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Foreign direct investment, smart policies and economic growth

Abstract: Developing economies need foreign direct investments to complement domestic investment with a view to increase capital accumulation, productivity and growth rates. But, foreign direct investments (FDIs) may have costs in addition to the well-known benefits to the host country. Generating higher net benefits from FDI necessitates design and implementation of ‘smart’ investment policies by the host countries rather than the current orthodoxy of ‘neutral’ FDI policies, which is based on liberalizing the FDI inflows and aim to attract ‘any’ kind of FDI. In this article, we discuss such polices and how they relate to host country circumstances.
Key words: FDI, smart policies, growth, productivity, spillovers, technology

I. Introduction
Economic growth requires investment, and investment needs to be financed by savings. Developing countries are characterized by relatively low savings and thus need savings of other countries in order to accelerate capital accumulation and growth. This necessitates developing countries to devise policies aiming at attracting foreign investment.
It is, thus, no surprise that developing countries have relaxed capital controls and implemented policies to attract international investment during the last few decades. With an improved perception of risk adjusted investment return differentials between developed and developing countries, the relaxation of capital controls in developing countries process has led to a substantial increase in foreign capital flows to developing countries since then. The United Nations

Conference on Trade and Development (UNCTAD) statistics show that in 2012, developing countries have, for the first time, received more foreign capital than developed economies.
Foreign capital inflows take three forms differing markedly in terms of volatility and their effects: international portfolio equity investments, foreign direct investments (FDIs) and external debt. FDIs are less volatile than international portfolio equity investments and external debt (Prasad et al., 2003). International portfolio equity investments deepen domestic financial markets and improve corporate governance of the domestic firms (Bekaert et al., 2010; Kose et al., 2009; Levine, 2001) External debt flows may not be as effective as equity investments as they may lead to inefficient capital allocation under poorly supervised banking systems and generate moral hazard problems in the case that debt is guaranteed by the government and/or international financial institutions (Kose et al., 2009). FDI can provide short- and long-run external finance to the country while generating technology spillovers and provide better management practices (Borensztein et al., 1998; Javorcik, 2004).
Some economists argue that foreign capital inflows are essential for prosperity and stability (Fischer, 1998; Mishkin, 2006; Summers, 2000). By contrast, other economists claim that foreign investment flows may be associated with instability exacerbating economic fluctuations (Bhagwati, 2004; Rodrik, 2011; Stiglitz, 2002). Nevertheless, even sceptical economists feel that FDI is an important type of foreign capital inflows. For example, Stiglitz (2000: 1076) says:
‘The argument for foreign direct investment, for instance, is compelling. Such investment brings with it not only resources, but technology, access to markets, and (hopefully) valuable training, an improvement in human capital.’
From an economist’s point of view, FDI has costs as well as benefits to the host country. A well-designed (‘smart’) FDI policy may lead to positive and higher net benefit to the host countries than a plain vanilla FDI policies. This article sets out a simple framework of analysis of costs and benefits of FDI to host the country and argue that FDI policies should be designed carefully based on the various characteristics of the host country in order to maximize benefits to it.
In the second section, we discuss potential benefits of FDIs. The third section analyzes potential costs of FDIs. In the fourth section, we outline FDI cycle. The fifth section discuss smart polices that might help host countries to reap more from FDIs. The sixth section concludes.
II. Benefits of FDIs to host countries:
Restating the known The host country may receive several categories of benefits from FDI inflows  First, many developing countries struggle with high current account deficits and low international reserves. FDI inflows provide stable financing for the current account deficits and strengthen international reserves in such developing countries.
Second, developing countries usually have significant gaps between potential and actual GDP due to lack of physical and human capital. FDI may be instrumental in increasing domestic production capacity and provide employment opportunities. Thus, FDI may contribute to income generation in the host country.
Third, FDI leads to generation of fiscal revenues to the host government. Given that developing countries have a low-revenue base, this benefit is crucial. Fourth, export-oriented FDIs increase export volume of developing countries. They also may increase diversity of export opportunities. Developing countries might reap their comparative advantages by using FDIs.
The above-mentioned categories are macroeconomic benefits. FDI may also generate microeconomic benefits for developing countries. Technology transfer, both managerial and technical, is perhaps the most crucial channel through which FDIs might provide micro-based benefits for developing countries. Multinational corporations (MNEs) usually have strong technology and research and development (R&D) credentials than their domestic peers. They also utilize more recent production technologies. These features of FDI might create positive technological spillovers for domestic firms in developing countries. These technological spillovers would occur via different channels: vertical linkages with domestic suppliers; horizontal linkages with competing domestic firms in the same industry; and transfers of skilled workers.

