A2 Economics – pros and cons of FDI

With the CIE exams looming here are some notes on foreign direct investment (FDI) which could be part of an essay question on development economics. As with most essays in CIE paper 4 you will need to evaluate an economic issue and that could be the contribution that FDI has on increasing the standard of living in developing countries.

Foreign Direct Investment involves a multi-national corporation (MNC) building a manufacturing plant, or other physical investment, in the economy in question. Such investment will undoubtedly bring benefits for the selected country; but there are also some serious drawbacks which must be taken into account in evaluating the desirability of FDI. Through their activities, MNCs provide foreign direct investment (FDI) to the economies in which they operate. This is investment that is necessary to produce a good or service in a foreign country. FDI, therefore, involves capital flows between countries. It should not be confused with portfolio investment, which is the purchase of shares by foreign investors in businesses that are located in another country – see image below.

Benefits

• FDI can help to plug the savings gap – the difference between the level of savings and the amount of investment needed.

• The MNC will import valuable foreign exchange into the country

• A large amount of jobs will be created directly – i.e. employed in the new factory

• But employment will also be created indirectly, through the multiplier effect.

• MNCs can introduce new technology into the country – and educate their workers as to its use

• If profitable, they generate valuable tax revenue for the government.

Drawbacks

• MNCs tend to invest in urban areas. This widens the gap between urban and rural incomes – and aggravates the problem of rural-urban migration.

• Many MNCs have been accused of exploiting their workforces. For example, they may force workers to work in unsafe, or simply miserable, conditions; they may employ children, and pay shockingly low wages (by Western standards).

• MNCs are also accused of exploiting local environments, by polluting air and rivers, cutting down rainforests, or by reducing biodiversity.

• Any dividends and profits are likely to be shipped back to the international headquarters somewhere in the developed world.

• Finally, MNCs often use inappropriate, capital-intensive production methods, thus preventing countries from exercising their comparative advantages in labour-intensive industries.

Source: Development Economics Toolkit – Tutor2u

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