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Possible Negative Effects Of Fdi On Host Countries Economics Essay

Foreign direct investment indicates the participation by country X into country Y over a long period of time. It is the most important instrument for globalizing the international economy. It is the investment of real assets in a foreign country (Choe 2003). It involves participation in joint venture, management, technology transfer and “know-how”. It is a measure of foreign ownership of assets. FDI is seen by many as essential to help the economies of both emerged and emerging markets (Greenaway and Gorg 2004). Sometimes FDI could be a catalyst for changing the society as a whole and so we must think in terms of social, economic and cultural factors and thoroughly analyse all the effects of FDI so as to understand the true long term impact. Outward FDI and inward FDI are the two types of FDI, resulting in a net FDI inflow which could be positive or negative.

It is well known that FDI inflows provide a lot of economic benefits like innovations, technology spill over and increased competition (Dunning and Fortainer 2007). But as globalization and foreign investment continue to increase, emerging economies are desperately looking to attract foreign investment. This can have a lot of undesirable outcomes. In this case, FDI can have a lot of negative effects like political unrest, job loss, human rights abuses, environmental degradation and many others. This essay analyses the possible negative effects of FDI on the host countries.


Dunning was a pioneer in the field of foreign direct investment. His eclectic paradigm consisted of

Ownership advantages (production techniques, technological capabilities, patents, trademarks and copyrights)

Location advantages (availability of raw materials, low cost labour, special tariffs etc)

Internalization advantages (benefits that accrue to a firm as a result of licensing, joint ventures and agreements)

Eclectic paradigm combines the macro-economic theory of international trade and the micro-economic theory of the firm. The decision of MNEs to redeploy production across borders arises from the benefits that these firms acquire from different but interrelated advantages.

Dunning argues in his theory that FDI will take place when these three advantages occur simultaneously.


There is a long history of MNE criticisms. Most of them revolve around the possibility that they will go against the passage of laws that prevent socially undesirable practices like minimum wage requirements, health and safety regulations or ignore laws that have already been enacted (Narula and Lall 2006). There is also a lot of criticism that focuses directly on the relationship between the scope of economic growth and FDI. The entry of MNEs into LDCs might have both positive and negative effects. The MNEs might reinvest in the same industries in the host economy and may extend its market power (Greenaway and Gorg 2004). The repatriation of profits will drain out capital from the home country.

Instead of creating a positive effect on the distribution of income and social development, the activities of the MNEs might support oligarchy of indigenous suppliers and partners (Gastanaga et all 1998). Their inappropriate use of capital intensive technology might produce small labour elite while forcing many workers to be unemployed or underemployed if the rigidities of the local labour market fail to deploy them to better productive occupations. Their strict control over technology, export channels and higher management functions may block the beneficial spillovers externalities anticipated in the more optimistic scenarios. This greatly affects the economy as a whole.


The negative impacts of FDI are well portrayed in matters related to operation, profits distribution and investment. The backward sections of the host countries will be in a very bad shape when FDI has negative effects. The negative impacts are clearly understood where the host countries have some kind of national secrets, not meant to be revealed to the rest of the world. The defence of a country has faced a lot of risks due to the foreign direct investment in the host country (Gastanaga et all 1998). The major part of FDI is formed by huge MNEs. They sometimes fund the political parties and take undue favours and benefits and they also indulge in corruptions. As a result there would be a lot of pressure put on host governments by home countries’ governments. It has been observed that the home country governments are facing a lot of problems with FDI. They have very less control over the functioning of the companies that are functioning as the wholly owned subsidiaries of overseas companies (Greenaway and Gorg 2004).


The environmental hazards of globalization have been in the spotlight for a very long time. A lot of theories suggest that FDI affects the environment. The MNEs invariably exploit the natural resources like minerals for their benefits. In many countries the rules and regulations as regards environment are very lenient (Narula and Lall 2006). The MNEs take undue advantage of these lenient laws and rules. They exploit the natural resources to the fullest extent possible. It has been observed that there has been a significant increase in air and water pollution due to the activities of the MNEs.

FDI provides capital to create a new enterprise or to expand the scope of the existing enterprises. As a result FDI promotes output growth and ultimately results in increasing pollution emissions (Gastanaga et all 1998).


The Bhopal gas tragedy is a very good example of the possible environmental effects of FDI. It was a huge catastrophe that happened in1984 at a pesticide plant operated and owned by Union Carbide at Bhopal. Methyl isocyanate gas and many other poisonous toxins were released by the plant. Over 500,000 people were affected by this. It was estimated that around 2300 people died immediately and another 8000 people within the first week. Today, after 26 years toxic chemicals continues to leak and that pollutes the groundwater, adding to the woes of the people. The new born babies also suffer greatly. They are blinded or crippled at birth itself. This is a striking example of how foreign direct investment can seriously damage the environment in the host countries.