MNEs have four options to get their raw materials and intermediate goods. First, they might establish facilities to produce their own raw materials and intermediate goods. Second, they might purchase raw materials and intermediate goods from other MNEs in the same host country. Third, they might import their raw materials and intermediate goods. Fourth, they might purchase raw materials and intermediate goods from the domestic suppliers. This last option, referred to as the vertical spillovers, is the main channel that would generate technological transfers to domestic suppliers. MNEs might provide technical assistance, training and other knowledge sharing conduits to increase the quality of the domestic suppliers. Some MNEs also help domestic suppliers to modernize their production facilities.

 This cooperation might be beneficial for both parties. While MNEs can get raw materials and intermediate goods with high quality, domestic firms will improve their productivity, human capital and production facilities Technology transfer through competition within the same industry is called horizontal spillovers. The entrance of MNEs might lead to adaptation of new technology, higher productivity and more efficient resource allocation by spurring domestic competition. Many domestic firms in developing countries use outdated technologies in the lack of intense competition. They make huge profits even if they use these outdated technologies. Consumers and the economy in general pay the bill of this inefficiency. In sum, MNEs might encourage and force domestic firms within their industries to use their inputs more efficiently and increase their productivity.

 Transfer of skilled workers will be another conduit of technology transfer. MNEs usually hire most skilled workers in the host countries’ labour market since they tend to offer higher wages than domestic firms. These skilled workers improve their human capital through training and on-the-job learning. Spillovers occur when some skilled workers transfer from MNEs to big domestic firms or become entrepreneurs sharing their business and production experiences with domestic firms. This sharing process creates technology spillovers.1

 Providing external finance opportunities to their domestic partners and suppliers is another potential benefit of FDIs. Given that MNEs has better access to finance easily, they might ease credit constraints of their domestic partners and suppliers by providing them external finance. For example, Toyota increased its advance purchases and early payments when its domestic suppliers in Thailand hit by financial problems due to the Asian financial crisis. As another example for easing access to finance, Unilever provided financial support to five suppliers in Vietnam in order to upgrade equipment and cover the costs of extensive training (UNDP, 2001). Using a cross-country firm-level panel data with time-series data on restrictions on international transactions and capital flows, Harrison et al. (2004) find that FDIs reduce credit constraints of domestic firms by providing additional source of finance and freeing up scarce domestic finance.

 III. Potential costs of FDI to host countries:

Debunking the myths In addition to benefits, FDI may also generate costs to host countries. It is important to underline these potential costs in order to understand the net effects. First, as for other enterprises, the main objective of the MNEs is profit maximization. Profit repatriations along the FDI cycle exacerbate current account balance of the host countries. Possible damage from such outflows may become more significant if the outflows are sudden leading to destabilization risks.

 Second, even if FDIs may increase exports of host countries they may also increase the imports. The MNE supply chains involving imported raw materials and intermediate goods would exacerbate trade balance of developing countries. At the extreme, where the major or only value proposition of the hosting developing country to the investor is large domestic market and low labour costs, with low human capital, weak technological level and light regulations, net trade effect is most likely to be negative to the host country. In general, if the FDI targets domestic country only and imports a major part of its raw and intermediate products, its net balance of payment effect will be negative.

