RESTRICTED
WORLD TRADE WT/WGTI/W/8/Add.1
26September 1997
ORGANIZATION(97-4003)
Original: English Working Group ontheRelationship
between Trade andInvestment
IMPLICATIONS OFTHE RELATIONSHIP BETWEEN TRADE AND INVESTMENT
FOR DEVELOPMENT AND ECONOMIC GROWTH
Work Undertaken inOther Intergovernmental Organizations
Addendum
Atitsmeeting of2and3June1997, theWorking Group requested theWTO Secretariat to
prepare apaper which would present theresults ofwork undertaken inother intergovernmental
organizations onthesubjects covered byItemIoftheChecklist ofIssues Suggested forStudy
(WT/WGTI/M/1, paragraph 11).Pursuant tothisrequest, theSecretariat invited UNCTAD andother
intergovernmental organizations working inthisareatoprovide asummary description ofwork carried
outonthese subjects.
Thisaddendum reproduces thecontribution from UNCTAD.WT/WGTI/W/8/Add.1
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TRANSNATIONAL CORPORATIONS, FOREIGN DIRECT
INVESTMENT AND DEVELOPMENT1
Note bytheUNCTAD Secretariat
Thispaper hasbeenprepared bytheUNCTAD Secretariat asacontribution tothediscussions
ontheimplications oftherelationship between trade andinvestment foreconomic growth and
development bytheWTO Working Group ontheRelationship between Trade andInvestment atits
meeting inOctober 1997. Itisbased largely onwork byUNCTAD 'sDivision onInvestment,
Technology andEnterprise Development andtheUnited Nations Centre onTransnational Corporations,
thecurrent andformer focalpoints, respectively, within theUnited Nations forallmatters related to
foreign direct investment andtransnational corporations. Itismeant tobeanoverview paper, with
references indicating where more in-depth discussions canbefound.
Table ofContents
Page
INTRODUCTION ...............................................3
I. TRENDS INFDI POLICIES AND FDI FLOWS TO DEVELOPING
COUNTRIES .............................................4
II. EFFECTS OFTNCs ONDEVELOPMENT THROUGH TRADE .............7
A. Direct effects ofTNCs ontrade ..............................9
B. Indirect trade effects ....................................12
C. Transfer pricing .......................................14
D. Concluding remarks ....................................14
III. DIRECT EFFECTS ONDEVELOPMENT ..........................15
A. Savings andinvestment ..................................15
B. Technology transfer andinnovation ...........................16
C. Entrepreneurship andlinkages ..............................18
D. Employment andskilldevelopment ...........................19
E. Other effects .........................................20
IV. FOREIGN DIRECT INVESTMENT, TRADE AND DEVELOPMENT:
CONCLUDING REMARKS ....................................21
REFERENCES .................................................24
Annex Table 1.Developed anddeveloping countries: FDIinflows, aspercentage of
world inflows .............................................29
Annex Table 2.Developed anddeveloping countries: FDIoutflows, aspercentage of
world outflows .............................................30
1Thepaper, initsfinalform, willbepartofUNCTAD ’sSeries ofTechnical Papers onaPossible Multilateral Framework
onInvestment. Under theoverall direction ofLynn K.Mytelka, theSeries isimplemented byateamledbyKarlP.Sauvant
andPedro Roffe andcomprising Victoria Aranda, Anna Joubin-Bret, Assad Omer andJörgWeber; itsprincipal legal and
economic advisors areArghyrios A.Fatouros andSanjaya Lall. Thepresent paper wasprepared byManuel R.Agosin
andbenefited from comments received from John H. Dunning, Persa Economou, Dieter Ernst, Fabio Fiallo,
Padma Mallampally andZbigniew Zimny.WT/WGTI/W/8/Add.1
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INTRODUCTION
Transnationalcorporations(TNCs)arefirmsthatcontrolassetsandengageinproductionactivities
inmore thanonecountry.2Theinternational production activities ofTNCs, based astheyareonthe
resources andcapabilities drawn fromthedifferent locations inwhich TNCs operate, haveimportant
implications fordevelopment, especially ofhostdeveloping countries. These activities cover theentire
value-chain ofproduction, ranging, among others, from raising capital, establishing newproduction
facilities oracquiring productive assets, andengaging directly inthemanufacture ofgoods orthe
provision ofservices todeveloping newtechnologies. Transnational corporations engage inthese
activities incountries outside theirhome economies bymeans offoreign direct investment (FDI)3,as
wellasnon-equity arrangements (such aslicensing, franchising, original equipment manufacturing,
orsubcontracting ofcomponents orfinished goods) thatmaybecloser toarm'slength arrangements.
Firms invest abroad because oftheexistence ofaconjunction of(a)firm-specific assets from
which theycanderive monopoly rents (ownership advantages); (b)difficulties orhigher costs in
exploiting these assets through arm's-length transactions (internalization advantages); and
(c)location-specific advantages ofindividual countries (Dunning, 1981, 1993a, 1993b). The
location-specific advantages thatarefound tobethemostappealing toTNCs arethesizeofthedomestic
market,thegrowthofthedomesticeconomy,opennesstointernationaltrade,andattractivecombinations
ofcostandproductivity(UNCTC,1992a).Dependingupontheimportancethatfirmsplaceonexploiting
theirfirm-specific advantages within theirowncorporate production systems, international production
maytakeplace intheformofFDIorofnon-equity arrangements between firms thatcontain varying
elements ofarm's-length transactions. Both FDIandnon-equity arrangements have effects on
development; thefocus ofthispaper. Theyarerelated tothecapital, technology, managerial capabilities
andaccess tomarkets thatTNCs possess ortowhich theyhaveaccess. Inparticular, theintangible
assets withgrowth-promoting qualities thatTNCs canoftenprovide arenotreadily available inmarkets,
andareparticularly scarce indeveloping countries.
Theglobalization oftheworld economy entails agrowing interpenetration among economies
(UNCTAD, 1994a, Chapter III). TheroleofFDIinthisprocess hasbecome more important; in
recent years, world FDIhasgrown more rapidly thanworld exports andsalesofforeign affiliates now
exceed world exports invalue (UNCTAD, 1996a). Foreign direct investment, moreover, involves
alinking ofproduction systems thatrepresents "deep" integration, asitinvolves relationships atthe
levelofproduction thatbring factors ofproduction together, ascompared with"shallow" integration
duetotrade, which generally involves arm'slength relationships (UNCTAD, 1993a). Integration due
toFDIitselfisbecoming deeper asanincreasing number ofTNCs pursue complex integration strategies
thatfavour closely integrated production anddistribution networks rather thanstand-alone orsimple
integration strategies withlimited linkages within theoverall networks ofTNCs. Under complex
integration strategies, firms engage inconsiderable cross-border specialization through avertical and
2Transnational corporations areincorporated orunincorporated enterprises comprising parent enterprises
andtheirforeign affiliates. Aparent enterprise isafirmthatcontrols assets usedinproduction abroad. Aforeign
affiliate isanincorporated orunincorporated enterprise ina(host) country inwhich afirmresident inanother
(home) country hasastake thatpermits alasting interest inthemanagement ofthatenterprise.
3Foreign direct investment isdefined asaninvestment involving alongterm relationship andreflecting a
lasting interest andcontrol byaresident entity ofonecountry (theforeign direct investor orparent enterprise)
inanenterprise resident inacountry other thanthatoftheforeign director investor (foreign affiliate). Itincludes
equity investments aswellasnon-equity arrangements thatgiverisetothecontrol ofassets usedinproduction
abroad.(SeeUNCTAD,1997a,annexB,forafullerdefinitionandadescriptionofFDIdataasusuallymeasured.)WT/WGTI/W/8/Add.1
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horizontal intra-firm division oflabour across borders, including increasingly atthefunctional level
(UNCTAD, 1993a, Chapter V).
From thepoint ofview ofTNCs, complex integration strategies allow firms toreapgains
associated witheconomies ofscale andscope fortheproduction ofanintermediate product ora
production-related function. Such strategies alsopermit firms tolocate eachproduction activity or
corporate function where thecost-productivity combination isthemostfavourable fromtheviewpoint
ofachievingmaximumprofitabilityfortheTNCasawhole.Oneimplicationisthatcountries,regardless
oftheirlevelofdevelopment, maybeinaposition tohostaspecific TNC activity thatmatches their
locational advantages. Nothaving toattract thefullrange ofproduction activities ofaTNC gives
countries theability tospecialize in"niche" production.
Thispaper examines theroleofTNCs inhostdeveloping countries ’growth anddevelopment.4
Itisorganized asfollows. Section Ireviews briefly therecent changes indeveloping countries 'attitudes
andpolicy regimes towards TNCs andthesurge ofFDItodeveloping countries inthe1990s. Section II
looks attherelationships between, andimpacts of,FDIandother forms ofTNC activity ontrade,
and,through trade, ongrowth anddevelopment. Section IIIexamines channels through which FDI
affects directly growth anddevelopment inhostdeveloping countries; theseinclude, inthemain, effects
onsavings andcapital formation, technology transfer anddomestic innovation, localentrepreneurship
andtraining andhuman capital formation. Section IVdraws thediscussion ofdevelopment effects
together andtouches upon some policy implications forhostandhome countries.
I. TRENDS INFDIPOLICIES AND FDIFLOWS TODEVELOPING COUNTRIES
Inrecent years, therehasbeenasea-change intheattitudes ofdeveloping country governments
towards FDIandTNCactivities. Untilthemid-1980s, many governments viewed TNCs withsuspicion
andtended tocurtail theirfreedom ofaction through outright prohibitions, limitations ontheindustries
inwhich theywereallowed tooperate, restrictions onprofit remittances andcapital repatriation, or
theimposition ofstringent performance requirements (albeit sometimes inexchange fortaxbreaks
orsubsidies). Bycontrast, alarge number ofdeveloping countries nowwelcome TNCs andhave
liberalized veryconsiderably theirrules andregulations towards them (UNCTAD, 1995a, Chapter
VI;UNCTAD andtheWorld Bank, 1994): overtheperiod 1991-1996, some 95percentofatotal
of599changes intheFDIregimes ofcountries wereinthedirection ofgreater liberalization (UNCTAD,
1997a). Thesituation isnowoneofcompetition overFDI, andthere isgrowing concern about the
costofincentives granted toTNCs. Thisisprima facieevidence thatdeveloping countries nowperceive
FDIasmaking apositive contribution totheirdevelopment. Generally, changes inFDIregimes have
beenpartandparcel ofabroader setofreforms thathasincluded theopening upoftheeconomy to
foreign trade, greater emphasis indevelopment strategies onattaining international competitiveness,
privatization ofstate-owned enterprises, andderegulation.