Opening up for capital mobility and attracting huge amounts of FDI inflows will undoubtedly have a positive effect on the job offers of companies and therefore on employment. But the effects of structure and reallocation are not clearly understandable for all types of labour (Tobin and Susan 2005). While on one hand, the skilled labour will derive benefits from firms’ increased efforts towards extra employment, on the other hand, the impacts on unskilled labour are not positive. Thus when job opportunities are being created, a lot of people are thrown out of jobs as well. This is especially true in case of LDCs that primarily rely on labour-intensive techniques. But unfortunately the majority of the FDI happens in capital intensive industries. MNEs do not cater to the labour-intensive industries and so a lot of people in those industries remain unemployed (Kwang and Singh 1996).

“Crowding out effect”

The inflow of foreign capital invariably ‘crowds out’ local investment (Tobin and Susan 2005). This effect can be felt if the domestic markets are targeted by the foreign companies and the domestic companies are unable to compete with the foreign companies (Borensztein et all 1998). Hence a lot of companies are forced to shut down and as a result people lose jobs. Foreign companies generally buy local firms to shut it down completely and gain monopoly. The bottom-line is that the employment opportunities created by the MNEs are limited to the skilled sector alone.


Foreign firms cut working positions through privatization deals or mergers and acquisitions and always make use of their normal suppliers which could increase imports (Lipsey 2002). The increase in the growth of wages in foreign firms can result in a similar growth in domestic firms that are unable to cover this growth with a corresponding rise in productivity. The net result is that the firms lose their ability to compete. The competitiveness of the local firms decrease and they are unable to match the foreign firms and ultimately they are thrown out of the market. Also many MNEs source their supplies from abroad rather than buying from the local firms. This greatly limits the ability of the local firms especially the small scale and cottage industries (Choe 2003).

Dual economy

This is another major negative impact of FDI. Since it concentrates so much on the skilled sector, a dual economy invariably emerges (Lipsey 2002). There will be two types of sectors in the economy- A vastly developed foreign market and an underdeveloped domestic market.


There is no doubt that there has been a huge increase in FDI inflows over the last two decades. But the effects of FDI on the economic growth of the host countries are still unclear (Lall 2002). FDI’s higher productivity holds only when the home country has a sufficient stock of human capital. As a result FDI contributes positively to the growth of the economy only when the host countries are able to absorb properly the technologies that are transferred to them by the MNEs. The foreign firms by competing in the financial and product markets due to their superiority in production methods and technologies displace the domestic companies. It has generally been observed that foreign direct investment contributes to the growth of the economy by stimulating the progress in technology rather than by increasing the total capital accumulation in home countries (Kwang and Singh 1996). It is highly important to carefully assess the effects of foreign direct investment on the economic growth of the host economies.

Some theories argue that FDI will damage allocation of resources and slow the rate of growth (Boyd and Smith 1992). A lot of studies reveal that FDI does not accelerate the growth of the economy and generally do not find positive spill over between domestic and foreign firms. Aitken and Harrison’s (1999) study reveals that there is no positive spill over of technology from foreign firms to domestic firms in Venezuela between 1979 and 1999. Hadded and Harrison’s (1993) study reveals that there is no growth enhancing spill over in some countries. While very good economic policies may stimulate both FDI and growth, the results are not consistent with the view that FDI has a good impact on growth that is not dependant on some other growth determinants. Also MNEs bring in finance to the host countries. As a result money flow increases in the economy and this results in an increase in the aggregate demand. Thus the prices go up and an inflationary situation in the economy is created in the economy. The people then start borrowing and the interest rates again go up. Ultimately, the local investment gets crowded out.


MNEs normally tend to repatriate the profits and other funds like royalties and management fees back to their home countries and this will worsen the capital accounts of the host countries. There will also be a huge amount of imports of capital goods and intermediate products and this would deteriorate the current account of the host countries (Tsai 1994). FDI also has an adverse effect on the Balance of Payments (BOP). This is because it harms the export prospects of the host economies. In the short run, FDI improves the foreign exchange position of the recipient nation. But this is not so in the long run and the negative impact that it has might reduce the earnings of foreign exchange on current as well as capital accounts (Lipsey 2002).


MNEs normally select superior workers, who command higher wages. They often exploit the work force that is available in the host countries. MNEs also take undue advantage of low cost labour (Borensztein et all 1998). There is no consideration at all for working conditions. The wage share of the total output will be extremely low. The workers have very less bargaining power and the trade unions also will have only a limited role to play. Cultural differences are bound to exist between top management and the rest of the workers. Sometimes the untested technology that is used by MNEs affects the health of the people working in such companies.

Nike would be a very good example wherein the MNEs exploit the people for their benefits. Nike actually employed children in many countries like India, Vietnam China and Indonesia. Twelve year old girls were forced to work in Indonesian shops for more than 70 hours in a week producing Nike shoes in extremely unhealthy plants. Thus the MNEs indulge in the exploitation of labour and that is extremely harmful and bad for the host countries.


