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Foreign Direct Investment and Economic Development

1.1 Aim of Research: The potential contribution of Foreign Direct Investment (FDI) to economic development and world integration has gained greater recognition in the last two decades (Jerome & Ogunkola, 2004). The decline in concessional aid which created a preference for long-term and more stable financial flows no doubt played a key role in pushing FDI to its new position of prime importance (Jerome & Ogunkola, 2004). This position was further strengthened by lessons learnt from the Asian financial crises of 1997 which showcased FDI as a more sustainable and credible alternative to other forms of foreign investment (Jerome & Ogunkola, 2004). Much more than simply providing capital inflows, FDI has been shown to stimulate economic growth of a country by attracting other investments while hopefully creating desirable spill over effects through the transfer of technology, knowledge and skills to domestic companies. FDI has also been shown to have the potentially to spur competion, innovation and improvements to a country’s export performance- a situation that is equally desirable for healthy economic growth (Jerome & Ogunkola, 2004). These indirect impacts of FDI are indeed the main reason behind the increased political interest in FDI in many countries; particularly in the developing countries leading to a frenzy of public subsidies, diplomatic initiatives and promotional activities; all geared towards attracting foreign investors (Mabey and McNally, 1998).

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Although FDI has some potential negative impacts, which includes tax avoidance, anti competitive and restrictive business practices by foreign affiliates, possible negative effects on industrial development and on national security among others (ref) – policy makers are increasingly becoming less concerned about these fears as they pursue increased FDI inflow. Consequently, as at year 2002 FDI had grown to become the single most stable source of private capital for developing countries and transition economies and accounted for almost 50% of all private capital flows world over (Jerome & Ogunkola, 2004).

The domestic policy framework of a host country is of crucial importance in the determination of how much FDI flowed to her and the net impact it had on the host economy (UNCDTAD, 1999). The need therefore to design and implement a mix of policies that not only attracted FDI but also maximized its potential benefits while minimizing the associated negative effect stands out as a real challenge. Many studies carried out in this area and based on empirical evidence unsurprisingly shows that while some countries have been quite successful in this regard others have not (UNCTAD, 1999).

Most African countries and indeed sub Saharan African countries have recorded little or no success in their bid to attract FDI. Beginning from 1970, the average FDI inflow into Africa has remained rather modest. The continent recorded an annual average of US$1.9 billion between 1983 and 1987, US$3.1 billion from 1988 to 1992 and US$4.6 billion in 1991-1997 (Jerome & Ogunkola, 2004). This is despite concerted efforts by African leaders to improve the investment climate in their various countries, particularly in the 1990’s. Although the region recorded a tangible improvement in FDI inflow beginning from mid 1990 as a result of countries liberalizing their economic regimes and adopting economic reforms that included the tightening of government spending, the containment of inflation and pushing down of exchange rates FDI inflow has not boomed within the region and remains significantly lower than foreign aid.

2.3 Foreign direct investment in Southeast Asia ( got frm FDI in emergin economies, Cotton L and Ramachandran, V 2001)

The success of ASEAN countries in the last two decades has encouraged other developing countries into attempting to fuel economic growth with export-led foreign investment.

Many African countries today have similar economic situations to Southeast Asia in the 1960s (Lindauer and Roemer 1994). In general the similarities lie in the significant natural resources, colonial legacies inherent in political and economic structures and the great need for human capacity building. For this reason, it seems there is some basis for comparison and application of lessons learned (Court and Yanagihara 1999).

This research therefore examines India and Nigeria with a view to determining why Nigeria has been relatively unsuccessful compared to India in its bid to attract foreign direct investment. It focuses particularly on the effects the various policies and reforms adopted by both nations have had on the inflow of foreign direct investment. This is with the aim of ascertaining how Nigeria might replicate the success recorded by India.

This research in this regard has therefore been driven by the sole objective of determining why India has been successful in its bid to attract foreign direct investment and to comparatively investigate the possibility of replicating India’s success in Nigeria.

