FDI influences to the host country & Policies recommended to host countries

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Executive summary

 

With the ongoing globalization, Foreign Direct Investment has been one of the most discussed and studied topic despite the recent trend of decline cause by the recent economy downturn. This study focuses on FDI issues in the policy perspective in the host countries, it begin with the introduction of the fundamental patterns of FDI such as definitions and classification. The second part of this article has been contributed to the review of the theories and studies that tries to explain the origin and motives of the generation of FDI and this part also touch the control issue of FDI in theoretical way. The third part of FDI focus the effort on the influences, positive or negative, of the FDI to the host countries’ concern.  Then after the brief description over the general objects of FDI polices, the major part of the study finally focuses on offering policy recommendations to the host country governments to attract and regular foreign investments in such a manner that will benefit the host economy continually.

 

List of figures:

 

Figure 1.0 Vernon (1966)’s Product Life Cycle model………………………………..5

 

Figure 2.0 Product manufacturing and consumption in PLC stages ………………….6

 

Figure 3.0 Hennart’s bundling model of optimal foreign entry mode…………………7

 

Figure 4.0 FDI as a non-debt finance source…………………………………………10

 

 

Content page

 

Executive summary………………………………………………………………………………………….. 1

List of figures:…………………………………………………………………………………………………. 2

Content page…………………………………………………………………………………………………… 3

  1. Basic patterns of FDI…………………………………………………………………………………. 4
  2. Literature review……………………………………………………………………………………….. 5
  3. FDI influences to the host country………………………………………………………………. 8

3.1      Resource transfer……………………………………………………………………………… 8

3.2      Spillover effect………………………………………………………………………………… 9

3.3      Balance of payments………………………………………………………………………… 9

3.4      Pro-competitive and anti-competitive effect………………………………………. 10

3.5      Sovereignty effects…………………………………………………………………………. 11

  1. Host country FDI policy goals…………………………………………………………………… 11
  2. Policies recommended to host countries……………………………………………………… 11

5.1      Policies to promote FDI………………………………………………………………….. 12

5.1.1     Tax incentives……………………………………………………………………….. 12

5.1.2     Investment codes………………………………………………………………….. 13

5.2      Policies to regulate FDI…………………………………………………………………… 13

5.2.1     Policies coherence…………………………………………………………………. 13

5.2.2     Competition policy………………………………………………………………… 14

Reference list:……………………………………………………………………………………………….. 16

Appendix 1 Categories of Tax incentives………………………………………………………….. 19

 

 

 

1.        Basic patterns of FDI

 

Base on the trend of fast and continual growth of international trade and the fact that multinational companies (MNCs) account for more than two thirds  of the global trade (Kokko 2003), it’s worth to study Foreign Direct Investment (FDI) which is currently the most popular foreign entry mode rather than other entry modes like exporting and licensing, has been defined by United Nations as an investment involving management control of a resident entity in one economy by an enterprise resident in another economy (UNCTAD 1999).  And International Monetary Fund (IMF) defined it as an investment that is made to acquire a lasting interest in an enterprises operating in an economy other than that of the investor with the purpose being to have an effective voice in the management of the enterprise (IMF 1993). There are many more definitions from other perspectives, but there are two major common features shared by most definitions. One feature is control, such as “effective voice in management” as the IMF’s definitions states and “management control” in United National’s concept. In term of share holding, investment has been requested of more than 10 percent share holding in order to be considered as FDI behavior in normally understands. The other feature is that FDI is a long term basis, this characteristic of FDI help differentiate from portfolio investment which is characterized as short term with a high turnover of securities. In term of the classification of FDI, from the view of the host countries FDI can be grouped as (Kojima1985) trade orientated FDI which increase the original trade volume by generating excess demand for imports and supply for export and anti trade orientated which decreases the trade by producing the products which are previously import products.

