Economic Growth: Foreign Direct Investments vs Trade - Essay Example

Economic Growth: Foreign Direct Investments v. Trade On the average, the long term growth rate of the United s real gross domestic product (GDP) for a hundred years from 1903 to 2003 was 2.2 per cent. This growth is considered one of the most exemplary in the world. Figure 1 shows the real GDP per person in for this period. However, the real GDP per person in the country more than doubled between 1963 and 2003 (Parkin 425). In the rest of the world, specifically Asia, the growth in real GDP was even greater. Figure 1 A Hundred Years of Economic Growth in the United States Sources: Romer; Parkin and Bureau of Economic Analysis Specifically, a look at the world's seven biggest economies (United States, Japan, Canada, France, Germany, Italy and United Kingdom) shows that real GDP per person has grown steadily from 1963 to 2003. However, the United States still displays the highest growth rate in this period as shown in the left panel of Figure 2. The rest of the world also displayed increasing growth rate, but at a much slower pace than the seven biggest economies which resulted to a wider gap between the real GDP per person among these countries as shown in the right panel of Figure 2. Figure 2 Economic Growth around the World Source: Parkin and International Monetary Fund The rest of Asia, on the other hand, as represented by Hong Kong, Singapore, Taiwan South Korea, and China also showed tremendous gains in their economies as shown by their real GDP per person growth depicted in Figure 3. China, the world's newest economic superpower, showed an exponential growth in its real GDP. A question, prompted by the above, is what are the underlying causes of economic growth' Furthermore, why is it that some countries grow faster than others' Is trade a major engine of economic growth' Or is it foreign direct investments' A major goal of this paper is to debate the effectiveness foreign direct investments and trade in fostering economic growth, and in the end answer the question on whether 'developing countries are right to increasingly shift resources towards attracting foreign direct investment rather than promoting trade in their objective to achieve economic growth'' Admittedly, these questions must be answered amidst the shift in economic policies of governments especially in low developed countries. The shift in economic policies is often on the reallocation of economic resources to finance activities geared toward attracting foreign direct investments rather than the other needs of those nations. Figure 3 Economic Growth in Asia Source: See Figure 2 Economic theories postulate that, for economic growth to be persistent economies must pursue three activities - these activities generate ongoing economic growth: saving and investment in new capital, investment in human capital, and discovery of new technologies. From these three activities emerged different economic growth theories, however, these theories are not the topic of this reading, but rather foreign direct investments and trade. International trade promotes the development of comparative advantage in the global economy, allows for the trade of similar goods - for example, United States imports automobiles and at the same time exports other types of automobiles, the diversity of taste of people is given an outlet, and economies of scale is enhanced. Trade has a very important role in promoting and sustaining long term economic growth that foreign direct investment doesn't (Kurgman and Obsfeld; Marrewijk, Ottens and Schueller). Nonetheless, the role of foreign direct investment in the development process can not be underscored either. Hence, developing countries had shifted a considerable amount of their resources into attracting foreign direct investments or FDIs. For example, in the Sub-Saharan Africa, governments have shifted policies to attract FDIs. Fiscal holidays and tax holidays are awarded generously to investors. Moreover, investors often require that the country improve its property rights in favor of the FDI and improve infrastructure and service support systems which is usually at the expense of the average taxpayer. These factors are important in the foreign direct investment decision making process in selecting their locations for investments (Cleeve 137), hence unless the country improve these factors first, the county will not be able to attract FDIs. It is generally accepted that foreign direct investments provide host countries an engine of growth. First, the entry of foreign companies is said to be that more efficient than their local counterparts and is expected to produce benefits in terms of higher wages for workers, lower prices or better quality for consumers and/or higher fiscal income for public collectivities (Fuji Olechko 170). Second, the diffusion of new ideas to local firms produces productivity gains in these firms and growing returns for the host economy as a whole (De Mello 20). In terms of the development of the host country's competitiveness, which is a basic requirement for any economy to be able to compete successfully in international trade, literature suggests that foreign direct investments do help enhance competitiveness. In Gugler and Brunner's analysis of Michael Porter's Diamond, they listed four broad attributes which promote or impede the creation of competitive advantage: 1. "Factor conditions: the nation's position in factors of production such as skilled labour, infrastructure, physical resources and technologies, necessary to successfully compete in a given industry; 2. "Firm strategy, structure and rivalry: the conditions in the nation governing how companies are created, organized and managed as well as the nature of domestic rivalry; 3. "Related and supporting industries: the presence or absence in the nation of supplier industries and related industries and institutions (research, education) that