Governments with over-optimistic expectations from foreign direct investment should be aware that it does not necessarily increase employment and can have negative effects on a fragile economy.
ONE of the myths that appears to be indestructible, despite growing evidence to the contrary, is that of the generally positive and desirable nature of foreign direct investment (FDI). It is certainly seen as being preferable to other forms of foreign capital inflow, such as commercial borrowing and portfolio investment. Furthermore, it is considered to be eminently advantageous in its own terms, and something to be actively sought by governments of developing countries. In fact, access to more FDI is now touted as one of the major benefits of the recent economic globalisation, which is supposed to outweigh its many negative effects.
In India, this perception has, if anything, intensified in recent times. Witness the Budget speech of the Finance Minister, in which he announced a reduction on corporate tax paid by foreign companies from 48 per cent to 40 per cent, despite the shocking shortfalls in tax collection in the current year. This concession was explicitly declared to be a means of wooing more FDI into the economy.
Of course, one can quarrel with the Finance Minister's (false) notion that tax concessions will work to attract more FDI into a stagnating economy. But the more fundamental mistake is to assume that it is necessary to attract FDI in whatever form into the economy, and that this justifies tax and other concessions.
An important book by David Woodward (The next crisis? Direct and Equity Investment in Developing Countries; Zed Books, London and New York, 2001) shows just how problematic such an assumption can be. Woodward's book contains a penetrating and occasionally startling analysis that lays bare in a succinct way many of the current myths about FDI.
To start with, Woodward reveals how little we actually know about even the extent of FDI, and especially stocks of FDI, in different countries. It emerges that official data - including those produced by the International Monetary Fund (IMF) and the World Bank - almost certainly underestimate to a substantial extent, the true value of inward FDI stocks and their absolute rate of increase. Far from trying to improve this state of affairs, the Fund and the Bank have promoted the liberalisation of foreign investment regimes, which actually tends to reduce the availability of data and even the possibility of collecting it.
This matters not only because it is useful for a host country to know the exact stocks of inward FDI, but because inadequate assessment of their extent may lead to policy misjudgment and failure to anticipate potential crises. As Woodward points out, the lack of information on the extent of external liabilities contributed to the external debt crisis of the 1980s, and a similar process may be under way with respect to private investment today. Moreover, since FDI is not unambiguously positive, such lack of knowledge of the extent of inward FDI stocks can even be dangerous in other ways.
Consider, for example, the foreign exchange effects of FDI, which are often simplistically assumed to be positive. In actual fact, the foreign exchange effects are much more negative than what emerges from an idealised view of FDI. Woodward shows that positive effects arise only where new productive capacity is created in the export sector, or in very strongly import-substituting sectors. If FDI takes the form of purchase of existing capacity, even in the export sector it will have a negative foreign exchange effect even if export production goes up, unless the productivity of capital increases enough to offset the other increased foreign exchange costs. At lower levels of import substitution, the effects of "greenfield" FDI on new capacity are much more ambiguous, and may be negative.
Similarly, Woodward indicates how misleading it may be to assume that FDI necessarily contributes to increased employment. In fact, the employment effect will depend on a whole range of variables, including the balance between greenfield FDI and the purchase of existing assets; the labour intensity of new productive capacities or new organisational techniques; the extent to which FDI-based production substitutes for existing production and their relative labour intensities, and so on. In general, therefore, it is not the case that FDI creates much more net employment unless it is really very large in scale and heavily involved in greenfield activities, and even in such cases it need not be more employment-intensive.
Large-scale flows of FDI also have effects on other domestic economic policies. To begin with, reliance on such flows imposes severe constraints on domestic government policy because of the fear of withdrawal, and of course the potential impact of disinvestment increases as the FDI stock grows. Further, FDI is embodied in the presence of multinational corporations (MNCs) which tend to be large and powerful lobbies in the matter of domestic policies.