Theswing inattitudes towards TNCs mayhaveinfactgonetoofar.Attimes, TNCs arenow
being expected singlehandedly tosolve practically alldevelopment problems: improve theavailability
ofscarce capital andforeign exchange, upgrade exports, transfer newtechnologies, helpimprove income
distribution, andincrease employment. While TNCs cancontribute tothedevelopment effort, there
arethings theycandoandothers thatfallbeyond theirken. Moreover, thequantity andquality of
FDIandthecontribution thatTNCs make todevelopment depend alsoonthepolicy environment in
hostcountries and,more importantly, theproductive assets available locally. Onthepolicy side,this
4Foracomprehensive review oftheroleofTNCs indevelopment, see,UNCTC (1988), Lall(1993), Dunning
(1993a), andCaves (1996, Chapter 9),aswellastheindividual volumes oftheWorld Investment Report Series
(UNCTC, 1991 and1992c; UNCTAD, 1993a, 1994a, 1995a, 1996a and1997a) andthevolumes oftheUnited
Nations Library onTransnational Corporations .WT/WGTI/W/8/Add.1
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goeswellbeyond mere liberalization ofFDIregimes toinclude policies related totrade, exchange
ratesand,generally, macroeconomic stability. Deliberate efforts toimprove human capital andthe
physical andsocial infrastructure arealsoindispensable inorder toenhance thequality ofFDIthat
countries canattract.
Liberalization hastaken place inallaspects ofpolicies related toFDIandTNC activities.
Ithasgonefarthest inLatin America, perhaps because policies inseveral countries inthatregion used
tobethemost restrictive before therecent changes. Now there arefewrestrictions leftonFDIor
thelicensing oftechnology. However, theliberalizing trend isalsostrong inAfrica andAsia.
Inmost developing countries, TNCs arenowallowed tooperate inmost industries ofthe
economy.Inaddition,limitationsonprofitremittancesandtherepatriationofcapitalhavebeengenerally
dropped orrelaxed significantly. Thepractice ofimposing performance requirements (UNCTC and
UNCTAD, 1991), oftenasacounterpart fortaxincentives, isalsobecoming lessimportant.5National
treatment andaccess toincentives available todomestic firms hasalsobeenguaranteed inmostofthe
reformed FDIregimes. Infact,some countries arenowgranting affiliates ofTNCs better thannational
treatment, inthesense thattheyarethebeneficiaries ofincentives thatarenotavailable todomestic
producers. Itwasoften thecaseinthepastthataffiliates ofTNCs were denied access todomestic
financial markets, onthegrounds thatthisrestriction forced TNCs tofinance theirinvestments inthe
hostcountry bybringing inscarce foreign exchange; inmany countries these limitations haveeither
beendropped oraresimply nolonger operative.
Theliberalization ofFDIregimes hasbeencomplemented withthesigning ofanincreasing
number ofbilateral investment treaties (BITs). Developing countries havesigned alarge number of
suchagreements -notonlywithdeveloped countries butalsowithother developing countries andwith
countries intransition (UNCTAD, 1996a, pp.134-148). Ofthe1,330 treaties inexistence upto
1January 1997, about two-thirds hadbeensigned inthe1990s (180in1996alone) (UNCTAD, 1997a).
Inaddition, most regional integration agreements nowcontain investment clauses.
Asthelocational advantages ofdeveloping countries areperceived tohaveimproved, TNCs
maybeengaged inaprocess ofstock adjustment tohigher levels ofdesired FDIwhich could lead
tosignificant FDIinflows intodeveloping countries foranextended period. Atthesame timethat
theliberalization moves described haveoccurred, FDItodeveloping countries hassoared: FDIinflows
todeveloping countries rosefromanaverage of$20billion annually during 1983-1988 toanaverage
of$95billion in1994-1995, toreach $129 billion in1996. Asshown inAnnex table 1,theshare
ofalldeveloping countries, andofAsian countries inparticular, intotalFDIhasgrown significantly
sincethemid-1980s: Asian countries arenowreceiving upto24percentoftotalFDIinflows, compared
withjust11percentinthe1983-1988 period. Latin American countries, ontheother hand, sawtheir
share oftotalFDIinflows decline sharply inthe1980s, owing totheprotracted economic crisis of
mostcountries intheregion. During the1990s, FDIhasreturned substantially toseveral countries
inLatin America. Reflecting thisriseinFDIflows, theratioofFDIinflows togross fixed capital
formation (GFCF) indeveloping countries isnowmore thantwice thatofdeveloped countries -8.2per
centascompared with4.4percentin1995 (UNCTAD, 1997a).
5Performance requirements thataffect trade (trade-related investment measures, orTRIMs) areprohibited
under World Trade Organization (WTO) rules. These include local content andtrade-balancing requirements
(UNCTAD, 1996a, p.151). There areother performance requirements thatarenotprohibited byWTO.
Nonetheless, developing countries have tended torelylessandlessonthem, partly inthehope ofattracting
additional FDIinflows.WT/WGTI/W/8/Add.1
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Theflows ofFDIhavetended toconcentrate inafewAsian andLatin American countries.
InthecaseofAsia, inflows intoChina loom large: China 'shugemarkets andtheavailability ofskilled
butlow-wage labour hasbeenveryattractive toTNCs. Since theopening upoftheChinese economy
toinward investment, FDIinflows havesurged, andthecountry nowreceives around 12percentof
world inflows. These flows arelargeevenbythestandards oftheChinese economy. They haverisen
from 0.6percentofGDP in1983-1988 toover7percentinthemid-1990s.
Butinvestment inother Asian countries hasalsobeenlarge, representing, inthecaseofsome
EastandSouth-East Asian countries, anintensification oftrends thathavebeeninoperation since the
early 1980s. During the1990s, there havebeensharp increases inFDIflows toIndia, Indonesia,
Malaysia, Pakistan, Philippines, Republic ofKorea andSingapore. Very recently, FDIinflows have
beenrising significantly inother countries aswell(e.g., VietNam andSriLanka). Theregion 's
economieshavereceivedinvestmentsnotonlyfromTNCsbasedintraditionalhomecountries(especially
Japan), butalsofrom TNCs from theregion itself, inparticular from, among others, theRepublic
ofKorea, Hong Kong, Special Administrative Region ofChina, andSingapore.
Several countries inAsiaarebeing drawn intoapattern ofoutward-oriented growth ledby
TNCs, particularly fromJapan. Asfirms fromthedeveloping countries intheregion improve their
owncompetitive andtechnological capabilities, theyhavealsobegun toassume aleadership role.
Themost important traitofthispattern ofdevelopment isthatitisoriented towards theacquisition
ofnewcomparative advantages onworld markets. Thishasrequired highratesofinvestment toGDP,
aswellasaccess tointernational markets (UNCTAD, 1995a, Chapters IVandV);TNCs havehad
asignificant roleinthisrespect inseveral ofthecountries oftheregion. Infact,thegrowing degree
ofeconomic integration achieved within theregion andthepattern ofgrowth thathasemerged (the
so-called"flyinggeeseformation")hasbeenbroughtaboutmainlybyFDI(UNCTAD,1995a,ChapterV;
Ozawa, 1992).
Asregards Latin America, FDIhasresponded favourably totheimproved macroeconomic
conditions oftheregion.6Asurvey ofTNC affiliates inArgentina, Chile andColombia revealed that
executives attached thehighest importance tomacroeconomic stability asareason impelling their
companies toinvest intheregion (Agosin, 1996). Thecountries receiving thelargest inflows have
beenArgentina, Mexico, Brazil (since 1994), Chile, Peru(alsosince1994), andColombia. However,
several smaller recipients (e.g,Bolivia, Ecuador, Paraguay, andCosta Rica) havealsoexperienced
sharp increases ininflows ofFDI(seeECLAC, 1997, p.17).FirstinArgentina andmore recently
inBrazil,inflationhasbeenbroughtundercontrolandgrowthhasresumed,albeitwithsomefluctuations.
Special conditions havealsobeenpresent. Inparticular, privatizations ofpublic utilities andother
state-owned firms haveattracted large inflows ofFDI. InBrazil, privatization isjustbeginning and
maybeexpected toinduce large inflows ofFDIonceitgetsunder way.
NAFTAhasbeenanimportantfactorinfluencingFDIinMexico.SeveralTNCshaveestablished
orupgraded production thereinorder totakeadvantage oftheenlarged market provided byMexico 's
membership inNAFTA. Ashare ofFDIinflows intoArgentina hasalsoresponded tothepullofthe
larger market provided bythecountry 'smembership inMERCOSUR (together withBrazil, Uruguay,
andParaguay). InChile there hasbeenalongupswing inFDI, mainly inmining andother natural
resource-related industries, dating backto1987. Adebt-equity swapprogramme thatoperated between
1985 and1990 started theupsurge andattracted theattention ofinvestors. Thecountry 'srecent
association withMERCOSUR islikely toencourage investment inmanufacturing forthatmarket.
6Foranin-depth analysis ofFDItrends inLatin America andtheCaribbean, seeECLAC (1997).WT/WGTI/W/8/Add.1
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While itistruethatFDIinflows areheavily concentrated inafewhostdeveloping countries -
the18countries shown intable1accounted forover80percentofthetotalFDIinflows intodeveloping
countries in1995 -itisalsothecasethatmany small countries areabletoattract large andgrowing
FDIinflows relative tothesizeoftheireconomies .Forexample, inflows intoAfrican countries as
awhole, relative toAfrican GDP, areabout thesameorder ofmagnitude asflows todeveloped countries.
Insomecountries where theabsolute magnitudes ofFDIaresmall -suchasAngola, Bolivia, Costa Rica,
Gambia, Ghana, Nicaragua, Seychelles, andZambia -theratioofFDItoGFCF isbetween 15and
70percent(seeUNCTAD, 1996a, annex table5;andECLAC, 1997, p.23).Nonetheless, thefact
remains thatAfrican countries havebeenunable toattract FDIintheamounts thattheirgovernments
woulddesire.Inabsoluteterms,FDIintoAfrica-andintootherlow-incomecountriesinLatinAmerica,
AsiaorthePacific -havelargely stagnated. Theproblems thatmake these countries lessattractive
toforeign investors arewell-known: pooreconomic performance, inadequate legalframeworks for
business, inadequate human resources, unstable domestic economies andpolitical systems, weak
institutions, small domestic markets, andpoorinfrastructure. Governments inAfrica areacutely aware
ofthese problems andhavemade efforts toovercome them (seeUNCTAD, 1995b).
Animportant aspect ofthesurge inFDIduring the1990s istheimpressive increase inoutward
investment byTNCs based indeveloping countries themselves, mostly butnotexclusively inother
developing countries. Whereas approximately 6percentofallFDIoutflows originated indeveloping
countries in1983-1988, thisshare wasalmost 14percentin1995-1996 (seeAnnex table2).
South, East, andSouth-East Asian firms account forthebulkofthese outflows. Inthese
countries, asalready noted, thelongswing inexport-oriented growth hasledtotheemergence ofstrong
TNCs thatinvest inothercountries oftheregion andinfinalmarkets indeveloped countries (UNCTAD,
1997b). Infact,forsome ofthese countries, FDIoutflows arenowrelatively more important than
forthemajor home countries ofTNCs. Theratioofoutward FDItoGFCF inthe1990s hasaveraged
over9percentinSingapore andnearly 6percentinMalaysia. Thisratioishigher thantheonefor
developed countries, which hasremained atabout 5percent(UNCTAD, 1997a, Annex Table B.5).
