Case For and Against Foreign Direct Investments | Economics

In this article we will discuss about the case for and against foreign direct investments.

The foreign direct investment is that form of investment in which the foreign investors not only have the ownership of assets but also control the activities that generate the income flows in the recipient country. It, therefore, involves both the transfer of capital and the transfer of management and know-how.

Direct investments are presently the principal channel of international private capital flows. In the LDCs, the major proportion of foreign direct investment has gone into the extractive industries (mining, cultivation and plantations).

The share of manufacturing industries and distribution has been very small. It is only after the economy takes off and infra-structure is created that the foreign investors show some interest in investing in the manufacturing industries, provided the country either has a large domestic market or there can be substantial cost advantage in setting up enterprises for turning out goods for export. Between 1991-92 and 1997-98, the foreign direct investments in India rose substantially from 129 million dollars to 3.56 billion dollars.

During 1998-99, the inflow of foreign direct investments declined sharply to 2.46 billion dollars on account of the enforcement of sanctions after the Atomic blasts in May 1998. However, the flow of FDI could reach the level of 3.90 billion dollars by 2001-02.

According to a study made by PHDCCI for the period August 1991 to March 2003, the FDI inflows that stood at $ 97 million in 1990-91 had risen to $ 4.66 billion in 2002-03. The share of FDI inflows into India coming via mergers and acquisitions route as opposed to Greenfield projects has increased in the 1990’s.

While during the period prior to 1991, total FDI inflows in the Greenfield projects were over 90 percent of the total FDI inflows, in the period after 1991, this share has declined to about 60 percent. According to UNCTAD’s World Investment Report released in September 2003, FDI flows to India rose by $ 3.4 billion in the year 2002. In contrast, FDI inflows to China in that year rose by $52.7 billion. The FDI inflows into India have greatly accelerated since 2006-07 from US $ 7.7 billion in 2005-06 to US $ 19.8 billion in 2008-09.

The FDI inflows declined to US $ 18.8 billion in 2009-10 owing to world recession. In the fiscal year 2011-12, the FDI inflows rose to US $ 36.5 billion. The FDI inflows in India stood at US $ 30.8 billion in 2013-14. The FDI inflows in India are spread across a range of economic activities like financial services, manufacturing, banking services, construction and information technology services.

There has been some controversy related to the desirability or otherwise of the foreign direct investments (FDI) particularly in the less developed countries.

Case for Foreign Direct Investments:

The main arguments in support of FDI are as below:

(i) Efficient Control and Management:

In case of foreign direct investment, the control and management of the business are handled by the foreign investors. Their expertise in management and policy-framing ensures both internal and external economies. The large inflow of FDI can certainly improve industrial efficiency in a great measure.

(ii) Availability of Advanced Know-How:

The foreign direct investment not only brings in scarce capital resources but also scientific, technical, managerial and administrative skills and the advanced techniques of production. The flow of advanced skills and latest techniques accelerate the pace of economic transformation in the recipient countries.

(iii) Continuous Flow of Capital:

In the case of foreign loans, the capital inflow may be once­over. On the opposite, the foreign direct investment involves long term commitments of foreign investors on account of their handling of control and management. That results in a continuous inflow of foreign capital by way of setting up of enterprises, expansion and modernization almost on a continuous basis.

(iv) Growth of Indigenous Enterprise:

The FDI promotes the growth of indigenous enterprise. The foreign enterprises or investors allow the local producers to set up small scale ancillary units. This may be accomplished by them either directly through providing financial or technical assistance in these lines of production or indirectly through creating demand for products or services of ancillary units.

(v) Filling Up of Saving and Foreign Exchange Gaps:

The development process in the LDCs often remains hindered on account of gaps existing between targeted and actual levels of saving and foreign exchange. These gaps do not permit the investment and production to achieve the target of planned rates. The foreign direct investment fills up both saving and foreign exchange gaps in the developing countries and paves the way for their steady growth.

(vi) Reinvestment of Profits:

A part of the profits earned by the foreign investors is re-invested for financing the expansion or modernisation programme. In this way, the country can maintain a higher rate of investment and capital formation.

(vii) Higher Social Return:

The value added as a result of FDI is invariably higher than the return on foreign investments. It signifies that the social return from FDI is greater than the private return.

(viii) Risk-Bearing by Foreigners:

The investment activity remains inhibited in the LDCs on account of a high rate of risk. Since the indigenous capitalists are risk-shy, the investment process remains clogged. The foreign investors undertake risks and make a significant contribution in furthering the industrialisation of the LDCs.

(ix) Larger Tax Revenues:

In the LDC, the activities of foreign investors result in the generation of production and profit. By the taxation of profits, production and exports, the government can get hold of larger tax revenues that can be diverted towards the execution of development programmes.

(x) Creation of Employment:

The setting up of new enterprises and diversification of activities by the foreign investors help in the creation of more and more employment opportunities in the LDCs. That brings about a larger generation of incomes and alleviation of poverty.

(xi) Expansion of Market:

A major handicap in the development process in the LDCs is the small extent of market. The foreign investors organise concerted sale campaigns to market their products in the host country and try to exploit its market fully. In addition, they try to cater to the needs of foreigners by enlarging exports. The expansion of market for home-produced goods is a powerful catalyst for growth.

(xii) Increase in Real Wages:

The setting up of new enterprises through foreign investment causes an increased demand for skilled and other categories of labour that result in an increase in real wages. Sometimes the foreign investors secure the services of special categories of labour from their home countries. They are invariably paid higher wages. As the local labour acquires similar skill and training, they can also secure higher wages.