 

 

 

 

2.        Literature review

 

The eclectic theory (Dunning 1977) tried to answer the question why there will be a need of the a particular product from a foreign country rather than home country  by combining three major hypothesis: industrial organization hypothesis, location hypothesis and internalization hypothesis. In this theory, three are three necessary conditions need to be met for a company to adopt FDI strategy. Firstly, the company need to have ownership advantages over the competitors in the host country. Such ownership are often take form of ownership of some intangible assets such as advanced technology, reputations and management and marketing skills. Secondly the company will get a higher return for the company to use such ownership rather than lease them or sell them. Thirdly the maximum of the profitability could be achieved if the company combine such ownership with some local assets in the host country which will directly lead to a oversea expansion.

 

Another theory aiming at finding out the rational of FDI is the product life cycle (PLC) theory. The PLC model was originally designed by Vernon (1966) to explain the post war expansion of the US multinational corporations. The model as shown in the figure below divide the product life into four stages which make up a complete life cycle: introduction, growth,  maturity and decline.

Figure 1.0 Vernon (1966)’s Product Life Cycle model

The product life cycle was first used in explaining FDI by Petrochilos (1989) who suggested that MNCs tend to engage in FDI in certain product life cycle stages.

Figure 2.0 Product manufacturing and consumption in PLC stages (Source: Moosa 2002)

 

According to Petrochilos (1989)’s product life cycle hypothesis, there are also four stages of a complete life cycle. At the first stage when the product is first introduced, consumption and manufacturing happen in the home country only, and with the maturity of the product, the products begin to be exported to the foreign countries and in this stage the foreign countries are net importers of the particular products. But in the third stage when the products are commonly accepted and manufactured by other competitors which causes gradual standardization of the products in manufacturing. Also during this stage maybe both stimulated by opportunity created by oversea demand, manufactures start to turn to FDI in the foreign countries especially the large consumer market of the product but the host country is still the exporter. And in the last stage the major production centers have been move to the foreign markets even including the research and development activities and thus the host country become the net importer of the product.

 

The Petrochilos (1989)’s product life cycle hypothesis provide a valuable perspective in understanding the necessity of FDI usage in the particular product life cycle stage, but this theory has not clearly discussed about the problem regarding the “control” of the company which as mentioned previously is one of the common feature in different FDI definitions. Below is another theory developed by Hennart (2009) which will touch this core issue. This model is base on the Walker (1891)’s residual claimant theory which later had been further developed by many scholars to suggest that who has the right to claim the residual revenue controls the company.

Figure 3.0 Hennart (2009)’s bundling model of optimal foreign entry mode

 

Hennart (2009)’s bundling model of optimal foreign entry mode as demonstrated in the figure above shows that during the FDI practices, the entry mode of the company into the foreign market is determined by the transactional characteristic of assets provided by both the multinational company side and the local owners. This implication of this bundling model is that not only the ownership advantages owned by the multinational company need to be considered in the cross boarder investment, but also the transactional character of the local firms who provide with the local assets also need to be taken into consideration. And more over such transactional characters of assets may changed with time goes. For example, when the advanced technology that previously was owned only by the multinational companies is easily transferrable then with the gradual digestion of such ownership advantages the local partners will finally reach the residual claimant if their local assets such as distribution channel are still not transactional to the multinational corporations.

 

3.        FDI influences to the host country

 

Below the discussion will be focused on four major kind of influence brought by the FDI behaviors to the host country.

 

3.1    Resource transfer

 

The first impact if the resource transfer effect brought by the multinational corporations in term of capital investment and technology transfer. Capital investment and technology is more desirable in the developing countries to boost the economy, for example according to the date released by United Nations(2007) in the World Investment Report, FDI flow into Southeast Asia continued to growth rapidly with a 19% year on year growth to a record high USD 200 billion and the host countries such as China and India which witnessed the fastest economy growth are among the top destinations of the FDI. Behind these economy miracles the FDI had played an important role as the source of capital and technology input to fuel the economy behind their current success.