Some Latin American firms havealsobegun tomake largeinvestments abroad, mainly inother
countries intheregion. Companies thathavedeveloped firm-specific assets haveledtheprocess.
There havealsobeeninstances ofinvestment infinalmarkets fortheexports oftheinvesting firms
andanembryonic trend towards integrated production forregional markets, particularly inthecontext
ofMERCOSUR.Thesetrendsinoutwardinvestmenthavecontributedtothechangesinattitudestowards
FDIandTNCs inthecountries concerned.
II. EFFECTS OFTNCs ONDEVELOPMENT THROUGH TRADE
Thissection discusses therelationship between TNCs andtrade andtheeffect ofTNCs on
growth anddevelopment through trade. Foreign direct investment hasbeenconventionally regarded
asasubstitute oralternative totrade. Thus thefirstquestion thatneeds tobeaddressed relates tothe
relationships thatexistbetween FDIandtrade.
Inthemanufacturing sector, thesequence thatfirms have usually followed intheir
internationalization isthattheyfirstexport aproduct tooverseas markets and,atalaterstage, begin
producing itinthose markets (UNCTAD, 1996a, Chapter III).Thisisbecause tradeislessrisky than
FDI,partly because itinvolves lesssunkcosts. Asaforeign market becomes consolidated, FDImay
become desirable, firstinsmall amounts andinancillary activities (trading services, storage, repair,
after-sales servicing) andlaterinthefullproduction oftheproduct. So,ifthesequence holds, the
direct effects ofFDIaretrade-replacing asfarasanygiven product isconcerned. Thisisofsome
concern forhome countries andfortheirlabour unions, whosometimes tendtooppose outward FDIWT/WGTI/W/8/Add.1
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onthegrounds thatitleads tojoblosses. However, eveninthiscase, FDImayhavepositive indirect
effects ontrade andfurther investment flows, asitmaygiverisetoastream ofexports ofinputs,
intermediate goods, machinery, andservices. So,eveninthemanufacturing sector, theneteffect of
FDIontrade maywellbepositive.
Inrecent decades, there havebeeninvestment flows todeveloping countries thatarerelated
directly totheuseofthose countries asexport platforms formanufactured goods. Astrade and
investment barriers fall,suchexport-oriented investments maywelloutweigh those thataremade just
toservice thedomestic markets ofthehostcountry, increasing thelikelihood ofpositive effects of
FDIontrade. More generally, withtheriseofintegrated international production, tradeandinvestment
arenowlinked incomplex ways andareincreasingly jointly determined bythelocational decisions
offirms (UNCTAD, 1996a, Chapter IV).Although itisdifficult topredict onanapriori basis what
thenettrade effects ofFDIwillbe,itisverylikely thatunder suchconditions FDIinmanufacturing
willgiverisetotrade flows from hostandhome countries thatwould nothavetaken place without
it.
Inthecaseofnatural resources, FDIhasalways ledtotheexpansion oftrade. Infactforeign
investment hasoften beenaprecondition fortrade onalarge scalebymany resource-based countries
andisclearly trade creating. Ontheother hand, intheservices sector, there aretechnical barriers
tocross-border trade, asmany services canbedelivered toforeign markets onlythrough FDI. However,
investment insuchservices often create newflows ofimports ofgoods andtradable services intothe
hosteconomy.
Thepresumption ofthissection isthat,formostdeveloping countries, tradehaspositive effects
onlong-term growth.7There aretwoimportant reasons tobelieve that,ceteris paribus ,more open
economies (i.e., those possessing larger shares oftrade toGDP) cangrow faster thanmore closed
economies. Thefirstoneisrelated tomarket size. Whereas mostdeveloping countries haverelatively
small domestic markets, bothbecause oflowpercapita income and/or small populations, international
markets fortheproducts actually orprospectively produced byindividual developing countries are
unlimited, withtheexception ofcountries withlarge market shares insome primary commodities.
Thesecond reason isthat,inmostdeveloping countries, investment andproductivity growth arehighly
dependent onimported capital goods andtechnology. Thismeans thatinvestment andtechnology
acquisitiondependultimatelyonthecapacitytogenerateforeignexchange.Inordertoensureasustained
riseintheinvestment rateandhighproductivity growth, asteady expansion inexports isrequired.
Given thecharacteristics ofdeveloping country exports, which tendtobeconcentrated inoneora
fewcommodities withlowprice andincome elasticities ofdemand inworld markets, theonlyway
toachieve highandsustained ratesofexport growth without deteriorating terms oftrade isthrough
export diversification.
7Thisisafairly recent notion. Advocates ofimport substitution haveargued infavour oflimiting trade flows
inorder todevelop domestic industries. Asmodern economic history hasshown, thisview, however unpopular
today, hasconsiderable merit: practically allcurrently industrialized nations ofsignificant economic sizewent
through animport-substituting phase thatallowed them toreapeconomies ofscale andgreater degrees oftechnical
efficiency through learning bydoing which eventually transformed them intoexporters ofmanufactures. This
istheclassical argument fortemporary infant industry protection, anditstillholds forafewlarge developing
countries. (Foramodern version ofthisargument, seeRodrik, 1992.) Most developing countries, however,
aretoodependent oninternational trade tobenefit from protection.WT/WGTI/W/8/Add.1
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A. Direct effects ofTNCs ontrade
What doTNCs havetodowithallthis? Theactivities ofTNCs, bothoftheFDIvariety and
alsomore arm'slength relationships between TNCs andfirms indeveloping countries, havesignificant
effects ontradeflows. Inorder tounderstand thewaysinwhich TNCs andFDIaffect trade, onemust
distinguish between different types ofFDI(andotherTNCactivity) according tothedifferent objectives
ofTNC involvement indeveloping countries. Broadly speaking, onecandistinguish between natural
resource-seeking investment, market-seeking investment, efficiency-seeking investment, and
strategic-asset-seeking investment.8
Natural resource-seeking FDIistheoldest formofTNC involvement indeveloping countries.
Itisundoubtedly trade-creating ontheproduction (oroutput) side: FDIisoften aprecondition for
theproduction ofprimary commodities forforeign markets, especially indeveloping countries, and
generates astream ofexports ofnatural resources thatwould nothaveotherwise occurred. From the
sideofinputs used andconsumption generated, there arealsopositive trade effects, since
natural-resource-oriented FDIisusually accompanied byaflowofimports ofcapital goods, specialized
intermediate inputs, andconsumer goods.9
Market-seeking FDIbecame thepredominant motive forinvesting inthemanufacturing sector
ofdevelopingcountriesinthe1960sand1970sduringtheheydayofimport-substitutionindustrialization.
Thismotivation alsowasparamount inthewave ofUnited States investments inEurope intheearly
postwar period andinJapanese investment intheUnited States since theearly 1980s. Generally,
market-seeking investment inmanufacturing isagross substitute forexporting fromthehome country,
anditsexistence hasarisen mainly fromimport barriers inhostcountries. Ithastrade-reducing effects
ontheproduction side,buttrade-creating effects inasfarasinputs usedinproduction areconcerned,
since import substitution leads toachange inthecomposition ofimports towards intermediate inputs
andcapital equipment. Itispossible forthetotallevelofimports toremain unchanged or,insome
cases, eventoincrease (export growth andcapital inflow permitting). Anymarket-seeking investment
willalsonormally havemultiplier effects ondomestic demand andproduction, which could leadto
significant indirect increases inimports.
There arecauses other thantrade barriers formarket-seeking investment. Insome cases,
significant transport costsmaymake investment inahostcountry anefficient alternative toexporting
toit.Differences inconsumer tastes andtheneedtoadapt aproduct tolocalconditions andinputs
mayalsorecommend catering tothedomestic market through investment rather thanexporting. In
these cases, market-seeking FDIhasnotrade effects inproduction (since itdoesnotreplace exports)
andpositive effects inconsumption. Indirect effects ontrade arealsopositive.
Recently, theformation orstrengthening ofregional groupings hasgiven risetosignificant
investments inorder toserve theenlarged markets oftheintegration schemes.10Thishasbeenmost
evident inthecaseofNAFTA, where therehavebeenlargeinvestments inMexico fortheUnited States
markets (both byUnited States-based TNCs andbyTNCs fromotherhome countries, especially Japan),
andinEurope, where theSingle Market programme (completed attheendof1992) gaverisetoawave
ofFDIinflows inthelate1980s andtheearly 1990s (UNCTC, 1993). Ithasalsobeeninevidence
8See,forinstance, Dunning (1993b), Introduction; andOzawa (1992).
9Newly hired workers willnormally consume partoftheir wages onimports, although, given thecapital
intensity ofTNC activities inmany natural resources, thiseffect maybesmall.
10These investments reflect notonlythedesire ofTNCs toposition themselves inspecific enlarged markets
butalso, insome cases, tothelocational advantages offered bylow-wage siteswithin those markets.WT/WGTI/W/8/Add.1
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withinvestments byEuropean TNCs (andothers) inCentral andEastern Europe, countries withwhich
theEuropean Union hassigned trade agreements, andinArgentina after theestablishment of
MERCOSUR inthelate1980s. While theseinvestments haveanelement ofinvestment diversion and
mayhavetaken place elsewhere intheabsence oftheintegration schemes, thelarge markets towhich
theyaredirected ensure economies ofscale which wereoften absent inearlier market-seeking FDI.
Thismeans thattheprobability thatmarket-seeking investments mayreduce therecipient country 's
welfare ismuch lower inthese cases thaninthetariff-hopping investments made during the
import-substitution period. Totheextent thattheyleadtoefficient production andtothespread of
suchproduction, theymayturnouttobewelfare-improving when theworld economy isconsidered
asawhole. They undoubtedly raisetherateofgrowth ofrecipient countries when theyincrease their
capital stock.
Inthese cases, investment istrade-creating inbothproduction andconsumption: itgenerates
anewstream ofexports from hostcountries andastream ofimports ofcomponents, inputs, capital
equipment, andservices from home countries.
