The Benefits of Foreign Direct Investment to Third World Host Countries

The Benefits of Foreign Direct Investment to Third World Host Countries

Our primary concern in this chapter is with the impact of foreign direct investment on the Third World and the relationship between MNCs and host countries. Considerable debate surrounds these topics. Defenders of MNCs argue that FDI stimulates economic growth and development. MNCs augment scarce local resources and bring with them a package of assets that can seldom be matched by indigenous firms.  Elements of this package include:

Many Third World countries are characterized by low rates of domestic savings. As a result, their economies are dependent upon external capital flows to finance new investment. FDI offers one means by which scarce local capital can be supplemented. To be sure, MNCs demand a price for injecting fresh capital into the host countryís economy. Specifically, foreign investors prefer to repatriate a large portion of the profits they earn abroad. Yet the terms of FDI often compare favorably with those accompanying other sources of external financing. Commercial loans from Northern banks, for instance, carry interest charges that must be paid regardless of whether the local investment they finance proves profitable. In contrast, although MNCs share in the benefits from FDI, they also bear much of the risk. If one of its Third World subsidiaries loses money, an MNC will find that there are no profits to repatriate. Indeed, the headquarters of the firm may well choose to inject new capital into the failing subsidiary in an attempt to turn the operation around and salvage its initial investment. FDI also offers certain advantages over foreign aid. Although foreign assistance may be provided on favorable financial terms, it often comes with political strings attached, whether implicit or explicit. This is seldom the case for FDI.

Although some Third World countries have managed to establish impressively modern manufacturing sectors, the vast majority of the new technology created worldwide still originates in the laboratories and universities of the North. Indeed, MNCs account for 80% of all civilian research and development expenditures worldwide.  MNCs provide one mechanism by which Northern technology is transferred to the Third World. MNCs tend to invest in the most technologically advanced sectors of Third World economies, supplying goods and services that are beyond the technological capacity of local firms to produce efficiently. MNCs also aid in technological diffusion through means such as licensing technology to other firms or passing along knowledge, skills, and techniques to local partners through joint ventures.

Management Expertise
The Third World subsidiaries of MNCs often organize production more efficiently than do local firms due to superior management skills and techniques. MNCs possess great experience in managing large-scale enterprises. Branch plant managers can draw upon the vast storehouse of information and expertise contained within the corporation as a whole. Knowledge of modern management methods is spread through the training of indigenous personnel, whose representation in the ranks of management typically grows at the expense of expatriates the longer the MNC subsidiary is in place.

Marketing Networks
Even where local firms can match MNCs in price and product quality, they may lack easy access to the extensive foreign marketing networks available to Northern firms. MNCs often possess long-standing relationships with, or even control over, Northern wholesale and retail outlets, enjoy greater information about market demand and consumer tastes, and command larger advertising resources.

The Costs of Foreign Direct Investment to Third World Host Countries

Critics argue that the economic and political costs of FDI often outweigh the benefits.  Many criticisms center around differences between foreign and domestic firms and the ways they do business.

MNCs are accused of earning excessive profits in Third World countries, made possible by their oligopoly position in local economies.  The largest proportion of these profits is repatriated to shareholders in the firmís country of origin rather than reinvested locally. According to some studies, MNCs also overcharge for technology transfers to their own subsidiaries and rely more heavily upon imported parts and machinery than do domestic firms. Each of these practices tends to reflect negatively in the host countryís balance of payments position.

Critics contend that MNCs often borrow from the already scarce supply of local capital rather than bring new investment funds into the country. Because of their size and resources, foreign firms typically receive preferential terms from local banks when borrowing money, as compared with local firms. Another criticism is that MNCs discourage local entrepreneurship by often entering a country through the acquisition of an existing Third World firm or using superior resources to drive native competitors out of business.