Third, the MNEs usually conduct their R&D activities in their home countries or developed countries. Due to the lack of human capital and inclusive institutions, many MNEs are reluctant to move their R&D plants to developing countries. This decision creates an obstacle for developing countries to reap full technological spillovers from FDIs. Domestic market-oriented MNEs might also not use new technologies in their production facilities. When MNEs do not face intense competition in host countries’ markets, they follow this strategy. This decision also reduces technology spillovers from FDIs in developing countries.

Fourth, FDI may generate market-stealing effects (Aitken and Harrison, 1999). MNEs have larger scale and more advanced than domestic firms in developing countries. MNEs with their advanced technologies, easy access to finance and large economies of scale might steal demand from domestic firms and acquire their customers. At the end, MNEs might force some domestic firms to exit from the market and increase market concentration. This effect damages industry dynamics in developing countries.

Fifth, even if FDI provides additional external finance opportunities to their domestic partners and suppliers, they might exacerbate credit constraints of domestic firms. When MNEs borrow heavily from domestic banks (instead of using internal funds or borrowing from international markets), they might exacerbate access of domestic firms to finance. For example, using firm data from the Ivory Coast, Harrison and McMillian (2003) find that domestic borrowing by MNEs increases credit constraints of domestic firms. This negative effect mainly occurs due to underdeveloped financial markets.

 Finally, FDI, as for other capital inflows, may lead to real appreciation of local currency decoupled from relative productivity gains of the host country. That damages the balance of payment accounts by reducing the competitiveness of domestic products and by incentivizing the domestic consumption by reducing the cost of imported products.

IV. The FDI cycle

FDI is realized following a decision process by the investor. A corporation that decides to make cross-border investment is a relatively sophisticated one. The FDI decision by such a corporation could be safely assumed to be based on some kind of forward looking maximization calculation of the net present value (NPV) of (i) its FDI (cash outflows for the corporation and its country, cash inflows for the host country), (ii) future repatriation of profits or divestments (cash inflows for the corporation and its country, cash outflows for the host country) and (iii) terminal value (if any) of the FDI in the host country. In Figure 1, the cash flows of a typical FDI cycle with a finite investment horizon is depicted from the point of view of the investor.

The investor may opt to ultimately repatriate all profits and divestment proceeds of the initial FDI. Or, it may keep part of the profits and initial investment(s) in the host country. In any case, the investor maximizes the NPV of its investment(s). This ‘FDI Cycle’ is presented in a general form in Figure 1 For the host country, FDI generates domestic incomes in addition to initial and subsequent capital movements.

 At the other side of the same equation lies the host country and its economy. The host country expects maximum net benefits to its 

economy and society from foreign investment. The profit maximization strategy of the investor, however, may or may not yield the maximum benefit from foreign investment to the host country. It is not unconceivable that an international investment may yield negative net economic benefits to a host country.

A number of cases can be imagined as examples to such a situation. For example, one can contemplate an environmentally hazardous investment that is financially attractive to the investor but yielding, overall, such environmental damage to the host country that has social as well as direct economic costs (e.g., damaging touristic revenue generation opportunities) outweighing the benefits from the FDI. Another example could be investments needing unskilled labour that ultimately provide negative economic incentives in the form of weakening demand for skill acquisition by the labour force. The ultimate net effect of FDI is obviously the result of counteracting gross benefits and costs.

 V. Generating long-run benefits from FDIs: The need for smart FDI policies

 Although FDI provide benefits of foreign exchange accumulation and external finance and increase tax revenues, these benefits do not generate long-run economic growth directly. Economic theory suggests that productivity is the key driver of long-run growth (Acemoglu, 2009). FDI can increase the productivity of domestic firms by labour training, alternative management techniques, imitation, incorporation of new inputs and vertical and horizontal linkages. These are the main channels through which technology spills over from MNEs to domestic firms (de Mello, 1999; Saggi, 2002).

