Name: Rebecca Buchholz Student No: 130550 Course: Foreign Trade and Economic Development Lecture/Tutor: Katrin Arnold

What potential effects do multinationals have on developing countries?

Word Count: 2520

Introduction The Multinational Corporation (MNC) has been a central feature of economic activity in the past decades. According to the World Investment Report 2001, Foreign Direct Investment (FDI) by MNCs in 2000 grew faster than any other economic aggregated indicator1. The spread of MNCs around the globe continues to generate controversy about their benefits and costs to host countries. However, before commencing an analysis of the pertinent issues, it is important to briefly define the terms MNC as well as FDI: an MNC is most simply defined as a cooperation or enterprise that conducts and controls productive activities in more than one country2. Cross border expansion takes place through Foreign Direct Investment (FDI), which is defined as international capital flows in which a firm of one country creates or expands a subsidiary in another3. Importantly, the distinguishing feature of MNC expansion through FDI in comparison to other forms of capital flows, is that it retains the control and ownership over its proprietary technologies4. In this essay the benefits and costs of MNCs are assessed mainly by looking at FDI in developing countries. The essays discussion is divided into 3 parts: the first part deals with a general theoretical cost benefit analysis, the second lists some general criticisms of MNCs, and the third part discusses a number of case studies. The discussion will attempt to illustrate that the effects of MNCs on developing countries depend often on policies and that there is no directly positive or negative effect in general between FDI and economic development in developing countries. Costs and Benefits of FDI/MNC Foreign Direct Investment flows may serve to supplement capital scarcities in developing countries, influencing investment levels and the balance of payments positively or they may actually lead to a reduction of domestic capital. Firstly, according to the two-gap model, capital and savings are low in developing countries,

1 P.1, UNCTAD World Investment Report 2001- Promoting Linkages, Overview, Internet Edition 2 p.534, Todaro, M. and S. Smith (1997) Economic Development, 6th ed Addison-Wesley 3 p. 168, Krugman, P. and Obstfeld, M. (1997) International Economics Theory and Policy,
Addison and Wesley 4th edition. 4 P.4, Blomstrom, M and A. Kokko (1996) The Impact of Foreign Investment on Host Countries: A Review of Empirical Evidence, Working Paper www.worldbank.org/html/dec/publications/workpapers/wps1700series/wps1745/wps1745.pdf

thereby limiting investment and economic growth5. The benefit of FDI is to fill these two gaps through providing capital as well as higher tax revenues6. The tax revenues benefit the government through increasing the funds available to improve public infrastructure and induce investment. For example in China foreign affiliates tax contributions accounted for 18% of the countrys total corporate tax revenues in 20007. Generally, raising investment levels through higher capital availability increases growth. However, Coleman and Nixon argue that although in the short-run a positive effect on growth may take place, in the long-run the effect is likely to be negative as the repatriation of profits, negotiated tax concessions, transfer pricing and intra-firm trading as well as payments of royalties, technical, and managerial fees to the parent company result in a negative outflow of capital8. Further, MNCs might lower the domestic capital availability by borrowing on local capital markets. In Latin America for example, American MNCs financed over 80% of their investments from local borrowing9, which means that MNCs did not supplement domestic scarcities but consumed them further. This is likely to discourage local investment rather than stimulate it. The impact of FDI therefore depends on whether it discourages domestic investment or stimulates it by providing additional incentives. However, the negative capital outflow might be offset by other factors such as technology and knowledge transfer, backward linkages and increased export competitiveness. Firstly, FDI can lead to technology transfer and knowledge transfer of managerial and marketing expertise which otherwise is more difficult to obtain through trade10. Secondly, with new more advanced technology in place, as well as managerial know-how, there is a possibility for spillovers (unofficial technology transfer) and linkages (increasing local economic activity) into the economy. Local firms can copy the new technology, or they are forced through increased competition to upgrade their technology and innovate11 in order to remain as suppliers to the 5 p. 13, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 6 p.538, Todaro, M. and S. Smith (1997) Economic Development, 6th ed Addison-Wesley 7 p.4, UNCTAD World Investment Report 2001- Promoting Linkages, Overview, Internet Edition 8 p.368-370, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in
D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 9 p.369, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 10 p.13, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 11 p. 7, Blomstrom, M and A. Kokko (1996) The Impact of Foreign Investment on Host Countries: A Review of Empirical Evidence, Working Paper www.worldbank.org/html/dec/publications/workpapers/wps1700series/wps1745/wps1745.pdf p. 276, Held, D. et al (1999) Global Transformations, Stanford University Press