are internationally competitive; and 4. "Demand conditions: the nature (from a qualitative and/or quantitative point of view) of home demand for the industry's products or services." Foreign direct investments indirectly enhance factor conditions of the host country. In attracting FDIs, host countries needed to improve their infrastructure which is a basic decision making factor for FDIs in choosing a location. When an FDIs enter an economy, technology transfer is highly likely. Moreover, as the FDIs enter the market, for example the retail market, competition in that sector becomes more intense, hence creating a scenario of survival of the fittest. Unless local companies shape up - improve productivity, strategy, and structure - they will not survive in a highly competitive environment. In a manufacturing setting, for example in the Philippines, automobile assemblers which are foreign direct investments require that their suppliers also relocate to ensure the smooth flow of raw materials. As such FDIs promote the development of supporting industries. Moreover, as FDIs enter an economy demand for local products and services increase. FDIs usually source out several of their raw materials from the host economy as it is most cost effective to do so, and of course, the FDIs require local labor for their labor force. The usual rallying cries of critics for foreign direct investments is that these investments will exploit the host country's natural resources and people, and that it will further enhance the gap between the poor and the rich. However, a look at the history of the General Agreements on Tariffs and Trade, then World Trade Organization shows otherwise. For example, after China became a member of the WTO I 1986 overseas manufacturer and services provides flooded into the country (Sutherland 125). "Who could have imagined in 1986 that within 20 years two German companies would be contracted to build and operate a $145 million hospital in Shanghai' Or that by 2007 there would be around 1,200 auto-parts-manufacturing operations with overseas investment in China -- holding 50 percent of the market' Or that Volkswagen would export its Chinese-made cars to more than 80 countries'" (Sutherland 125). It is clear from China's example, the newest economic superpower, that foreign direct investments are closely linked to the development of trade within the host country. The foreign direct investments that flowed into China now make up a bulk of the products and services that China trade with the rest of the world. It is also interesting to note that the efforts of China in attracting foreign direct investments into the country have also benefited its neighboring Asian economies. Its economic development influenced the emergence of economic subgroup such as the Association of South East Asian Nation or ASEAN. ASEAN's trade and investment patterns have been significantly affected by "China's vertiginous growth" (Das 285). In Malaysia, foreign direct investment strategy is central to the government's master plan in driving the nation's economy onwards. As a matter of fact, the country established the Industrial Development Authority or ADA in 1965 to "help local and foreign enterprises seeking to operate in the country and coordinate industrial development" (Foreign Direct Investment 1). The federal government of Malaysia acknowledges that attracting the right kinds of foreign investment can provide the support it needs to follow up on its impressive track record of growth. Shifting economic resources in order to attract foreign direct investment should not be the focus of such shift, rather the focus of any government in reallocating scarce economic resource is in attracting the right kind of foreign investments. The right kind means the foreign investments that will eventually promote its competitiveness in the international trade and not the kind that will take flight whenever the economy experiences a down turn. Within the biggest economy in the world, international investment has also stimulated the economic growth it had been experiencing. Robert Kimmitt confirms that "International investment in the United States fuels the U.S. economy by creating well-paid jobs, importing new technology and business methods, and providing healthy competition that fosters innovation, productivity gains, lower prices, and greater variety for consumers" (62). This shows that not only developing nations are shifting their economic resources in attracting FDIs, but also economic superpowers such as the United States are doing so. In spite of China's economic success brought about, though partly, by foreign direct investments, FDIs do have their externalities. Although, general contention supposed that foreign direct investments have substantial positive effects a growing literature has shown that there is nothing automatic about such positive mechanism (Durand 393). An unintended consequence or externality of FDIs is displayed by the retail sector in the Mexican peninsula. During the late 1990s "elite transnational multi-format retailers expanded rapidly" (Durand 393) which eventually changed the make up the retail market in their host countries. In Mexico, for example, the entry of the discount retailer Wal-Mart rapidly modernized the country's retail market, but at the expense of local firms and employees. The figure below presents that the FDIs in the retailing sector of a developing country has tradeoffs. Positive effects such as productivity spillovers will happen while negative effects such as lower wages can also result from the foreign direct investment. This means that in some sector of the host nation, productivity gains will be recorded while productivity losses are recorded in another. It seems that no matter how FDIs are managed, there will always be both positive and negative results. Figure 4 Potential externalities from Foreign Direct Investment in the retailing