The Economic and Social Impacts to India and Its Citizens from Inward Foreign Direct Investment


: Risks and benefits of FDI: Hypothetical postulations and empirical evidence



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2.4: Risks and benefits of FDI: Hypothetical postulations and empirical evidence


As explored throughout this chapter, it is argued that FDI is an important outlet for valuable resources that developing countries need for their citizens and the economy. However, as mentioned in the Introduction, the disadvantages and benefits to the host country as a result of FDI is controversial both in theory and in relation to empirical evidence. This section will explore the hypothetical benefits and drawbacks that FDI is often purported to bring to the host country, and review empirical evidence that support or refute such claims. As there is a substantial body of literature regarding almost every aspect of how FDI affects host countries (Lipsey and Sjoholm, 2005), this section will review five of the main areas associated with advantages and disadvantages of FDI: economic growth and poverty reduction, domestic industries, technology transfer, employment.

2.4.1: FDI and economic growth and poverty reduction


FDI is often purported to spur economic growth and decrease poverty, however, research does not bear this out (Nunnenkamp, 2002; Alfaro and Johnson, 2013). Lipsey (2003, p. 297) argues that:

It is safe to conclude that there is no universal relationship between the ratio of inward FDI flows to GDP and the role of growth of a country.

Similarly, Carkovic and Levine (2002) investigated 72 developing and developed host economies from 1960-1995 and did not find that FDI exerts a robust and positive influence on economic growth.

Other research contends there are certain preconditions that developing countries need to attain before economic growth can occur in correlation to FDI: openness to trade (Balasubramanyam et al, 1996); technological threshold (De Mello, 1997); financial market development (Alfaro et al, 2004); sufficiently qualified labour force (Borensztein et al, 1998). Thus, developing countries need to have reached a minimum level of economic development before they can realise any growth-enhancing effects of FDI (Nunnenkamp, 2002; Alfaro and Johnson, 2013).

Nunnenkamp (2002) maintains that it is often simply assumed that FDI will contribute to the alleviation of poverty through fostering economic growth. However, research findings also cast doubt on this claim (Nunnenkamp, 2002; ODI, 2002). While there are few studies that have explicitly investigated the links between FDI and poverty alleviation (Nunnenkamp, 2002, p. 35), the Overseas Development Institute (2002) conclude that there is not a direct link between FDI and poverty reduction. However, Gohou and Soumere (2012) did find empirical evidence linking FDI to poverty reduction in Central and East Africa. Other research has drawn indirect links between FDI and poverty alleviation (ODI, 2002) however, these indirect links are unlikely to occur where the incidence of absolute poverty is high (Borensztein et al, 1998). Thus, developing countries need to have attained a certain level of development and economic growth before FDI can prompt further growth or indirectly assist with poverty reduction. Nunnenkamp (2002, p. 34) aptly captures this argument:

To put it more bluntly, poverty tends to severely constrain the role FDI can play in eradicating poverty.


2.4.2: FDI and the domestic industry:


The presence of foreign TNCs is often professed to make domestic industries and firms more competitive (OECD, 2002; Alfaro and Johnson, 2013). It is argued that because foreign TNCs are more efficient and productive than domestic firms (Lipsey, 2000; Borensztein et al, 1998; Alfaro and Johnson, 2013), their presence within the local industry can spur competition between itself and domestic firms and propel the domestic firms to strive for higher productivity, lower prices, and more efficient resource allocation (OECD, 2002). The counter-argument is that TNCs actually lower competition in domestic markets because they tend to raise the level of market concentration in host economies (OECD, 2002; Herzer, 2012). Market concentration is the extent or degree to which a relatively small number of firms account for a large percentage of the market share (Singh, 2002). Levels of market concentration have increased worldwide due to the increase in corporate M&A that have increasingly taken place since the 1990s (OECD, 2002; Singh, 2002; Chang, 2014). As mentioned above, M&A are criticised as an easy way for TNCs to monopolise markets and curb competition (Singh, 2002; Chang 2007, 2014; Harms and Meon, 2013).

The OECD (2002) states that while it may be preferable for a stronger foreign competitor to replace a less productive, domestic one; national, anti-monopoly policies are needed to safeguard competition within the host country. The OECD (2002, p. 16) suggests this may be even more important in the case of developing countries:

Empirical studies suggest that the effect of FDI on host-country concentration is, if anything, stronger in developing countries than in more mature economies. This could raise the concern that MNE entry into less-developed countries could be anti-competitive.