MuchofFDIinservicesismarket-seeking.Sincemanyservicescanonlybedeliveredtoforeign
markets through FDI,insuchcasesFDIhasnoadverse tradeeffects inproduction andmayhavepositive
trade effects inconsumption byinducing newexports ofmachinery andother services (consultancy
anddesign, forexample) fromthehome country oftheinvesting TNC (UNCTC, 1989; Sauvant and
Mallampally, 1993; UNCTAD andtheWorld Bank, 1994). Itmayhaveindirect, longer-term positive
effects ontheexports ofgoods (orservices) from hostcountries. Forexample, FDIinbanking,
telecommunications, orpublic utilities maylower thecosts ofthese non-traded inputs andrender
internationally competitive hostcountry producers inseveral sectors where noexports hadtaken place
priortotheforeign investments. Thissituation maychange asservices become moretradable (Sauvant,
1990; UNCTAD, 1994b)
Efficiency-seekingFDIoccurswhenTNCsbegintolocatepartoftheirvalue-addedchainabroad
inorder toimprove theprofitability oftheiroverall operations. Theoldest suchinvestments havebeen
labour-seeking investments. Aswages roseinhome countries, TNCs sought toobtain access tolow-cost
labour indeveloping countries through locating inthemthelabour-intensive segments oftheirproduction
processes. Thishasbeenacharacteristic ofJapanese investment inAsia; United States investment
inMexico, Central America, andAsia; andEuropean investment inCentral andEastern Europe.
More recently, asrealwages haverisenovertimeinsome oftheAsian countries firsttoindustrialize
withanoutward-oriented strategy, labour-seeking investment hasmoved ontoother, lower-wage Asian
countries.
Labour-seekinginvestmentsaretrade-creating,sincetheygiverisetoexportsfromhostcountries.
Inmany cases, theyalsoleadtoadiversification inthecomposition ofhost-country exports towards
manufactures. Ontheconsumption side,suchinvestments alsotendtobetradecreating, since alarge
share oftherawmaterials usedinproduction (andacertain proportion ofwage goods) areimported.
Ofcourse, labour-seeking operations ofTNCs indeveloping countries cantakeforms other
thanFDI. Labour-intensive partsoftheproduction process canbeundertaken indeveloping countries
through various contractual arrangements between domestic firms andTNCs (andevenlarge firms
from home countries thatarenot,strictly speaking, TNCs). Allofthese forms aretrade creating.
ThebenefitsofFDIandotherformsofinvolvementbyTNCsinlabour-intensiveindustriesindeveloping
countriesarecloselyrelatedtoassistinghostcountriesinovercominginformationaldisadvantagesrelated
toaccessing markets. Intheabsence ofTNCinvolvement, itmaybeverycostly forfirms indeveloping
countries topenetrate themarkets ofdeveloped countries. Information isbynature opaque andcostly
toobtain. Transnational corporations andbuying groups indeveloped countries provide several kindsWT/WGTI/W/8/Add.1
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ofinformation thatarecrucial tosuccess inthese markets: theyhaveready-made marketing channels
andcontacts withclients anddistributors, andtheyoften supply product design, technology, andkey
inputs.
Thelocation oflabour-seeking operations abroad hasoften beenattacked inhome countries
ofTNC-parent-firms, inparticular bytrade unions, onthegrounds thattheycause unemployment.
Thisneednotalways bethecase, since theycreate aflowofexports ofcomponents, inputs, and
machinery; inaddition, theycreate employment inhighly-skilled services (e.g., design ormarketing).
More thanreducing employment athome, labour-seeking investments change itscomposition towards
higher-wage employment, which causes unemployment atthelower endofthewage scale butraises
thedemand forhighly skilled andhigh-wage labour.
Labour-seeking investments alsooccur intheservices sector. Forexample, dataprocessing,
which isverylabour-intensive, cananddoestakeplace indeveloping countries, where labour costs
arelower thaninthehome country oftheinvesting TNC (e.g., inBarbados). These services canbe
undertaken onbehalf ofaservice ormanufacturing TNC, either byanaffiliate orbyasubcontractee
inadeveloping country.
There areother, more complex forms ofefficiency-seeking investments thatareclosely related
totheemergence ofintegrated international production. Oneincreasingly important formfordeveloping
countries iscomponent outsourcing (UNCTAD, 1995a, Chapter IV).Themaindriving force ofthis
hasbeentheincrease inwages inthedeveloped countries, particularly inJapan andEurope. Thesecular
appreciation oftheyenandtheEuropean currencies vis-à-vis theUnited States dollar hasbeenastrong
incentive forthiskindofFDIbyJapanese andEuropean TNCs wishing toremain globally competitive.
Ithasalsobeenextensively usedbyUnited States TNCs incertain industries, suchasautomobiles,
electronics andpersonal computers, forexample. Themainlocational advantage ofsome developing
countries islowunitlabour costs(related notonlytorelatively lowwages, buthighlabour productivity
aswell). These operations require labour ofgreater skills thanistypical oflabour-seeking FDI.
Therefore, theytendtobeconcentrated intheoutward-oriented andrelatively industrialized developing
countries.
Theextreme form ofcomponent outsourcing isoriginal equipment manufacturing, wherein
afirminadeveloping country undertakes tosupply aTNC withafullymade manufacturing product
thatwillbearthebrand name oftheTNC. Thisisoneoftheforms thatinter-firm agreements have
taken sofarbetween TNCs andfirms indeveloping countries. Several firms from theRepublic of
Korea began their penetration ofmarkets ofdeveloped countries through theproduction of
original-equipment-manufacturing products, which theylaterreplaced withtheirownbrand names.
Besides advantages related toknowledge ofthemarket andtotechnology, TNCs possess service and
distribution systems, which developing country firms would havetosetupfromscratch. Forthistype
ofrelationship tobepossible, thelevelofmanagerial, entrepreneurial andtechnological capabilities
ofthedeveloping country firmmust befairly advanced.
Componentoutsourcinggeneratestradeandrepresentsastepupthe"qualityladder"fromsimple
labour-seeking relationships. Notonlydoesitexpand exports (andimports) butitalsoleads toa
diversification ofexports inthedirection ofmore complex products.
Inbothlabour-seeking andcomponent-outsourcing activities, access tomarkets plays akey
roleasregards thecontribution ofTNCs todevelopment, beitthrough FDIorthrough other contractual
relationships. Besides theinformational advantages ofTNCs, when aproduct istraded within the
network ofaTNC, itmaybelesslikely tobesubject toprotectionist threats thanwhen theexporter
isanindependent developing country firm. There are,infact,specific lawsindeveloped countries
thatfavour theprocessing abroad ofinputs originating intheimporting country (intheUnited States,WT/WGTI/W/8/Add.1
Page12
United States Tariff Schedule 806/7 rules oforigin). Thisprocessing isnormally undertaken bya
subsidiary oftheoriginating company orbyasubcontractee.
Stillanother formofefficiency-seeking FDIishorizontal FDIindifferentiated products; this
islesscommon indeveloping countries andtends tobeassociated largely withinvestment flows (for
example, inautomobiles, computers, chemicals, consumer goods) among developed countries. It
occurs because oftheneedtoadapt products tothetastes orquality requirements ofaparticular market.
These investments require arelatively large market, astheyarerelated tothedemand fordifferent
brands ofasimilar product inindustries thatarecharacterized bysignificant economies ofscale. As
themarketsofdevelopingcountriesareenlargedthroughregionaltradingarrangements,theseinvestments
arelikely tobecome more common inthose countries aswell. Infact,therearegrowing cross-border
investments inthese industries inNAFTA andMERCOSUR. These investments aretrade-creating
andwelfare-enhancing. Therecipient country endsupexporting some brands oftheproduct and
importing others, atlower costtotheconsumer. Welfare increases notonlyowing tolower costs of
production butalsototheavailability ofgreater variety.
Strategic-asset-seeking FDIusually takes place atanadvanced stage oftheglobalization of
afirm'sactivities. Firms, including afewfromdeveloping countries, mayinvest abroad inorder to
acquire research anddevelopment capabilities (e.g., Japanese orKorean investment inmicroelectronics
intheUnited States). Asalready noted, integrated international production involves thelocation of
anycomponent inthevalue added chain where itcontributes mosttotheTNC'sprofitability. Thus
itmaybeefficient forafirmtorelocate design, research anddevelopment (orother highvalue-added
activities) from itshome basetoanoverseas affiliate. Some developing countries are,orcanmake
themselves, abletoattract thiskindofFDIthrough investment inhuman resources andinfrastructure;
forexample, theavailability ofskilled personnel andtherequisite telecommunications infrastructure
havecontributed tothelocation ofresearch-and-development centres andheadquarters 'services by
TNCs inSingapore; software development inIndia; andservice centres forairline reservations in
theCaribbean. These investments aretrade-creating inproduction andconsumption. Forthedeveloping
countries involved, thiskindofFDIistantamount toexporting high-skill labour services. Anditusually
gives risetoexports ofservices andequipment from TNC-home countries.
B. Indirect trade effects
Thetradeeffects ofFDIdonotstophere. There arealsoindirect effects through theexchange
rateandtheavailability offoreign exchange. Balance-of-payments effects figured prominently inthe
literature onFDIinthe1970s (see,forexample, LallandStreeten, 1977; Gray, 1993; andUNCTAD,
1997a, Chapter II,forasummary ofempirical findings), mainly because mostdeveloping countries
(with theexception ofoilexporters) faced abinding foreign exchange constraint togrowth. Therefore,
countries wereinterested inFDInotonlyforitsmore direct contribution todevelopment, including
throughthetrade-effectsdiscussedabove,butalsofortheadditionalimportsthatitmadepossiblethrough
therelaxation oftheforeign exchange constraint. Inaddition, itwassoonrealized that,since FDI
inflows eventually giverisetooutflows ofprofits, theoutflows could eventually belarger thanthe
inflows. More precisely, theissue revolves around thecomparison between theinflow offoreign
exchange associated withaninvestment project andthepresent value offuture outflows ofprofits,
using asthediscount factor theinternational interest rateatwhich thecountry canborrow. Normally,
onecanexpect thatdiscounted future outflows willbelarger thanthecapital originally invested, since
profit rates, particularly indeveloping countries, arewellabove international interest rates.
However, aninvestment project mayhaveother balance-of-payments effects thatmustbetaken
intoaccount: itmaygenerate netexports oritmaysaveforeign exchange bysubstituting domestic
production forimports. Bycontrast, investments innon-tradable products (most services, construction)
usually havenegative balance-of-payments effects, since mostsuchprojects require imported inputsWT/WGTI/W/8/Add.1
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andneither generate norsaveforeign exchange ontheoutput side.11Thisprovides arationale forthe
preference ofdeveloping countries forFDIinexport sectors.
Theevaluation ofthebalance-of-payments effects ofFDIdepends crucially onthemostlikely
counterfactual: whatwould havehappened intheabsence oftheFDI(LallandStreeten, 1977)? Would
theactivity have been undertaken byadomestic firm, perhaps under licence toaTNC orina
subcontractual relationship, ornotatall?Andthisis,ofcourse, amatter ofconjecture. Theissue
isnowlesspressing, as,inthepresent times ofmuch higher international capital mobility, growth
indeveloping countries isnotasconstrained byforeign exchange availability asitwasinthe1970s
and1980s. Thisisnottosaythatbalance-of-payments effects areunimportant forallcountries or
thattheycould notbecome important again inthefuture (seeUNCTAD, 1997a, Chapter II,pp.85-94).
