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The false debate: choosing between promoting FDI and domestic investment

Cecile Fruman's picture

Should we focus our efforts on foreign investment or domestic investment?” Policymakers in developing economies often ask this question when the World Bank Group advises them on how to improve their countries’ investment climate or investment promotion efforts. Our answer is: They do not need to choose one over the other. In order to grow and diversify, an economy needs both domestic investment and foreign direct investment (FDI).  The two forms of private investments can be strong complements.
 
Recognizing the Potential Benefits of FDI
 
The economic benefits of FDI were identified a long time ago. A Harvard Business School paper published 30 years ago summarized the benefits of FDI based on an extensive review of economic literature (Wint, 1986). In short: Benefits traditionally attributed to FDI include job creation, transfer of technology and know-how (including modern managerial and business practices), access to international markets, and access to international financing.

Granted, some of these benefits also occur thanks to domestic investment. For instance, domestic investments create jobs in a host economy – usually many more than FDI. However: What FDI does well is enhance or maximize some of the benefits already generated by domestic investments in a developing economy.
 
To stay with the example of job creation: Foreign firms might not create as many jobs as the domestic private sector, but they often create better-paid jobs that require higher skills. That helps elevate the skills level in host economies. The same can be said for other FDI benefits. For instance, more advanced technologies and managerial or marketing practices can be introduced in a developing economy through foreign investment, and at a much faster rate than would be the case if only domestic investment were allowed. Moreover, through partnerships with foreign investors who have existing distribution channels and commercial arrangements around the world, developing countries’ firms can benefit from increased market access.



In China, millions of rural residents each year migrate to cities to seek work. As they find jobs in modernizing industries, they gain the skills they need to earn higher incomes. In this photo, an employe in Chongqing is learning higher-level computer skills. Photo: Li Wenyong / The World Bank
 

Of course, FDI is not a panacea. Some FDI projects fail; others generate negative externalities, such as corruption, environmental degradation or fraud. But domestic firms can also fail, and they are also perfectly capable of engaging in fraud or bribery or of damaging the environment. The conclusion we draw from experience and economic literature is that FDI – like domestic investment – is not good or bad in itself. It can be both. This is why Ted Moran wrote that “FDI can be beneficial for development or detrimental to development.
 
How can FDI benefit a developing economy?
 
In simple terms, FDI can help a developing country acquire an industrial base and achieve export competitiveness much faster than the “infant industry” policies with which many countries have experimented (e.g., import substitution, forced joint ventures, etc.). China offers striking evidence of such an “FDI-led industrial take-off” (Ozawa, 2011). The country very cleverly used inward FDI, welcoming foreign participation in select sectors – through carefully designed “negative and positive lists” – to help build its manufacturing and export capacities, first in light industries (such as textiles and toys) and later in higher-value-added activities (such as automotive goods and electronics). In fact, while many host developing economies sought to limit the amount of foreign participation in joint ventures (JVs), China was perhaps the only country in the world to require a 25 percent minimum foreign equity position in JVs, to ensure that foreign investors were committed to the investment. China also used outward FDI (that is, investments made by emerging Chinese multinationals in a foreign country) to access additional and more advanced technologies – not just natural resources –  through mergers and acquisitions.
 
Would China have achieved the same economic progress had it relied only on domestic investment, without letting FDI flow (both ways)? Maybe, but it would have taken China a much longer time to get to where it is now. FDI acted as a great “accelerator,” helping China fulfill its national socioeconomic objectives while “catching up” with and even surpassing the world’s leading economies.

Through a long-term vision and the disciplined implementation of conducive and targeted policies, China was able to harness the power of FDI, both inward and outward. The country followed that strategy both to strengthen the competitiveness of its economy and domestic firms, and to generate a massive volume of jobs and exports – and, as a result, it succeeded in lifting a large portion of its enormous population out of poverty.
 
Many developing countries have been able to harness FDI to build their industrial base with some success. However, fewer are at a stage where they can leverage outward FDI as China and other BRICs (Brazil, Russia and India) have, thanks to the growing number of large firms capable of competing internationally. But there is no reason why more developing economies will not be able to follow the same path eventually.
 
Achieving Development Goals through Clear Investment Policy and Promotion Strategies
 
FDI can accelerate the “catching up” process of a developing economy and facilitate its integration within regional and global value chains (RVCs and GVCs). Yet without a clear strategy, sound policies and solid institutions to implement them, achieving all the potential benefits of FDI is difficult. When seeking to harness the power of investment for promoting economic growth, policymakers should not pose the question, “Should our priority be domestic or foreign investment?” but rather, “What can we do to make the two forms of investment work together, in order to generate the maximum benefits for our economy and our population?
 
Host countries need to create an environment that fosters the transfer of FDI benefits into the domestic economy. Backward and forward linkages between foreign and domestic firms rarely happen on their own. Without such linkages, foreign investment – particularly in the extractive industries – can operate as an “enclave” within the host economy. Closing the door to FDI, or making it operate under heavy restrictions and performance requirements (such as forced local content) can often be counterproductive. On the other hand, if they are designed and implemented in the right way, sound investment policies and promotion strategies that include robust components for the development of linkages can help countries achieve the positive outcomes to which they aspire.
 
Sources and further reading:  



Public policy in China encourages employers to invest in more on-the-job training, so that young migrants – like these workers in Chongqing – can explore additional career-development pathways and truly integrate into their adopted cities. Photo: Li Wenyong / The World Bank

 

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