 

 

 

3.2    Spillover effect

 

The second impact to the host country is called as spillover effect. Spillover effect is different from transfer which requires full price for the host country or local firms to get benefit from the inflow FDI, spillover refer to the benefits enjoyed by the host country from the presence of the multinational corporations but without paying all the price. The spillover could take forms of management skills, industrial productivity and advanced technology and so on, as concluded by Blomstrom (1989) that spillovers or the external effects from FDI are the most significant channels for the dissemination of modern technology. What’s more many local firms adopt the following strategy to treat the multinational companies as examples which save a lot of cost form them. Just like how the Cisco staffs comment Huawei, one of the most successful and fast growing IT company in China, “ If Cisco stop research and development, Huawei will get lost” (Unknown 2007). There is not substantial proof to verify this angry comment from the Cisco, but it to some extend explain one of the reasons why Huawei can shorten the distance with the global IT giants like Cisco.

 

3.3    Balance of payments

 

The third impact is the balance of payments effect. As demonstrated in the Figure 4.0 below, inflow FDI in equity and reinvested earning actually can be classified as a source of saving in the financial account rather than debts. In case the investment is more than the current savings, the current account balance will be in a deficit status, and because the limitation of the reserved assets, the source of offset the deficit would depend on the increase of the non-debt foreign capital or debt foreign capital. And because of the possible negative impacts of foreign debts such as debt trap and financial crisis, net FDI inflow which can be considered as non debt foreign capital is better in solving this deficit as the role of balancing of payments.

Figure 4.0 FDI as a non-debt finance source

 

3.4    Pro-competitive and anti-competitive effect

 

The third kind of impact of inflow FDI is regarding to the changes of competitive level in the host country. Many empirical studies on the relation between FDI inflow and concentration level suggest that concentration level decreases with the growth of FDI inflow (sees also Frischtak & Newfarmer 1994) which is easy to understood as the participation of the multinational companies would increase the competition and force the local companies to compete hard to keep their original market share. But some researches find out different conclusions. Lall (1979)’s case study in Malaysia, a developing economy with a quite open system to the foreign direct investment demonstrated that there was actually a correlation between the FDI inflow and the anti-competition phenomenon in term of increasing concentration in the industries. Also there are similar research results in other developing countries where multinational corporations recreate similar oligopolistic industrial structure in the host countries as they did similarly in the home countries (Knickerbocker 1973).

3.5    Sovereignty effects

 

Last but not least, the sovereignty effects also worth mentions. The issue  of sovereignty come from the worry that when the host country depend largely from the business operation of mutational corporations, these MNCs actually control a certain portion of economy of the host country. What’s more, there are also critics saying that MNCs may promote policies that favor their operations which may not be the best interest of the host country. There are many more direct or indirect impact accompanied with the inflow of the FDI especially during the FDI surges such as cultural imperialism and negative effect on environment.

 

4.        Host country FDI policy goals

 

Different countries may have different FDI policy goals, usual objects of FDI policies includes: obtaining capitals, job creations, technology transfer, maintaining control over key industries, export promotion and so on. A particular country may have a set of goals regarding to the host country’s needs and situations. For example, China’s FDI policies since its economy reform and opening up more than 30 years ago have been focusing on technology transfer and export promotion aiming at boost its economy in a short term. Please notice that the policies recommended below may not be comprehensive enough to cover every field of FDI policies.

 

5.        Policies recommended to host countries

 

With the advantages and disadvantages of inflow FDI to the host countries discussed above with theoretical and factual support, blow some recommendations in field of policy making have been provided to host country governments to attract and regulate FDI to benefit the economy development of the host countries.

