Developing and transitioning economies often find themselves in a difficult position regarding industrial policy; despite the need to develop complex industries and participate in the global marketplace, their infrastructural assets as well as their access to capital tend to lag behind more advanced economies. As a result, their industrial policies commonly focus on attracting foreign direct investment (FDI), in an effort to improve their industrial base and catch up to developed economies. The prospects of technological transfers and job creation often drive local interest for these investments.

Because of the risks inherent in establishing new industries, let alone in developing countries, the efforts of multinational corporations in these regions tend to take the form of large-scale, export-oriented projects. Justified by the need for massive capitalization and the substantial number of jobs they represent, these large investments often find themselves the recipients of subsidies. These subsidies can take many forms. Continuous compensations for the jobs provided, tax incentives, laxer local environmental regulation can all be used to this effect, depending on local priorities.

Unfortunately for developing countries, the positive economic impacts are not always worth the risk. The cost of these subsidies, as well as the crowding-out effects these large industrial projects can generate on local employment, can outweigh their benefits. As a result, the literature on the topic draws a hazy picture.

Agosin and Machado (2005)1 produced a major analysis of these patterns, studying the effects of FDI on 12 different countries in 3 different regions (Africa, Asia and Latin America) in the 1971-2000 period. The results of the study showed that depending on the national context, FDI either crowded-out or crowded-in domestic investment. Experiences in Asia presented more crowding-in dynamics, while experiences in Latin America presented more crowding-out. African countries presented mixed results, with crowding-in, crowding-out and neutral results depending on the country. The authors pointed to the particularly open FDI policies implemented in Latin America – versus the more restrictive policies in Asia – as potential explanations for the disparity. Other studies support this thesis, finding that human development is more positively related to FDI when the FDI policies are more restrictive, confirming that governance is a particularly important factor in the benefits produced by these investments23.

Governance is not the only factor influencing the crowding out effects of FDI on local economies. Industrial linkages between local industries and FDI projects are also an important mediating factor in these dynamics4. In addition to confirming the mixed results of FDI for developing economies, Giuliani and Macchi’s 2014 review of the literature offer a wide-ranging survey of the factors influencing these dynamics5, including governance and industrial linkages.

These findings do not imply that foreign direct investment should be discouraged completely, of course. However, they do suggest that industrial policies intent on benefitting from FDI projects require foresight regarding both the establishment of industrial inter-linkages with local industries and solid governance principles, to avoid transforming these projects into economic enclaves which offer very little benefits, at best, to the host country.

 

Related keywords

Foreign direct investment

Enclave economy

Economic development

Crowding out

 

Significant papers

[1] Agosin, M. R. and R. Machado (2005). “Foreign investment in developing countries: Does it crowd in domestic investment?” Oxford Development Studies 33(2): 149-162.

[2] Morrissey, O. and M. Udomkerdmongkol (2012). “Governance, Private Investment and Foreign Direct Investment in Developing Countries.” World Development 40(3): 437-445.

[3] Reiter, S. L. and H. K. Steensma (2010). “Human Development and Foreign Direct Investment in Developing Countries: The Influence of FDI Policy and Corruption.” World Development 38(12): 1678-1691.

[4] Gerschewski, S. (2013). “Do local firms benefit from foreign direct investment? an analysis of spillover effects in developing countries.” Asian Social Science 9(4): 67-76.

[5] Giuliani, E. and C. Macchi (2014). “Multinational corporations’ economic and human rights impacts on developing countries: A review and research agenda.” Cambridge Journal of Economics 38(2): 479-517.

 

Other references

Ang, J. B. (2009). “Do public investment and FDI crowd in or crowd out private domestic investment in Malaysia?” Applied Economics 41(7): 913-919.

Driffield, N. and C. Jones (2013). “Impact of FDI, ODA and migrant remittances on economic growth in developing countries: A systems approach.” European Journal of Development Research 25(2): 173-196.

Eregha, P. B. (2012). “The Dynamic Linkages between Foreign Direct Investment and Domestic Investment in ECOWAS Countries: A Panel Cointegration Analysis.” African Development Review 24(3): 208-220.

Gallagher, K. P. and M. Shafaeddin (2010). “Policies for industrial learning in China and Mexico.” Technology in Society 32(2): 81-99.

Gerschewski, S. (2013). “Do local firms benefit from foreign direct investment? an analysis of spillover effects in developing countries.” Asian Social Science 9(4): 67-76.

Herzer, D. (2012). “How Does Foreign Direct Investment Really Affect Developing Countries’ Growth?” Review of International Economics 20(2): 396-414.

Inekwe, J. N. (2013). “FDI, Employment and Economic Growth in Nigeria.” African Development Review 25(4): 421-433.

Johansson, H. and L. Nilsson (1997). “Export processing zones as catalysts.” World Development 25(12): 2115-2128.

Jain, V., A. K. Gopalaswamy, et al. (2014). “Dynamic linkages between foreign direct investment and domestic investment: Evidence from emerging market economies.” International Journal of Economics and Business Research 8(1): 1-20.

Lautiera, M. and F. Moreau (2012). “An empirical criticism of the “FDI development” convention.” Revista de Economia Contemporanea 16(3): 393-414.

Ndikumana, L. and S. Verick (2008). “The linkages between FDI and domestic investment: Unravelling the developmental impact of foreign investment in sub-Saharan Africa.” Development Policy Review 26(6): 713-726.

Paniagua, J. and J. Sapena (2014). “Is FDI doing good? A golden rule for FDI ethics.” Journal of Business Research 67(5): 807-812.

Pathak, S., A. Laplume, et al. (2015). “Inbound foreign direct investment and domestic entrepreneurial activity.” Entrepreneurship and Regional Development 27(5-6): 334-356.

Rasiah, R. (2003). “Foreign ownership, technology and electronics exports from Malaysia and Thailand.” Journal of Asian Economics 14(5): 785-811.

Saglam, B. B. and A. Y. Yalta (2011). “Dynamic linkages among foreign direct investment, public investment and private investment: Evidence from Turkey.” Applied Econometrics and International Development 11(2): 71-82.