Foreign direct investment is a decision made by a company to invest in a foreign country. This is mainly done when the foreign entrant buys a company in the foreign country or extends its operations into that foreign country. Most companies engage in foreign direct investment for various reasons such as to take advantage of untapped resources and markets. They also aim at maximizing various incentives provided by the host countries such as tax exemptions, tax holidays, land subsidies, low corporate taxes and export processing zones (Fernandez, 1996). This is mainly prevalent in developing economies where most resources are underutilized due to lack of adequate capacity.
Foreign direct investment is a major source of external finance to the host countries. Most businesses in developing economies suffer lack of capital due to unwillingness of commercial banks to issue loans. The banks normally cite high risk levels in most of the developing economies. This capital injection by foreign entrants creates a lot of job opportunities for locals. This leads to improved wages which in effect raises the demand. Most households can afford the basic necessities due to increased levels of employment.
Most of the developing countries experience frequent price shifts that leads to market volatility (Masson, 2002). This creates a lot of uncertainty in the market since it affects long term planning. However, the prevalence of foreign direct investment in an economy can counter this since these investments take longer to set up and have more permanency than majority of the short term engagements by speculators. This leads to economic stability characterized by strong currencies.
Foreign direct investment also leads to resource transfer. There is usually an influx of technocrats hired by these investors for the execution of various responsibilities. Due to the high costs associated with the nature of work they do, these foreign investors often tend to train locals on various technical applications that further boosts the technical know-how of the expatriates. The developing economies eventually get integrated into the larger global economy through export of completed products and also importation of raw materials.
The prevalence of foreign direct investment in a country increases the competitiveness of a country’s products both domestically and internationally. This is mainly attributed to the introduction of advanced production processes which forces local companies to upgrade their systems in order to remain competitive in the market. This eventually leads to improved quality products.
The labor force in the host country benefits through the acquisition of globally accepted knowledge and skills on various production processes. This improves the quality of the work force in such a country. It eventually leads to production of quality products that leads to higher income earnings. The rise in wage levels in the economy implies more income for households which increase their propensity to consume. The rise in consumption increases the demand for products in the economy. This increased demand leads to rise in price levels for goods. Increased prices encourage more investors both local and international to invest in production processes since they are assured of higher returns. This increases the supply of such products and eventually the prices will settle at equilibrium. This influx by investors leads therefore leads to greater demand for consumption goods which then triggers more investment in order to meet the increased demand.
The national income equation of a country is, Y=C+I+G+(X-M). Where; Y represents national income of a country, C represents consumption spending, I represents investment spending including foreign direct investment, G represents government spending and (X-M) represents net exports. From the above equation, increased foreign direct investment will boost investment spending which will eventually increase the national income of the country (Lin, 2000).
The increased investment level in a developing economy improves the revenue bases for the government through increased tax revenues. This enables the government to undertake its other development projects. This leads to improved infrastructural developments such as roads, health and educational facilities, telecommunications and social amenities. This improves the quality of life for the citizens.
The increase in aggregate demand of a country due to foreign direct investment can only be justified in the short term. Most of these foreign entrants repatriate most of their initial capital outlays to their mother countries after a few years. This jeopardizes the balance of payments situation of the host country. Foreign direct investment is therefore beneficial to the host country only if the investors will reinvest their earnings in the host country in order to generate more capital and boost national income.
Foreign direct investments are also known to create negative externalities in the job market of the host country. In most instances, the foreign entrants usually pay higher wages than the local firms. This has the effect of improving the consumption ability of the workers but may be detrimental in disrupting the labor market of the host country. When the wages increase, there will be increased supply of labor which will eventually lower the demand. This creates distortions in the labor market which may then cause unemployment. Unemployment will imply reduced propensity to consume for the workers and the economy will shrink. This is due to the effect of low consumption which will reduce the national income.
There is a close relationship between foreign direct investment and the level of exports of a country. Foreign direct investment is known to augment the host country’s capital reserves which are crucial for the continued exploitation of its competitive advantage (Truman, 2009). This is also enhanced through technological transfers by the foreign investors to the host country. The foreign entrants also participate actively in opening new foreign markets for the host countries that are exploited by the locals boosting national income. However, these foreign entrants may primarily target the local market in the host country and therefore not expand export levels. Due to their greater technical capabilities and comparative advantages, foreign companies may inhibit the establishment and growth of local firms which may curtail the growth of a country’s exports. Growth of local firms may further be limited by these foreign entrants through exploitation of locally cheap labor and available raw materials. The intensified competition between foreign firms and the local ones may also increase the volume of imports in the long run. This is due to low technological capabilities of locally established firms in developing countries.