FDImayalsobeexpected tohaveanimpact ontherealexchange rateand,through thischannel,
onfuture trade flows. Normally, allincreases incapital inflows, nomatter ofwhat typeorwhere
invested, willappreciate theexchange rate,12simply because itraises thesupply offoreign exchange
andthereby lowers itsrealprice. Putinanother way,capital inflows imply anincrease inabsorption
andariseindomestic demand, which bidsuptheprices ofnon-tradables, while (insmall countries)
theprices oftradables remain constant.13
Itisimportant todistinguish between theshort-term (or"impact") effect andlong-run effects
ofFDIontherealexchange rate. Thetotaleffect canbeobtained byadding botheffects. Asalready
noted, theimpact effect ofallcapital inflows istoappreciate theexchange rate. However, FDIhas
lessofanimpact effect ontheexchange ratethanother purely financial types offoreign capital inflows,
since asignificant share ofFDItakes theform ofimported capital goods. Over time, thelong-run
effect ontherealexchange ratewilldepend onthesectoral allocation ofFDI. Ifforeign capital is
invested primarily intradables, theadditional generation orsaving offoreign exchange willappreciate
theexchange ratefurther. Thisisparticularly thecasewhen theinvestment projects involved raise
productivity. Ontheother hand, FDIintonon-tradables increase theirsupply (andoften productivity)
andlowers theirrelative price, thereby counteracting theimpact effect ofthecapital inflow towards
appreciating therealexchange rate. Experience hasshown, however, that,inpractice, theimpact
effect dominates long-term effects andtheexchange ratetends toappreciate when there isasurge in
FDI, regardless ofthesector towhich itgoes.
Theseconsiderationsareparticularlyimportantforsmallcountriesthatsuddenlybecomeattractive
asinvestment sitestoTNCs. When locational advantages areperceived tohaveimproved markedly,
thecapital stocks desired byTNCs inaparticular country mayexperience adramatic increase, leading
toverylarge inflows ofFDIforaperiod thatcanbequite protracted. Thismaycause asignificant
realappreciation ofthecurrency, discouraging exports. Thisisthedisadvantage ofbeing small in
ahugeinternational capital market. Since non-traditional exports, being recent entrants intotheexport
basket, arelocated atthebottom wrung ofthecomparative advantage ofacountry 'sexports, theyare
thefirsttobediscouraged. Thiscanbeharmful forcountries basing theirdevelopment strategies on
11Asalready noted, some FDIinservices mayhaveindirect positive effects onfuture production oftradables
byimproving thehosteconomy 'ssystemic competitiveness.
12Thenominal exchange rateisdefined astheprice indomestic currency ofoneunitofforeign currency;
therealexchange rate, astheratio oftheprices oftradables tonon-tradables.
13Inoneextreme case, therealexchange rateremains unchanged: thatiswhen theCentral Bank fixes the
exchange rateinnominal terms andsucceeds insterilizing completely theeffects ofcapital inflows onthemoney
supply. Inpractice, most, ifnotall,episodes ofcapital inflow have ledtoexchange rateappreciation.WT/WGTI/W/8/Add.1
Page14
export diversification. However, itdoesnotmean thatFDIisundesirable; itdoesmean that,insome
cases, itmayneedtobephased inataslower ratethantheratedetermined solely bymarket forces.
C. Transfer pricing
Transfer pricing atartificial values oftransactions conducted within TNCs -between parent
companies andtheirforeign affiliates andamong thelatter -usedtobeaserious concern ofhost
developing countries inthe1970s (Plasschaert, 1993). Atthetime, profit remittances wereseverely
restricted, andprofit taxratesinhostcountries wereoftenhigher thanthose applied inhome countries.
Itisoflessconcern nowthatforeign affiliates canremit profits withgreater easeandthatincome tax
ratesonforeign company profits havetended todecline inmostdeveloping countries, which nowusually
apply national treatment toTNCs ontaxmatters.
Nonetheless, theissueisstillimportant. Ifforeign companies areabletoextract theirprofits
from hostcountries viaintra-company transactions atartificial prices, thebenefits ofFDItohost
economies areaccordingly reduced. Incentives maystillremain fordoing so,especially incountries
thathavenotsigned double taxation treaties withhome countries ofTNCs. Also, insome developing
countries, corporate taxesarehigher thaninthehome countries ofinvesting TNCs. Themore complex
therelationships between parent firms andforeign affiliates, thegreater aretheopportunities forabusive
transfer pricing. Suchrelationships caninclude loans fromparent firms totheiraffiliates, management
andconsultancy contracts, technology licensing arrangements, purchases ofinputs, andsales (or
purchases) ofcomponents to(from) parents orfrom affiliates inthirdcountries.
Thesigning ofdouble taxation treaties goesalongwaytowards solving theproblem, because
itremoves mostoftheincentive forabusive transfer pricing. Thisisespecially sointhecaseofhost
countries whose corporate income taxratesarelower thanthetaxratesofhome countries: witha
double taxation treaty, profit taxes paidinthehostcountry arecredited against thetaxliability ofthe
parent company athome. However, insome developing countries corporate taxratesarehigher than
inthehome countries ofTNCs, inwhich casedouble taxation treaties maynotbeenough todissuade
affiliates fromtransferring profits totheirparents through abusive transfer pricing practices. Moreover,
some TNCs channel partoftheirprofits through taxhavens, inwhich casedouble taxation treaties
areuseful forneither hostnorhome country. Thebasic dilemma isthatTNC activities areglobal
andtaxing authorities areatbestnational.
D. Concluding remarks
Alltold,under current conditions ofincreasing globalization andtrade liberalization inmost
developing countries, FDIandother forms ofTNC activity areprobably trade-creating bothonthe
production sideandthatofconsumption. Surely, onecanfindcases where thisisnotso.But
trade-replacing FDIisprobably rare,except when tradebarriers actasaninducement forFDI. Foreign
direct investment andTNCactivity increasingly tendtoconcentrate onproduction forglobal orregional
markets. FDIinservices isalsoveryimportant, butitisalsolikely tobetradecreating andtoenhance
thecompetitiveness ofdeveloping country exports inthelongrun.Thetransit fromshallow todeep
integration andtheemergence ofintegrated international production insome industries hastightened
therelationship between trade creation andFDI.
Small countries mayneedtoguard against toomuch FDItooquickly. Ashasbeenremarked,
"therestoftheworld 'spockets areverydeeprelative toasmall economy 's...absorptive capacity"
(Dornbusch andEdwards, 1994, p.103). Flows ofFDIthataretoolargefortheabsorptive capacity
ofahosteconomy appreciate theexchange rateandruntheriskofretarding outward-oriented
development. Policies tosmooth outFDIstock adjustment overtimemaybeinorder, especially in
countries thatsuddenly become veryattractive assitesforforeign investment.WT/WGTI/W/8/Add.1
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Thedangers oftransfer pricing havediminished asforeign exchange constraints indeveloping
countries haveeased andcorporate taxrateshavefallen. Buttheyhavenotdisappeared altogether,
andtheissue needs tobefollowed closely atthenational andinternational levels. Inthemeantime,
itisimportantthatdevelopingcountrylegislationonFDIincludeclearaccountingrulesregardingtransfer
pricing.
III. DIRECT EFFECTS ONDEVELOPMENT
Theimpact ofTNCs andFDIondevelopment ofcourse doesnotstopattheirlinkages with
trade.14Ontheonehand, bytheirverynature, TNCs possess valuable resources thatareonlyvery
imperfectly tradable onmarkets. These resources usually have growth-enhancing characteristics:
technology, management know-how, skilled labour services, access tomarkets. Inaddition, TNCs
canmake acontribution togrowth inamore traditional manner through raising theinvestment rate
andexpanding thestock ofcapital located inacountry. Ontheother hand, TNC activity canhave
adverse effects ondevelopment precisely forthesame reasons: where acountry isineffect ableto
develop indigenous resources, theverypresence ofTNCs caninhibit theiremergence; thisisthe
traditional argument infavour ofrestricting FDItothose activities thatcannot bedeveloped bydomestic
entrepreneurship. Liketheinfant-industry argument forimport substitution, thisposition canbelabelled
the"infant entrepreneurship argument" (foranargument along these lines, seeBruton, 1988).
A. Savings andinvestment
There hasbeenanunsettled controversy about theeffects ofcapital inflows onsavings and
investment thathasraged since theearly1970s (see,e.g.,Weisskopf, 1972) andthathasbeenrevived
recently. Inthe1990s, large capital inflows intoseveral developing countries havenotgenerally led
toincreases intotalinvestment. Infact,inmany countries thathaveexperienced surges offoreign
capital, investment hasremained unchanged anddomestic saving hasfallen (Agosin andFrench-Davis,
1996). Ifforeign savings merely crowds outdomestic savings withnochange intheinvestment rate,
theusefulness offoreign capital forcapital formation, akeyfactor indevelopment, canbequestioned.
Clearly, FDIisaparticular formofforeign capital. Thechannels through which capital inflow
candiscourage domestic saving arefairly wellunderstood: ifexchange-rate appreciation ensues, it
encourages consumption andmayalsorelaxliquidity constraints totheconsumption ofdurables, since
animportant portion ofcapital inflow isintermediated bythebanking system; if,inaddition, capital
inflow causes stock market andrealestate booms, thewealth effects onconsumption canbequite
significant. However, FDIislesslikely thanother kinds ofcapital inflows tohavetheseeffects because
itisassociated withrealinvestment. Asalready noted, FDIputslessdownward pressure onthereal
exchange ratethandoother forms ofcapital inflow. Indeed, ithasbeenobserved thatcountries where
FDIdominates capital inflows haveexperienced moresignificant increases ininvestment thancountries
where capital inflows have been mostly ofthefinancial variety (compare theAsian exporters of
manufactures andChile, ontheonehand, withArgentina, Brazil, orMexico, ontheother).
Thepointhasfrequently beenmade thatFDIislikely tohavemore favourable effects oncapital
formation when ittakes theform ofgreenfield investments thanofmergers andacquisitions, which
nowaccount fornearly halfofworld FDIflows (UNCTAD, 1997a). Thisisquestionable. When
adomestic firmispurchased byaTNC, theproceeds willoften beusedtomake other investments,
either ofafinancial orrealnature. Asfarascapital formation isconcerned, theultimate transformation
14AnexcellentsurveyofthesubjectiscontainedinCaves(1996,Chapter9).Lall(1993)providesacompilation
ofimportant articles written over theyears, with anintroductory overview. UNCTC (1992c) contains an
examination oftheeffects ofTNC activities ongrowth through capital formation, technology, human resource
development andenvironmental quality.WT/WGTI/W/8/Add.1
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oftheproceeds ofthesaleofanexisting firmintorealinvestment, consumption, ortheaccumulation
offoreign assets iswhatreally matters. Andthiswilldepend ondomestic economic policy more than
onwhether theforeign investment represents animmediate addition tothecountry 'scapital stock.