However, there is no guarantee that FDI has significant positive effects on the productivity and thus the long-run economic growth. First of all, the sector of the FDI is likely to determine the potential of technological spillovers that can diffuse to the domestic firms. For example, an FDI consisting of the establishment of a beverage bottling plant is likely to provide very little technological spillover to the host country than a chip manufacturing plant. The absorptive capacity of domestic firms also matters for the technology spillovers to happen as it determines domestic firms’ ability to reap the potential benefits of FDIs. Therefore, positive benefit reaping from FDIs necessitates design and implementation of ‘smart’ investment policies by the host countries aiming at generating maximum net economic benefits to its society.

Such policies might, among others, target:

• Incentives with a view to attract FDI into sectors that generate a higher total economic value for the host country (and even deterring FDI into sectors which would generate negative net economic value) through increasing the technological and management spillovers to local companies in the host country; and

 • extending the FDI cycle in order to keep the as large a possible amount of investment proceeds in the host country.

 On the other hand, varying degrees of initial endowment and economic development in the host country may require a different look at various types of FDI; not all types of FDI may bring all kinds of net benefits to all types of host developing economies at all stages of development. In the previous section, some preconditions determining the effectiveness of FDI were discussed.

In these lines, this section discusses a selective list of FDI policy tools for the host countries. This list is not intended to be comprehensive.

1. Attracting FDI to increase low-skilled employment opportunities and mid-level technology transfer

 For social purposes, increasing low-skilled employment is a very critical objective especially in the earlier stages of economic development when constraints on domestic capital accumulation, saving capacity and entrepreneurship lead to limited domestically driven job opportunities. For example, in Singapore during period covering the second half of 1950s until 1970s, the primary objective in attracting FDI was to produce employment opportunities (Yulek, 1998). Given the low level of domestic technology level in developing countries at the earlier stages of economic development, midlevel technology transfer is also another crucial objective to economic catch-up process.

At the initial stage, the quality of infrastructure (communications, electricity, roadways, transportation, highways, ports, etc.) plays an important role to reap benefits from FDIs. In their empirical study, Wheeler and Mody (1992) find that while the quality of infrastructure was important for developing countries to attract FDI from the USA, it was not so important for developed countries.

Many MNEs invest in developing countries to exploit the low cost of natural resources and large market sizes. In order to achieve this, they need to access all regions of a country at a lower cost. Therefore, they need a threshold level of infrastructure such as level paved roads, interconnected railroads and better ports. Fast communication systems and wellfunctioning electricity grids are also needed to attract and gain more benefits from FDIs. These infrastructure investments are crucial for domestic firms to increase their absorptive capacity. These infrastructure investments are needed even if a country wants to attract FDI in most primitive manufacturing sectors. Some developing countries, such as China, Mexico, Thailand, Brazil and Turkey, reached a certain level of quality in infrastructure investments that can be considered world class. Some of these countries moved from being attractive to labour-intensive FDI to capital intensive thanks to these developments and rising level of labour costs. However, low quality of infrastructure is still one of the most severe obstacles for African and some South Asian countries to attract and benefit from more FDIs (see Asiedu, 2006).

In order to benefit from FDI, developing countries should ensure a business environment in which MNEs and domestic firms do business together. For example, MNEs might buy their intermediate goods from domestic firms. Contract enforcement, as a factor of business environment, is crucial to making this happen. If MNEs perceive that the level of contract enforcement is low in the host country, domestic linkage will become a risky alternative for these MNEs, and therefore, they will respond to weak enforcement by internalizing production of intermediate goods or importing them (Dixit, 2011; Perez-Villar and Seric, 2015).


Another area of smart investment policies that can enhance net benefits from FDI is access to finance. FDI domestic firms also need external finance to provide intermediate inputs to MNEs because these MNEs want to maintain a certain quality level. In a cross-country study, Alfaro et al. (2004) find that countries with underdeveloped financial markets could not gain from FDIs. In another paper, Alfaro et al. (2010) find that a well-functioning financial system allowed host countries to reap benefits from FDI through increasing total factor productivity.