 

 

5.1    Policies to promote FDI

 

5.1.1            Tax incentives

 

One of the most used policies by the host government to the foreign investors is tax incentives. Tax incentives refer to any tax relative policies used by the government that help release the tax burden of business entities in order to encourage foreign investment in a particular manner (UNCTAD 2000). Tax incentives usually take forms of reduced corporate income tax rate, tax holiday, permit of use of accelerated depreciation in accounting practices, exemptions from import duties and so on (see also Appendix 1.0). It’s said that tax incentives are more favorable to developing countries which tend to use fiscal incentives rather than financial incentives such as loan guarantees and grants that are used in developed countries to FDI because tax incentives will not lead to a immediate consumption of government funds. There are usually four major steps to enact effective and pragmatic tax incentives polices: designing, granting, implementation and control (UNCTAD 2000). The design of the tax incentives to attract foreign investment should indentified industries, geological location and valid time and other limitations that need to be applied to the tax incentives policies. For example, since the 1990s China had build up many high technological park or special economy zones to attract FDI in its high tech industries such as software development in these zones in the major big cities, and only when multinational corporations perform their investment under such limitations they can enjoy the tax incentives. The implementation and control of the tax incentive policies will be easier when the policies have been designed in a clear and predictable manner for actual practices. And in the implementation and control parts, durability of tax incentive policies should be clarified. It will be of great importance to adhere to the deadline which has been set in the beginning as extension for the tax incentives will probably be demanded to have an extension or even make it a permanent tax policy which will bring loss to the host country. What’s more the over use of the tax incentive policies will lead to the “race to the bottom” phenomenon in which governments race to have the lowest tax rate to attract FDI, this phenomenon has been quite obvious in the fast growing Asian economies, the most popular destinations of the FDI.

 

5.1.2            Investment codes

 

Market with large potentials such as China and India are the major destinations that would considered in the foreign expansion plan by the multinational corporations, even with risks most MNCs would try hard to extend their involvement in these large markets. But relatively small economies, would not have such advantages. In this case, in order to attract the interest of the international investors, the enactment of investment code would be of great help to attract FDI. The investment codes are designed by the host countries to offer legal security and transparency by providing a series of guarantees and a few restrictions for the reference of foreign investors for them to get to know the host country markets more conveniently rather than reading a lot of rules and laws.

 

5.2    Policies to regulate FDI

 

5.2.1            Policies coherence

 

Attracting FDI should not be the end of FDI policies it but a means to boost industrial development (UNIDO, 2002). Policies coherence which is the indicator to examine the consistence between government goals and FDI polices plays an critical in ensuring that the FDI policies will turn out to be effective and generating long term interests and healthy economy environment. To have coherent policies at the first place means to have long term well designed policies objectives, if the governments have different objective in a short period, then the policies will also change overtime which cause a lack of predictability in policy intentions. Secondly, in term of policies making, policies should be enacted in such a manner that all the policies are made to achieve the set government objective, and different departments of the government should have consistent policies. Coherence also need to be generated between the policies of state governments and the central government to create synergy effect. Last but not least, such coordination should also be found in the jurisdiction system which is more stable and trust worthy than the policy field.

 

5.2.2            Competition policy

 

As mentioned above, one of the negative effect that FDI could bring to the host countries is anti-competitive impact which will hamper fair competition and raise economy sovereignty concern. Under such circumstances, competition policy could be effective in avoid the appearance of anti-competitive impact of FDI. The competition policy in most cases take the form of legislation. And the restriction of merger and acquisition (M&A) is the most used policy to prevent foreign dominance in the domestic industries. Take China as an example, currently the second largest FDI recipient behind the United States (UNCTAD 2010), in the last century the competition policy was mainly achieved by performance requirement which have direct rules about the requirement of technology transfer, export and ownership of the joint venture business that the multinational corporations should meet. But since the entry into WTO in 2001, under the treaty of WTO, China has been required to gradually remove the performance requirement such as the restriction of the set up of foreign owned companies. Then China had turned to the legal field to achieve its competitive policies. In 2008, the so call Anti-Monopoly Law came into effect and had since played an important role in preserving the economy sovereignty. In 2009, an announcement made by the Ministry of Commerce of the People’s Republic of China (MOFCOM) was released to stop the acquisition of Huiyuan Juice, the leading Chinese soft drink brand, by Coca-cola according to the Anti-Monopoly Law with the explanation that such acquisition will lead to highly market share concentration by Coca-cola in the domestic Carbonated soft drink market. And similar anti monopoly laws could also been found in other jurisdiction system in many other developed and developing countries. The competition policy on one hand could help prevent anti-competitive effect of FDI and on the other hand could also help achieve the goal of technology transfer and spill over from the MNCs as the competition policy will help maintain a fair market for the health and fast growth of the local firms in the host country.

