Disadvantages of Foreign Direct Investment

By: EconomyWatch   Date: 29 June 2010

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“As investors search the globe for the highest returns, they are often drawn to places endowed with bountiful natural resources but are handicapped by weak or ineffective environmental laws. Many people and communities are harmed as the environment that sustains them is damaged or destroyed -- villages are displaced by the large construction projects, for example, and indigenous people watch their homelands disappear as timber companies level old-growth forests. Foreign investment-fed growth also promotes western-style consumerism, boosting car ownership, paper use, and Big Mac consumption rates towards the untenable levels found in the United States -- with grave potential consequences for the health of the natural world, and the stability of the earth’s climate, and the security of food supplies.” 

-- Hillary French, “Capital Flows and the Environment,” Foreign Policy in Focus, 1998

 

One of the measurements of economic development in a low-income economy is the increase in the nation’s level of capital stock. A developing nation may increase the amount of capital stock by incentivizing and encouraging capital inflows, and this is done more commonly through the attraction of foreign direct investments, or FDIs. It has been widely discussed and upheld that amongst various forms and modes of capital inflows, FDIs are favoured in particular because of its long term durability and commitment to a host countries economy and would be less susceptible to short term changes in market conditions, therefore ensuring a certain level of continuity and stability in the money flow.

However, many developing economies have tried to restrict, and even resist, foreign investments because of nationalist sentiments and concerns over foreign economic and political influence. 

One pertinent reason for this sentiment is that many developing countries, or at least countries with a history of colonialism, fear that foreign direct investment may result in a form of modern day economic colonialism, exposing host countries and leaving them and their resources vulnerable to the exploitations of the foreign company.

While FDIs may increase the aggregate demand of the host economy in the short run, via productivity improvements and technological transfers, critics have also raised concerns over the efficacy of purported benefits of direct investments. This theory follows the rationale that the long-run balance of payment position of the host economy is jeopardized when the investor manages to recover its initial outlay. Once the initial investment starts to turn profitable, it is inevitable that capital returns from the host country to where it originated from, that is the home country. 

The key implication is this: While the levels of FDI tend to be resilient during periods of economic uncertainty, it has the potential of adversely affecting the net capital flow of a developing economy especially if it does not have a healthy and sustainable FDI schedule. 

It is also often argued that FDIs generate negative externalities in the labour market of the host economy. Why so? All firms are profit maximizing entities, and one way to achieve this is often the most direct approach of cost reduction. FDIs may enter the host country for unique strategic reasons but there is ultimately the need to achieve returns on investments. 

Evidence shows that multinational companies do pay a slight premium over local-term wages, but does this really benefit the host economy? Paying a premium for the price of labour may improve the consumption power of workers, but it also has the detrimental ability of disrupting the local employment market. When prices rise, supply increases while demand falls. Similarly, when the price of labour increase, wage premiums in this case, this creates a distortion and creates a disequilibrium in the labour market. Job matching stops being efficient and may even create unemployment. 

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