Foreign direct investment (FDI) is playing a growing role in economic development. FDI flows to the developing world quadrupled from an annual average of $12.6 billion in 1980-85 to $51.8 billion in 1992-93, and rose to $70 billion in 1994. Developing countries received 32 percent of total world FDI during 1992-94, up from 20 percent in the first half of the 1980s. The share of FDI in the gross capital formation of developing countries more than doubled between 1986 and 1992, surpassing 6 percent in 1993.
While FDI is surging, other forms of capital flows to developing countries are diminishing (see table). Aid has continuously declined as a share of capital inflows since the 1960s, when it was the most important source of external finance for developing countries; it now accounts for only one fourth of their capital inflows. Commercial loans, a major source of capital flows in the 1970s, have virtually disappeared since the debt crisis of the 1980s. Portfolio investment, which boomed when stock markets in developing countries caught the attention of investors in the 1980s, is important but is also volatile and risky - as demonstrated by outflows from Mexico in December 1994.
Unlike other forms of capital inflows, FDI almost always brings additional resources- technology, management know-how, and access to export markets - that are desperately needed in developing countries. Investors are exacting, however, when it comes to deciding which countries are the most desirable sites for investment, and the lion's share of FDI has been going to a handful of countries, mostly in East Asia and Latin America. In 1994, 11 countries accounted for about 76 percent of total FDI flows to the developing world. Nevertheless, some countries (including many island countries) have received amounts of FDI that are large in proportion to the size of their economies. But FDI flows to many other countries, particularly in sub-Saharan Africa, have stagnated.
Why East Asia and Latin America?
More and more developing countries reduced barriers to FDI and improved business climates. At the same time, multinational corporations are responding to increased competition by considering a broader range of locations for their facilities. These mutually reinforcing trends have combined with technological changes in communication, transportation, and production to make "the global marketplace" a reality for investment decisions. The days of producing shoddy high-cost products for sale in local markets are passing; most foreign investors are interested only in sites where they can produce to international standards of quality and price.
This globalization means that the old distinction between export-oriented production and production destined for the local market is weakening and even disappearing. Countries that want to develop must offer good business conditions both for exporters and for production for local markets. The emphasis may differ, depending mainly on the size of the local market, but providing the combination is increasingly important. Countries in East Asia and Latin America have received the most FDI because they have adjusted their strategies to keep up with globalization.
Some of these countries initially based their development on exporting labor-intensive manufactured goods to the industrial countries. Recently, many have recognized that technological advances and intensified competition have increased the capital and skill intensity of production in many industries. This means that countries can no longer count on low labor costs alone but also need high quality, productive labor to sustain their comparative advantages. Those that have succeeded in attracting FDI have focused on improving general education, industrial skill training, and labor and managerial discipline. Facilitating companies' efforts to upgrade technology has also been crucial in maintaining their competitive edge.
The development of other successful countries was initially based on import-substituting industrialization. …