Sizing Up Foreign Direct Investment

Does a common myth about foreign investment discourage countries from seeking its benefits?

October 30, 2002

Does a common myth about foreign investment discourage countries from seeking its benefits?

According to good old economic theory, capital is supposed to flow out of rich countries — which often have too much of it already — to poorer ones, which don't have enough.

This is indeed what happens around the world — even though lots of capital also flows between rich countries, and nowadays increasingly between developing countries.

Of all the kinds of capital which flows into developing countries, many economists believe that foreign direct investment (FDI) is the best — because it is the most advantageous to the host country.

FDI is usually defined as the foreign purchase of 10% or more of voting stock of a factory, a bank, a port — or some other asset in the developing country. It implies a lasting interest on the part of foreign management.

Sometimes, the investment takes the form of a "greenfield" investment. In those cases, the foreign investor builds a factory, buys machines — and sets out to produce goods from scratch. Other times, it involves the purchase of existing assets.

But even when foreigners acquire existing assets — for example, when a developing country privatizes a concern by selling it to foreigners — expenditures for modernization and expansion usually follow.

More often than not, FDI brings quite a lot along with it: Solid owners, modern management, up-to-date technology, "deep pockets" which can finance modernization and expansion, export networks — as well as other desirable goodies.

But one of the greatest advantages of FDI is that it is thought to be less fickle than loans or stock purchases (commonly called "portfolio investment"). Unlike portfolio investors, direct investors do not pick up and run at the first sign of trouble.

Furthermore, the foreigners only earn money — get paid — when the investment pays off. If the venture does not succeed, the foreigners will find themselves with a money-losing asset.

The developing country is under no obligation to keep up foreign currency payments for dividends or to pay off any debt. That helps ensure that the developing country will not have excessive foreign exchange outflows.

All of that makes it very different from bank loans and bonds. When a country gets its capital through those channels, its foreign lenders expect to be repaid — even if there is no actual income available to pay them.

All of these factors — imported top-flight management, steady investment and foreigners accepting some risks if things go bad — is why governments the world over are competing to attract FDI.

And investors have been obliging. FDI inflows into developing countries rose from an average level of $62 billion in 1990-1995 to over $184 billion in 1999 — and remained close to that level even as the world went into recession in 2001.

So why then do some of the world's most august authorities — such as the World Bank, the United Nations Conference on Trade and Development, not to mention Joseph Stiglitz (a recent recipient of the Nobel Prize in economics) — keep criticizing FDI? A key reason is the distribution.

The critics argue that, "Most FDI flows have remained concentrated in just a few developing countries." That's how the World Bank's 2002 Global Development Finance put it, for example. And the problem was raised earlier — as the World Bank's World Development Report of 1997/98 — directed by Mr. Stiglitz — complained:

"Despite the sizeable increase in FDI to developing countries in the past decade, most of that investment goes to only a few countries. The majority of countries benefit only marginally…"

It is perfectly true that over the last 30 years a handful of developing countries have attracted the bulk of FDI. This raises two questions. What does it mean? And is it really such a bad thing? We will examine the question closely in Part II.