market. Thirdly, the higher product quality brought about by new technology in addition to the fact that MNCs bring to the country certain knowledge of international market conditions and improved access to foreign markets should increase exports12. As Gemmell points out these possible higher export earnings can increase the balance of payments to offset the negative impact of repatriation of profits13 as outlined in the paragraph above. On the other hand others argue that that the transfer of capitalintensive technology might be either of an inappropriate nature for developing countries facing excess labour supply14, or take place as a one-off demonstration effect15 instead of being diffused throughout the economy. In general it is argued that MNCs creates enclaves in the economy, which have little connection with the rest of the economy16. As a result the spillover and linkage effects may be insignificant. The impact of FDI thus depends on how far integrated the MNC is in the local economy in that potential spillovers can be captured. MNCs are often expected to benefit the labour market through either increased employment or by increasing the amount of skilled labour by providing training. Firstly, when MNCs undertake new investment, they are likely to directly increase employment and indirectly increase jobs in supplier firms17. Secondly, they are likely to pay higher wages and provide better training than local firms18. Both of these impacts may influence economic growth positively through a) increasing productivity and b) by providing income that can be put to productive use. Also, the skills acquired by MNC employees can later be diffused to local firms when they switch jobs to local firms. In addition, one could argue that if the MNC has higher standards of policies and practices within the affiliate, these would tend to raise the standards of local firms wanting to remain competitive. This would be especially true for export goods, which need to meet a certain quality standard. However all these benefits are based on the assumption that FDI creates new investment. Lougani points out that FDI often comes
12 p.24, Blomstrom, M and A. Kokko (1996) The Impact of Foreign Investment on Host Countries: A Review of Empirical Evidence, Working Paper www.worldbank.org/html/dec/publications/workpapers/wps1700series/wps1745/wps1745.pdf 13 p. 92, Gemmell, M. (1987) Surveys in Development Economics 14p. 96, Gemmell, M. (1987) Surveys in Development Economics 15 p.16/17, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 16p.14, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 17 p.365, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 18 Hanson, G. (2001) Should Countries Promote Foreign Direct Investment?, G24 Discussion Paper Series UNCTAD&Center for Internatioanl Development Harvard University

in the form of take-over of local firms by an MNC19 and similarly UNCTADs World Investment Reports names Mergers and Acquisitions as the main stimulus behind FDI20. If FDI entails the take-over and privatisation of local firms, then it is unlikely to increase employment by a significant amount. On the other hand, it might still increase the level of skilled labour in the country. Criticisms of MNCs MNCs in developing countries have been criticised for exercising too much foreign control. Firstly, as elaborated above this can take the form of negative outflows of capital as profits are repatriated instead of being reinvested in the country. Further, FDI under the umbrella of the parent company may put the interest of the company as a whole before the interest of the country it is operating in21. As the UN outlines, the more national units become conditioned to indirect, harmonized control procedures, the more difficult it becomes for them to respond unilaterally to the needs of the local economy22. As a result one could argue that the profit-maximising interest of the MNC by definition does not consider domestic economic growth and thus is not a viable sustainer or initiator of long-term growth. Secondly, many economists argue that MNCs inhibit the development of local enterprise by a) suppressing the expansion of indigenous firms as suppliers of intermediate goods through intra-firm trade23; b) by pre-empting the best investment opportunities; c) by diverting funds from the domestic market24; and d) by receiving tax concessions, exemption from import duties and direct subsidies which tend not to be offered to local firms25. These conditions favour the MNC at the expense of local firms and thereby, in the presence of the additional competition posed by MNCs, may stifle the expansion of a competitive domestic industrial base. However arguably, whether FDI 19 p.6, Loungani, P. and A. Razin How beneficial is Foreign Direct Investment for Developing
Countries? www. Imf.org 20 p.1, UNCTAD World Investment Report 2001- Promoting Linkages, Overview, Internet Edition 21 p.351, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 22 p.351, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 23 p. 539, Todaro, M. and S. Smith (1997) Economic Development, 6th ed Addison-Wesley 24p.14, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 25 p.1, Hanson, G. (2001) Should Countries Promote Foreign Direct Investment?, G24 Discussion Paper Series UNCTAD&Center for Internatioanl Development Harvard University

