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How do FDIs Affect Economic Growth?

Scott Blackmer
Scott Blackmer
March 1st, 2021

Empirical evidence and literature show an overall positive relationship between FDI and economic growth. Research found that Foreign Direct Investment and commercial transactions are the most relevant factors in any country's economic growth.

The benefits of FDI on host economies and societies are widely known: Foreign Direct Investment is a vehicle for transferring technology, know-how, and management practices, via licensing agreements, imitation, and more advanced processes introduced by foreign firms, increasing efficiency and productivity. More so, FDI improves infrastructures and human capital by providing better training for local workers, and encourages new jobs' creation, leading to higher per capita incomes and household savings. Foreign Direct Investment also exerts a positive effect on domestic investment, supporting capital accumulation, providing funds, and contributing to overcome domestic saving gaps. Likewise, it increases the exporting capability in the host country and enhances competition in domestic markets, which leads to lower prices and higher real incomes for consumers.

Foreign Direct Investment inflows also have downsides, such as uneven distribution of FDI benefits in host countries, natural and human resources exploitation, and environmental degradation due to low ethical standards of big corporations. Despite this, empirical studies concluded that FDI contributes to income growth in host countries beyond what domestic investment would typically trigger.

FDI benefits do not accrue mechanically and evenly across countries. The magnitude of FDI’s effect on a country’s economic growth depends on several factors, which affect its absorptive capacity.

Unlike in domestic investment, FDI interaction with the level of human capital in the recipient country enhances its contribution to economic growth. Evidence reveals that countries achieve high productivity of FDI only when they have a minimum threshold stock of human capital. Moreover, it shows a degree of positive (and at times neutral) relationship between human capital development and the effects of Foreign Direct Investment on growth. Market structure, technology gaps and the educational level in a country may also limit a its capacity to take advantage of FDI externalities. That is because wide technology gaps inhibit the ability of the local employees to learn, either because the gap is too great to bridge, or because the perceived gap simply deters MNCs from attempting to bridge it.

FDI leads to different outcomes depending on countries’ income levels and economic development. On one side, holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets.

On the other end of the spectrum, a recently published report by the European Investment Bank analyses the relationship between countries’ income levels and FDI, classifying them into four groups: high, upper-middle, lower-middle, and low income. The research found that moving from low to middle-income countries, FDI’s effect on growth gets larger. On the other hand, it diminishes transitioning to high-income countries. Specifically, low-middle and high-middle income countries experienced a relatively strong impact, whilst low and high-income ones recorded a much smaller effect, as highlighted in the figure below. The rationale lies in that FDI, apart from providing capital accumulation, supports the import of positive externalities in terms of new inputs and technologies. Therefore, Foreign Direct Investments are more beneficial for developing economies that have higher demand for investment and higher need for advanced technologies compared to developed countries.

The institutional system plays a key role in influencing the cross-border flow of capital, including FDI. Countries with better-developed institutions relative to their income group peers show a positive effect of FDI on growth. There are several socio-economic and political characteristics of recipient economies that favor FDI and its positive impact on the economy, including government stability, law and order, financial liberalization, privatization policies, bureaucratic quality, and efficient domestic financial systems. Besides, favorable domestic conditions provide fairer rules, thus allowing a more effective allocation of resources and exploiting FDI more efficiently. Institutional quality differs among country income groups, with higher income coinciding with higher average institutional quality.

On the other hand, from an investor’s viewpoint, institutions play a crucial role in reducing the production and transaction costs involved in FDI. Countries that uphold democracy and political rights facilitate entry to the markets, protection of vested interests, minority rights, consequently offering growth-enhancing opportunities. More so, a stable institutional environment may increase spill overs from FDIs as it directly affects the business operating conditions. By contrast, lack of transparency and corruptive activities may lead to increased costs, while the threat to confidentiality in technological know-hows might impose additional constraints for foreign investors. Therefore, to create a positive FDI – growth nexus avoiding high sunk costs, an effective legal framework is necessary.

Whether our clients’ target country for FDI is institutionally structured or entails barriers-to-entry and structural uncertainties, First Law International relies upon an elite legal network with a solid structure, providing the firm with an invaluable foundation on which to base its expansion plan. FLI works across 100+ jurisdictions and can help firms gain a better oversight and give them access to domestic legal experts with industry subject-matter experience. As previously highlighted, FDI involves high costs when carried out in host countries with low institutional quality, pervasive corruption, and uncertainty due to arbitrariness. An enterprise needs to be up to date on Anti-corruption and Anti-Bribery regulations, as well as be aware of laws and policies in foreign countries. We require all our member firms to undertake the FLI’s Anti-corruption and Anti-bribery compliance training. Thanks to that, our partners have the expertise to deal with the main corruption issues targeted by the FCPA, Anti-Bribery, Anti-Money Laundering, OECD, and other similar, country-specific legislation. Moreover, our custom-made alert workflow system and legislation deep-dive are divided by jurisdictions and areas of law, so that our customers receive pre-emptive and actionable memos on legal implications of regulatory and legislative changes.

We have extensive experience representing the interests of global investors in a wide range of capacities and navigating global sensitive matters. FLI enables clients to identify optimal courses of action depending on their global interests, cross-referenced with local counsel’s guidance in streamlining corporate and business-strategy. The unique combination of industry experts and multi-jurisdictional legal advisors that First Law International provides represents a great advantage for our clients, who can engage in FDI activities at lower costs and risks.

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Scott Blackmer

Scott Blackmer

Scott leads the Americas Management Team. Previously a partner at WilmerHale, Scott advises private and federal clients in technology and is regarded as a leading authority in intellectual property and international trade. He has served as an advisor on privacy, data protection and digital identity to various Fortune 500 entities as well as government organizations.

With extensive experience in all matters related to data protection and cybersecurity, in both consumer and human resources contexts, Scott is an expert in a wide range of legal issues that companies face in online and mobile business, especially across borders.

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