Foreign Direct Investment

FDI stands for Foreign Direct Investment, a component of a country's national financial accounts. Foreign direct investment is investment of foreign assets into domestic structures, equipment, and organizations. Foreign direct investment is thought to be more useful to a country than investments in the equity of its companies because equity investments are potentially "hot money" which can leave at the first sign of trouble, whereas FDI is durable and generally useful whether things go well or badly

The resilience of foreign direct investment during financial crises may lead many developing countries to regard it as the private capital inflow of choice. Although there is substantial evidence that such investment benefits host countries, they should assess its potential impact carefully and realistically

Economists tend to favor the free flow of capital across national borders because it allows capital to seek out the highest rate of return. Unrestricted capital flows may also offer several other advantages. First, international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second, the global integration of capital markets can contribute to the spread of best practices in corporate governance, accounting rules, and legal traditions. Third, the global mobility of capital limits the ability of governments to pursue bad policies.

In addition to these advantages, which in principle apply to all kinds of private capital inflows,the gains to host countries from Foreign Direct Investment (FDI) can take several other forms:

• FDI allows the transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. FDI can also promote competition in the domestic input market.

• Recipients of FDI often gain employee training in the course of operating the new businesses, which contributes to human capital development in the host country.

• Profits generated by FDI contribute to corporate tax revenues in the host country.

Foreign Direct Investment ( FDI) versus other flows

Despite the strong theoretical case for the advantages of free capital flows, the conventional wisdom now seems to be that many private capital flows pose countervailing risks. many host countries, even when they are in favor of capital inflows, view international debt flows, especially of the short-term variety, as "bad cholestero.

In contrast, FDI is viewed as "good cholesterol" because it can confer the benefits enumerated earlier. An additional benefit is that FDI is thought to be "bolted down and cannot leave so easily at the first sign of trouble." Unlike short-term debt, direct investments in a country are immediately repriced in the event of a crisis.

Recent evidence

To what extent is there empirical support for such claims of the beneficial impact of Foreign Direct Investment?

A comprehensive study by Bosworth and Collins (1999) provides evidence on the effect of capital inflows on domestic investment for 58 developing countries during 1978-95. The sample covers nearly all of Latin America and Asia, as well as many countries in Africa. The authors distinguish among three types of inflows: Foreign Direct Investment, portfolio investment, and other financial flows (primarily bank loans).

Countries should concentrate on improving the environment for investment and the functioning of markets. They are likely to be rewarded with increasingly efficient overall investment as well as with more capital inflows." Although it is very likely that FDI is higher, as a share of capital inflows, where domestic policies and institutions are weak, this cannot be regarded as a criticism of Foreign Direct Investment per se. Indeed, without it, the host countries could well be much poorer.

Fire sales, adverse selection, and leverage. Foreign Direct Investment is not only a transfer of ownership from domestic to foreign residents but also a mechanism that makes it possible for foreign investors to exercise management and control over host country firms—that is, it is a corporate governance mechanism. The transfer of control may not always benefit the host country because of the circumstances under which it occurs, problems of adverse selection, or excessive leverage.

Both economic theory and recent empirical evidence suggest that Foreign Direct Investment has a beneficial impact on developing host countries. But recent work also points to some potential risks: it can be reversed through financial transactions; it can be excessive owing to adverse selection and fire sales; its benefits can be limited by leverage; and a high share of Foreign Direct Investment in a country's total capital inflows may reflect its institutions' weakness rather than their strength. Though the empirical relevance of some of these sources of risk remains to be demonstrated, the potential risks do appear to make a case for taking a nuanced view of the likely effects of Foreign Direct Investment. Policy recommendations for developing countries should focus on improving the investment climate for all kinds of capital, domestic as well as foreign.