The increase in productivity in the firms managed- by foreign entrepreneurs and managers also brings in higher wages for the workers. Thus direct foreign investments can become instrumental in raising the real wages or real purchasing power of the working classes in the host country.

(xiii) Beneficial Effect on the Balance of Payments:

The LDCs are generally faced with problem of widening balance of payments deficit. The foreign direct investment tends to immediately narrow down the BOP deficit. The foreign investors may prefer to undertake investment in agriculture and extractive industries, the products of which are largely exported to foreign countries.

That ensures large inflow of foreign exchange which is often much more than remittance of profits to the foreign countries. The net effect is that the BOP deficit in the host countries can be reduced through foreign direct investments.

(xiv) Inducement to Invest Abroad:

The foreign direct investments inculcate greater initiative and the capacity of risk-taking among the entrepreneurs belonging to the LDCs. They become interested in undertaking investments in other LDCs. For instance, Indian business firms during the last few decades have set up business collaborations in some countries of Asia and Africa.

Case against Foreign Direct Investments:

The foreign direct investment has some defects on account of which there is opposition to it particularly in the LDCs.

The main arguments against the foreign direct investment are as below:

(i) Heavy Cost:

In order to induce the foreign investors to undertake investment on a substantial scale, the host country has to bear a quite heavy cost in the form of providing land, water, power and transport and communication facilities. In addition, they are provided such facilities as development rebates, rebate on undistributed profits, additional depreciation allowances, subsidized supply of inputs and tax holiday for some specified period. Thus the cost of foreign direct investment to the LDCs is definitely on the high side.

(ii) Limited and Lop-Sided Development:

It has been the experience of the most of the less developed capital-receiving countries that the foreign investors have preferred to set up the enterprises in either extractive industries or in the industries of mass consumption. The flow of foreign direct investment has remained very little in capital goods industries, public utilities and import-substitution industries, which can become the nucleus of self-reliant industrialisation. Thus the foreign direct investment can be accredited with only very limited and unbalanced or lop-sided development.

(iii) Economic Exploitation:

The foreign direct investment is opposed on the ground that it has been responsible for the exploitation of the human and natural resources and markets of the LDCs. The manufactured products are exported to their mother countries by the foreign investors at very low prices. Those products are then re-exported to third countries with or without processing at very remunerative prices. In addition, there is regular repatriation of capital and remittance of profits by the foreign investors to their home countries.

(iv) Little Increase in Employment:

The LDCs invite the foreign investors to set up new projects with the expectation that they will create more employment opportunities for their unemployed work force. But this benefit does not actually materialise. They set up such projects or adopt such production techniques as have very small employment potential. Many often certain categories of labour force are imported by them from their mother countries. According to UNCTAD, the net impact of foreign direct investment on employment and wages of workers in LDCs may well be negative.

(v) No Skill Formation:

The foreign direct investments are supposed to assist in skill formation by providing training facilities to the workers in advanced and modern techniques. In fact, the foreign enterprises show little interest in providing training facilities to the indigenous labour. Some lower and middle level routine posts are offered to the native work force. All senior executive and technical posts are reserved for the personnel from their own countries.

(vi) No Transfer of Technology:

The LDCs expect that foreign investment will result in the transfer of latest productive techniques and technical know-how to the host countries. In reality, the production techniques being used by foreign enterprises are kept as guarded secrets by them. They do not permit the indigenous entrepreneurs to have access to it. Sometimes obsolete plants and equipment are thrust upon the LDCs in the form of transfer of turn-key projects.

In certain cases, the technology transferred has very high capital-intensity and it is inconsistent with factor endowments of the host countries. The latter have to bear heavy cost of foreign technology in the form of excessive depreciation requirements and increasing unemployment. Thus the economic and social cost of the transfer of technology is prohibitive from the point of view of the poor countries.

(vii) Discouragement for Domestic Capital and Enterprise:

The foreign direct investment has a discouraging effect on domestic capital and enterprise. Since the more profitable investment opportunities are grabbed by the foreign investors, the indigenous entrepreneurs get greatly demoralised. The already shy domestic capital fails to find proper investment avenues.

(viii) Concentration of Industries:

The foreign direct investment is likely to cause greater concentration of industries near the mineral-rich regions and in large centres of population or port cities. In these areas, there is already much industrial activity. Thus there is greater concentration of industries at only a few selected places, while vast regions of the LDCs remain industrially backward. So there is an increase in regional disparities in industrial growth in developing countries on account of direct foreign investments.

(ix) Emergence of Monopolies:

The enterprises set up by the foreign investors drive out the indigenous competitors from the market. They also acquire patent rights about the products and processes. Slowly they emerge as powerful monopolies and exploit the host countries.

(x) Uncertain:

Since the foreign direct investments are basically induced by profit, they can be rightly called as fair-weather friends. There is much uncertainty about such investment. During the period of boom, when there is little need of foreign investment, large inflow of capital from abroad takes place. On the contrary, it may not be forthcoming when the host country is passing through recession or contraction. Therefore, foreign direct investment is not dependable for long-term expansion of the economy.

(xi) Political Domination:

The foreign investors, after they assume control of some vital sectors in LDCs, start interfering with their economic and political decision-making. They dictate terms which may be more in the interest of their mother countries, rather than the host countries. History of the LDCs is replete with instances when the foreign investors and traders reduced the natives to the position of serfs.