Firms often prefer mergers andacquisitions when entering aforeign country because, through the
purchase ofanexisting firm, theforeign company buysintoanongoing concern anddoesnothave
tostartdenovo.However, thepurchase ismore often thannotfollowed bysequential FDI(i.e., by
investments inmodernization andcapacity expansion) which isoften larger thantheoriginal purchase
(UNCTAD, 1995a).15
Thecapital contribution ofFDImaybeparticularly important inprivatizations, which usually
alsorequire significant sequential investment inorder tomake privatized firms profitable. Privatized
firms areoftenverylarge, andsufficient capital resources areusually notavailable todomestic groups.
Even thelatter'sborrowing capacities oninternational capital markets maynotbelarge enough for
theamounts normally involved. Thisisalsothecasewithinvestments inmining. Domestic firms
(even state-owned) having theknow-how tooperate mining concerns maynothaveaccess tothehuge
amounts ofcapital required bythisverycapital-intensive activity. Thatiswhysome countries have
sought theparticipation ofconsortia ofTNCs intheexpansion oftheirmining investments.
Itissometimes claimed thatFDIleads tohome country investment levels thatarelower than
those thatwould haveoccurred initsabsence, andthatthisistantamount toexporting jobsabroad.
Theissueathandisabout thecounterfactual toFDI: ifinvestment abroad hadnottaken place, would
thefirmhaveinvested thesame amounts athome? Theanswer tothisquestion isnotstraightforward.
Iftheforeign investment hadnotbeenprofitable, neither might ithavebeentoinvest athome. And
foreign direct investments canstimulate upstream ordownstream investments inthehome country.
Thesame considerations apply toFDIoutflows from developing countries.
B. Technology transfer andinnovation
Perhaps themostimportant contribution thatTNCs canmake tohostdeveloping countries is
intheareaoftechnology.16Almost bydefinition, developing countries lagbehind developed countries
asregards thegeneration andapplication oftechnology. Thesame goods areproduced indeveloping
countries withtechnologies thatareoutdated indeveloped countries; andsome goods arenotproduced
atall,because thetechnological know-how isnotavailable indeveloping countries. Since technology
isanon-rival good, inthesense thatitsuseorconsumption doesnotdiminish itsvalue foranother
agent, thehugetechnological gapbetween developed anddeveloping countries needs tobeexplained.
Contrary towhatneoclassical growth models postulate (e.g., Mankiw, 1995), technology isnotafree
goodthatisclearly specified andreadily available forusebyanyfirmanywhere. Inimportant respects,
technological assets contain atacitelement thatisnoteasily transmittable orreplicable inanother
environment.
Inaddition, technology markets areopaque andsubject toinformational failures. Buyers have
adifferent setofinformation thansellers. Ifbuyers knew exactly whattheywerebuying, theywould
notneedtomake thepurchase, since theywould already know thetechnology. Ontheother hand,
sellers havestrong incentives towithhold information frombuyers. Firms tendtoguard carefully their
technological assets, since theycanbecopied andusedbyothers whohave notinvested intheir
development. Thisisallthemore soincountries withpoorly developed intellectual property regimes.
15Forthecases ofArgentina andChile, seeChudnovsky, López, andPorta (1996) andRiveros, Vatter, and
Agosin (1996), respectively.
16Accordingly, thissubject hasbeendealt withinseveral United Nations studies. See,forexample, UNCTC
(1987), UNCTC (1990a), UNCTC (1990b), andChen (1993).WT/WGTI/W/8/Add.1
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Theutilization ofideasalsorequires human capital thatiscapable ofdoing so,andthisisaparticularly
scarce resource indeveloping countries.
AlargeproportionofallinnovationtakesplacewithinTNCs(UNCTAD,1995a,ChapterIII.B).
There areseveral reasons forthis. Inthefirstplace, research anddevelopment involves large sunk
costs andtherefore require large markets tobeprofitable. Onecantherefore expect research and
development tobeconcentrated inlargefirms, andincertain areas suchasbiotechnology, instrategic
partnerships andalliances among large firms (Mytelka, forthcoming). Transnationality and
research-and-development expenditures arealsohighly correlated, withcausal links running inboth
directions. Ontheonehand, proprietary technology figures prominently among theintangible assets
thatimpel firms toinvest abroad through equity participation aswellasnon-equity arrangements (e.g.,
licensing, franchising, turnkey operations). Ontheother hand, transnationality enlarges themarket
overwhich thefirmcanexploit technological assets andisastrong incentive toundertaking research
anddevelopment. Ashasbeenargued, since ideas arenon-rival goods withessentially zeromarginal
costsofproduction, monopoly rentsgenerated bythem--and,therefore, theincentive toproduce them -
arestrongly correlated withthesizeofthemarket overwhich theycanbedeployed (Romer, 1993).
TheseconsiderationsindicatethatFDIcanmakeanimportantcontributiontotechnologytransfer
andtodomestic innovation. Indeed, thetechnological contribution ofFDIhasthree aspects (Romer,
1993). Inthefirstplace, itcaninvolve theintroduction ofanewtechnology notpreviously inuse
inthedomestic economy and,therefore, theproduction andconsumption ofanewgood. Second,
aforeigninvestmentwithatechnologicalcomponentusuallyrequirestheintroductionand/ordevelopment
ofnewhuman skills needed tooperate thetechnology (with theattendant externalities). Third, domestic
innovation depends onthenumber ofideas thatareavailable intheeconomy. Thus theintroduction
ofanewideaincreases thestock ofideas andstimulates domestic innovation.
Ofcourse, FDIneednotautomatically make atechnological contribution. Insome cases, it
orientsitselftoactivitiesforwhichtechnologiesarealreadywell-knowninthehosteconomy.Moreover,
ithasnotbeenunusual forTNCs inthepasttocontinue toderive rents from outdated technologies
indeveloping country operations. Domestic policy clearly caninfluence theextent towhich FDImakes
atechnological contribution. Pureimport-substitution policies mayencourage TNCs toundertake
market-seekinginvestmentsthatfailtoincorporatestate-of-the-arttechnologies.Export-orientedpolicies,
ontheother hand, aremore likely toencourage theintroduction ofthemost advanced technology.
Thedegree ofdiffusion tothehosteconomy isimportant when evaluating thecontribution
ofFDItotechnological upgrading. Diffusion refers toanimportant (though nottheonly) form of
externality connected withtechnology. Ifthere were nodiffusion atall,thedevelopmental effects
ofFDI, evenwhen introducing newtechnologies, might besmall, since asignificant proportion of
theadditional output made possible byaninvestment project would becaptured bytheTNC inthe
formofmonopoly rents. Some technologies maybemore susceptible todiffusion todomestic firms
thanothers. Thisisthecaseoftechnologies that,inorder tooperate them, donotrequire highly
specialized human resources unavailable inthehostcountry andavailable onlywithin TNCs.
Thequestion arises astowhether itispreferable toobtain technology through FDIorinmore
unpackaged forms, suchaslicensing (even though these forms maywellinvolve elements ofcontrol
bytheparent firms). Japan andtheRepublic ofKorea haverelied heavily onlicensing technology
fromTNCs, while Singapore mainly relied onFDI,attracting itintospecific industries. There isno
ready-made recipe inthisrespect. Much depends ontheexpected gains withrespect totechnological
capacity building andmovement towards higher value-added production through onerather thanthe
other. Twoconsiderations areimportant inmaking thedecision. Thefirstoneiswhether thetechnology
isavailable inunpackaged form. Transnational corporations aremorelikely tolicense oldertechnologies
from which theyhavealready derived significant rents thannewer technologies thatareattheheartWT/WGTI/W/8/Add.1
Page18
ofthecompanies ’business interests.17Thesecond consideration istheavailability inthehostcountry
ofentrepreneurial andtechnical skills tooperate newtechnologies andearnprofits doing so;theposition
ofcountries inthisrespect isbound tochange overtime, ashuman resources andtechnological
capabilities improve. Indeed, TNCs areentering intocollaborative relationships withfirms and
institutionsfortechnologygenerationanddevelopmentinsomedevelopingcountries(UNCTAD,1995a).
Joint ventures between TNCs andfirms indeveloping countries canfoster thetransfer of
technologyandimprovementsintheinnovativecapacitiesofdevelopingcountryfirms.Whiletheformer
mayhaveanimportant technological lead, thelatter alsohaveintangible assets thatarevaluable to
thepartnership (e.g., knowledge ofthedomestic orregional market, oftheways ofdoing business
inthehostcountry, ormarketing channels unavailable toTNCs without considerable investment).
Recent participation ofTNCs andlocal groups intheprivatization oftelecommunications inLatin
America areacaseinpoint. These jointventures haveledtothemodernization ofanindustry ofkey
importance forglobal competitiveness.
Oneaspect oftechnology concerns organizational andmanagement practices including, among
others, strategic marketing capabilities. Management maybeconsidered asasortof"soft" technology.
Management technologies arediffused through various channels (UNCTAD, 1995a, Chapter III),
including, among others, jointventures between domestic firms andTNCs orthrough themigration
ofexecutive personnel from TNC affiliates todomestic companies (Ernst, Ganiatsos andMytelka,
forthcoming). Transnational corporations cantherefore contribute tothespread ofmodern management
techniques tohostcountries. Andsuchsofttechnologies maybediffused more easily thanhard
technologies thatareembodied incapital equipment andthatrequire highly skilled complementary
human resources. Anexample isjust-in-time management ofinventories. Pioneered inJapan, ithas
beenemulated widely byUnited States andEuropean TNCs. Innovations suchasthese haveagreat
potential forimproving theproductivity andcompetitiveness ofdeveloping country firms.
There havebeenconcerns thatFDIandnon-equity TNCactivities could leadtoanaccentuation
ofthestructural heterogeneity ofdeveloping countries, withforeign affiliates orlarge domestic firms
withstrong linkstoTNCs increasing theirtechnological leadoversmall andmedium-sized domestic
enterprises. Thelatter suffer fromacute disadvantages withregard totechnological orforeign market
information andtoaccess tocapital markets (UNCTAD, 1993b). Insome cases, FDImayhaveled
toawidening ofthegapbetween foreign firms andsmall andmedium-sized enterprises; inother cases,
small firms havebeenabletoparticipate insophisticated original equipment manufacturing andeven
higher-end original design manufacturing. Clearly, italldepends ontheinitial degree ofstructural
heterogeneity andonactive government policies toovercome therelative backwardness ofsmall and
medium-sized enterprises.
C. Entrepreneurship andlinkages
Itissometimes claimed thatFDImayhaveadverse impacts ontheindigenous development
ofentrepreneurialtalentsbypre-emptingbusinessopportunitiesandcrowdingoutdomesticentrepreneurs.
Thiswasoneoftherationales fortheeffort thatgovernments ofdeveloping countries made inthe1970s
to"unpackage" FDIandtoattempt toobtain fordomestic firms some oftheassets associated with
TNCs. Insome countries (e.g., theRepublic ofKorea), suchpolicies paidoffhandsomely interms
ofthedevelopment ofdomestic enterprise. Inothers, results weremixed: domestic entrepreneurship
didnotfareaswelleventhough FDIwasdiscouraged. Thedebtcrisis alsoweakened thecapacity
ofdeveloping countries tounpackage, since foreign borrowing wasnolonger available tothem.