crowds out domestic private investment or whether it in fact increases it, depends on the level of backward and forward linkages created in the economy. Another criticism against MNCs is that they operate in monopolistic and oligopolistic markets which allows them to retain supernormal profits. Byres argues that by operating in oligoplistic markets, MNCs maintain prices above the competitive level26. Oligopolistic market power is likely to impose welfare costs on the population. Further, Loungani points out through FDI, foreign investors can gain crucial inside information about the productivity in their control. This informational advantage can result in foreign direct investors being in a position to retain highproductivity firms under their ownership and sell low-productivity firms to uninformed local savers27 clearly reducing the benefits of an MNC to the local economy. Secondly, MNCs often employ specific tactics derived from their size and scope such as global financial strength through cross-subsidisation, cross-selling, acquisitions and/or perceived international and local interdependence which serves to deter entry by enabling them to compete in as many of their competitors core markets28. The impact of FDI operating in oligoplistic market structure depends therefore on how far it exercises its market power to reduce domestic competition and expansion. Case Studies Three case studies of FDI in China, EPZs in Mexico and FDI in Latin American help to illuminate the theoretical discussion. China is a major recipient of FDI. Some economists suggest that Chinas export growth has been stimulated by FDI. For example, Lemoine finds that almost all of Chinas export growth during 1990s can be attributed to foreign-invested enterprises, mostly FDI driven by non-Japanese Asian countries into labour-intensive export processing activities29. Another positive impact of FDI has been per capita income growth in FDI concentrated regions30, which can be attributed to increased 26 p.14, Byres, T.J. (ed) (1972) Foreign Resources and Economic Development 27p.5/6, Loungani, P. and A. Razin How beneficial is Foreign Direct Investment for Developing
Countries? www. Imf.org 28 p.363, Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries 29 p.11, Graham, E. and E. Warda (2001) Foreign Direct Investment in China: effects on Growth and economic Performance, internet publication 30 p.3, Graham, E. and E. Warda (2001) Foreign Direct Investment in China: effects on Growth and economic Performance, internet publication

employment as well as increased productivity in these areas. Warda argues that one reason why FDI has been beneficial in China for domestic economic factors is that the entry of foreign firms was conditioned by the industrial policy laid out by the state31. In addition foreign firms were forced to purchase their production inputs from local suppliers, which as explained in the theoretical discussion above, creates linkages in the economy. However Lemoine argues that because FDI in China has been concentrated in labour-intensive production, the benefits are limited to job creation while generating little in the way of technology transfer nor in integrating domestic Chinese enterprises into integrated global production structures32. Although an analysis to assess the impact of FDI on the Chinese economy is controversial and any conclusion will depend on the factor looked at and the data used, it is clear however that FDI at least partly contributed positively to the economy by creating jobs, stimulating exports and improving productivity in certain regions of the country. MNCs often invest into Export Procession Zones (EPZs) as they constantly search for cost-saving locations, particularly in terms of wages costs. The consequent shift in manufacturing, assembly and component production away from high-wage countries has contributed to the popularity and spread of EPZs. Export Processing Zones are defined as labour-intensive manufacturing centres that involve the import of raw materials and the export of factory products33. The EPZs can be beneficial due to their potential ability to facilitate industrial development as MNCs provide scarcities such as technology, capital, inputs and access to export markets. However critics point out that these investments tend to be volatile as the withdrawal of tax and trade incentives may result in an immediate relocation on the part of the multinational corporation34. Further, the EPZs are often based, as in the case of the maquilas in Mexico, on unskilled, low-wage and non-unionised labour. Non-unionised workers are unlikely to be able to demand improved working conditions and higher wages presenting another impediment for the development of the concerned countrys labour market. Additionally, EPZs mostly operate as enclaves in the economy, which is unlikely to foster a beneficial transfer of skills and technology throughout the entire
31 p.7, Graham, E. and E. Warda (2001) Foreign Direct Investment in China: effects on Growth and economic Performance, internet publication 32 p. 11, Graham, E. and E. Warda (2001) Foreign Direct Investment in China: effects on Growth and economic Performance, internet publication 33 P.201 Desai, V. and R. Potter (2002) The Companion to Development Studies, Arnold- Oxford University Press Inc., New York 34 p.202 Desai, V. and R. Potter (2002) The Companion to Development Studies, Arnold- Oxford University Press Inc., New York

