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Foreign Direct Investment and Regional Development

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Published: Wed, 13 Sep 2017

Over the past decades, it has been argued whether foreign direct investment and policies that attract more of it, contribute towards the development of a region. Foreign direct investment raised after the end of the Second World War and its aim was the control of overseas production and service operations. Every country occupies a place in the investment development path, which is determined by the nation’s flows of inward and outward investment, with different strategies and different frames for every stage of the path. The emergence of new dynamic markets in the developing world, low cost labor and loose legislation of working rights was the initial motive for multinational enterprises to engage in foreign direct investment. Though these motives stimulated the rise of foreign direct investment, other reasons helped too, such as the seek for know-how and technology or the creation of assets. After 1970, and the adoption of neoliberal approaches from developing nations under the pressures of developed economies, rendered the state less powerful to intervene with the process of development and open their markets to foreign direct investment, even if the state has a high stake in the process. Many theories have been deployed to understand the extend of human development beyond the economic factors. Social indicators such as life expectancy and education were added into the equation as well as environmental indicators, though many neoliberal institutions such as the World Bank insist on perceiving development mainly in economic terms. To understand and measure economic and social development the United Nation Development Program synthesized the Human Development Index to include basic economic and social indicators. For measuring environmental development, the university of Yale in collaboration with various institutions developed the environmental performance index, a mix of many environmental indicators into one. These two indicators are the main measurements of development in this essay.

Dicken’s definition about direct investment is that “direct investment is an investment by one firm in another, with the intention of gaining a degree of control over the firm’s operations. Foreign direct investment is simply direct investment across national boundaries, that is, when a firm from one country buys a controlling investment in a firm in another country, or where a firm sets up a branch or subsidiary in another country”. Direct investment is different from portfolio investment, which is investment in firms without the intention of gaining control over operations but only financial reasons. Foreign direct investment can indicate and measure transnational corporate activity, but it doesn’t capture the full range of corporate operations, due to the variety of ways that transnational corporations can organize their production chains, through joint ventures or alliances. (Dickens, 2007)

Based on the investment development path, states can experience five stages of development of investments, and are categorized based on the tendencies these states have on being an inward or outward investor. This tendency is defined by the competitive advantages domestic firms have over foreign (the C advantages), the advantages gained by the resources and capabilities a country possess (the D advantages), and the advantages gained by the joint exploitation with foreign firms of the resources and capabilities both corporations possess (their E advantages). At the first stage the D advantages of a country are perceived as not existent, except those coming from natural resources. At this stage, outward investment is minimal, and foreign firms prefer to trade and not invest on these economies, because there are no C advantages of domestic firms. Discouragement for investment might be insufficiency in transportation systems or communication or more importantly uneducated, untrained or unmotivated workforce. In stage 2, states experience a rise of inward investment and outward investment stays at minimum levels. The growth of domestic markets might be the incentive for foreign firms to invest in production. Domestic firms must possess some desirable D advantages in order for foreign firms to invest. The D advantages also raise on this stage. Outward investment, if there is any, is for the purpose of market seeking or improving capabilities in developed countries. In stage 3, states experience a decrease in the growth rate of inward investment and a raise in the growth rate of outward investment. Domestic firms start to obtain their own C advantages and compete with foreign firms at the same industries. Government intervention at this stage is less significant. Government policies trying to attract foreign direct investment will target industries whose firm’s C advantages are weaker in comparison with foreign firms but D advantages are stronger. At stage 4, a country’s outward investment stock is greater or even with the stock owned by foreign firms. Domestic firms not only compete with foreign firms in domestic market but are capable of penetrating foreign markets as well. As domestic firm try to maintain their competitiveness by subcontracting operation to lower stage locations, outward investment continues to raise. Inward direct investment at this stage derives from other stage 4 or 5 countries seeking asset creation or by lower stage countries seeking to improve their own capabilities. At the last stage of the investment development path, the net of investment first fluctuates and then comes to a state of equilibrium., though both outward and inward investment tends to increase. At stage 5, most corporate cross border transactions come at the form of intra-trade, the C advantages of corporations depend on the firm’s ability to create assets and most inward investment comes in the form of knowledge seeking from lower stage countries or as a rationalized investment from stage 4 or 5 countries. One more characteristic of this stage is that multinational corporations lose their national identity and do not act towards national interest as they operate on a global scale. (Dunning J., Narula R., 1996).

