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Foreign Direct Investment
(FDI)
Multinational Corporations
• FDI is investment by firms based in one
country (home country) in productive
activities in another country (host
country).
• MNC or TNC is a firm that undertakes FDI.
• (Corporation: a type of firm composed of
a legal entity that is separate from the
individuals who own it).
Importance of FDI for LDCs
• FDI is the most important source of
resource flows to developing countries. In
2004, it accounted for 51% of these.
• For LDCs as a whole it is more important
than ODA.
• For a number of LDCs ODA is still the main
source of foreign finance.
• FDI represents a small share of private
investment in LDCs
– Total investment by local firms is greater than
total investment by MNCs.
– In 2004, FDI was responsible for less than
20% of total private investment in LDCs.
• FDI is qualitatively very different from
local investment:
– Economic and political power of MNCs
– Large size
– Superior technical and managerial expertise,
know-how and technologies
Potential benefits and costs of
MNCs for host developing countries
1. MNCs can supplement insufficient foreign
exchange earnings.


Funds flowing into the LDC from abroad bring in
foreign exchange.
Activities of MNCs usually export oriented → ↑ in X
earnings → positive impact in BoP.
BUT: MNCs also engage in activities that result in
foreign exchange outflows:
–
–
–
Repatriation of profits
Imports of raw materials
Borrowing from parent corporation in home country
2. MNCs can supplement and improve
upon local skills and technology.
Technical and managerial expertise and new
production technologies brought in by MNCs
can be adopted by local workers and firms.
→ Improvements in physical and human
capital.

BUT: In practice, linkages between MNC and
local economy are limited. Also, MNC
often hire people from home country.
3. MNCs can supplement insufficient
domestic savings and lead to increased
investment.

Inflows of foreign funds leading to new
investments → formation of (new) physical
capital.
BUT:
a. Inflows may not lead to new investment, as
sometimes, rather than create new capital,
MNCs buy existing capital: ‘cross-border
mergers and acquisitions’ (M&As), of
increasing importance in LDCs.
b. Investment and new capital formation using
local resources (borrowing from local banks
or issuing equity). This diverts the use of
local savings from domestic to foreign
investors → negative effects for local firms,
as less savings are available.
4. MNCs can lead to greater tax revenues in
the host country.
BUT:
a. MNCs enjoy many privileges that may lower
the amount of tax paid.
b. Transfer pricing, artificial accounting system
that allows MNCs to lower their stated
profits.
5. MNCs can help promote local industry.

By purchasing locally produced goods and
services as inputs, they support and
promote development of local industrial
activities → growth of exisiting local firms or
establishment of new ones (‘backward
linkages’).
BUT:
a. MNCs often import their needed inputs from
abroad.
b. Competition by MNCs forces local firms to
shut down or does not permit new local firms
to be established.
6. MNCs can increase local employment
and help lower UE in the host country


By establishing productive facilities in the
host country and hiring local workers
Through the creation of backward linkages
BUT: the impact will be limited if...
a. MNCs create few backward linkages
b. MNCs import capital-intensive technologies
c. MNCs’ technologies make use of cheap local
labour, but the possibility of the MNC
relocating offsets the benefit for local labour
force.
7. MNCs can lead to higher economic
growth in the host country


Through increased levels of investment,
improved technology and increases in
human capital
Increased local investment through the
creation of backward linkages.
BUT, in addition to arguments above:
a. MNCs and environmental degradation.
 They prefer to invest in countries with less

environmental restrictions.
MNCs are mainly responsible for the production
of the bulk of industrial pollutants.
b. MNCs promote inappropriate consumption
patterns in developing countries, where
populations can less afford to spend their
incomes on unnecessary goods.
c. MNCs may divert government resources
away towards building infrastructure to meet
MNCs needs, in order to become attractive
as a host country.
d. MNCs may use their economic and political
power to bring about policies that may work
against economic development objectives.
– MNCs tend to invest in countries with weak
labour protection laws and weak
environmental regulations
– LDCs governments have a weak bargaining
position, as MNCs may threaten with
relocation.
5. Competition between LDCs to host MNCs
and the ‘race to the bottom’.
– Competition ≈ efforts to accomodate MNCs
demands.
– Sacrifice of needed policies for economic
development.
– Examples: weak labour protection laws, weak
environmental regulations; tax benefits that
lower tax revenues; diversion of local
resources for infrastructure that benefits the
MNC. Also, excessive liberalization of the
economy, including currency convertibility on
the foreign account, which can be risky for
the developing country.