Sometimes the foreign policies that have been adopted are not keenly appreciated by the workers of the host countries (Tobin and Susan 2005). FDI is also disadvantageous for the people who are investing themselves. It may result in enormous travel and communication expenses. The differences in culture, language and religion that are always existent between the investor’s country and the home country may also create a lot of problems in FDI related cases. Another disadvantage of direct foreign investment is that a firm might lose its ownership to a foreign firm (Borensztein et all 1998). This has caused many firms to look at FDI with a lot care and caution. It is also worth noticing that there is a lot of instability in a particular geographical area. This creates lots of troubles for the investor. The market size and the condition of the home country are vital factors for foreign direct investment. The investors face considerable challenges in cases where the host countries do not have good connections with their advanced neighbours. It is important to understand that the host countries’ governments are facing a lot of problems with FDI. The governments have less control over the operations of the companies that are subsidiaries of foreign firms. This invariably results in serious issues. The investors do not have to abide by the host countries’ economic policies. FDI also has a lot of negative effects on the balance of payments of the host countries. The MNEs face a lot of risks like changes in exchange rates, expropriation by the government a lot of other actions that might be possibly taken against them (Okamoto and Fredrik 1999).

FDI is a lot more costly than licensing and exporting and more risky too (Lall 2002). The most important factor which MNEs look at if they invest abroad is the stability in political circumstances and an open free market. This factor is, to a great degree unpredictable. When a firm invests abroad, it generally faces political risks as compared to licensing and exporting. The positive effects which accrue to an economy due to foreign investors are completely wiped out if the increase in competition from foreign companies results in a reduction in the domestic firms’ production. This ultimately leads to increasing average costs of production. The technology spill over undoubtedly benefits the local companies, but the competition effect that is there in the market neutralises all the positives that accrue to the domestic companies. The domestic firms are forced to produce less output and this leads to an increase in their average costs (Lall 2002).

MNEs may also take unfair advantage of the liberal tax concessions and increasing investment allowances (Dunning and Fortainer 2007). At times, it is quite possible that the host country has a higher tax slab. MNEs often inflate the price they pay for intermediate goods that are purchased from overseas firms. In this way they transfer prices. MNEs actually register higher profits with overseas firms, whereas in the home countries’ accounts, lower profits are shown. Thus MNEs save a lot of tax by ‘profit transferring’. There is also lot of chances of proxy FDI occurring from tax havens like Mauritius (Okamoto and Fredrik 1999)


A majority of research indicates the negative effects of FDI. There a lot of arguments which indicate the negative effects of foreign direct investment. But it is not possible to generalize these arguments for FDI and that depends on a lot of factors like the type of foreign investment and whether the firms have long term or short term goals in mind. The type of industry and the development of the host countries are important factors as well. It also depends on how efficiently the host countries’ governments frame policies to properly utilize the benefits of spill over. As far as environmental effects are concerned, there is a lot of evidence to show that FDI contributes to environmental degradation. However degradation of the environment is a trend that began with the earliest forms of industrialization and is not peculiar to the developing countries alone. Pollution will be everywhere. Environmental protectionists have concentrated on the environmental impact of FDI because developing countries lack the policies and regulation that may protect the environment. In the end these regulations are meant to slow down the effects of continual resource use and also to provide the host countries’ citizens with the same rights as the developed countries. FDI might promote the economic development of the country by contributing to growth in exports and productivity. But the real nature of the relationship between MNEs and the host countries varies between industries and countries. It can be assumed that the characteristics of the host economy’s policy and industry environment are very important factors that determine the net benefits of FDI (Tsai 1994). But when all factors are analysed the positives outweigh the negatives.

An analysis of the present trends in FDI reveals that the emerging economies receive a disproportionate share of inflows as compared to outflows. The developing countries lack policies, laws and regulations. In the countries where the markets are undeveloped and the necessary level of education and infrastructure development has not been reached, reaping the benefits from a foreign presence will be impossible and the impact of FDI on the economic growth will not be very much (Tsai 1994). Yet, even in these scenarios, an increase in FDI inflows is better than none at all. An analysis of the East-Asian countries shows that firms which use FDI properly by creating and implementing technological development and national policies will be very successful in their efforts. MNEs alone will not be able to solve underdevelopment, political instability and poverty problems. They stretch beyond the limited capability of corporations. As a result even a good combination of public pressure and FDI cannot achieve great results in reduction of environmental degradation, human rights abuses financial volatility and cultural tensions (Kwang and Singh 1996). The task for business leaders and governments is to manage properly the complex relationships between themselves and to create an agenda that does not focus exclusively on limiting the scope of FDI or battling exploitation. Ultimately it is the responsibility of the governments of developed countries and MNEs to help developing countries in building the infrastructure that is needed to reap fully the benefits of FDI, to constantly provide financial assistance and to reinvest the profits earned inward rather than repatriate them. Although, there are a lot of negative effects of FDI, it is important to remember that having some FDI is more beneficial than having none at all.

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