The World Bank (2007) assured that attracting foreign direct investment is at the top of the

agenda for most countries.

Nunenkamp and Spatz (2003) argued that developing countries have been strongly advised by
international organizations and other external advisors to rely primarily on FDI as a source of
external finance and it is superior to other types of capital inflows in stimulating economic growth.
FDI is traditionally thought of as funds transferred by a multinational corporation (MNC) from a
source country to a “host” country in order to finance the setting-up and operating of a subsidiary
or an affiliate there.
Direct investment differs crucially from portfolio investment in that the former involves the
investor in actually operating a production facility in which it has a “lasting interest” whereas
portfolio investment refers to the purchasing of shares, or other financial assets, and does not
entail any management role for the investor.
Lasting interest: it is taken to mean a share of 10 percent or more of the voting rights in an
enterprise.
Why do firms invest abroad?
FDI depends on imperfect competition. Investing abroad increases a firm’s profits by extending
exploitation of some monopolistic advantage possessed by the firm, for instance a unique technology,
ownership of a patent not available to others, or the special skills (manual, technical, or managerial)
of its employees in a way not possible from the home base.
The additional advantage resulting from expansion into a new overseas location may take a variety of
forms such as reduced transport cost, cheaper labor or raw materials, availability of tariff
protection, or preferential tax treatment by the host country government.
It is differentiated between two alternative motives which may prompt MNCs to set up operations
in specific locations:
Horizontal (market seeking): it includes the attraction by the prospect of increasing profitability
by setting up production units in developing countries in order to sell their products into the local
markets.
Vertical (efficiency seeking): it includes the attraction by the availability of cheaper inputs and
hence lower production costs in the host countries than at home.
There are many operating problems confronting MNCs in developing countries. These include:
 Bureaucratic problems: for example the complex regulatory systems and procedures relating to
obtaining permissions to invest and to open a business; employing foreign workers; and
registering property.
 Financial problems: currency conversion controls; restrictions on remission of profits,
dividends, and royalties to the source country; difficulty in obtaining credit locally.

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 Legal problems: inability to enforce contracts effectively; lack of protection for investors;
difficulty in establishing and enforcing property rights (including rights in intellectual property).
 Governance problems: corruption; poor macroeconomic management which leads to weak local
economic performance, failure to control inflation, volatility of exchange rates, postponement of
spending on infrastructure and utilities; inability to control crime; civil disturbance.
The impact of FDI on Host Developing Economies
Developing countries that seek to attract inward FDI do so because they expect the impact of that
investment to be beneficial for the home economy. There is still a very active debate on many
aspects of the impact of inward FDI.
In what follows the impact of FDI on host developing country economies is examined with
respect to:
1. The effect of capital inflows: the flow of capital from the source to the host country will help
to alleviate any shortage of domestic savings, adding to the local capital stock and thus leading
to a permanent increase in the growth rate (higher level of per capita income).
2. The package of know-how and skills that accompanies FDI: FDI funds are often accompanied
by a beneficial package of technological know-how and skills (manual, technical, entrepreneurial,
and managerial) all of which are typically in short supply in developing countries. The components
of this package will raise average productivity directly in the host country and there will be
beneficial spillovers.
3. Implications for the host-country balance of payments: two keys issues arise with regard to
the balance-of-payments impacts of FDI in developing countries:
a. The relative merits of financing investment through FDI and through portfolio foreign
investment (PFI).
b. The expected impact of the operation of MNCs on current payments and receipts.
4. Tax take: the contribution to local fiscal revenue. The operations of MNCs, and the increased
levels of economic activity that they promote, should result in increased tax revenue for the
host government. This benefit will be reduced or limited to the extent that the host has offered
inducements to incoming firms in the form of tax holidays, free or subsidized premises, or
exemption from import tariffs, value-added tax, or other fiscal impositions.
5. Environmental impacts: the environmental impact of FDI in developing countries has three
possibilities:
a. The capacity multinationality gives to a firm to shift any environmental problems
associated with its processes from countries which are intolerant of such problems to
developing countries because of their greater need for industrial development and their
weaker regulatory capacity.
b. A considerable slice of FDI in developing countries happens to be industries which are
inherently pollution-intensive, in particular, mining and petroleum extraction.
c. A contrary view sees MNCs operations in developing countries as likely to be less polluting
than the activities of local firms.

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6. Socio-economic effects: except for extreme cases where incoming MNCs replace local
competitors and buy nothing from local firms, it seems likely that their advent will lead to an
increase in employment in the host economy. Further, wage-rates paid by MNSs tend to be
higher for any given skill level than those paid by local firms. MNCs increase disparity between
rural and urban incomes as they cluster in the largest towns. Besides, the nature of the goods
produced by some MNCs may encourage undesirable or inappropriate patterns of consumption.
7. Political effects: the main concerns are:
a. MCNs may possess considerable bargaining power.
b. MNCs can put themselves above the law.
c. Extraterritoriality where governments of MNCs’ home countries may attempt to impose
their domestic legislation on the overseas subsidiaries.
d. Anti-capitalist sentiment.
Policies on FDI
The host country should work in three directions:
a. Removing obstructive and unnecessary regulation of FDI
b. Reinforcing the domestic economy
c. Improving the quality of governance
These three directions can be achieved by the following procedures:
1. Improving the skill levels of labor force; facilitating provision of better access to primary,
secondary, and tertiary education.
2. Upgrading physical infrastructure: providing reliable, well developed, transport systems, public
utilities, and telecommunications.
3. Opening up certain closed service activities such as banking, insurance, telecommunications,
retailing and healthcare.
4. Removing the more restrictive controls on the free movement of capital.
5. Continuing the process of liberalizing trading regimes.
6. Combating local corruption.
7. Upgrading soft infrastructure laws, institutions, and financial markets.
8. Reinforcing and broadening legal support for business activity especially in the commercial
sphere.
9. Removing legal, administrative and regulatory barriers to enterprise activity and fostering
competition in the marketplace.
10. Providing long term stability in legislation affecting foreign investors.
11. Assuring protection of property rights, including intellectual property.
12. Assuring enforcement of contract.
13. Providing long term macroeconomic stability.