Why Foreign Direct Investment Has Increased in Recent Decades

Introduction to Foreign Direct Investment

According to the OECD (Organisation for Economic Co-operation and Development), one of the major trends in the global economy in recent decades is the increase in foreign direct investment (FDI) (2001, p. 101). Foreign direct investment is the process of establishing, owning, and controlling the production of goods and services in a foreign country — or, more simply, it can be defined as real assets held abroad. It is closely associated with transnational corporations that expand their global activities.

Foreign direct investment plays an important role in driving economic growth, increasing productivity, and promoting development. However, some argue that FDI destroys local capability and that natural resources are extracted without sufficiently compensating poor and needy countries. Despite these concerns, the importance of FDI in international economic activity has increased significantly, in part because FDI has been growing at a much faster rate than world GDP. From the 1980s to the present, foreign direct investment has increased approximately eleven times while GDP has increased only four to five times (Urata et al., 2000, p. 80).

The Economist also reported that FDI grew five times faster than world trade and ten times faster than world output (The Economist, 1995). Keeping these benefits in mind, almost all countries of the world now provide a welcoming environment for investors and actively seek to attract greater investment flows. Countries have also recognized that they need to redesign both their general economic policies and their specific FDI policies in order to attract more investors.

Historical Shifts in FDI Perception and Growth

Looking back fifty years, foreign direct investment was considered unhelpful, counterproductive, and a vehicle for introducing inappropriate technology into developing countries. However, a very different view of FDI has emerged over the last two to three decades, and today it is widely regarded as highly beneficial for economic growth. This shift illustrates how FDI has passed through various stages, with its perceived importance fluctuating over time. It was considered significant at the beginning of the twentieth century, viewed negatively in the middle of the century, and has been growing in importance ever since.

The growing importance of foreign direct investment is evident from the fact that over the last fifteen years, countries have recognized its significance and its positive role. FDI contributes to development strategies for technology and makes available the capital needed by countries for development. This is the reason countries have started competing for FDI, designing and formulating liberal investment policies at both national and regional levels. Furthermore, various home-country measures — including matchmaking services and guarantee funds — are promoted to encourage FDI flows to developing countries. However, no comprehensive multilateral framework for FDI has yet been established.

Foreign investment has shown impressive growth in recent decades, contributing to genuine integration of the global economy. It has also played a crucial role in reducing the cost of transport and communication and has helped diffuse new products, technologies, and improvement techniques across different parts of the world. Economies that are "open" and maintain a liberal attitude toward foreign investment consistently outperform "closed" economies that do not avail themselves of this opportunity.

A notable example of FDI-driven success is China. A number of East Asian countries, particularly China, have attracted impressive volumes of FDI, which has resulted in extensive economic growth and established China as a star performer in the global economy over the last two to three decades (Urata et al., 2000). Experts suggest that if China continued growing at the same pace, living standards would double approximately every seven years. One of the principal factors behind the success of the Chinese economy is that it has become one of the world's largest recipients of foreign investment. China's share of world exports was 1.9% in 1990 and grew to approximately 8.5% in more recent years, placing it as the third-largest economy globally, behind only the United States and Germany. Today, China produces approximately 75% of the world's photocopying machines, DVD players, and textiles; 50% of the world's refrigerators and digital cameras; and nearly 40% of the world's personal computers. China now accounts for approximately 40% of all FDI flows to developing countries.

The rapid expansion of FDI at both regional and national levels is also attributable to the liberalization of FDI policies. Recognizing the benefits of foreign direct investment, many countries have liberalized their FDI policies to attract greater inflows. Some countries have also implemented incentive policies — for instance, exemptions from corporate income tax. Countries that have enhanced their local capabilities through FDI, such as Ireland and Singapore, have also benefited in the long run; their local suppliers have evolved into global exporters. By contrast, countries that have not developed local capabilities and linkages have achieved very few long-term benefits from FDI.

FDI and Economic Growth

A substantial body of literature addresses the relationship between foreign direct investment and economic growth and development. As noted above, FDI operates through a number of channels in contributing to development (UNCTAD, 1999). These include income and employment levels, access to markets, market structure, technology, government revenues, and social and cultural dimensions. The following sections explain how FDI generates benefits across these areas.

Several empirical studies have shown that foreign direct investment contributes to factor productivity and income growth in host countries to a greater degree than domestic investment alone would have generated (Aghion and Howitt, 1998). While measuring the precise magnitude of FDI's impact is difficult — and some studies have found evidence of crowding-out of domestic investment — most researchers conclude that FDI has a net positive effect on growth and actually helps stimulate domestic investment. Although crowding-out does occur in some contexts, the overall effect is positive.

It is also important to note that FDI's effect on the least developed countries may be more limited, because in order to benefit fully from foreign direct investment, developing countries need to reach a certain threshold of development in areas such as education, infrastructure, and health. Countries with underdeveloped financial markets similarly face difficulty in reaping the full benefits of FDI.

Conclusion

Foreign direct investment has increased tremendously in recent decades because it is an essential component of a successful international economic system and acts as a catalyst for development. It is a source of economic development and modernization not only for emerging economies and countries in transition, but also for developing countries more broadly. Countries today are therefore focused on how to pursue domestic policies that maximize the benefits of foreign presence in the domestic economy.

Several interconnected factors explain the increase in FDI in recent decades, including growth in trade and investment integration, technology transfers, human capital enhancement, increased market competition, and enterprise development. Together, these channels demonstrate why foreign direct investment has come to occupy such a central place in the strategies of both developed and developing nations seeking sustained economic growth.

References

Aghion, P., & Howitt, P. (1998). Endogenous growth theory. MIT Press.

OECD. (2001). New horizons for foreign direct investment. Global Forum on International Investment.

The Economist. (1995, June 24). Survey on multinationals. p. 3.

Urata, S., & Kawai, H. (2000). The determinants of the location of foreign direct investment by Japanese small and medium-sized enterprises. Small Business Economics, 15.

UNCTAD. (1999). World Investment Report. UNCTAD.

Wei, Y., & Balasubramanyam, V. (2004). Foreign direct investment: Six country case studies. Edward Elgar Publishing.