This research has become necessary given Nigeria’s continuing failure in attracting foreign direct investment particularly in the non oil and gas sector, despite adopting various FDI friendly reforms and policy adjustments (UN, 2009). While various studies have associated this failure to the importation of good but unsuitable reform programmes which were either adopted from other nations without careful comparison and analysis as to the workability of these policies in its peculiar case; or were some one-size-fits-all programmes handed down by World bodies like the IMF and WTO to the country which unfortunately the nation had to abandon half way as it discovered midway that these programmes were actually unsuited to its particular context.

This study serves as a guide to policy makers as they explore various policies geared towards attracting foreign direct investment into Nigeria. This work particularly fills a research gap which has been created as a result of researchers failing to draw on the successes of similar developing nations who have achieved the same objective as is being sought by Nigeria. This research was conducted therefore to fill this gap. The result should serve as a useful guide to policy makers particularly in Nigeria as they draw up and implement various FDI related policies.

In a similar study by Ajakaiye (2006), China and India’s approach to attracting FDI were compared and a recommendation made to Nigeria suggested adopting India’s approach. However, the study failed to provide a critical comparison between Nigeria and India hence the recommendation left a gap in practical essence.

This study fills this gap by answering such questions as: “what are the FDI policy similarities and differences in Nigeria’s approach to FDI as compared to India’s?”,

‘how possible is it for Nigeria to replicate India’s success in attracting FDI by using the Indian approach” “what factors contribute to any differences that may exist?” “what lessons can Nigeria’s policy makers learn that if adopted in national policies will make the nation more attractive to foreign investors?”

1.3 Chapter Outlines

This study will be reported in the following outline. This outline has been chosen to facilitate readability, enhance comprehension and ensure consistency in presentation.

Chapter 1: Introduction

1.1 The Aim of the research

1.2 The Rationale of the research

1.3 Chapter outlines

This chapter introduces the over all aim of the research project and the reason why the research is considered both necessary and timely. It also contains an outline of the structure of the entire report.

Chapter 2: Literature Review

2.1 Introduction

2.2 FDI Trends globally

2.3 Review of relevant FDI theories

2.4 Review of Country FDI Policies and their Impact on inward FDI

2.5 FDI trends in India and Nigeria

Relevant literature on FDI including its determinants and the impact of country policies on its inward flow are critically reviewed. It also details the trend in FDI flow globally and into both Nigeria and India. Finally a summary of the main points in the chapter is provided and a hint into the content of the next chapter duly provided.

Chapter 3: Research methodology

3.1 The research Problem (what the research seeks to achieve)

3.2 Data requirements and how this will be collected

This chapter reiterates the major objectives of the research and outline the questions that major questions it addresses. It then details how these objectives will be met and the questions answered. The sources of data and the type of data used in the comparative analysis will also be provided. A summary of the main points in the chapter will then be provided and a peep into the contents of the next chapter supplied.

Chapter 4: FDI Policies in india and Nigeria from 1990 to date

4.1 FDI Policies in India and their Impact

4.2 FDI policies in Nigeria and their Impact

4.3 Comparison of Nigeria and India’s approaches to

Here the key FDI policies in both countries since 1990 are outlined and compared. The aim is to qualitatively ascertain the possibility of adapting successful Indian FDI policies in the Nigerian context.

Chapter 5: Summary and Conclusion

Differences in policies and differing impacts, along with lessons and recommendations from the overall study are provided in this chapter.

(Bennett’s observation- not yet A grade. Push it up well.)


2.1 Introduction

This chapter outlines the global trend in ForeignDirect Investment and presents a critical analysis of the various theories of FDI. In this analysis particular attention is paid to the role of country policies in the determination of the flow of FDI. Various categories of host government FDI policies will be mentioned while investigating the impact of national FDI policies (a category of host country FDI policies) on FDI inflow.

2.2 Global Trend in FDI

The world economy has recorded a marked increase in both the flow and stock of FDI within the last 3 decades (ref??). On the average the yearly FDI outflow increased from $25 billion to $1.2 trillion between the years 1975 and 2000 (ref). This was however followed by a slight fall in recorded values (UN, 2006). It gradually rose back again to $1.2 trillion by the end of 2006 (Fig 2.1). As at year 2000, about 77,000 multinational parent companies with some 770,000 affiliates in foreign markets collectively employed more than 50 million people outside their home countries with total generated revenue accounting for approximately one-tenth of global GDP (ref). These foreign affiliates generated an estimated $22 trillion in global sales. This was almost double the global exports which stood at $12.6 trillion (UNCTAD, 2000).

