Negative Aspects of the FDI Impact

By addressing the potential costs of inward FDI and the market failures in the FDI process, this subsection outline options for domestic policies to mitigate the negative aspects of the impact of FDI. MNCs can provide developing countries with proprietary assets, which are usually firm specific and difficult for domestic firms to acquire independently. Because MNCs are unwilling to part with their ownership advantages, FDI become particularly important for developing country to acquire these advantages and to establish competitiveness. However, the associated costs of inward FDI and MNC presence to developing countries should not be neglected. In the investment process, there are market failures and the objectives of MNCs can differ from those of host governments, which may possibly lead to adverse effects on development. Effective FDI policy in the context of constantly changing world economy is a demanding task. The challenge lies in to access to the proprietary assets of MNCs, but to disentangle these two kinds of effects, taking measures to maximise one and minimise the other.

Potential costs of FDI

FDI may provide host countries a package of tangible and intangible valuable assets. But it also offers a mixture of positive and negative effects. As most countries undertook substantial revisions in their FDI regimes, with a view towards FDI liberalisation, in some cases, the shift towards market forces may have been carried too far, too early, or in an inappropriate manner because possible costs of FDI were often ignored. Literature has identified cases in which certain costs of FDI can mitigate or even reverse the potential benefits of FDI. Three costs are particularly relevant. First, there are potential negative effects of FDI on the host economy by ‘crowding out’ domestic investment and suppressing local entrepreneurship. Secondly, there is an imminent risk that increased imports and profit repatriation could cause deterioration in their balance of payments.

Thirdly, transfer-pricing practices, tax allowances and other financial incentives granted to foreign firms may reduce tax revenues of host country.

The central concern is to what extent FDI may crowd out domestic investment. This question has been studied theoretically, through the way of including domestic investment into growth equations (Borenstein et al., 1998) or estimating investment equations that incorporate FDI (McMillan, 1999; Agosin and Mayer, 2000). It should be cautioned that MNCs improve welfare only if they generate benefits beyond those that are generated by the domestic firms they displace. The risk of ‘crowding out’ domestic firms by FDI can take two forms: in product markets by adversely affecting local firms in competing activities and in factor markets by reducing access for local firms (particularly to finance).

In this case, increased consumer surplus due to foreign entry must be weighed against losses in producer surplus. Foreign entry has short-term and long-term effects. In the short run the productivity of domestic firms may be reduced, while in the long run, the increase of competition induced by FDI may force inefficient domestic firms to exit and surviving efficient firms to improve their performance, leading to improvement of social welfare (Hu

and Jefferson, 2002).

The neoliberal approach to inward FDI led many governments not only to remove all restraints to FDI inflows but also to abandon their tools to guide and bargain with MNCs.

Countries got engaged in a (financial) ‘incentive wars’.¹⁵ This ‘incentive wars’ lead countries into a financial incentives-competition race towards the sky, a fiscal incentives-competition race towards zero, or a policy-competition race towards the bottom (UNCTAD, 1999). In fact, financial, fiscal and policy incentives are among a portfolio of location advantages that include access to markets and immobile tangible and intangible resources. There are much more important advantages that developing countries can offer.

Attracting FDI by only focusing on providing incentives in practice rarely makes a country win the competition for FDI attraction. It does not contribute to its economic development as well. The building of a favourable investment environment is a key that affects the business operation at the micro-level and is claimed to influence the competitiveness and growth of a country at the macro-level (Ng and Tuan, 2002).