sector of a developing country Source: Sutherland 395 Given the advantages of attracting foreign direct investments, governments and their policy makers should also develop trade at the same time. Over dependence on FDIs for long term economic growth is not sound as proven by what happen in Thailand in 1997 and the rest of Asia during the 1997 Asian financial crisis. The over dependence of nations on foreign capital to stimulate economic growth risks the happening of an economic collapse. This is especially when such inflow of foreign capital reverses in times of capital flight. In the current financial crisis, emerging market economies in Central and Eastern Europe "may be vulnerable to a reversal of capital flows if the global credit squeeze is prolonged or global GDP growth falls sharply" (Felices, Hoggarth and Madouros 26). This could adversely affect both these nations. If that happens, it is another 1997 Asian currency crisis all over again. We know how devastating the effect of the 1997 Asian currency crisis - in spite of its name, it did impact the whole world. Attracting foreign direct investments and developing trade are two goals that should not be taken independently by economic managers. In order to achieve economic development capital must be present and sometimes the easiest way to get capital is through foreign direct investments, and such capital should be used to enhance the country's competitiveness because "[economic] development means something more than just economic growth" (Cho and Moon 5). Economic development is "quantitative growth [such as gross national product] and qualitative change (e.g., improved techniques of production)" (Cho and Moon 5). Fortunately, shifting resources in order to attract foreign direct investments is not indefinite. Studies have shown that if a nation experiences economic growth, foreign direct investments will most likely flow into the economy without too much expense on the part of the taxpayers. As shown by Pradhan, in the case of Malaysia and India, it is economic growth that promotes foreign direct investments rather than the other way around. The researcher believes that in time other developing countries will attain such economic stage and then worries on whether the government is right in shifting economic resources in attracting FDIs will eventually disappear. One of the most basic concepts in economics is the presence of tradeoff. The above discussion on the merits of foreign direct investments and trade, and whether governments are right in allocating so many resources in attracting FDIs rather than promoting trade shows that tradeoff also exist in this situation. A study of economics and the economic development of developing countries show that foreign direct investments, in the long run, highly likely promote trade. However, in accepting FDIs into the economy, governments must also realize that by doing so sectors of the local economy will inevitably suffer. As such, policy makers must account for these externalities in their concessions to the FDIs. Otherwise, economic development in specific sectors while other sectors in the country are rapidly dying is not worth it. A nation full of discontent no matter how high the real GDP per person is will always spiral down to chaos. Lastly, on the question whether foreign direct investments promote development, the answer truly depends on how the host economies direct such investments. Nevertheless, the debate will rage on maybe more intense than ever before. This debate - whether it is prudent for countries, especially less developed countries (LDCs), to try to attract FDI to help stimulate their growth and development (Griffith 1174) - is central to the theme of this reading. The answer is that there is no really universal result of foreign direct investments since countries differ in their economic fundamentals, policies regarding FDIs, and above all, their objective in attracting FDIs in the first place. Therefore, the answer to whether 'developing countries are right to increasingly shift resources towards attracting foreign direct investment rather than promoting trade in their objective to achieve economic growth'' is, again, depends on how these governments act toward the foreign direct investments. Works Cited Bureau of Economic Analysis. Cho, D. & Moon, H. "A nation's international competitiveness in different stages of economic development." Advances in Competitiveness Research 6.1 (1998): 5-19. Cleeve, E. "How Effective Are Fiscal Incentives To Attract FDI To Sub-Saharan Africa'" The Journal of Developing Areas 42.1 (2008): 135-153. Das, D. "Foreign Direct Investment in China: Its Impact on the Neighboring Asian Economies." Asian Business Management 6.3 (2007): 285-301. De Meelo, L. "Foreign direct investment in developing countries and growth: a selective survey." The Journal of Development Studies 34.1 (1997), 1-34. Durand, C. "Externalities from foreign direct investment in the Mexican retailing sector." Cambridge Journal of Economics 31 (2007): 393-411. Felices, G., Hoggarth, G. & Madouros, V. "Capital inflows into EMEs since the millennium: risks and the potential impact of a reversal." Bank of England. Quarterly Bulletin 48.1 (2008): 26-36. Foreign Direct Investment . "Supplement: Malaysia - FDI Strategy - Masterplan drives the nation on." Foreign Direct Investment August ( 2007): 1. Fuji, Olechko, D. "Inversion extranjera y productividad en Mexico." Investigacion Economica 62.248 (2004): 147-173. Griffith, W. "Does Foreign Direct Investment Promote Development'." Journal of Economic Issues 40.4 (2006): 1174-1176. Gugler, P. & Brunner, S. "FDI Effects on National Competitiveness: A Cluster Approach." International Advance Economic Research 13 (2007): 268-284. International Monetary Fund. Kimmitt. R. "In Praise of Foreign Investment." The International Economy 22.2 (2008): 62-64. 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