Motives for foreign direct investment are market exploitation, cost reduction or strategic asset acquirement. New markets attract foreign direct investment, with several benefits for setting up close to a new market such as, closer interaction with suppliers and customers or the image of the firm as quasi-local. Policies of contagious markets towards foreign investment might be crucial, as the firm uses those markets to export products. Strategic motives constitute an important motive for foreign direct investment, as multinational enterprises tend to target oligopolistic industries that compete on global or regional scale. Therefore, the decision of the investment is not made autonomous and takes into consideration the behavior, acts and expectations of the firm’s competitors. Multinationals seek to move earlier in recent opened markets for various reasons, such as to establish a first mover advantage, manage to acquire certain sites or build up a brand name. Low cost is one more incentive for foreign direct investment and especially low labor cost. Multinational enterprises move operations from region to region to exploit low labor cost relative to other costs, such as transportation, energy or raw materials. Some other aspect that affect inward investment are the political stability, the policy environment and the infrastructure. Corporations will be reluctant to invest in a political environment that is not stable. Policies that favor foreign direct investment and constant reform is a major attraction for transnationals. Lastly, if the infrastructure is unorganized and the rule of law barely existent, will discourage firms to invest, due to the lack of protection towards their property and income. (Estrin S., Hughes K., et.al, 1997).

Foreign direct investment and transnational enterprises can rise from the lack of local and near market’s intangible assets, such as knowledge, managerial and marketing skills or technology. If a firm has some of these assets in its possession and wants to deploy them in global production, three ways to do it are subsidiary production, joint ventures and licensing. Subsidiary production and joint ventures include equity participation while licensing suggests arm’s length transactions for the acquisition of technology or skills. All three forms of investing offer advantages and disadvantages. For example, subsidiary production overseas might reduce costs from operations. On the other hand, set up cost that are related to subsidiary production might be discouraging. Determinants for the selection between joint ventures, licensing and subsidiary production are the transaction costs involved which are shaped by each host country’s policies, and are defined from the degree of how much of the assets traded are proprietary, the level of complexity and tactical importance of the transaction and the frequency of these types of transactions. The intangible assets that multinational enterprises possess are the ones that give multinationals their superior advantage from local firms and based on the nature of those assets the choice of operations vary. For example, a firm in technology industry would prefer control over an investment to avoid leaks of knowledge and information. (Blomstrom M, Kokko A., et.al, 2000).

The approach of international investment for international production coincided with the reform in many developing nations regarding their industrialization policies, answering to pressures from developed economies and international institutions. The raise of neoliberal ideologies compelled many developing nations to adopt policies that supported free markets and attracted foreign investment, policies such as reduced tariffs, infrastructure reform or reduced taxation. These types of policies can be interpreted as ‘a race to the bottom’, because they lead up in nations undermine each other to attract foreign investment. Such actions might result in lower wages, environmental negligence or insufficient contribution towards the tax base. In the recent decades, most countries have adopted policies favoring foreign investment, even countries with communist or authoritative regimes, with few exceptions. This implies that national economies are connected with multinational enterprises, with firms possessing significant power in the relationship. In many cases, corporate power undermines the power possessed by the nation states. (Williams G, Meth P., 2014).

As transnational corporations came to dominate and shift the global economy through global investment and economies of scale, national governments clearly have an interest about these economic flows, either negative or positive. For a national government, there are two kinds of this investment. Domestic firms investing outwards or foreign firms investing inwards. Policies that are set by national governments, usually refer on inward investment, though some policies restricting outward investment might exist, such as the demand for government authorization before an outward investment completes. Developed countries tend to be more open towards inward foreign investment than developing, though that’s not always the case. Examples like France’s strict policies, or Singapore’s liberal ones. However, the tendency for favorable foreign direct investment policies is growing. (Dickens, 2007).

In the past century, scientist from different fields, such as economic, social or environmental, evolved theories aiming to understand and shape development. The classical approach that most nations applied after the end of the Second World War, was the economic growth theory, conceptualized by economist John Keynes. This approach emphasized the crucial role of national governments in shaping economic growth, by investing in new infrastructure projects, such as roads or damns, even if the state had to borrow money. The projects would offer needed jobs to the unemployed population, which in turn would increase the purchasing power of the working class, which in turn would help provide needed cash flows in the market. Though, if the citizens preferred to purchase goods and services from other nations, the wealth generated for their own nation would be at lower levels. (Hopper P., 2012). With the collapse of the Bretton Woods regime, some theorist believed that state intervention was slowing down economic growth, and better rates would have achieved if the market was regulated by itself. These ideas were drawn from the work of Adam Smith. Neoliberals approach was that the reduction of state intervention and letting the market decide on wages and prices, would lead to better economic growth and therefore well-being. They argued that this approach would achieve optimal resource allocation with consequent benefits. (Willis K., 2004). Critical modernist development theorists believe that mankind possesses the necessary intellectual and practical know how to support more people on earth than ever before. Therefore, they hold high, social indicators in indicating development. Critical modernist aim to “extend the benefits from economic growth to a world of people, starting with the poorest while, in the process, transforming social relations of control to democratize all aspects of existence, and rethinking relations with nature to ensure both continued livelihoods and the fecundity of nature”. (Peet R., Hartwick E., 1999).