The complexity of industry determines what type of external finance domestic firms need. In general, domestic small- and medium-sized enterprises (SMEs) produce intermediate inputs for MNEs in low-tech (such as textiles and food) and medium-tech (e.g., automobile) industries. Therefore, in countries and industries with low- and medium-level technological sophistication, developing a well-functioning banking system plays a crucial role for benefiting more from FDIs.

While the literature shows that SMEs are usually dependent on bank finance (Beck et al., 2008), there has been an ongoing debate on what kind of banking structure is more beneficial for financing SMEs. A common finding is that small and domestic banks are more likely to provide credits to SMEs because they have a comparative advantage in relationship lending, which is based primarily on soft information gathered by the loan officer through personalized contacts with SMEs, their owners and managers, and the local community in which they operate (Berger and Udell, 1996). The role of small and domestic banks becomes crucial especially when credit bureaus and informative financial statements are not available within the system. On the other hand, large and domestic banks have a comparative advantage in arms-length or transactionbased lending based on hard quantitative data (Berger and Udell, 2006). If credit bureaus and informative financial statements are available, large and domestic banks will also be beneficial for SMEs in accessing credit. As in the case of large domestic banks, foreign banks also have a comparative advantage in arms-length lending. When foreign banks make loan decisions, they generally rely on hard information such as credit scores and demand valuable collateral such as real estate. Therefore, foreign banks are less likely to finance SMEs (Berger et al., 2001). In sum, a domestic-based banking system might be more beneficial for SMEs to reach a certain level of capacity and thus sell intermediate inputs to MNEs in low- and medium-tech industries.

2. Attracting FDI to increase high-skilled employment opportunities and high-level technology transfer

At the later stages of economic development, host countries need to attract FDIs that provide high-skilled employment opportunities and higher levels of technology transfer. Other types of FDIs will not provide significant net positive benefits at these more mature stages of development. Therefore, smart policies should also be different at these stages. Promoting human capital is one of these smart policies. Human capital determines an individual’s ability to implement new techniques (Cosar, 2011; Nelson and Phelps, 1966). As noted by Van den Berg (2001:226), ‘it is the quality of the labour force, its accumulated experience and human capital, its education system, and so on, that determines an economy’s ability to create new ideas and adapt old ones’. Even if MNEs are willing to share technology and knowledge with domestic firms, the realization of this transfer also requires the presence of sufficient levels of human capital in the host country. Therefore, technological spillovers from FDIs might depend on the level of human capital in the host country.

Borensztein et al. (1998) find that FDIs from Organisation for Economic Co-operation and Development (OECD) countries to a developing country have a positive growth effect only when the host country has reached a human capital threshold somewhere between 0.52 and 1.13 years in terms of male secondary school attainment. In another empirical paper, Xu (2000) finds that the technology transfer of USA-based MNEs increased the host country’s productivity growth only when the country had reached a minimum human capital threshold of 0.52–1.13 years (in terms of male secondary school attainment over the age of 25). These results indicate that the positive effects of technology transfer are not realized for the least developed countries.

Domestic firms might need external finance to transfer technology and managerial skills from MNEs. Host countries need a wellfunctioning, market-based financial system in order to attract R&D and technologyintensive FDIs and to gain technological spillovers from them. They should transfer technology, do their own R&D investment and improve corporate governance in order to cross an absorptive capacity threshold level. The financial literature underlines that a market-based financial system is superior to a bank-based financial system in fostering innovative technologies and improving corporate governance. A bank-based financial system is better at financing short-run, low risk and well-collateralized projects. Innovative young entrepreneurs cannot provide a past track record and sufficient collateral. Due to the uncertain nature of innovative ideas, asymmetric information problems occur between entrepreneurs and financiers. Since acquiring information about firms is more costly for banks, they want to extract a larger share of the expected payoff from the potentially profitable investments. This attitude might reduce incentives for firms to make R&D investments and innovation (Xu, 2012). Therefore, the banking system is often reluctant to finance these entrepreneurs due to the high uncertainty and information asymmetries (Beck et al., 2005). It is also possible that powerful banks might collude with incumbent firms in order to prevent new entrants. Since new entrants are crucial for innovation (as in Schumpeterian equilibrium à la Aghion and Howitt (1992)), a bank-based financial system might not be R&D and innovation friendly.