Figure 2.1: FDI Outflow, 1982-2006 ($-billions)

Source: United Nations, World Investment Report, 2006 (New York and Geneva).

The reason behind this aggressive growth in global FDI compared to world trade is not far fetched. Multinational firms whilst seeking avenues to sidestep protectionist barriers erected by various governments in the 70’s saw FDI as a very useful avenue to achieve this aim. However, despite the world wide decline in trade barriers FDI has continued to grow as organisations are arguably believed to now perceive it as a strategic means of circumventing future trade barriers. Also, contributing to the observed global FDI trend are the various political and economic changes taking place in most developing countries in recent years as they jostle for a share of the FDI boom. The adoption of democracy and the shift towards free market-driven economies have served to favour the expansionist strategies of multinational companies (ref?).

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Most countries located across Asia, Eastern Europe and Latin America have continued to attract heavy FDI inflows as a result of the various reform programmes adopted by these nations (UNCTAD. 1999). Many of these countries implemented various privatization programs that allowed foreign investors to buy various state owned companies thereby increasing the flow of long term capital into their economies. This was also backed by a dismantling of various government restrictions on FDI making their nations the toast of foreign multinationals. Between the years 1992 and 2005, of the 2,266 changes made in FDI laws by various countries all over the world, the UN (2006) notes that 94% favour the free flow of FDI(ref) (fig. 2.2)

Figure 2: National regulatory changes governing FDI, (1992-2005)

Source: United Nations, World Investment Report, 2006 (New York and Geneva).

This desire by various national governments to promote and facilitate FDI is reflected in the dramatic increase in the number of bilateral investment treaties aimed at fostering investments between countries. By 2005, a 12 fold increase in such treaties was recorded by the United Nations. The number of treaties rose from 181 in 1980 to 2,495 by the end of 2005 (UNCTAD, 2006).

Furthermore, increased globalization of world markets and rising homogeneity in consumer needs both aided by developments in communication technology have also contributed towards the observed increase in global FDI flow (Hill, 2009). Many firms therefore now consider the establishment of a significant presence in all major regions of the world a significant part of their corporate strategy e.g. Toyota Group, WalMart stores etc thereby pushing up the global FDI flow (Hill, 2009).

The major target of FDI has historically been the developed nations of the world. The United States of America rose to dominate global FDI after the Second World War. Between 1945 and 1960 about 75% of world FDI flow went to the United States including reinvestment profits (UNCTAD, 1999). FDI has since then however spread to become a global phenomenon. At first it circulated amongst the OECD countries however it is now tilting heavily towards the developing economies (Ayanwale, 2007).

The US dominance of the global FDI inflow was as a result of its large wealthy domestic market and favourable economic and political environment (Ayanwale, 2007). The openness of the US to foreign investors also served to encourage foreign direct investments. Most investing firms originated from Great Britain, Germany, Japan, Holland and France (Ogunkola and Afeikhena, 2006). The total investment into the United States stood at $177 billion in 2006 followed by the United Kingdom, Europe’s largest recipient for the same year at $169 billion (UNCTAD, 2006).

Figure 2.3: FDI inflows by region ($ billions) 1995-2006

Source: United Nations, World Investment Report, 2006 (New York and Geneva).

World FDI flow has shown tremendous increase in recent years beginning particularly from the 1990s. This increase was largely driven by the integration of international capital markets and large scale cross boarder mergers and acquisitions (UNCTAD, 2005). FDI grew to overtake world trade within the same period. Between 1990 and 1997, global FDI inflow grew by an average of 50% between 1998 and 2000 (see Table 2.1)

Table 2.1: Regional allocation of FDI (Billions of dollars)

Although FDI into the advanced nations accounts for a major share of total world FDI inflow, total FDI inflow into the world’s developing economies has shown significant increase in recent years as shown in (Table 2.1). The major target of the increased inflow into the developing world has been the emerging economies of South, East and Southeast Asia. The top recipient within this region has been China – attracting $70 billion in 2005 and 2006 (UNCTAD, 2006). Latin America also accounts for a significant share of the total FDI inflow into the developing economies.