The distortions in the export import market of a developing country have adverse effects on its balance of payments. These deficits can create foreign exchange shortfalls and have negative consequences on the economy by reducing the level of investments. Higher exchange rates will reduce the amount of imports into the economy. This will reduce the level of production by those firms that rely on foreign raw materials in their production processes. Reduced production by these firms will reduce labor requirements and may cause the laying off of workers.
Higher exchange rates increase the cost of imported raw materials which in effect pushes up prices. The rise in prices reduces the disposable income available to consumers (Pearson, 1999). The foreign investors in the host country can trigger foreign exchange imbalances through repatriation of profits. It is therefore imperative for the regulatory authorities to monitor the activities of such firms in order to protect the economy. This is however a tall order since most of the host countries enter into non interference agreements with these investors at inception. These foreign investors are able to monitor the macro economic situations in host countries that enable them to shift their investments to low risk areas. This enables them evade the negative consequences associated with any variations in the macroeconomic variables such as inflation and unemployment. This is to the detriment of the host country’s economy which suffers from such actions.
Most foreign direct investors in developing countries control large chunks of foreign exchange transactions due to their many activities especially for multinationals. Any failure by the regulators such as the central banks of such countries to implement effective monetary policy can lead to high inflation. This will be an indicator of instability in such an economy and any potential investor will be unwilling to invest. There are multinationals who venture into developing economies and establish political connections with the regimes in those countries. They enjoy political patronage which in effect contributes heavily to inflationary pressures. Some are even known to engage in corruption and other unethical practices. Such an economy experiences stunted growth with serious ramifications on other economic indicators such as employment levels, price stability and investments. This is a common scenario in some of the developing economies in parts of Asia and Africa.
The role the host governments play in regulating foreign direct investment is crucial in protecting domestic industries. These governments should have the ability to intervene in the economy so as to offer protection to the locally established firms. The governments must come up with strict monetary policy frameworks that will curtail any inflationary tendencies. This is through regulation of the amount of currency in circulation in order to curb inflation. They must also liberalize the market sectors in order to enhance fair competition in the market. Most governments in developing countries are known to own either wholly or partly some of the firms in most of the competitive sectors of the economy. This discourages most foreign entrants who may be willing to venture into such economies. This is because most of the firms where these governments have control enjoy various incentives such as tax exemptions and waivers. This makes such markets uneven and highly inclined. Key market indicators such as price levels, inflation rates and interest rates become unpredictable and have very wide variances (Fischer, 2003).
Less government control of market forces will encourage lenders like banks and other financial institutions to offer credit facilities to investors both local and foreign. This is because such markets will be depicted as being less risky to operate in. Reduced cost of credit will also lower the price levels of commodities since more foreign investors will be willing to invest in such economies thereby boosting production and value addition. It will also encourage fair competition since most of these foreign investors have the capacity of sourcing cheaper foreign funds to the disadvantage of local investors who rely on their local finance providers.
The role played by foreign direct investors in the economies of developing countries cannot be underestimated. Most of these investors help in leveraging exchange markets in most of these economies they operate through multiplicity of factors. However, since they are private entities and their main role is profit maximization, their activities must be clearly outlined. This will protect the locally established firms who have nowhere else to turn to in times of economic turmoil. The government agencies in the regulatory sectors in these developing countries must therefore be alert to ensure that the country’s competitive advantage is not at risk. This will ensure that there is mutual benefit amongst all the participants in the economy.
Fernandez, M. (1996) Foreign Direct Investment. Journal of Development Economics, 85(2), 31–38.
Fischer, A. (2003). Role of macro economic factors in growth. Journal of Monetary Economics, 32(3), 48–51.
Lin, H. (2000). Macro Economic Theories and Policies. Oxford. Oxford University Press.
Masson, H. (2002). Price Stability. London. Haman Press Ltd.
Pearson, T. (1999). Price Stability and Foreign Direct Investment. American Economic Review, 90(2), 105–109.Truman, S (2009). Macroeconomic Uncertainty and Private Investment in Developing Countries. International Journal of Central Banking, 1(3), 53-75