The Effects of Foreign Direct Investment on the Home Country
Foreign Direct Investment (FDI) could be defined as a minimum 10 percent investment of equity or capital by a firm based in one country (home economy) to an enterprise resident in another country (the host economy). The new entity then becomes a multinational enterprise (MNE). Many companies prefer FDI to exporting to gain access to new or larger markets, gain cost advantages in the host country and in response to trade barriers. There has been significant global growth of FDI since 1982. Although the United States is the largest home and host country of FDI, outflows have exceeded inflows. Japan in contrast, receives much less inflows than outflows. Cultural and financial management variations between countries do seem to influence the direction of FDI flow. Strategic governmental trade policies in recent years have supported the globalization to a more efficient world economy. Companies often get governmental assistance in attaining international economies of scale and first mover advantages.
The huge inflows of FDI into the United States could be due to the falling value of the dollar in the late 1980’s and early 1990’s indicating exchange rates play a significant role in the choice of either horizontal or vertical FDI opportunities over exporting. Honda successfully used vertical FDI in the 1980s by establishing high quality operations in the United States. The company utilized U.S. suppliers for machine tools and parts capitalizing on currency exchange rates and local responsiveness. FDI is often preferred over licensing in the high technology or specialized industries, and in many cost sensitive industries. Significant research is necessary to evaluate the advantages of trade vehicles and their effects on the home country. Parent companies lobby for governmental policies that support free trade in order to gain competitive advantages in developing global markets. Many businesses suffer losses for many years focusing on long-term growth potential. This paper will analyze the possible effects of FDI on the home country.
Home country governments influence the ability of firms to invest in foreign countries. The radical view of FDI was popular until the end of the 1980’s, and equated to the economic domination by companies rather than the economic development of nations. Radical policies were prevalent in communist countries and in Latin America in the 1960s-1970s. Radical regimes regularly expropriated multi-national companies and prohibited outward FDI. The collapse of communism, and the growth of the free market view marked the beginning of policies encouraging capital and technology transfers.The Smith and Ricardo Market Imperfections approach to FDI, involves maximizing gains and minimizing the costs of FDI. Most countries have adopted policies somewhere between the radical and free market approach, while still imposing some restrictions on outward FDI (Pragmatic nationalism).
There are many potential benefits of FDI on the home country. Improvement in the balance of payments can be realized through increased inward earnings, potential home country exports and foreign expertise that can be transferred back to the home economy. Opportunities to be exposed to new work practices and technology, can aid the home economy in managing and exploiting technology and knowledge-based assets. Higher living standards are also a general long-term benefit of outward FDI, due to the added value characteristics of comparative advantage, and more affordable products and services.
Outward FDI could also detract from a home country’s capital stock. A negative balance of payments is possible if earnings aren’t realized in an acceptable time period. Also, if FDI is a substitute for direct exports or aimed at serving the home market from a low cost location, the balance of payments could be adversely affected. It could be argued however, that home country exports could be displaced over time by host country production whether it is by another foreign competitor or local companies opening their own domestic operations. Thus, the opportunity cost is a loss of potential first mover advantage, as well as the loss of existing exports. In most cases studied, outward FDI results in complementary increases in exports over time, offering home country comparative advantages through efficiently organizing production to supply growing foreign markets.
Reduced home country employment is an issue when FDI is substituted for domestic production (offshore production). Long-term home country resources are best utilized where they can add the most value and offer a comparative advantage. The impact of investment depends on whether the home country’s comparative advantage is in research and development, natural resources, or skilled labor-intensive industries. If efficiencies are realized then generally consumers of the home country benefit from reduced product prices. There is great wage disparity between the United States and many developing countries. It could be argued that outward FDI flow has created a higher emphasis and value on the research and development class in relation to the unskilled class of workers in the United States. It is the role of government to balance the inefficiencies through policies that promote long-term consumer benefits of the home country. Assisting employees through educational assistance programs and training is one possible solution to elevating the lower skilled workforce.
Governments can encourage and restrict FDI in their home countries. Encouragement is offered in policies toward foreign risk insurance, financing arrangements, tax incentives, and pressuring foreign governments to remove trade barriers. Capital flow control restrictions are used in attaining balance of payments and in limiting funding of foreign investments. Many governments also utilize manipulation of tax rules in order to encourage firms to invest in the home country. Political disruptions or prohibitions in trading with certain countries are other ways that FDI outflows are restricted.
World leaders have removed many restrictions on FDI in recent years resulting in phenomenal growth in the movement of capital. Capital abundance has been associated with countries that have lower interest rates and strong currencies as evidenced by the United States economy over the past twelve years. The Uruguay round of GATT and more recently the policies of the World Trade Organization (WTO) have included the services and intellectual property policies which now accounts for over half of all investment flows.
Outward FDI is a strategic option that firms can now utilize for comparative advantages and increasing the home country’s national economy. Small countries for instance have small local markets and need to invest abroad for future economic growth and to fight against foreign competition. Home countries are also more inclined to plan production in countries that are near the developing customer base, decreasing transportation costs and enabling greater growth in attainment of economies of scale. It’s important that the WTO and home country governments include issues such as human rights and environmental regulations when analyzing the trade-offs of outward FDI.
In conclusion, it is apparent that outward FDI will continue to be a vehicle that companies will pursue in gaining comparative economic advantages resulting in higher revenues and profit growth. Customers should benefit from competition, which supports downward pricing, and the home country’s desire to get closer to their foreign customers thereby adapting to their preferences and production standards (local responsiveness). Relationship studies have shown a complementary correlation between outward FDI and exports. The benefits to the home country are even greater when both countries have strong currencies, low interest rates and an increasing GNP. Home country governments must analyze their balance of payments, and associated global risks when constructing outward FDI policies in serving its own national economic interests.
Charles W.L. Hill, “International Business: Competing in the Global Workplace”, Part III – The Global Trade and Investment Environment –
National Academy Press, Office of Internal Affairs Committee on Japan – “Global Economy, Global Technology, Global Corporations”- Open book web access
Chapter 3, pp.24-39 – “Foreign Direct Investment” – http://books.nap.edu/books/0309058473/html/index.html
National Bureau of Economic Development – “Effects of Outward Foreign Direct Investment on Home Country Performance – http://www.nber.org/books/ito9/
Edward M. Graham – Institute for International Economics, Washington, DC – “On the Relationships Among Direct Investment and International Trade in the Manufacturing Sector: Empirical Results for the United States and Japan”- http://www.ap.harvard.edu/papers/RECOOP/Graham/Graham.html
Royal Economic Society – Media Briefing – “Effects of Foreign Investment “-