Africa however, has attracted an almost insignificant amount of FDI inflow when compared to the other regions of regions of the world. The continent as a whole attracted only $39 billion in 2006(ref?). Various factors have been identified as being responsible for the comparatively meagre FDI inflow. Some which includes political unrest, poor infrastructure, policy issues amongst others (Hill, 2009; UNCTAD, 2006).

According to international guidelines drawn from IMF and OECD recommendations, FDI may be defined as any direct investment that reflects the aim of obtaining a lasting interest by a resident entity of one economy (called the direct investor) in an enterprise that is resident in another economy (the direct investment enterprise). This ‘Lasting Interest’ or long-term relationship between both parties is often accompanied by the exertion of some degree of influence and control by the investor on the management of the enterprise. The initial transaction establishing the relationship and all subsequent capital transactions between the two bodies and among affiliated enterprises are also classed as FDI ( IMF, 1993; Duce and España, 2003 ).

Furthermore, in a bid to make a clear distinction between FDI and other forms of portfolio investments, the IMF in its Balance of Payments Manual ( 5th ed. 1993) recommends the ownership of at least 10% or more of a company’s capital by a foreign investor as the basis line for classification as FDI (IMF, 1993; Duce and España, 2003). Although it is recognised that this not a hard and fast rule (as there are deviations from this rule in certain circumstances) however, for purposes of uniformity and avoidance of ambiguity this definition will be adopted in this study (Duce and España, 2003 ).

FDI occurs either in the form of green-field investment or as a merger and acquisition. A ‘Green field’ investment entails the establishment of a wholly new operation in a foreign country. While a merger and acquisition involves the buying of an already existent firm in a foreign country. A merger and acquisition though often lumped together as a form of FDI could be further separated into two forms based on the percentage of foreign ownership. A majority stake in a firm by a foreign enterprise of between 50 to 99 percent may be termed an acquisition while a foreign ownership of between 10 to 49 percent could be considered a merger .

2.4 Why Countries Seek to Attract FDI

Many countries, particularly the developing ones view FDI as a major stimulus to economic growth. Its perceived ability to deal with economic obstacles such as shortages in financial resources, technology, and skills has made it the centre of attention for policy makers in the developing countries of Latin America, Asia and recently, Africa (Mwilima, 2003).

Despite the prevalence of this view of FDI by policy makers, the literature on the FDI-growth relationship is rather inconclusive in some ways. Many studies conducted in this area have often arrived at different and sometimes even contradictory results. The basis however for most of these empirical studies have been the neoclassical and endogenous growth models. These studies have often viewed FDI as an important source of capital. They also assert its capacity to complement domestic investment, create new jobs and enhance technology transfer which unarguably leads to economic growth (Ajayi, 2006). However, while a positive FDI-growth linkage is not unanimously accepted, macroeconomic research studies nevertheless support a positive role for FDI given particular economic environments (Ajayi, 2006). Three main channels through which FDI can bring about economic growth are identifiable in literature.

First, capital inflows in the form of FDI can represent additional resources that a country needs to boost its economic performance. This is especially so in developing countries where lean domestic savings may act as a constraint for economic development (Mwilima, 2003). Secondly, FDI can help increase a country’s output and productivity through the introduction of a more efficient means of using existing resources and by absorbing unemployed resources. De Gregorio (1992) for instance showed using a panel of 12 Latin American countries, that FDI is approximately three times more efficient than domestic investment. Finally, FDI can act as a stimulant for the development and dispersion of technological skills through the activities of transnational corporations’ and through linkages and spill-overs among firms (Mwilima, 2003). Bolrensztein et al (1998) using 69 developing countries showed that FDI flows impacted positively on economic growth through the effect it has on the level of technology in the host country.