Market failures in the FDI process

Markets are not perfect and market failures may lead agents to fail to exploit endowments or to develop new endowments. Where market mechanism is weak and supporting institutions are absent, information may not flow efficiently, risky projects may never be undertaken, costly learning may not be undergone, and externalities and linkages with other agents may result in under-investment (Stiglitz, 1996). There are detailed analyses of market imperfections in developing countries. While many macroeconomic models rely on some forms of market imperfection, they do not adequately address where these imperfections stem from. Based on advances in game theory and the economics of information¹⁶, the literature in this area has witnessed a remarkable explosion since the 1980s. This literature explains the source of distinctive institutional characteristics of the informal economy in developing countries. The market imperfections in developing countries include: fragmented labour and credit markets, persistent lack of market clearing, pervasiveness of long-term contracts, unequal treatment of similar workers or firms, and so on.¹⁷ These market imperfections are typically difficult to explain within the traditional neoclassical theory. Neither are most of them consistent with traditional understanding of monopoly or oligopoly. Accordingly many scholars have pointed out the irrelevance of neoclassical economics to the context of developing countries and the need for alternative paradigms. The economics of information provide a cogent explanation of many institutional characteristics in developing countries, within the context of an analytical framework grounded on the same methodology as the traditional approach.

With regard to market failures associated with the process of inward FDI, however, the research has been rare and the focus hitherto is the effects of government policies on market imperfections and the investment decisions of MNCs (cf. Brewer, 1993). The proper consideration of the role of MNCs in development requires a more complex framework for analysing the development process, taking account of the market, as well as institutional, imperfections. According to Lall (2000), there may be market failures in the investment process caused by information and coordination failures. MNCs may have

15 See UNCTAD (1996a, 1996c).

16 The idea of the possible failure and decadence of markets has been advanced in works by Akerlof (1970) and Arrow (1971).

17 For a detailed discussion see Mookherjee and Ray (1999).

inadequate information on potential locations selection and the investment decision-making maybe subjective and biased. Prospective investors, even the largest firms, do not always conduct systematic worldwide search for opportunities. Most firms consider only a small range of potential locations (IFC and FIAS, 1997). The coordination between investing firms and host country governments plays a crucial role in the FDI process.

However, there may be failures of coordination between MNCs and host countries. In order to attract MNCs’ mobile assets, effective promotion could go beyond simply focusing on advertisement into coordinating the supply of immobile assets according to the specific needs of MNCs. However, a developing country may not be able to meet MNCs’

needs because of the limitations in technology, human capital, infrastructure and institutions.

The market failure also arises from divergences between the private interests of foreign investors and the public interests of the host country. Private and public interests may diverge for both foreign and domestic investment. However, some divergences are specific to foreign investment because it differs from domestic investment in that the focus of decision-making lies abroad and the foreign investor has less commitment to the host economy and is also more mobile (Lall, 2000). The basic objectives of MNCs and host country governments are different: governments seek to promote welfare and development while MNCs seek to enhance their performance and profitability. Therefore, FDI inflows are not always in the best interest of host countries and some can have adverse effect on development. In some scenarios, MNCs’ objectives may differ from those of developing countries. For instance, the presence of MNCs in a host economy may crowd out local firms, thus conflicting with the goal of domestic enterprise development. MNCs may advocate stronger intellectual property right protections while a host country may favour weak ones to permit greater diffusion of technologies.

Another source of market failure in the investment process and afterwards, relates to the fundamental mechanism of market – competition. According to the mainstream explanation of FDI, as discussed in Section 3.4.4, FDI itself is a manifestation of market failure. The existence of market dominance, as well as the abuse of it, is one of the fundamental market failures that economists and policy makers attempt to tackle. Three sources of market dominance that are under the control of competition policy, collusion, predatory practice and M&A, are directly related to FDI. The interface between competition policy and FDI, as discussed in Subsection 3.4.4, necessitates a policy solution for the market failures in the FDI process. In developing countries, without an effective competition policy as necessary market-supporting institution, market failures in the FDI process in terms of market dominance are becoming a prominent issue and cast potential negative effects on industrial development.

