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Is FDI a force for good?

FDI is often praised for the benefits it brings to its destination locations. However, these benefits are dependent on a variety of factors.

Huawei China FDI
Huawei is being viewed with increasing suspicion in the West, with many companies ramping up FDI screening measures. (Photo by Sean Gallup/Getty Images)

Foreign direct investment (FDI) is a key driver of globalisation. As a poster child of contemporary economic thinking, in the World Bank sense, its virtues have been upheld since the early 1980s.

Although the consensus remains that FDI is a force for ‘good’ with regards to economic development, its shortcomings and dangers are no secret either. The extent to which FDI is positive is largely influenced by the type of investment in question (mergers and acquisitions (M&A) versus greenfield), its industry, the destination country and the intention of the investor.

The good

Economic orthodoxy holds that FDI creates ‘direct’ benefits such as new capital and jobs, which in turn boost a recipient government’s tax revenues and foreign exchange.

However, the most substantial economic development impact of FDI comes from its spillovers, or ‘indirect’ benefits, such as the transfer of labour skills, technology and management practices, the fostering of competition and innovation, and the increased integration with global supply chains.

For example, in terms of driving innovation, foreign-owned firms account for one-quarter of research and development carried out by businesses in France, Germany and Spain, 30–50% in Portugal, Sweden and the UK, and more than 50% in Austria, Belgium and Ireland, according to a recent report from EY.

More generally, there is a strong positive relationship between GDP and FDI, and FDI helps remove global market imperfections, insofar as globalisation offers a form of comparative advantage, says Glenn Barklie, chief economist at Investment Monitor.

Additionally, FDI can also help to elevate export levels (a component of GDP), he adds. For example, an automotive company could establish its original equipment manufacturing plant in the UK and export cars to elsewhere in Europe. For some developing economies a rise in exports could also mean becoming more connected globally, thereby potentially increasing imports.

Good practice FDI can also bring positive benefits in terms of helping to position the host country to provide better regulations, be it business-related, environmental and/or social, concludes Barklie.

More often than not, FDI and ‘social progress’ fall into a virtuous cycle, according to a study from Deloitte. For example, social progress components such as water and electricity supply, educational opportunities, and personal and political rights help attract FDI by providing the infrastructure, skilled workforce and secure political environment necessary for businesses to develop.

On the other hand, FDI then creates demand for additional investment into infrastructure and education, and foreign companies can directly support the provision of healthcare, education and other social services.

What type of FDI?

The aforementioned benefits of FDI began with job creation; however, certain forms of FDI create more jobs as others.

This is where the distinction between cross-border M&A and greenfield FDI is particularly important. The former does not necessarily create jobs or new facilities, as it simply involves a company changing its legal ownership and management after being taken over or merging with another company.

On the other hand, greenfield FDI always creates new jobs and/or facilities from the ground up. It tends to be long term and ‘sticky’ – not bolting off in times of crisis – which is why governments are most keen to attract this type of FDI. Foreign portfolio investment, on the other hand, is highly volatile and short term.

To put things in perspective, greenfield FDI was valued at $795bn globally in 2019, creating 2.2 million jobs, according to fDi Markets. And when a greenfield foreign investor establishes a presence abroad it creates not only direct employment but also indirect employment.

Direct employment is jobs created by the company for its operation, while indirect employment refers to jobs created by other companies due to the initial investment by the foreign investor’s company. A Microsoft Economic Impact Study in 2008 estimated that for every job created by Microsoft in the state of Washington, 5.81 jobs were created indirectly.

“The more people with jobs, the more people there are paying taxes – contributing to the government’s income,” says Barklie. “Additionally, it has been argued that multinational companies tend to pay higher than the private sector median wage, which means that more people have higher levels of disposable income, which in turn means they are likely to spend increased amounts in the local economy.”

The increase in employment also means a reduction in unemployment benefits, which in most countries is provided by the government.

The injection of capital investment has similar benefits. For example, when a chemicals company sets up a manufacturing plant overseas, it will likely pay other companies to build a warehouse and purchase machinery, thereby setting off a positive externality cycle once more, adds Barklie.

Although cross-border M&A has a less tangible impact than greenfield FDI, it can help safeguard jobs that may have been under threat if a company was struggling. As with greenfield FDI, cross-border M&A can also bring best practices, innovation and technology that in turn bring efficiency savings and improved education for the recipient country’s workforce.

Indeed, research from the London School of Economics (LSE) suggests that in emerging markets such as Colombia, where technological development and global integration often lags, multinationals buying up existing local firms are more effective at encouraging innovation than they are when engaging in greenfield FDI.

The bad

FDI is by no means strictly positive, however.

Cross-border M&A, for example, makes up a whopping 80% of global FDI flows, according to the UN Conference on Trade and Development (UNCTAD). However, this mainstay of the FDI world does little to create new jobs or develop the local economy.

