Foreign Direct Investment Flows into Developing Countries: Impact of Location and Government Policy

By Tarzi, Shah | The Journal of Social, Political, and Economic Studies, Winter 2005 | Go to article overview

Foreign Direct Investment Flows into Developing Countries: Impact of Location and Government Policy


Tarzi, Shah, The Journal of Social, Political, and Economic Studies


This study addresses vital questions: First, why a select group of developing countries receives the lion's share of Foreign Direct Investment (FDI), while the overwhelming majority of less developed countries are left behind? Second, whether and to what extent FDI inflow is a function of a country's FDI policy regime?

The study identifies market size, the rate of growth in market size, economic competitiveness, infrastructure, and worker productivity as key location factors. Further, several specific FDI and trade policies are germane to attracting a significant volume of FDI. These include lowering the ratio between the volume of FDI that is approved, as against the FDI actually undertaken by streamlining the approval process and removing arbitrary foreign ownership ceilings in sectors open for FDI deter foreign investment. In addition, the ability of foreign direct investors to repatriate capital and remit profits, setting up special economic zones to facilitate FDI, lowering regulatory burdens, and flexible labor policies are desirable vehicles for attracting FDI.

Key Words: Foreign Direct Investment; Developing Countries; Multinational Enterprises; Economic Development.

I. Introduction

The beneficial impact of Foreign Direct Investment (FDI) on a nation's economic growth and development has been widely recognized. National governments in the developing world have increasingly come to view FDI as a valuable source of capital; as a highly advantageous source for accessing Western technology, technical and managerial know-how; and as a way to create and upgrade human capital. FDI provides international market access and vital contacts in world markets, and serves as a platform by which to increase national exports. Firm specific assets - capital; technology; technical, managerial and human resource skills; jobs; and access to markets - often lacking in many developing countries are vital to economic development. These special attributes of Foreign Direct Investment are considered as the sine qua non of fast-emerging growth economies in Asia (China in particular). Even India, a country that for decades implemented highly restrictive policies against foreign ownership of domestic assets, is vying with other countries in the region to attract FDI.

According to one authoritative study, the economic benefits to developing countries from global capital market access may have been roughly as substantial as benefits achieved from access to trade in goods and services. The limited gain in access to global capital markets may be nearly equal to the approximately $350 billion a year in additional GDP, or 5% additional increments in GDP, that have accrued through trade in goods and services. Within the mix of global capital (bank loans, portfolio investments and FDI), the latter is reported to have an especially beneficial impact. The study suggests that "...a rise of one percentage point in the ratio of the stock of FDI to GDP will raise GDP by 0.4 %. In the 1990s the ratio of FDI to GDP in the developing countries went up from 7% to 21%. That rise of 14 percentage points implies an improvement in GDP of 5.6%."1 This increase is exemplified by China's astounding economic growth, partly fueled by the inflow of a huge volume of FDI during the last 15 years.

FDI is the most desirable form of capital inflows for development and growth, compared to other types of foreign capital. Bank debt, for example, is highly risky because the borrower is obligated to pay the loan even if the income of the debtor falls drastically. To be sure, in 2001 developed countries agreed to cancel twenty billion of the developing countries' debt. Still 47 developing countries, including 37 African countries, owe total of $-422 billion. The risk and volatility of bank debt is compounded by loans denominated in foreign currencies, short maturities, or floating interest rates. Similarly, portfolio equity investments with a very short time horizon are highly prone to capital flights, which occur if investment earnings do not materialize due to other macro-economic events such as currency crises, banking crises, and other financial calamities. …

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