On the other hand, a market-based system is better at financing projects with high risk and intangible inputs due to better information production and monitoring and a richer set of risk management tools (Allen and Gale, 2000). As a key dimension of a market-based financial system, stock markets are crucial for access to finance for R&D investment and innovation.

Young entrepreneurs need external finance to commercialize their promising ideas and uncover innovations. However, providing finance is not enough to turn ideas to production because young entrepreneurs also need strategic advice and other managerial support in building a firm (Keuschnigg, 2003). Different types of finance, therefore, are needed to pave the way for young entrepreneurs who want to sell their new products to MNEs. Venture capital (VC) is one of the alternative ways to provide finance and operational knowledge to young and innovative firms.

Promoting VC firms might increase the entry of young and innovative entrepreneurs to the market. As time passes, these entrepreneurs sell intermediate inputs to MNEs in technology and R&D-intensive industries and form joint ventures with MNEs. Production and partnership relations with MNEs increase technological spillovers and productivity for domestic firms.

The relationship between intellectual property rights (IPR) and FDI is quite complex. A weak IPR system increases the probability of imitation, which erodes a firm’s ownership advantages and makes a host country a less attractive location for MNEs. On the other hand, a strong IPR system may also have a negative impact on FDI by making licensing a viable alternative to FDI. The effect of IPR protection on FDI might also depend on the technology intensity of a sector. It is accepted that IPR protection plays a more crucial role in attracting FDI in industries with high technology and R&D intensity.

Javorcik (2004) examines the effect of IPR on FDI by considering these complexities. She found that weak protection deters MNEs more in IPR-sensitive sectors such drugs, cosmetics and healthcare products, chemicals, machinery and equipment, and electrical equipment. Her results also show that a weak IPR system encourages MNEs to set up distribution facilities rather than to set up production facilities. In sum, protecting IPRs might attract more R&D and technology-intensive MNEs and thus increase technological spillovers.

Countries that provide attractive inputs costs (such as low labour costs) are often weak at protecting IPRs. This creates a trade-off for MNEs. Therefore, MNEs are usually reluctant to transfer technology to their foreign affiliates due to the risk of imitation. Using data on USAbased MNEs, Branstetter et al. (2006) test the hypothesis that protecting IPRs induced MNEs to engage in more technology transfer. They use royalty payments and the R&D expenditures of US multinational affiliates as indicators for technology transfer. Their results show that increased protection of IPRs increases technology transfer from MNEs to reforming countries.

In order to evaluate the effects of IPR reform, economists have developed a number of dynamic general equilibrium models of two regions, the North (the developed country) and the South (the developing country). In these models, while the North innovates, the South imitates technologies that have been invented in the North. According to Helpman (1993), stronger IPR protection in the South reduces the rate of southern imitation and, therefore, retards industrial development.

On the other hand, Branstetter et al. (2006) show that these costs could be offset by benefits that arise from increased production and technology transfer by the MNEs. Using detailed data on USA-based MNEs, Branstetter et al. (2011) test this theory. They find that USA-based MNEs expanded their production activities and transferred more technology after IPR reform in developing countries. These effects were greater in technology-intensive industries. The authors underline that while most R&D spending by US MNEs was concentrated in the USA, some foreign affiliates made R&D expenditure to modify the parent firm’s technology to local circumstances and conditions. In line with this argument, their empirical results showed that IPR reform increased the R&D expenditures of US MNEs in technology-intensive industries.

Bilir (2014) argues that the effect of IPR reforms on technology transfer differs by industry. She differentiates industries based on their product life-cycle lengths. Her theoretical model indicates that IPR reform does not attract more MNEs in industries with short product lifecycles because developing countries are less likely to imitate the product before obsolescence. On the other hand, protecting IPRs attracts more MNEs only in industries with relatively long product lifecycles. To test this theoretical prediction, Bilir (2014) constructs an industry-level index of product cycle lengths by calculating the average length of time during which a given patent continues to be cited by subsequent patents. A long average forward citation lag indicates that the technology exhibits lasting relevance to future innovation. Using data on US firms’ global operations across 37 industries and 92 countries between 1982 and 2004, she finds that protecting IPRs increased MNEs relatively more in industries with long product lifecycles.