In the Washington Consensus, it was decided the support of neoliberal policies and regulations by a ‘free market’, despite the beliefs that national states were important actors in state development. Despite each nations regimes and ideologies, all nations exercise sovereignty and that provides them with two unique options to influence development. First, though they may get criticized by the international community and international institutions, they can implement policies in other areas that will influence their development. Second, states “are institutions that claim to represent the collective will of their people”. Regardless their regime (democratic, authoritative or communist) no other institution – non-governmental organizations, multinational corporations or international development institutions- can make the same claim at this scale. This power combined with their ability to legislate can make the state an important actor in regional development. (Williams G., Meth P., 2014).

The word “region” is multifaceted and its meaning changes based on the context of use. It can be used to describe a small area around someone’s house or a big multistate area as well. As global trade arises, economic researchers are starting to recognize the importance of multinational regions. Economists differentiate between development and growth. Though growth is an important aspect of development it does not capture the entire picture. Investments that provide low wage jobs might increase the overall size of the economy but not the income per capita. Economic development insinuates that the quality of life increases by improving per capita income. However, that alone is not a complete indicator of economic development. There are more factors that shape development, such as education or life expectancy and infant mortality. Focusing on the economic aspect does not help determine local development, because it is a part of a larger frame of community development. (Blair J, 1995). Economic development relates to improving material welfare, mainly for the lower income brackets; the elimination of mass poverty and all the factors leading to that such as illiteracy or disease; configurations of the inputs and outputs of the economy and policies shifting production from the agricultural sector towards industrial activities; provision of employment towards all the working age population not just a privileged minority and a wider range of participant groups in the decision making process of economic or other policies, that shape their welfare. (Kindleberger, 1977). From the economic scope, development takes place when a state who has been static manages an annual increase of their gross national income between 5% and 7%. An alternative indicator is the growth of gross national income per capita to demonstrate the ability of a state to increase their income in relation with their population growth. Development in every society has three fundamental objectives. The first is to increase the access to basic resources, such as food, healthcare and housing and towards a more equal distribution of these resources. Second is the raise of the standard quality of life, not only the basic income levels, which raise only the material well-being, but also education services and human rights, that raise awareness and self-esteem. Third, to broaden the range of social choices accessible to individuals, that helps them unshackle from ignorance and misery. (Stephen, Todaro, 2006).

The Human Development Index is “a composite index measuring average achievement in three basic dimensions of human development-a long and healthy life, knowledge and a decent standard of living” (Jahan S., Jespersen E., 2015). Its aim is to measure development and allow cross-border comparisons. The United Nations Developing Programme conceives human development as the creation of an environment that helps people reach their potential, experience a productive and creative life in accordance to their interests and needs and widen the range of choices that help people lead lives that they perceive as valuable. Human development index reflects this, by measuring life expectancy, education and gross national income per capita. Human development index has been developed by UNDP and is published in the Human Development report since 1990. Upon its introduction, HDI gained increased attention, due to the fact that measuring gross domestic product and gross national income was inadequate. It is considered as an upgrade of the existing indicators of private purchasing power, to include quality of life and welfare into the equation. The Human Development Index is used broadly by governments to evaluate and design economic and development policies. (Hou J., Walsh P., et.al, 2014).

A truly developed nation seeking to maintain development, should decide on development policies not only based on human development indicators but also with concern of the environment. The Organization of Economic Cooperation and Development does not recognize a particular set of indicators rather than the existence of many. There is a core set of primary indicators to evaluate environmental performance such as gas emissions and greenhouse effects, water resources and availability, biodiversity etc. Specific sector indicators also help to form policies in certain industries such as agriculture or transportation. Lastly, there are environmental indicators that integrate environmental apprehensions into economic policies and shape the management of national resources. (OECD, 1998). The Environmental Performance Index is an indicator developed by Yale University and many various institutions, that evaluates a nation’s environmental performance. it consists of two categories, the protection of human health and the protection of the ecosystem. EPI examines nine core categories, such as greenhouse gas emissions or water resources, with more than twenty indicators, and measures the performance of states in reaching global environmental goals. (Hsu A., et.al, 2016).

The purpose of this research is to examine if inward foreign direct investment is beneficial towards the development -economic, social or environmental- of different regions. For this research, data from 172 countries were gathered. More specifically, foreign direct investment inward and outward flows were collected from the United Nations Conference of Trade and Development and are measured in millions of dollars, human development index scores were extracted from the United Nations Developing Programme and the environmental performance index scores were taken from the official environmental performance index site powered by Yale university. For analysis of the data, regression analysis will be used, as well as Pearson’s correlation.