17Firms arealsoprone tolicense technologies inindustries characterized byrapid obsolescence, butthey
dosousually toother TNCs andinexchange forcross-licensing.WT/WGTI/W/8/Add.1
Page19
Nowadays, therestriction ismostly onthesideofdomestically available human resources and
entrepreneurial talents.
Foreign direct investment mayhavecrowding outeffects ondomestic firms iflarge foreign
firms borrow ondomestic financial markets, raising domestic interest ratesandreducing theprofitability
ofinvestment projects forsmall andmedium-size domestic firms without access tointernational capital
markets. Itmaybeargued that,iffinancial markets areintegrated, domestic interest rateswilltend
tomove towards levels prevailing ininternational markets. Ifthiswerethecase, theproblem would
lienotwiththepotential crowding outeffects ofFDIbutwiththeunwillingness oftheauthorities to
open updomestic financial markets tointernational trade infinancial assets. However, even in
developing countries withasubstantial degree offinancial openness, domestic interest ratestendto
behigher thaninternational rates, basically because domestic assets areimperfect substitutes forforeign
assets. There is,therefore, some rationale formonitoring thedomestic borrowing oflarge foreign
firms.
Ontheother hand, FDIprojects could promote domestic entrepreneurship indownstream and
upstream activities. Thisissue isclosely related totheextent towhich FDIgenerates backward or
forward linkages within thehosteconomy. Thegreater thedemand byaTNC affiliate fordomestically
produced inputs orservices, themore favourable willbeitsimpact onentrepreneurial development.
Likewise, there willbesimilar favourable effects ifagood orservice produced byaforeign affiliate
lowers thedomestic priceofaninput thatisusedfurther upstream intheproduction process. Domestic
purchases offoreign affiliates tendtoincrease ascompanies gainexperience inhostenvironments (see
studies citedbyCaves, 1996, p.232). Subcontracting relationships oftenbecome important overtime,
withtheconsequent transfer oftechnology andmanagerial skills. Indeveloping countries where TNCs
haveinvested heavily inthemanufacturing sector, thereisevidence thatsubcontracting hasbeenvery
brisk. InMexico, forexample, 37outofthe67affiliates examined inasurvey utilized local
subcontracting (UNCTC, 1992b). InArgentina, theprivatization oftelecommunications andpublic
utilities hasledtothedevelopment ofequipment andinput supplying firms (Chudnovsky, López, and
Porta, 1996). Inthenatural resources sector, FDIhastraditionally nothadstrong linkages withthe
domestic economy; FDIinChilean natural resource industries, forexample, hasbeenobserved to
havehadmuch lessimpact ondomestic firms through backward orforward linkages thanthatobserved
inmanufacturing (Riveros, Vatter andAgosin, 1996).
Generally, itwould appear thatforward andbackward linkages aremore likely tobegenerated
when FDIisinthemanufacturing orservices sectors thaninnatural resources, particularly mining,
where foreign affiliates often havefewinteractions withthedomestic economy. This, ofcourse, does
notmean thatFDIinmining isperseundesirable, since itmayconfer benefits thatareunrelated to
linkages.
D. Employment andskilldevelopment
There used tobeconsiderable concern inthe1970s thatFDIdidnotgenerate enough
employment, basically because foreign affiliates tended totransplant thecapital-intensive technologies
oftheirparents todeveloping country settings, withlittleeffort toadapt themtolocalconditions where
labour wasabundant andcapital scarce. Infact,TNCs tendtousemore capital-intensive technologies
thandomestic firms inthesame industry, aftercontrolling forother variables suchassize. Inhost
countries whose main attraction forTNCs isthehighquality oftheirmineral resources, TNCs create
verylittleemployment indeed. Mining isbyitsverynature averycapital intensive activity, and
possibilities fortechnology adaptation aresmall. However, therelevant question is,again, the
counterfactual: would investment bynational firms havetaken place intheabsence ofaTNC? Insome
cases where technologies areknown inhostcountries, theanswer could beaffirmative. Inindustries
inwhich newtechnologies areneeded, itisunlikely thatdomestic firms would haveinvested.WT/WGTI/W/8/Add.1
Page20
Perhaps more importantly, TNCs have generated significant employment through their
investments inexport-oriented, labour-intensive activities, primarily inmanufacturing butalsoincertain
services, indeveloping countries. These include theestablishment ofaffiliates inexport-processing
zones, aswellasthesubcontracting oflabour-intensive tasks toindependent suppliers. Although it
islimited inboththekindofjobsgenerated andtheirlong-term sustainability, suchemployment
generation hasproved tobeauseful strategy forseveral countries (UNCTAD, 1994a, Chapter IV).
Foreign direct investment canmake apositive contribution tohuman resource development
throughthetrainingandtransferofskillsthatareeitherunavailableorscarceinhostdevelopingcountries
(UNCTAD, 1994a, Chapter V).Itiswellknown thaton-the-job training hasstrong externalities, and,
forthisreason, market forces tendtoprovide lessthansocially desirable levels ofit.Thetechnological
superiorityofTNCsisalsoapotentialsourceofhumancapitalformation.Managerialskillshavealready
beenmentioned. Evenwhen notrequired todoso,TNCs oftenutilize hostcountry personnel inmiddle
(andsometimes top)management. Thereason isobvious: local people arebetter acquainted than
expatriates withtheways ofdoing business, tastes, customs, etc.ofthehostcountry. Training may
alsotakeplace atmore technical levels orontheshopfloor. These activities confer anexternality
ondomestic firms through staffturnover andshould, therefore, beencouraged through appropriate
policies.
E. Other effects
Foreign direct investment mayalsoencourage competition andpromote gains intechnical
efficiency inhostcountries. Thisisthecasewhen TNCs enter thedomestic markets ofdeveloping
countries, inindustries inwhich domestic firms arealready operating. Even inthelargest developing
countries, domestic markets tendtobesmall, andoligopoly ormonopoly conditions often prevail.
Under suchconditions, theentry offirms withstate-of-the-art technology mayprompt domestic firms
tomake greater efforts toimprove theirtechnical efficiency (UNCTAD, 1997a, Chapter IV). The
entry ofTNCs intoanindustry hasbeenfound tohaveapositive effect ontheproductivity ofdomestic
firms inanumber ofcountries (seeFrischtak andNewfarmer, 1993; UNCTAD, 1995a, Chapter III;
andUNCTAD, 1997a, Chapter IV).
Ontheother hand, incertain cases, theentry ofTNCs intosome industries ofhostdeveloping
economies hasbeenknown toleadtogreater market concentration. Bytheirverynature, TNCs operate
inconcentrated industries. Inaddition, theymaywindupdisplacing smaller andlessefficient domestic
firms, rather thanprodding them toincrease theirefficiency.18Transnational corporations withdeep
pockets maywindupmonopolizing anindustry, andthismaybeofconcern tothecompetition authorities
ofhostcountries. Theproblem maybeparticularly acute insome non-tradable services, where the
option ofliberalizing imports inorder tocheck themonopoly power ofproducers isnottechnically
feasible.
Income distribution inmost developing countries ismore unequal thanitisindeveloped
countries. Little isknown about thedistributional impact ofFDIandother TNC activities. Onecan,
however, speculate that,ifTNC activities leadtotheintroduction ofnewskills ortothetraining of
human resources notpreviously available orundertaken inhostcountries, itislikely thattheywill
18Ofcourse, thatisthenature ofcompetition: theother sideofthecoin oftechnological progress is
Schumpeterian "creative destruction". Inthecaseofrelations withforeign firms, however, there areseveral
more complicated issues involved. Onehastodowiththefactthatdisplaced domestic firms mayhaveeventually
becomecompetitive,givenappropriatepoliciesinhostcountries.Anotherrelatestointernationalincomedistribution
considerations: totheextent thatTNCs drive domestic firms outofthemarket, income distribution atthe
international level maybecome more concentrated.WT/WGTI/W/8/Add.1
Page21
make income distribution lessunequal, sincetheaccumulation ofhuman capital hasanequalizing impact
onincome distribution. IfFDIisinlabour-intensive industries, wages willbebidupandtheimpact
onincome distribution willbe,again, positive. Ontheother hand, FDIinsectors suchasmining,
which areverycapital-intensive andgeographically isolated, mayemploy littlelabour andgenerate
dualwage structures thatareunequalizing. However, except incountries where FDIislarge relative
tothesizeofthedomestic economy (e.g., asinSingapore orMalaysia), itseffect onincome distribution
willprobably beofasecond order ofimportance.
IV. FOREIGN DIRECT INVESTMENT, TRADE AND DEVELOPMENT: CONCLUDING
REMARKS
Since theonset ofthedebtcrisis intheearly 1980s, FDIhascome tobeperceived inamuch
more favourable lightthaninthepastbydeveloping country governments. While debtrepayments
arerigidly fixed andcancreate serious balance-of-payments problems regardless oftheusetowhich
theborrowing isput(especially when theyarenotdevoted toinvestment intradables), FDIprojects
generate outflows ofprofits onlywhen theyaresuccessful. Moreover, theproportion ofFDIgoing
toprojects fortheexport sector hasrisen, assome developing countries arebrought intoacloser
relationship withtheglobal production networks ofTNCs.
There aregood reasons forthisreassessment ofthepotential roleofFDIindevelopment.
Under current conditions andifthepolicy framework isadequate, FDIandother forms ofTNC
involvement indeveloping countries havethepotential formaking animportant contribution totheir
industrialization anddevelopment. Theformer term isused broadly toindicate moving upthe
value-added scale, beitintheproduction ofgoods associated withacountry 'snatural resource base,
higher-wage services ormanufactures. Inanincreasingly liberalized andglobalized world, thecurrent
needofdeveloping countries istostrengthen theircompetitiveness inworld markets, while accumulating
capital, bothphysical andhuman. Policies toensure thedeployment ofassets associated withTNC -
inparticular, technology, advanced skills andmarket access -areacomponent ofanindustrial strategy
thatpromotes thisgoal(UNCTAD, 1995a). Foreign direct investment inservice industries, prominent
inrecent FDIinflows intodeveloping countries, mayassist inimproving thesystemic competitiveness
ofhostdeveloping countries and,thereby, mayeventually encourage newexports bylowering thecosts
ofdoing business.
Foreign direct investment isnotazerosumgame. Outflows ofFDItodeveloping countries
arelikely tohavepositive effects onhome countries aswell. They usually leadtoanincreased flow
ofexports from thehome country. Cheaper imports intothehome country maycreate adjustment
problems, buttheyalsoinvolve significant welfare gains forconsumers. Insome cases, there may
belosses inemployment insome labour-intensive industries, butthereshould begains inemployment
inothers, which often payhigher wages thantheindustries affected byFDIoutflows todeveloping
countries. Foreign direct investment inservices indeveloping countries should havestrong benefits
foremployment andexports fromhome countries, since itoften leads totheexport ofmachinery and
highly-skilled services from thehome country.