Even greenfield FDI does not guarantee job creation as, in some rare and much-criticised cases, foreign investors hire and ship over labour from their country of origin.

There is also the risk that cross-border M&A will lead to the theft of knowledge and technology from the host country to the source/investor’s country. This is why many countries are increasingly wary of Chinese companies acquiring domestic firms, and are therefore establishing protectionist FDI screening measures, explains Barklie.

Furthermore, political concerns may arise if foreign companies become, or are perceived to be, too powerful in a recipient country, contends Barklie. For example, the UK government stated that Huawei is to be removed from the UK’s 5G networks by 2027 due to security fears and the protection of the domestic telecoms industry.

Tax is another key issue.

“Foreign investors may also set up a presence in a country for tax reasons – again without creating a real benefit to the local economy in terms of job creation,” says Barklie.

Ireland provides an example of this. Over the past 30 years, the country has gone from being one of the EU’s poorest countries to rubbing shoulders with the richest, thanks to ‘good’ FDI, notably of the greenfield variety. However, Ireland’s more recent economic boom (and troubles) have been driven by short-term capital flows; more specifically, the transferring of intangible assets for the purpose of lowering corporate tax.

Competition is usually a good thing, but in terms of taxation this is not always true. For decades, multinational companies have been able to avoid tax because agreed principles surrounding cross-border taxation are lacking.

When countries compete for FDI by offering fiscal or tax incentives to potential investors, the case for clear welfare gains for the host economy becomes ever more blurred.

There have been numerous examples in which regions or states within the same country compete to attract FDI projects without coordinating their actions, thereby allowing foreign companies to play the locations against each other and gain disproportionate rewards, such as free land and tax exemptions.

Another area that sits uncomfortably is when foreign investors engage in round-tripping, which means using their foreign subsidiaries to borrow in local capital markets to then lend back to the parent company. This type of investment is highly unproductive for the recipient country and increases the risk of capital flight.

Some of the world’s largest tech companies, such as Apple and Amazon, have been accused of issues such as tax avoidance. Although locations become more innovative when tech giants move in, the impact of these much-vaunted companies is not always viewed as positive.

Indeed, studies from LSE show that the FAANGs grouping – Facebook, Apple, Amazon, Netflix and Google – are particularly adept at keeping their knowledge and new ideas in-house, and are less likely to hire local workers.

“They collaborate less with local firms, and they are less likely to demonstrate their ideas and innovations and share them with the local economy,” writes professor of economic geography at LSE Riccardo Crescenzi. “So, the risk for the local economy is that a highly sought-after Google Campus – often supported by public resources and infrastructure – might become a Google Enclave.”

“Medium-sized, innovative multinationals are most likely to boost regional innovation,” he adds. “These ‘second-tier’ players might be the best partners to facilitate regional innovation and should be given more attention by policymakers, even if they are less well-known (and therefore harder to identify).”

The ugly

There are also environmental concerns regarding FDI. In sectors such as industrial machinery and non-renewable energy generation, for example, foreign investment can lead to increased pollution or ecological destruction if the investor disregards international best practices, or these practices are not enforced.

The track record of FDI in extractives is somewhat chequered, not just environmentally speaking but also in terms of reliably generating links and spillovers to local economies.

Sometimes, increases in FDI make developing countries more dependent on the depletion of natural resources to keep their economy running.

This is why the Deloitte report found that, along with foreign investment to tax havens, FDI driven by the availability of natural resources has the highest risk of not creating social progress in the recipient country.

Meanwhile, in FDI sectors such as construction, there are often claims of mistreatment of workers, and low pay. For example, the building of the football stadiums in Qatar for the 2022 World Cup – by local and foreign companies – has come under scrutiny due to poor worker safety, rights and pay.

Developing countries are particularly at risk of these dangers brought about by FDI, as they tend to be more resource or extractive-dependent and have weaker labour and environmental protection laws.

On the other hand, developing economies are also most likely to reap the benefits of foreign investment, not least because they attract a higher proportion of greenfield FDI over cross-border M&A compared with the developed world.

FDI is more likely than other forms of capital flow to take place in countries where the markets are more nascent – mostly developing countries – thereby bringing in the capital, know-how and technology that the recipient economy lacked.

In recent decades, developing countries have been targeted by foreign investors more than ever. In fact, in 2019 – for the first time – emerging markets absorbed more FDI than developed countries, according to UNCTAD. Moreover, capital spent on FDI in the developing world frequently far surpasses the amount of money sent through official development assistance.

The Covid-19 pandemic is expected to slam the brakes on FDI flows (particularly greenfield) to many countries, especially developing ones. This loss will highlight the immense benefits of FDI to those countries, as well as the dangers of being too reliant on it. In short, FDI is both ‘good’ and ‘bad’ – context is everything.