty alleviation and

social development must be among the core strategic moves of MNE, if they need to

constructively engage with key stakeholders in both countries.

Many researchers found that MNEs should interact with local community and create

rigorous value in the host country, towards the reduction of poverty and dependency. MNE

tend to have a multiplier effect towards poverty reduction through their contribution to

relevant schemes such as the Red Cross scheme that implement humanitarian actions and

other social corporate responsibilities (Tirimba & Macharia, 2014).

5. Conclusion

This report reviewed and analysed various literatures about the different ways that FDI

affects the emerging economies and its impact, through the following framework: the

financial impact, the impact on the economy, trade, technology transfer, and finally some

recommendations about the various ways that FDI can improve domestic productivity of the

host country. Different authors debated on the positive impact that FDI has on the host

economies, whereas other authors argued on the negative impact. The aim was to discuss

both parts and provide future recommendations. More and more foreign companies see the

opportunity to invest in another country however the impact produced might vary from a

country to another depending on the socio-economic situation of the host country,

therefore it is recommended that governments take into consideration both impacts on the

productivity of the economy before accepting the FDI.

12

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