It is worth noting some countries that were excluded from the model, due to insufficient data but amaze with their foreign direct investment inward and outward flows. Most notable is Hong Kong with inward flows reaching 114,054 million of dollars and outward flows reaching 125,109 million of dollars. Other notable countries are Cayman Island with inflows at 23,731 and outflows at 8,737 million of dollars, Macao with inward flows of 3,294 and outward flows of 681 million of dollars, Taiwan with inward flows of 2,839 and outward flows of 12,711 million of dollars and New Caledonia with inward flows of 1,781 and outward flaws of 62 million of dollars. Other nations that were excluded are Capo Verde, Cook Islands, Cuba, Curacao, French Polynesia, Gambia, Saint Kitts and Nevis, Saint Lucia, Saint Vincent and the Grenadines, Sint Maarten and Somalia.

Results of regression analysis of Human Development index and inward Foreign Direct Investment

Multiple R-squared: 0.09738, Adjusted R-squared: 0.09207

Pearson analysis results: correlation degree at 0.3120621

Estimate

Std. Error

t value

Pr(>|t|)

(Intercept)

6.625e+01

1.156e+00

57.322

< 2e-16

FDI inflows

2.342e-04

6.349e-05

3.689

0.000303

Results of regression analysis of Environmental Performance Index and inward foreign direct investment.

Estimate

Std. Error

t value

Pr(>|t|)

(Intercept)

6.741e-01

1.218e-02

55.329

< 2e-16

FDI inflows

2.866e-06

6.693e-07

4.283

3.08e-05

Multiple R-squared: 0.07412, Adjusted R-squared: 0.06867

Pearson analysis results: correlation degree at 0.2722476

In the case of HDI, the results show that for every million invested in a nation their human development index raises for 2.866e-6 = 0,000002866 points, with significance levels at 3.08e-5 = 0.0000308 < 0.05 indicating that the results are real, R-squared at 9.7% and correlation degree at 0.3 which shows low correlation.

In the case of EPI, the results show that for every million invested in a nation their environmental performance index raises for 2.342e-4 = 0.002342 points. With significance levels at 0.000303 < 0.05 indicating that the results are real, R-squared at 7.4% and correlation degree at 0.27 which shows low correlation

The common notion dictates that foreign direct investment is a needed tool towards development, without taking into account what the countries have to give up to attract such investments. Nowadays, multinational enterprises engage daily in foreign direct investment, trying to take advantage of the benefits that it offers, in regard with the position on the investment development path of the host country. States are pursuing the attraction of such investments, with little regard towards the dignity of their own citizens, their wages and their welfare, pressured by international development institutions and by governments of developed economies that have interests embedded in the host nation’s economies. Theorist have tried to find a pattern for the ideal process of development and the states position and role in it, with many advocating minimal intervention and others perceiving the government as an important actor. After decades conceptualizing development as an economic phenomenon alone, scientists and institutions have agreed that for a thorough measurement and understanding of development, social and environmental performances should be considered too, leading to the creation of complicated indexes that include them as well. Development will always be a controversial subject, with different opinions being dominant each chronological period, but the understanding that including many aspects in the concept – economic, social, environmental, freedom or equality related- enhances the outcome, shows that mankind is pacing on the right path.

REFERENCES

Blair J., “Local Economic Development, Analysis and Practice”, 1995

Blomstrom M., Kokko A., Zejan M., “Foreign Direct Investment, Firm and host country strategies”, 2000

Dickens P., “Global shift mapping the changing contours of global economy”, 2007

Dunning j., Narula R., “FDI and Governments”, 1996

Estrin S., Hughes K., Todd S., “Foreign Direct Investment in Central and Eastern Europe”, 1997

Hopper P., “Understanding Development”, 2012

Hou J., Walsh P., Zhang J., “The dynamics of Human Development Index”, the social science journal, 2014,

Jahan S., Jespersen E., “Human Development Report”, 2015

Kindleberger Herrick, “Economic development”, 3rd edition, 1977

OECD, “Towards sustainable development, Environmental indicators”, 1998

Peet R., Hartwick E., “Theories of Development”, 1999

Todaro M., Smith S., “economic development”, 9th edition, 2006

Williams G., Meth P., Willis K., “Geographies of developing Areas”,2nd edition, 2014

Willis K., “theories and practice of development”, 2004

Yale University, Yale-NUS College, National University of Singapore, Center for International Earth Science Information Network, Columbia University, Yale Center for Environmental Law & Policy, Principal Investigator and Director Professor Angel Hsu, “Global Metrics for the Environment”, 2016

Links to the Data:    

http://unctad.org/en/Pages/DIAE/World%20Investment%20Report/Annex-Tables.aspx

http://hdr.undp.org/en/content/human-development-index-hdi

http://epi.yale.edu/country-rankings


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