Some of the possible technological spillovers from FDI would emerge and propagate naturally, but some may not. Either to simply catalyze general spillovers propagation or to make use of more valuable components of them, host countries may need to devise specific carrot (if not stick) policies. A historical example argued by Prestowitz (1988: 34–35), among others, may be illustrious here: in 1960s, Japanese government raised tariffs against IBM`s computers forcing IBM to conduct FDI and start manufacturing in Japan. Ministry of International Trade and Industry (MITI), then, refused to permit the FDI unless IBM licensed basic patents to 15 Japanese companies.2 Further, IBM had to follow instructions of MITI in terms of types and number of computers to produce in Japan until 1979.3

Before China became a member of World Trade Organization (WTO), it had implemented performance requirements (compulsory FDI policies) to let MNEs invest in the country (Long, 2005). Such requirements included export proportion, local contents, balance of foreign exchanges, technology transfer and the creation of R&D centres. After the WTO membership, China have used voluntary polices to encourage MNEs to establish their R&D centres in China. Some of these policies include (Long, 2005: 329–30):

• Imported equipment and supporting technology for the MNEs R&D centres and used for pilot experiments are exempt from tariffs and other import taxes.

• Some technological development expenses of MNEs are discounted from the corporate income tax.

• Income from transfer of technology that has been developed solely by MNEs is exempt from sales tax.

• MNEs that have R&D centres in China are allowed to import and sell a small quantity of high-tech products on a trial basis in the local market, if they are goods produced as a result of the R&D by their parent companies.

Thanks to these compulsory and voluntary FDI policies, China has upgraded its technological level and increased its R&D activities. Since most of the developing countries brought its FDI policies in line with international standards and norms after the WTO, it is not possible for them to use compulsory performance requirements in order to gain more net benefits from FDI. However, there is still space available to implement some encouraging voluntary policies to achieve technological spillovers and productivity gains from FDI.

VI. Conclusion

Capital mobility in the form of FDI has been increasing rapidly since 1980. It is considered to be most beneficial one among the different types of global financial flows. In this article, we discuss some policy alternatives that might increases effectiveness of FDI for host countries, especially for developing ones. The brief conclusion is that a ‘liberalization’ policy aiming only at attracting ‘any’ kind of FDI may not yield significant net positive benefits and thus the maximum possible developmental effects from FDI. Therefore, host countries need to devise and implement ‘smarter policies’ to maximize net benefits from FDI.

Based on the economic structure of the host countries, multinational enterprises (MNEs) invest in different sectors. In general, MNEs invest in low-skilled/low wage industries in countries, which are at the initial stage of development. Such a country should give more importance to infrastructure, contract enforcement and a bank-based financial system to attract and benefit from FDI. But, this strategy could not provide the adequate momentum for long-run economic growth to more mature developing countries to catch-up developed countries. At the later stages of economic development, more refined policies are needed to attract more technology-based FDI that might provide high value added to a host country. Human capital, protection of IPRs, a market-based financial system and government guidance and enforcement are necessary to reap more benefits from FDI for a host developing countries at the later stages of economic development.




1. Friedman (2005) argues that China has recorded gains from such transfers of skilled workers.

2. The Japanese government’s argument apparently was based on competition as Prestowitz (1988: 34) quotes Shigeru Sahashi, a manager at MITI, saying he would appreciate if “the IBM ‘elephant’ would avoid trampling the Japanese mosquitos”. However, as Yulek (2013) emphasizes, MITI frequently intervened business decisions by forcing and even selecting foreign technology licencing.

3. Prestowitz (1988: 35) also argues that Texas Instruments, then the world’s largest semiconductor manufacturer, received the same treatment in early 1960s.


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