Third World governments particularly object to a common MNC practice known as ìtransfer pricing.î MNCs resort to this technique in an attempt to lower their overall tax burden or to evade restrictions on the repatriation of profits. Transfer pricing is essentially an accounting practice applied to intrafirm trade. Different branches or subsidiaries of the same firm, located in different countries, often exchange goods. A U.S.-based manufacturer, for instance, might produce parts in a factory located in Texas but ship these parts to a plant in Mexico for assembly. In turn, the assembled product is transported back to the United States for final sale. The price that the home firm charges the Mexican subsidiary for the parts or that the subsidiary charges the home firm for the assembled product is essentially arbitrary because these transactions take place within the same company and are not exposed to market forces. If, let us say, Mexico imposes a higher tax on corporate profits than does the United States, then the MNC can lower its overall tax bill by overpricing the parts shipped to Mexico while underpricing the assembled products that are ìsoldî back to the home firm in the United States. By manipulating the prices on intrafirm trade in this way, the Mexican subsidiary will show little profit on its books, thus avoiding the high Mexican tax rate, while the profit of the home firm will be artificially boostedóallowing it to be taxed at the low U.S. rate. This sort of practice is hard to detect because it is difficult to know what the products might have sold for in armís-length transactions among independent firms. Because most Third World countries tax the profits of foreign corporations at relatively high rates, they are often targets of transfer pricing schemes and suffer a loss of potential tax revenue as a result.

Some forms of FDI represent attempts to export pollution from Northern countries, where environmental enforcement is stringent, or to exploit reserves of cheap labor. In Ilo, Peru, for instance, local villagers suffer from serious respiratory and other health problems stemming from the air and water pollution produced by a nearby copper smelter plant owned by three large American corporations. The plant emits up to two thousand tons of sulfur dioxide into the air each dayóten to fifteen times the legal levels for similar operations in the United Statesóas well as streams of toxic wastes that make their way into the local water supply.

Mexico is host to 4,500 product assembly plants located along the border, a number that has doubled since 1994. Called maquiladoras, one half of these plants are U.S.-owned and the majority of their output is shipped to U.S. markets. In total, the maquiladora sector employs one million Mexicans and generates $10 billion per year in foreign exchange for the Mexican economy. Some of the U.S.-owned plants relocated to Mexico to take advantage of lax Mexican environmental laws and to break free of stricter regulations in the United States. A study by the American National Toxic Campaign found that of twenty-three such factories sampled, seventeen were responsible for significant toxic waste discharges. Compared with nearby San Diego, Tijuana's waste water contains ten times more chromium, eight times more nickel and three times more copper. Much of southern Californiaís furniture industry has moved across the border to escape severe air pollution controls on solvent emissions.

Mexico has recently taken steps to tighten its environmental laws and to crack down on polluters, but its enforcement mechanisms remain inadequate. Only fifteen environmental inspectors are available for the entire state of Chihuahua, which includes the major city of Juarez. Mexico's single landfill site for the disposal of toxic wastes is capable of handling only a small fraction of the country's toxic waste production. Most of the rest is dumped illegally, despite laws mandating that toxic wastes be returned to the country from which the raw materials orginated. The NAFTA side agreement between the US and Mexico set up a Commission for Environmental Cooperation. The Commission may investigate complaints by citizens that environmental laws in their own country are being ignored, but its recommendations are not binding on governments.

In addition to the environmental problems associated with maquiladoras, critics point out that the jobs created through these factories are extremely low paying and that work conditions as well as health and safety standards are far below those in the United States. The factory cities that have mushroomed along the border in recent years have proven unable to add new infrastructure fast enough to keep up with growing populations. Eighteen percent of Mexican border towns have no drinking water, thirty percent have no sewage treatment and forty three percent have insufficient garbage disposal. Moreover, maquiladoras have developed few backward linkages to the rest of the Mexican economy. Of the $23 billion in physical inputs consumed by the maquiladora industries yearly, only 2 percent is supplied by Mexican sources.

FDI also carries political risks. MNCs may appeal to their home government to exert pressure on a host state when disputes arise. The Hickenlooper Amendment, passed by the U.S. Congress in 1962, requires that aid be denied to countries that nationalize the assets of U.S. corporations without prompt and adequate compensation. The law has been applied, or its use threatened, on several occasions. More dramatically, the United States, through the use of CIA covert operations and economic pressure, took part in the overthrow of governments in Iran (1953), Guatemala (1954), and Chile (1973) after the assets of firms from the United States and other Northern countries were nationalized. Although other factors influenced these decisions, the desire of U.S. officials to defend U.S. corporate interests abroad played an important role in all three instances.