Direct Foreign Investment, Economic
Development, and Welfare
In previous chapters I analyzed in detail the arguments for and against protection, the relationship between major factor market distortions and optimal trade policy, and the problems that arise in managing the transition to a more liberal trade regime. These issues are central to the conduct of commercial policy. They are not, however, the only issues that preoccupy minstries of trade in developing countries. The treatment of direct foreign investment is also an important aspect of trade policy. Foreign firms dominate the production of resource-intensive exports and account for a large share of investment and employment in manufacturing in Sub-Saharan Africa, in numerous island economies, and in parts of Latin America and Asia.1 Nor is this likely to change anytime soon. The recent financial crisis in East Asia will no doubt make policy makers more cautious about accepting hot money and intensify the competition to attract direct foreign investment. If anything, foreign firms will be more important players in the near future.
Although most LDCs desire foreign investment (FI hereafter), they are also wary of its side effects. Policy makers want FI only on terms conducive to economic development. This leads, inevitably, to a certain amount of tension. If FI is valued as a source of employment, technology transfer, tax revenues, and marketing outlets, it is also feared as a powerful competitor that may discourage domestic investment.2 The fear that FI will strongly crowd out domestic investment is a legitimate economic concern, not just raw xenophobia. When the return on capital exceeds the social time preference rate, crowding out of domestic invest-____________________