some of the biggest financial crises that occurred after 1998 (Brazil, Russia and Argentina being the most prominent cases).
The volatility and the pro-cyclicality of international financial flows are what make even some globalization enthusiasts, such as Professor Jagdish Bhagwati, warn against what he calls ‘the perils of gung-ho international financial capitalism’.[14] Even the IMF, which used to push strongly for capital market opening during the 1980s and especially the 1990s, has recently changed its stance on this matter, becoming a lot more muted in its support of capital market opening in developing countries.[15] Now it accepts that ‘premature opening of the capital account … can hurt a country by making the structure of the inflows unfavourable and by making the country vulnerable to sudden stops or reversals of flows.’[16]
The behaviour of international
The case for welcoming foreign direct investment, then, seems overwhelming. FDI is stable, unlike other forms of foreign capital inflows. Moreover, it brings not just money but also enhances the host country’s productive capabilities by bringing in more advanced organization, skills and technology. No wonder that foreign direct investment is feted as if it were ‘the Mother Teresa of foreign capital’, as Gabriel Palma, the distinguished Chilean economist who is my former teacher and now a colleague at Cambridge, once ironically observed. But foreign direct investment has its limitations and problems.
First, foreign direct investment flows may have been very stable during the financial turmoil in developing countries in the late 1990s and the early 2000s, but it has not always been the case for all countries.[20] When a country has an open capital market, FDI can be made ‘liquid’ and shipped out rather quickly. As even an IMF publication points out, the foreign subsidiary can use its assets to borrow from domestic banks, change the money into foreign currency and send the money out; or the parent company may recall the intra-company loan it has lent to the subsidiary (this counts as FDI).[21] In the extreme case, most foreign direct investment that came in can go out again through such channels, adding little to the host country’s foreign exchange reserve position.[22]
Not only is FDI not necessarily a stable source of foreign currency, it may have negative impacts on the foreign exchange position of the host country. FDI may bring in foreign currency, but it can also generate additional demands for it (e.g., importing inputs, contracting foreign loans). Of course, it can (but may not) also generate additional foreign currency through exporting, but whether it will earn more foreign exchange than it uses is not a foregone conclusion. This is why many countries have imposed controls on the foreign exchange earnings and spending by the foreign companies making the investment (e.g., how much they should export, how much inputs they have to buy locally).[23]
Another drawback with foreign direct investment is that it creates the opportunity for ‘transfer pricing’ by transnational corporations (TNCs) with operations in more than one country. This refers to the practice where the subsidiaries of a TNC are overcharging or undercharging each other so that profits are highest in those subsidiaries operating in countries with the lowest corporate tax rates. And when I say overcharging or undercharging, I really mean it. A Christian Aid report documents cases of underpriced exports like TV antennas from China at $0.40 apiece, rocket launchers from Bolivia at $40 and US bulldozers at $528, and overpriced imports such as German hacksaw blades at $5, 485 each, Japanese tweezers at $4, 896, and French wrenches at $1, 089.[24] This is a classic problem with TNCs, but today the problem has become more severe because of the proliferation of tax havens that have no or minimal corporate income taxes.Companies can vastly reduce their tax obligations by shifting most of their profits to a paper company registered in a tax haven.
It may be argued that the host country should not complain about transfer pricing, because, without the foreign direct investment in question, the taxable income would not have been generated in the first place. But this is a disingenuous argument. All firms need to use productive resources provided by government with taxpayers’ money (e.g., roads, the telecommunications network, workers who have received publicly funded education and training). So, if the TNC subsidiary is not paying its ‘fair share’ of tax, it is effectively free-riding on the host country.
Even for the technologies, skills and management know-how that foreign direct investment is supposed to bring with it, the evidence is ambiguous: ‘[d]espite the theoretical presumption that, of the different types of [capital] inflows, FDI has the strongest benefits, it has not proven easy to document these benefits’ – and that’s what an IMF publication is saying.[25] Why is this? It is because different types of FDI have different productive impacts.
When we think of foreign direct investment, most of us think about Intel building a new microchip factory in Costa Rica or Volkswagen laying down a new assembly line in China – this is known as ‘greenfield’ investment. But a lot of foreign direct investment is made by foreigners buying into an existing local company – or ‘brownfield’ investment.[26] Brownfield investment has accounted for over half of total world FDI since the 1990s, although the share is lower for developing countries, for the obvious reason that they have relatively fewer firms that foreigners want to take over.At its height in 2001, it accounted for as much as 80% of total world FDI.[27]
Brownfield investment does not add any new production facilities – when General Motors bought up the Korean car maker Daewoo in the wake of the 1997 financial crisis, it just took over the existing factories and produced the same cars, designed by Koreans, under different names. However, brownfield investment can still lead to an increase in productive capabilities. This is because it can bring with it new management techniques or higher quality engineers. The trouble is that there is no guarantee that this will happen.
In some cases, brownfield FDI is made with an explicit intention of not doing much to improve the productive capabilities of the company bought – a foreign direct investor might buy a company that he thinks is undervalued by the market, especially in times of financial crisis, and run it as it used to be until he finds a suitable buyer.[28] Sometimes the foreign direct investor may even actively
Of course, the value of foreign direct investment to the host economy is not confined to what it does to the enterprise in which the investment has been made. The enterprise concerned hires local workers (who may learn new skills), buys inputs from local producers (who may pick up new technologies in the process) and has some ‘demonstration effects’ on domestic firms (by showing them new management techniques or providing knowledge about overseas markets). These effects, known as ‘spill-over effects’, are real additions to a nation’s long-run productive capabilities and not to be scoffed at.
Unfortunately, the spill-over effects may not happen. In the extreme case, a TNC can set up an ‘enclave’ facility, where all inputs are imported and all that the locals do is to engage in simple assembly, where they do not even pick up new skills.Moreover, even when they occur, spillover effects tend to be relatively insignificant in magnitude.[29] This is why governments have tried to magnify them by imposing performance requirements – regarding, for example, technology transfer, local contents or exports.[30]
A critical but often ignored impact of FDI is that on the (current and future) domestic competitors. An entry by a TNC through FDI can destroy existing national firms that could have ‘grown up’ into successful operations without this premature exposure to competition, or it can pre-empt the emergence of domestic competitors. In such cases, short-run productive capabilities are enhanced, as the TNC subsidiary replacing the (current and future)