The empirical analysis of the positive relationship of FDI and growth is often said to depend on the absorptive capacity of the country. The absorptive capacity here refers to the level of human capital development, type of trade regime and the degree of openness of the host nation (Borensztein et al., 1998). Despite doubts about the role of FDI in spurring economic growth as stated earlier, that it attracts both costs and benefits to the host nation is not disputed (UNCTAD, 2005). The net impact is however largely dependent on the domestic policy framework in the host country (Ajayi, 2006).

The view that increased FDI inflow is the key to closing the resource gap of developing countries, avoiding further debt build up and tackling the main causes of poverty has been lent credence by the experiences of some fast-growing newly industrialised Asian economies (UNCTAD, 2005). The Asian crises of the 1990’s further intensified the call for accelerated opening up to FDI since this is believed to not only provide access to stable capital inflows but also usher in greater technological know-how, higher-paying jobs, greater managerial skills, and new export opportunities (Ajayi, 2006 and Prasad et al., 2003)

Given the level of importance attached to FDI, it becomes imperative therefore that African policy makers learn how to attract a greater inflow of this all important resource. Although many countries have recently adopted various economic reform programmes aimed at improving the investment climate in their countries, the result has been anything but impressive. The next section reviews some of the vast literature on FDI which tries to explain the number of reasons for firms investing across national boundaries and the role government policies in influencing the flow of FDI.

2.5 Country Policies as Determinants of FDI

The diversity of theoretical explanations for the existence of FDI is without doubt very rich. Many scholars have at various times engaged in the theoretical reviews of the literature on FDI with a view to providing a coherent understanding of the various streams of thought, views and explanations of the FDI phenomenon. Some of these include Agarwal (1980), Hennart 1982, Kindleberger and Audretsch (1983) Lizondo (1991), Brewer (1993) amongst others. These works have helped shaped the present understanding of the subject of FDI and the many factors that impact on its free flow in and out of nations. This review therefore draws from many of these works with the particular aim of providing an understanding of the theoretical background, views and present thought on the how government FDI policies may impact on the flow of FDI.

2.5.1 Neoclassical Theory of FDI

FDI theory has generally followed either of two broad paths. Some scholars base their explanation of FDI on neo-classical theory of capital flows (Roberts, 2001) while others draw from the more recent theories which take into consideration the effect of market imperfections in international trade (Ireland, 1994). The Neo-classical theory of FDI which is based on the assumption of a perfect market argues that multinational corporations engage in international investments due to differences in returns on investments in different countries (Roberts, 2001). The theory claims that factors of production are moved from countries with low returns on investments to those with high returns (Xiaoqin, 2002). However, this was not supported by empirical evidence (Agarwal, 1980). More over since in reality the market is imperfect its assumption of a perfect market makes it unrealistic (Bello, 2005). Aliber (1970) and Caves (1988) drawing on this explanation of capital flows argue that government policies which determine the exchange rates for particular currencies have a significant impact on the flow of FDI in and out of a country. They argue that countries with undervalued currencies tend to attract FDI inflow while FDI flows out of countries with overvalued currencies. Despite the intuitive appeal of this approach, it offers no explanation for the phenomenon of FDI flows in both directions for a particular country at a particular time.

2.5.2 Market imperfections and FDI

A major paradigm change in the way FDI is understood came perhaps with the pioneering work of Hymer (1976). Hymer’s (1976) and Kindleberger (1969) criticized the neoclassical approach for it limited explanation of FDI. They instead stress the importance of structural market imperfections in fostering FDI. Hymer’s work marked the beginning of a new line of literature that views FDI as a firm’s reaction to imperfections that exist in the market. It also takes into consideration the monopolist and oligopolistic tendencies of MNEs (Lucas, 1988). Within this literature two related and overlapping streams of thought are identifiable (Dunning and Rugman, 1985). One is on industry structure as a source of market power for MNEs while the other is on transaction costs as barriers to other forms of international trade (Brewa, 2003). The distinction between both streams of thought is particularly emphasised in Dunning and Rugman’s (1985) review of Hymer’s dissertation. While they emphasise the importance of this distinction in analysing the efficiency implications of FDI, Brewer (1993) emphasised this distinction in examining the impact of government policies on FDI flow.