Policy implications

For developing countries, a passive laissez faire approach to inward FDI is not sufficient due to the existence of potential costs and market failures. While FDI provides a package of valuable assets and offers a mixture of positive and negative effects, this does not mean that simply opening up to FDI is the best way to obtain them. The market failures in the investment process and divergences between the objectives of MNCs and governments provide the space for government policies. Polices on FDI are needed to counter several sets of market failures: the first arises from information and coordination failures in the investment process; the second arises from divergences between the private interest of investors and public interests of host country, or the basic objective of MNCs and governments; thirdly, there are market failures in the FDI process in terms of market

dominance and the abuse of it. These market failures may lead a country cannot be able to attract the volume and quality of FDI they desire, or lead FDI to have negative effects on development.

Due to the existence of information imperfection, it may be worthwhile for country to invest in advertising to alter the perception of potential investors by improving its image, taking economic fundamentals as given, (Wells and Wint, 1990). Such kind of promotion can be extremely effective in raising the inflow of FDI and it quality, as demonstrated by the experience of Ireland, Singapore and Costa Rica (Spar, 1998). Due to the existence of the coordination failures, it is helpful if the host government discovers MNCs’ needs and meets them in the competition to attract FDI. The cases of large investment projects of MNCs in China have illustrated how the process of coordination influent the location decision of foreign investors. For example, in the competition for a large investment project in semiconductor industry, Shanghai and Suzhou endeavoured to provide almost whatever MNCs wanted in order to influent their location choice. The case of Costa Rica has illustrated that it was preparation to invest in training to meet Intel’s skill needs that attract the investment (Spar, 1998). Although there are divergences between the private interest of investors and public interests of host country, there is a considerable overlap between the objectives of MNCs and host countries. Since the overlap is incomplete, it is important for developing countries not only attempt to attract FDI, but also try to maximise its contribution to the ultimate goal of development. Policies matter, perhaps more than ever (UNCTAD, 1999).

In the FDI process, there are bargains between the host country and MNCs. The outcome of FDI is influenced by how effective the host country bargains with MNCs.

However, the bargaining power of developing countries is usually weak compared to MNCs. Weak bargaining power on the part of host governments may possibly result in the unequal distribution of benefits or abuses of market power by MNCs. Therefore regulation is needed. Necessary regulation consists of several aspects. One concern arises with respect to the environment. In their home country, MNCs face high environmental standards from environmental regulations. While in many developing countries, environmental regulations are lax or poorly enforced. Facing the danger of being a

‘pollution heaven’, developing countries should upgrade their level of environmental regulation. Another important regulation issue is that of transfer pricing. MNCs can now use transfer pricing over very large volumes of trade and service transactions to evade taxes or restrictions on profit remission. Developing country tax authorities are generally ill equipped to tackle this.

The capability of host countries to regulate firms in the means of competition policy emerges as an important policy issue. In the new context of FDI as discussed in Subsection 2.3.1, legitimate regulative instruments become less and less. Competition policy provides developing countries a standard tool to protect market competition and to ensure competitive business behaviour by firms, not only foreign but also domestic. Table 4-1 preliminarily summarises the potential effects of FDI on industrial development. At the firm level, FDI may crowd out or crowd in domestic firms. At the industry level, FDI may have both (static) structural and (dynamic) technological effects and the effects may be positive or negative. The effects at these two levels are closely interrelated. The next two sections of this chapter address the structural effect of FDI and Section 4.4 discusses the technological effect. The empirical evidence for these effects is simply summarised in this table, which highlights the directions for future empirical quests in this area (see the following sections in this chapter for details).

Table 4-1 Potential effects of inward FDI on industrial development: a summary Item Positive effects Negative effects Empirical evidence

Domestic

– By intensified competition – By reducing access for local firms to factors

– High product diversity and quality – High international competitiveness Increasing competition

Negative industrial performance – Higher price

– Low product diversity and quality – Low international competitiveness Market dominance of MNCs – Dominant positions of MNCs – MNC abuses of market dominance (anticompetitive practices of MNCs)