It is argued that domestic companies must reach a level of maturity to be able to compete with powerful and efficient TNCs or ‘crowding out’ will become more likely (Chang, 2007, 2014; Stiglitz, 2006; Herzer, 2012). ‘Crowding out’ occurs when foreign TNCs dominate the market and push domestic firms out of business (OECD, 2002; Nunnenkamp, 2002; Herzer, 2012). The timing of opening markets to TNCs is argued to be critical and premature liberalisation can have adverse effects on domestic firms (Chang, 2007, 2014; Stiglitz, 2006). Chang (2007) argues that when domestic firms are crowded out, the productive capabilities of the domestic industry can be enhanced in the interim as the TNC replacing the domestic one is more efficient and productive. However, in time, the domestic industry may suffer as TNCs are argued to keep their most valuable assets in their home countries to avoid losing them to competitors (Chang, 2007). Thus the domestic industry will encounter a ceiling in the level of sophistication it can attain if TNCs have too much market concentration in the domestic industry environment (Chang, 2007).

The counter-argument to the ‘crowding out’ thesis contends that TNCs and foreign investment cluster together and can actually ‘crowd in’ investment opportunity and create complementary activities for domestic enterprises (OECD, 2002; JBIC, 2002). Nevertheless, in keeping with the inconclusive nature of FDI spillover literature, evidence for a ‘crowding in’ effect is not compelling (Borensztein et al, 1998; Agosin and Mayer, 2000). Agosin and Mayer (2000) conclude the overall impact of FDI on domestic industries may depend on the government’s ability to target FDI projects that do not displace local firms, and on the readiness of competitive local businesses to take part in the complementary activities created by the foreign enterprise.

2.4.3: FDI and technology transfer


Technological transfer is one of the most discussed spillover effects in FDI literature (Lipsey and Sjoholm, 2005; OECD, 2002). Borensztein et al (1998) argue that technology diffusion plays a critical role in the process of economic development and growth rates in developing countries are, in part, explained by a ‘catch- up’ process in the level of technology. The economic literature identifies technology transfer to domestic industries as the most important outlet through which foreign corporate presence may produce a positive externality in the host country (OECD, 2002; Alfaro and Johnson, 2013). Lipsey (2000, p.2) argues that one aspect of FDI that is “almost beyond dispute” is that much of the world’s stock of technological knowhow is possessed by TNCs. However, it remains heavily debated in the literature to what extent and under what circumstances technology is transferred from foreign enterprises to the host country (Nunnenkamp et al, 2001; OECD, 2002; Alfaro and Johnson, 2013).

The OECD (2002) argues that technology transfer to the host country can occur through four ways: vertical linkages with local suppliers, and/or horizontal linkages with competing or corresponding business within the same industry, migration of skilled labour, and the internationalisation of research and development. Of the four channels, the evidence for technology transfer is strongest and most consistent with vertical linkages with local suppliers in the host country (OECD, 2002; Alfaro and Johnson, 2013). Once invested in a host country, the TNC may purchase some of the needed input materials from domestic suppliers and it is argued that the quality demanded by the foreign company often surpasses the domestic company’s capabilities (OECD, 2002). TNCs may provide technical assistance and training to local input suppliers to raise the quality of the supplier’s products and diffuse technology and technological knowledge in the process (OECD, 2002; Alfaro and Johnson, 2013).

Of course, on the other hand, TNCs may import the needed supplies from other locations in the production chain and not work with domestic businesses or share technological knowledge with them (O’Brien and Williams, 2007, 2013; Chang, 2007, 2014). The evidence for horizontal technology spillovers is very mixed (OECD, 2002; Alfaro and Johnson, 2013). As mentioned above, TNCs tend to avoid giving away their technological expertise and advancement to potential competitors and, thus, try to keep it from spilling over into host country domestic markets (OECD, 2002; Chang, 2007, 2014; Alfaro and Johnson, 2013). TNCs are criticised for bringing ‘out of date’ technology to host countries to avoid losing their technological advantages in the market (Chudnovsky and Lopez, 1999; Chang, 2007; Stiglitz, 2006; O’Brien and Williams, 2007, 2013).

There are host country prerequisites for technology spillovers to have an impact in the host country (De Mello, 1997; Nunnenkamp, 2002; Elmawazini and Nwankwo, 2012). First, the technology must be relevant to the domestic business sector (OECD, 2002) and second, domestic firms must have a level of capability to absorb it (Nunnenkamp, 2002; OECD, 2002; De Mello, 1997; Blomstrom et al, 1994; Borensztein et al, 1998). These studies refer to a ‘technology gap’ between the host country and foreign TNC and where the gap is larger, the less likely technology will spillover and are absorbed into the domestic economy (Nunnenkamp, 2002; OECD, 2002; De Mello, 1997; Blomstrom et al, 1994; Borensztein et al, 1998; Elmawazini and Nwankwo, 2012).