Industry Structure and FDI

The industry structure analysis argues that firms within oligopolistic industries possess economies of scale amongst other peculiar characteristics that confer on them sufficient market power that enables them overcome the challenges associated with competing with local firms in host countries where they have FDI facilities (Brewer, 1993). This theory provides an answer to the question of how foreign firms are able to overcome the competition from local companies who have the advantage of familiarity and proximity. It also highlights the importance of government anti trust policies (same as competition policies). These types of policies as a result of their impact on the industry structure affect the flow of FDI into a particular host country. While this area remains an important part of the theory on FDI, the literature focusing on the implications of antitrust policies as it relates to FDI has remained scanty and not yet fully developed.

The Internalisation theory of FDI

The internalisation theory of FDI is built on the works of Coase (1937) and Williamson (1975) which sought to explain the existence of firms. According to Coase (1937) and Williamson (1975), firms are organisations that replace market based transactions (where possible until further internalisation results in no further cost savings) with internal transactions that are hierarchically administered in a bid to avoid transaction costs associated with engaging in market based transactions. The internalisation theory of FDI drawing from Coase (1937) and Williamson (1975) posits that MNEs internalize transactions in a bid to overcome transaction costs that make other forms of international trade uneconomical when compared to FDI. This theory of FDI has enjoyed much emphasis in literature and therefore much more fully developed than the industry structure approach. This theory includes works by Rugman (1980), Buckley (1988), Dunning and Rugman (1985) amongst others.

Brewa (1993) notes that in international trade, transaction costs may arise either from natural causes, (i.e in this case transactions costs that arise as a result of other factors other than government policies) e.g challenges associated with pricing technology transfers, or from unnatural causes; in this case government policies (Brewa, 1993). Some government policies identified by Brewa (1993) include trade barriers, tariffs and quotas. These create market imperfections that make FDI a more attractive alternative than either exporting or licensing for firms wishing to serve a particular foreign market.

Brewa also identifies the weak enforcement of international licensing agreements by governments as an important motivation for FDI; since this makes licensing a problematic strategic alternative for firms when compared with FDI. The internalisation theory therefore argues that in the face of these market imperfections, firms in an attempt to protect themselves from loosing their competitive advantage and profitability are forced to internalise transactions involving goods and or technology by engaging in foreign direct investment projects (Brewa, 2003).

2.5.3 FDI as a Strategic Objective of firms

Brewer (1993) drawing from the internalisation theory of the firm viewed FDI as part of the strategic objectives of Multinational companies. These strategic objectives are classified into market-seeking, production cost-minimizing and raw material-seeking FDI. Furthermore by juxtaposing the production cost-minimizing and resource-seeking objectives, Brewer (1993) identified two fundamental types of strategic FDI projects embarked on by MNEs. These are FDI projects designed primarily to serve the foreign market where they are located while the other are those embarked on with the aim of providing low cost production sites for exports either to other markets or to other foreign production facilities (which may sometimes include the home country market). Therefore while the former type is aimed at increasing sales (which invariably also takes into consideration the market size objective as a subset) the latter is oriented towards decreasing costs (Brewa, 1993). This distinction is indeed important in analysing the impact of government policies on FDI flow. This is so because such government policies that affect market imperfections are varied according to the strategic nature of the FDI that the government seeks to attract. For example host governments will often subsidize inward FDI projects while restricting those FDI projects that import much of their inputs, since the former will profit the host country more than the latter (Guisinger, 1985).

2.5.4 Dunning’s Eclectic Paradigm

The most advanced and generally accepted theory that integrates the best aspects of the various literature on FDI is Dunning’s (1973), (1977), (1980), (1988) Ownership, Location and Internalisation theory (also called the eclectic paradigm). Dunning argues in the eclectic theory that three conditions are necessary for FDI to take place. First it posits that a firm must have enough market power to be able to effectively compete with local firms despite the disadvantage of being foreign. This is known as the ownership advantage in the OLI theory. The second condition is the ability of the firm to replace market based transactions with internal transactions (internatlization theory). This argues as earlier stated in this review that market imperfections must impose such ad


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