Reference list:

 

Blomstrom 1989, Foreign investment and spillovers: A study of technology transfer to Mexico, Routledge, London

 

Dunning, J. 1977, Trade, Location of Economic Activity, and the Multinational Enterprice: A search for an Eclectic Approach: The International Allocation of Economic Activity, Holmes and Meier, New York

 

Frischtak, C.R. & Newfarmer, R.S. ed, 1994, Market Structure and Industrial Performance, United Nations Library on Transnational Corporations Volume 15, Routeledge: London

 

Hennart J. F. 2009. Down with MNE-centric theories! Market entry and expansion as the bundling of MNE and local assets. Journal of International Business Studies, 40, 1432-1454

 

IMF 1993, Balance of Payments Manual, 5th edn, accessed on 8th Sep 2010 [online] available: www.imf.org/external/pubs/ft/bopman/bopman.pdf

 

Knickerbocker, F.T. 1973. Oligopolistic Reaction and the Multinational Enterprise Cambridge, MA, Harvard University Press

 

Kokko, A. 2003, FDI, MNCs and Policies, accessed on 8th Sep 2010 [online] available: http://www.fetp.edu.vn/shortcourse/0203/Trade03/Handouts/cs11-12.ppt

 

Kojima, K. 1985, “Japanese and American Direct Investment in Asia: A Comparative. Analysis,” Hitotsubashi Journal of Economics Vol 26 (110. 1, June)

 

Lall, S. 1979. Multinational and Market Structure in an open developing economy: the case of Malyasia, Weltwirtschaftliches Archive 115(no.2) 325-50

 

Moosa, I. A. 2002, Foreign direct investment: theory, evidence, and practice: Theory, evidence and practice, Palgrave: New York

 

Petrochilos, G. A. 1989, Foreign Direct Investment and the Development Process: The Case of Greece, Anebury, Cow Publishing Company Ltd

 

United Nations 2007, World Investment Report 2007: Transnational Corporations, Extractive Industries and Development, accessed on 8th Sep 2010, [online] available: http://www.unctad.org/en/docs//wir2007_en.pdf

 

UNCTAD 1999, World Investment Report 1999: FOREIGN INVESTMENT GAINS IN LATIN AMERICA, accessed on 8th Sep 2010, [online] available: http://www.unctad.org/templates/webflyer.asp?docid=3056&intItemID=2021&lang=1

 

UNCTAD 2010, World Investment Report 2010: Investing in a low-carbon economy, accessed on 11th sep 2010 [online] available: http://www.investmauritius.com/download/WIR10.pdf

 

UNIDO 2002, Industrial Development Report 2002/2003: Competing through Innovation and Learning, Vienna: UNIDO.

 

UNCTAD 2000, Tax Incentives and Foreign Direct Investment: A Global Survey, accessed on 10th Sep 2010 [online] available: http://www.unctad.org/en/docs/iteipcmisc3_en.pdf

 

Unknown 2007, 华为与思科的差距: The distance between Huawei and Cisco, accessed on 8th Sep 2010, [online] available: http://blog.sina.com.cn/s/blog_48a3708e0100088m.html

 

Vernon, V. 1966. International investment and international trade in the product cycle. Quarterly Journal of Economics 80, pp. 190-207

 

Walker, F. A. 1891 The Doctrine of Rent and the Residual Claimant Theory of Wages, Quarterly Journal of Economics, Vol. 5, p.433-4

 

 

Appendix 1 Categories of Tax incentives