2.4.4: FDI and employment


The role of FDI in host economies can raise expectations about the potential for TNCs to create high-quality jobs with higher pay and better working conditions (OECD, 2008; Lipsey, 2013). However, the presence of TNCs can also lower expectations for decent employment as TNCs are accused of taking advantage of lower wage structures and labour standards in developing host countries as well as violating human and labour rights (OECD-ILO, 2008; Hecock and Jepsen, 2013; Davies and Vadlamannati, 2013). The impact of FDI on employment in host countries is a complex one which raises many questions in the literature. One set of questions regards how much employment TNCs create in the host country. Other questions regard wages and whether foreign owned firms pay higher wages for domestic labour, whether this higher wage raises the overall wage levels in the host country and whether these higher levels of wage then spill over into domestically owned firms (Lipsey and Sjoholm, 2005). A final question relates to working conditions and if foreign corporations provide better working conditions.

The number of jobs created by FDI depends, amongst other things, on the type of FDI, specifically, if it is M&A or greenfield (OECD-ILO, 2008; Chudnovsky and Lopez, 1999, Yeates, 2001). Greenfield investment is argued to create more jobs than corporate M&A (OECD-ILO, 2008, ODI, 2002). The Overseas Development Institute (2002) concludes that foreign investment may not increase employment opportunities in host countries due to the capital-intensive technologies that are often utilised with foreign enterprises. However, Lipsey et al (2013) investigate employment growth in Indonesia and find that plants that were taken over by foreign owners demonstrated a strong effect of employment increase. The OECD-ILO(2008) report states that although the share of the labour force employed by foreign-owned enterprises appear to be relatively small, the impact of FDI in domestic markets may increase productivity and, thus, employment needs in domestic firms who are in competition with the high productivity of foreign firms.

There is no a priori reason to expect TNCs to offer better jobs with higher salaries compared to local competitors though there are postulations that TNCs rely more on pay incentives to ensure quality and productivity as well as to prevent worker migration which would minimize the risk of losing these advantages to domestic competitors (OECD, 2008; OECD-ILO, 2008). Lipsey and Sjoholm (2005) found that foreign firms pay higher employee wages in both developed and developing countries after controlling for firm specific characteristics. They concluded that in Indonesia, foreign owned plants paid wages that were 12% higher for lower skilled jobs and 20% more for higher skills in comparison to domestic companies. The Overseas Development Institute (ODI, 2002) found that FDI and foreign ownership are associated with higher wages for all types of workers but more so for skilled workers. They go further to argue that as increased wages occur for more skilled workers this contributes to wage inequality in host economies. Similarly, Nunnenkamp (2002) concludes that FDI can be expected to benefit skilled workers more than unskilled in developing countries, thereby worsening the relative income position for the poor.

An OECD-ILO (2008) report concludes that the direct impact of FDI on other working conditions is difficult to determine as the definition of employment conditions differs between studies. However, they conclude that TNCs have tend not to export the labour protections that are afforded in the home country, tending instead to adopt the labour conventions of the host country. They suggest this tendency may result because labour practices are often embedded in national policies and social norms of the host country (OECD-ILO, 2008). It may also result from a strategic decision whereby local affiliates are given greater degree of discretion as to how human resources are managed in the host country (OECD-ILO, 2008). Labour standards in developing countries are often much lower and enforcement of national protections are weaker (OECD-ILO, 2008). The lack of exportation of home country labour protections often results in the argument that TNCs are profiting from lower labour standards and protections in developing countries (OECD, 2008).

As mentioned earlier, UNCTAD (2013) in its World Investment Report contains a special focus on GVCs (see section 2.2.1.2). The report concludes that employment within these chains can be insecure and involve poor working conditions as a result of pressures on cost reduction from global buyers (UNCTAD, 2013). Employment conditions in GVCs are context specific on the industry, product line and position of activity in the GVC (UNCTAD, 2013). GVCs and the correlations with declining working conditions as well as the influence on lowered social policy and worker protections are explored further in the next chapter.

Thus, given the empirical evidence and theoretical arguments listed above, there are no apparent universal guarantees of positive spillovers from FDI to host countries (Alfaro and Johnson, 2013; Nunnenkamp, 2002; Lipsey and Sjoholm, 2005; Moran et al, 2005). However despite the odds, developing countries actively seek and compete for FDI and often providing sizable incentives and economic concessions in doing so (Alfaro and Johnson, 2013; Thomas, 2011; Erdogan, 2012; Farnsworth, 2010). The following section will explore why FDI remains high of the development agenda.




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