Asfarasdeveloping hostcountries areconcerned, foreign direct investment should notbe
perceived asapanacea, andTNCs should notbeexpected todoeverything. They probably donot
contribute much toemployment andmayhavelittleimpact onincome distribution. Andtheirpresence
canposecertain difficulties thatrequire regulation bythedomestic authorities ofhostcountries. But
theydopossess tangible andintangible growth-enhancing assets thatareinshort supply indeveloping
countries. Theextent towhich these assets cancontribute optimally tothecreation ofdynamic
comparative advantages indeveloping countries depends onthepolicy environment inways thatgo
wellbeyond themereliberalization ofFDIregimes andthegranting oflegalprotection andguarantees
toforeign investors.WT/WGTI/W/8/Add.1
Page22
Inthelightofthebenefits thatdeveloping countries canreapfrom acloser relationship with
TNCs, recent changes inpolicy regimes areonthemark. Thisofcourse doesnotimply theadoption
ofapassive approach toFDIinflows. Transnational corporations arebetter equipped toidentify current
locational advantages ofdifferent investment sitesthanthepotential comparative advantages thattheir
presence could helpdevelop. Identifying thelatter isataskforgovernments. Within aFDI-friendly
environment, there ismuch thatcanbedonetoattract thekinds ofinvestment thatassist inmoving
upthequality ladder inacountry 'sproduction andthatpromote export diversification. Thisincludes
encouraging FDIinindustries withtechnological spillovers andinindustries thatmove theeconomy
towards theproduction ofmore complex goods orservices.
Indeed, thegoalistoencourage FDIandother forms ofTNC activity thatassists inchanging
thehostcountry 'scomparative advantage. Inprinciple, thiscanbedoneinseveral ways. Agovernment
caneither discourage activities withcurrent comparative advantage (say, through theauctioning of
newmining concessions inmineral-exporting countries) orencourage (e.g., through taxrebates)
investmentinactivitiesthatcanacquirecomparativeadvantagethroughtechnologicalupgrading.Special
deductionsfromcorporateincomecanbeofferedforcertainexpenditures(intrainingdomesticpersonnel,
orinresearch-and-development expenditures) ortaxbreaks related totheintroduction ofnew
technologies, forthetraining ofpersonnel innewskills, orthebroadening oftheexport basket ofthe
country. Acomplement totheroute ofspecial inducements forprojects withdesirable technological
characteristics isforhostcountries toidentify TNCs thathavethetechnological attributes theyseek
andtoinduce themtoinvest inthecountry.19Another approach istoidentify current areasofstrength,
usepublic policy tocreate missing linksand/or tosupply needed elements tomake theseareasofstrength
attractive, andthentarget investors whomight catalyse these activities. When itcomes totheuseof
incentives toattract FDI, itisimportant toweigh theircosts andbenefits, consider possibilities of
back-loading versus front-loading andascertain asfaraspossible towhatextent incentives actually
make adifference inthelocational decisions ofTNCs (UNCTAD, 1996c).
Thechoice ofFDIregime depends onthecharacteristics ofeachcountry: itsdevelopment
objectives, macroeconomic setting, resource mix,specific deficits, onwhatispolitically feasible, and
onwhetheraparticularapproachtakencanachieveitsaimsratherthanfallinghostagetospecialinterests.
Thecapacity ofpolicy makers toconduct active policies willalsobecrucial. Governments thatdo
nothavethehuman resources toputinpractice (dynamically) efficient pro-active policies would do
besttoleaveresource allocation -FDIdecisions among them-tothemarket. Ofcourse, suchcapabilities
canbeimproved overtime.
HomecountriescanalsofacilitateoutwardFDItowardsdevelopingcountriesthroughappropriate
policies (UNCTAD, 1995a, Chapter VII). (Sothatthebenefits fromoutward FDIbewidely shared
inhome countries, itishowever important thattheirgovernments haveinplace effective adjustment
policies, including retraining policies.) Indeed, mostdeveloped countries pursue already policies with
thisobjective inmind, anddeveloping countries whose firms areinvesting abroad arebeginning to
adopt them aswell. Governments provide information onforeign markets, aswellasonlegal and
administrative frameworks abroad totheirforeign investors. Some governments alsosupply finance
through specialized public banks. Most home governments alsohaveinstituted investment-insurance
programmes forforeign investors. Some ofthese forms ofassistance have alsoalready been
multilateralized: theWorld Bank Group 'sInternational Finance Corporation provides bothequity and
loanfinancing toforeign investors; andtheMultilateral Investment Guarantee Agency (MIGA), also
oftheWorld Bank, insures foreign investors against political risksincountries thathavebecome MIGA
signatories.
19SeeWade (1990, pp.148-157) foradescription ofanapplication ofthisapproach inthe1960s and1970s.WT/WGTI/W/8/Add.1
Page23
While countries relymainly onnational policy instruments forattaining theirdevelopment
objectives withrespect toFDI,international instruments cansupport theirefforts (UNCTAD, 1996a).
Bilateral efforts, including through double taxation treaties aswellasbilateral investment treaties, have
beenparticularly important. Inspiteoftheirundoubted usefulness, double taxation agreements between
hostandhome countries, inparticular, arenotyetuniversal. Where possible, suchtreaties between
home countries anddeveloping hostcountries could include tax-sparing provisions, sothat(where
applicable) ashare ofthetaxes saved inthehostcountry doesnotwind upbeing paidtothetreasury
ofthehome country. Butthere arealsoother taxation issues thatarise. Theglobal nature ofthe
activities ofTNCs implies thatitisoften difficult toallocate profits between thedifferent productive
unitsofacompany, andtoassess thepricing ofcertain transactions. Thetransfer-pricing issueisbut
oneexample ofthetypeofissues thatarises when corporate activities arebecoming increasingly regional
orglobal, while thereach ofgovernmental authorities remains largely national.
Partly because ofthis,FDIissues arediscussed increasingly inregional, plurilateral and
multilateral fora(UNCTAD, 1996a, 1996b). TheroleofTNCs andFDIineconomic growth and
development, asreviewed briefly initsmultifaceted impact inthispaper, iscentral tothesediscussions,
inparticular fordeveloping countries, whose interests andconcerns needtobefullytaken intoaccount.WT/WGTI/W/8/Add.1
Page24
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Page29
ANNEX TABLE 1
Developed andDeveloping Countries: FDIInflows,
asPercentage ofWorld Inflows
(AsPercentage ofTotal FDIInflows)
1983-1988
(Annual
average)1991 1992 1993 1994 1995 1996a
Developed countries 78.3 72.2 68.9 63.6 59.6 65.0 59.6
Developing countries 21.6 26.2 28.6 33.5 37.9 30.4 36.9
Africa 2.3 1.7 1.8 1.7 2.3 1.5 1.4
Asia andthePacific 11.3 14.6 17.1 23.3 24.1 20.6 24.1
Latin America andthe
Caribbean 7.9 9.7 9.3 8.3 11.3 8.0 11.0
Central andEastern Europe 0.1 1.5 2.6 2.9 2.5 4.5 3.5
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Selected countries inAsia andthePacific
China 2.0 2.7 6.4 12.6 14.2 11.3 12.1
Hong Kong, China 1.4 0.3 1.2 0.8 0.8 0.7 0.7
India 0.1 0.1 0.1 0.3 0.6 0.6 0.7
Indonesia 0.4 0.9 1.0 0.9 0.9 1.4 2.3
Korea, Republic of 0.4 0.7 0.4 0.3 0.3 0.6 0.7
Malaysia 0.8 2.5 3.0 2.3 1.8 1.3 1.5
Philippines 0.3 0.3 0.1 0.6 0.7 0.5 0.4
Singapore 2.1 3.1 1.3 2.1 2.3 2.2 2.7
Thailand 0.5 1.3 1.2 0.8 0.6 0.6 0.7
Selected countries inLatin America andtheCaribbean
Argentina 0.6 1.5 1.5 1.6 0.3 0.4 1.2
Brazil 1.6 0.7 1.2 0.6 1.3 1.5 2.7
Chile 0.5 0.3 0.4 0.4 0.7 0.5 0.9
Colombia 0.6 0.3 0.4 0.4 0.7 0.8 0.9
Ecuador 0.1 0.1 0.1 0.2 0.2 0.1 0.1
Mexico 2.4 3.0 2.5 2.0 4.6 2.2 2.2
Peru 0.0 0.0 0.1 0.3 1.2 0.6 1.0
Venezuela 0.1 1.2 0.4 0.2 0.3 0.3 0.4
Memorandum item
World FDIinflows
(Billions ofdollars) 92.9 158.9 173.8 218.1 238.7 316.5 349.2
aEstimated.
Source: UNCTAD, 1997a.WT/WGTI/W/8/Add.1
Page30
ANNEX TABLE 2
Developed andDeveloping Countries: FDIOutflows,
asPercentage ofWorld Outflows
(AsPercentage ofWorld FDIOutflows)
1983-1988
(Annual
average)1991 1992 1993 1994 1995 1996a
Developed countries 93.7 95.8 89.2 85.7 83.5 86.0 85.0
Developing countries 6.3 4.2 10.8 14.2 16.2 13.9 14.8
Africa 1.2 0.5 0.2 0.3 0.2 0.2 0.2
Asia andthePacific 4.6 3.9 9.3 13.0 14.3 12.5 13.5
Latin America andthe
Caribbean 0.4 -0.2 1.3 0.9 1.7 1.2 1.1
Central andEastern Europe 0.01 0.02 0.05 0.1 0.3 0.1 0.2
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Selected countries inAsia andthePacific
China 0.5 0.5 2.0 1.8 0.8 0.6 0.6
Hong Kong, China 1.6 1.4 4.1 7.4 8.5 7.4 7.8
Korea, Republic of 0.6 0.8 0.6 0.6 1.0 1.0 1.2
Kuwait 0.3 -0.1 0.6 0.4 0.4 0.2 0.2
Malaysia 0.2 0.2 0.3 0.6 0.7 0.8 0.5
Singapore 0.2 0.3 0.7 0.8 1.2 1.2 1.4
Thailand 0.04 0.1 0.1 0.1 0.2 0.3 0.5
Selected countries inLatin America andtheCaribbean
Brazil 0.1 0.5 0.1 0.2 0.4 0.4 0.3
Chile 0.01 0.1 0.2 0.2 0.4 0.2 0.3
Mexico 0.1 0.1 0.4 0.01 0.4 0.2 0.2
Venezuela 0.1 0.1 0.1 0.4 0.3 0.1 0.2
Memorandum item
World FDIoutflows
(Billions ofdollars) 93.7 198.1 201.5 239.1 251.1 338.7 346.8
aEstimated.
Source: UNCTAD, 1997a.