Eco Today - Mar10:ET Master Page 2007 - ASKnLearn

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What Economic Effects may result from an Increase in Foreign Direct Investment into an Economy? Marwan Mikdadi, Head of Economics & Politics, St Paul’s School and former Principal Examiner, reviews the benefits and costs of foreign capital inflows. Exam Board AS Unit A2 Unit AQA ✓ 4(3.4.3) Edexcel ✓ 4(4.3.8) OCR ✓ F585 WEJC ✓ EC4(G) CCEA ✓ A2(2) Int. Bacc. Standard 5.4 Cambridge Pre-U International Economics (e) Key words Foreign Direct Investment Multiplier effects Competition Dutch Disease Footloose
Foreign direct investment (FDI) is often associated with the building of a factory in another part of the world, such as the Honda plant built in Swindon in 1992. However FDI is more than just the building of a factory as it can also be the purchase of a company or firm already in existence such as the purchase of Abbey National by Santander in 2004 or BAA by the Spanish construction conglomerate Ferrovial in 2006. FDI can therefore be defined as the ownership of productive assets such as factories, firms or other businesses either through outright purchase of a business that currently exists or by establishing a new firm. The UK and inward investment T he UK has traditionally been the leading recipient of FDI in Europe, often coming second only to the United States of America in global terms, although China is estab - lishing a greater foothold over global FDI. Much of the UK’s success in attracting FDI has been attributed to the flexible labour laws, low levels of corporation tax and regulation. However these advantages are being steadily eroded away. The difference between UK and Irish corporate taxes has increased to 16 per cent (UK corporation tax is 28 per cent and Irish corporation tax is 12 per cent). Moreover as the UK adopts the Social Chapter and EU working time directive it narrows the gap between the UK and other EU members. According to the World Investment Report the UK received $97 billion of FDI compared to the USA’s $316bn and France’s $118bn in 2008. 1 However, in 2008 the credit crunch may have resulted in the decline in the UK’s leading position, which may return to above that of France in 2009. In the developing world FDI is seen as one of the ways that countries can benefit from globalisation and economic growth therefore reducing their levels of poverty and closing the gap in income distribu - tion. FDI is often seen to only have benefits and whilst it may be true that advantages outweigh the disadvantages there are a number of countries, such as India, that have put restrictions on the level of FDI to protect their domestic businesses from competition by multinational corporations. But we first consider the potentially beneficial impact of foreign capital inflows. employment, and with that increases in the levels of income received by employees, reducing the numbers reliant on state welfare schemes. As incomes increase this should result in an increase in the level of consumption, which coupled with the multiplier effect should also result in an even greater increase in national income through subsequent increases in spending. Firms will react to the increase in consumption by raising the level of output and in so doing increasing both investment and levels of employment. This increase in both consumption and investment will result in an increase in the level of Aggregate Demand in the economy, therefore resulting in economic growth as shown in Figure 1. As unemployment falls and fewer people claim social security the govern - ment should find that it receives a greater amount in tax revenue in the form of increased income tax payments and also have additional funds diverted from the social security budget to spend on other areas such as health and educa - tion, contributing to an increase in the standard of living for the population. However, depending on where the economy is operating the impact of a large influx of FDI may be very different. Price Level Figure 1: More FDI boost output Most developed economies will operate with relatively low levels of surplus labour, particularly when they are experiencing economic growth and so close to full employment. It follows therefore that an increase in the level of FDI, causing AD to shift right from AD2 to AD3, in such circumstances, will result in demand-pull inflation in the economy. This is illustrated in Figure 1. If this is the case then it may necessitate an increase in the interest rate by the relevant central bank thus reducing the potential positive impact associated with the increase in FDI. However in many developing nations there is sufficient unemployment or underemployment to ensure that any FDI demanding an increase in labour is able to do so without resulting in an increase in the rate of inflation as AD can increase from AD1 to AD2, absorbing unemployed resources. In Figure 1 this increase in AD has no adverse effect on the rate of inflation. This case, of course, depends on whether the foreign investor is employ - ing domestic labour or instead bringing in its own workers. There are examples, especially in the developing world where firms have brought in their own workers to undertake many of the jobs that could not be done by unskilled domestic labour. Even in developed countries, especially as a result of an increasingly globalised labour market foreign investors will employ people from around the world and not confine them - selves to just the indigenous population. Furthermore, it is worth remembering that if a firm takes over an existing business, it may do very little to add to employment and indeed may actually reduce the size of the workforce as it seeks to obtain economies of scale and LRAS Employment and economic growth An increase in FDI is likely to result in an increase in levels of domestic 1. UNCTAD World Investment Report, published 17 September 2009. P2 P1 Y1 AD1 Y2 AD2 Y3 AD3 Real Output M ARCH 2010 3
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