And then, of course, the very competition to attract more FDI by governments with over-optimistic expectations regarding such investment, means that all sorts of concessions are offered, which may turn out to be very expensive for the economy in the medium or long term. Woodward suggests that such FDI promotion tends to focus heavily on the demand side, in terms of requirements imposed on host countries which involve changing their own policies in order to make themselves more attractive. Such unilateral concessions are increasingly sought to be entrenched through international agreements.
Another interesting point that Woodward makes is that much of the over-optimism surrounding foreign investment stems from a tendency to look at the host country in isolation from the developing world as a whole. But in fact there are strong negative spillover effects on other developing countries, which may outweigh whatever limited gains actually do accrue to the host country.
Woodward analyses the 1990s boom in FDI to developing countries, to conclude that it has the elements of a temporary surge similar to those affecting the market for equity (or portfolio) investment. While deregulation of foreign investment across the developing world has played a role, this has probably been less significant than the large-scale privatisation programmes, which have been a major source of both FDI and portfolio investment, and the debt-equity conversions, which were especially common in Latin America. Further, some flight capital may re-enter the country as FDI - some estimates suggest that this has been significant, for example, in China.
All these are clearly short-lived, or temporary forces. Even the globalisation of production can be seen as a finite conversion process, albeit one which is more prolonged and complex. But it is important to note that all these features make FDI, along with portfolio investment, strongly pro-cyclical in nature.
Even worse, FDI can contribute to the underlying fragility of an economy and make it more susceptible to balance of payments crises. Woodward considers several ways in which this can happen. First, as rapidly growing stocks of inward FDI generate similarly growing profits that form part of the foreign exchange outflow. Secondly, when FDI fuels an increase in imports, such as capital goods for investment projects and other such payments. Thirdly, because current foreign exchange costs of MNCs typically exceed the foreign exchange they tend to earn through exports of import substitution. Fourthly, through the role played by foreign affiliates, including those involved in retailing, in changing patterns of consumption through advertising and brand promotion.
For these and other reasons, FDI can contribute to large current account deficits, which tend to precede financial crises. They can also add to both the economic shocks preceding crises and to the process of contagion. Woodward provides examples of a number of East Asian economies and of Mexico prior to their respective financial crises. He does not mention Argentina, whose major crisis broke after this book was published, but it provides an even more classic example of his argument.
The "fire-sale" of domestic productive assets to foreign companies, which often accompanies attempts to come out of such financial crisis, may initially limit the reduction of FDI to the affected countries, as indeed happened in South Korea. But this occurs at a high long-term cost, in terms of the build-up of more FDI stock and further adverse balance of payments effects.
Once again, the case of Argentina over the past two decades provides a stark, if telling, example - indeed, it is almost as if this script were written for Argentina, in terms of the pattern of sale of public assets to foreign multinational companies in the early 1990s, followed by very adverse balance of payments effects which contributed in turn to the external debt build-up, which then precipitated the most recent crisis.
This more pessimistic - and more realistic - view of the impact of FDI provides a very different angle on the substantial and rapidly increasing stocks of inward FDI in a number of developing countries. Far from being a source of celebration, it may in fact be, as Woodward describes it, "an accident waiting to happen". The latest round of crises in emerging markets has perversely operated to strengthen both the positive attitude to FDI and efforts to promote it. But in the new climate, in which developing country markets are seen as riskier and international investors are becoming more risk-averse, efforts to attract more FDI will involve even more concessions on the terms of such investment. "The result will be to accelerate the build-up of liabilities without a commensurate effect on the now seriously limited capacity of national economies to bear them" (page 207) .
In fact, such a crisis appears to be almost inevitable, since any serious efforts to prevent it would require both a change in attitudes to foreign capital and a change in political structures. As Woodward says, "Only when governments represent the interests of their populations and both their business communities, and have (international) political influence proportional to the populations they represent, can we realistically expect to achieve an international financial and economic system which will genuinely serve the interests of people, and not of transnational companies" (page 215).
Until then, it looks as if the world will have to brace itself for the next round of financial crises, this time probably emanating from the balance of payments problems caused by the current adulation of FDI. And we in India will have to bear with further concessions to multinational investment that may not be in our long-term interest, even if such investment does choose to come into the country.