econony. Further as Gereffi outlines, whereas Mexicos EPZs were able to move to a second stage of component-supply manufacturing attracting higher technology investors and more skilled labour and developing training programmes, the heavy dependence on US MNCs makes it difficult for them to achieve later stages of the industrial pathway35. EPZs are not likely to foster significant spillovers and linkages in the economy. However, they might still represent better employment opportunities than those of local firms. A study of 18 Latin American countries suggests that the impact of foreign investment on domestic investment is partially policy driven. Weeks looks at data for 18 Latin American countries during 1970s-1990s, analysing the relationship between foreign investment and economic growth and the crowding-in (increasing investment)/crowding out (reducing investment) effect of foreign investment on domestic investment. He argues that a positive impact depends on whether a) foreign investment crowds in investment and b) the growth-inducing effect of foreign investments is greater than for the domestic investments they replace36. If the oligoplistic or even monopolistic market power often held by MNCs is abused, it is likely to crowd out domestic investment by stifling local entrepreneurship and subsequently have a negative effect domestic growth rates. Using a simulation model, he further observes that for 7 countries there were crowding out effects, for 2 countries there were crowding in effects and for the rest there was a non-significant effect of foreign investment on domestic investment37. In contrast to the general belief that foreign investment will increase domestic investment and growth rates, Weeks model observed a dominant negative, although largely non-significant effect of foreign investment on domestic investment. Weeks concludes by pointing out that the empirical differences do not seem explained by size of country or simple structural characteristics therefore, we conclude that the differences across countries and over time are, to a substantial degree, policy-driven38.

35 p.205 Desai, V. and R. Potter (2002) The Companion to Development Studies, Arnold- Oxford
University Press Inc., New York 36 P.4, Weeks, J. (2001) Exports, Foreign Investment and Growth in Latin America- Scepticism by Way of Simulation, Working Paper Series No. 117 SOAS, London 37 p.16 Weeks, J. (2001) Exports, Foreign Investment and Growth in Latin America- Scepticism by Way of Simulation, Working Paper Series No. 117 SOAS, London 38 p.22 Weeks, J. (2001) Exports, Foreign Investment and Growth in Latin America- Scepticism by Way of Simulation, Working Paper Series No. 117 SOAS, London

Conclusion The conclusion derived from this essays discussion is clearly that Foreign Direct Investment through Multinational Corporations bears both potential benefits and costs to the host developing country. Ideally FDI leads to an increase in local investment and economic activity by providing additional capital, know-how and technology in addition to access to export markets, which is otherwise scarce or unavailable. On the other hand, MNC operations can also reduce economic activity by crowding out domestic investment or actually not pervasively contribute to aggregate investment levels by creating enclaves within the concerned national economy. Moreover, one could argue that the potential costs and benefits of MNCs investment in developing countries depend almost entirely on the specific circumstances of each country and each project. As was outlined in the Latin American empirical simulation exercise, the impact of FDI was widely divergent among countries. Further, whether the potential benefits can be realized depends on government as well as MNC policy. To attract MNCs may result in a number of government incentives that are economically not beneficial to the national economy. In addition their profitmaximizing interest and market power might lead to a worsening in the countrys balance of payments. Government policy can be used to realize the benefits of FDI by implementing regulations designed to capture the gains of foreign investment for the local market, as was ably employed by China. In order for investors as well as recipient countries to achieve mutual benefits, it is therefore desirable to design legislation to ensure that the potential benefits can be captured and the potential costs avoided while not compromising Foreign Direct Investment levels.

Bibliography Blomstrom, M and A. Kokko (1996) The Impact of Foreign Investment on Host Countries: A Review of Empirical Evidence, Working Paper www.worldbank.org/html/dec/publications/workpapers/wps1700series/wps1745/wps1 745.pdf 1

Byres, T.J. (ed) (1972) Foreign Resources and Economic Development Coleman, D. And F.Nixon The Transnational Corporation and LDCs in D.Coleman and F. Nixon (eds) The Economics of Change in Less Developed Countries Desai, V. and R. Potter (2002) The Companion to Development Studies, ArnoldOxford University Press Inc., New York Gemmell, M. (1987) Surveys in Development Economics Graham, E. and E. Warda (2001) Foreign Direct Investment in China: Effects on Growth and Economic Performance, http://www.iie.com/publications/wp/2001/013.pdf Hanson, G. (2001) Should Countries Promote Foreign Direct Investment?, G24 Discussion Paper Series UNCTAD and Center for International Development Harvard University, http://ksghome.harvard.edu/~.drodrik.academic.ksg/g24-hanson.pdf Held, D. et al (1999) Global Transformations, Stanford University Press Krugman, P. and Obstfeld, M. (1997) International Economics Theory and Policy, Addison and Wesley 4th edition. Loungani, P. and A. Razin (2001) How Beneficial is Foreign Direct Investment for Developing Countries? http://www.imf.org/external/pubs/ft/fandd/2001/06/loungani.htm Todaro, M. and S. Smith (1997) Economic Development, 6th ed Addison-Wesley UNCTAD(2001 )World Investment Report 2001- Promoting Linkages, Overview, Internet Edition at www.unctad.org Weeks, J. (2001) Exports, Foreign Investment and Growth in Latin AmericaScepticism by Way of Simulation, Working Paper Series No. 117 SOAS, London http://mercury.soas.ac.uk/economics/workpap/adobe/wp117.pdf