Relationship between Trade, Investment and Development | Economics Optional Notes for UPSC PDF Download

Introduction

• Foreign direct investment (FDI) and trade are increasingly intertwined within the framework of efficiency-driven, integrated international production strategies pursued by transnational corporations (TNCs). Undoubtedly, FDI and trade mutually reinforce each other in this context, emphasizing the essential need for coordinated national policies between FDI and trade. However, a fundamental question remains unanswered: why do firms choose specific locations for their value-added activities? The factors that render certain locations appealing for particular activities become crucial. UNCTAD studies have identified various determinants of FDI flows, encompassing economic factors such as economic growth, market size, profitability, cheap labor, and developed infrastructure, as well as policy factors like private sector development, macroeconomic reforms, and liberalization. Nevertheless, a pivotal question persists: is development a prerequisite for encouraging investment, or does development follow investment? To further the educational process within the Working Group, three introductory sets of questions are proposed.
• The first set involves the basic question of investment regulation for development. It is said that FDI follows a country’s success, it rarely leads it. India is encouraging investment inflows for its development, and development needs policy direction. Hence, should investment flows also be directed? Infrastructure spending priorities of the Government would be a factor for attracting investment. Having limited resources, should investment inflows, therefore, be directed more towards infrastructure sectors to reach a level of development necessary to make FDI, trade and development conducive to economic growth? These questions are generic in nature and may apply to most of the developing countries, although stages of development, market size, geographical and regional factors would be relevant for individual countries.
• Secondly, while trade focuses on the distribution of economic goods, investment pertains to their production. In addition to capital, materials, and machinery, the consideration of labor as a crucial factor in production becomes imperative. If other elements of global production are liberalized, the question arises: can restrictions on the mobility of labor be conducive to the mutually supportive nature of trade and investment, as well as to economic growth and development? The ongoing debate on the unrestricted movement of capital might need to be complemented by an equally thorough examination of the free mobility of labor. If inexpensive labor significantly influences investment decisions, leading to increased profitability for investors that can be reinvested in the home country's economy, it might be fair to contribute to host country economies through returns generated by mobile labor working in the investors' home country.
• Thirdly, ‘more’ is not necessarily ‘better’ in the case of multinational corporate activities in developing countries. Studies have shown that between 25 and 45 per cent of FDI has a demonstrably negative impact on host societies. That is, the costs in terms of using scarce domestic resources inefficiently substantially outweigh the benefits of national income. Obviously, it introduces the need for competition and, thereby, efficiency. To ensure the greatest contribution to their own development, host governments may in fact have to refuse to grant the kind of treatment that many international companies want most. In fact, screening mechanisms can help developing countries sort out beneficial from detrimental foreign investment projects. This gives rise to the related question of investor’s obligations. Such obligations may be important for various economic, social and cultural necessities. Any study of trade and investment interface thus inevitably introduces concepts of TNC obligations, which are not new to the discussants here. We need to avoid tragedies of the type we had in Bhopal, India, a decade ago. We may also need to study obligations for protection of environment and sustainable development. Should TNCs, for example, not be asked to maintain the same environmental standards in host countries as they have in home countries, even though host country domestic investors have certain lower standards on account of lack of capital, technology or skills required, or on account of better assimilative capacities in their regions? These are issues that need further study.
• With this background, and with a view to coming back to these and other issues involving the development and economic growth dimension of the trade-investment relationship, let us further the educative process in certain critical areas, inter alia:
• The relationship between investment and trade liberalization and stages of development, in particular, the experiences of countries, including the present industrial countries, in this connection
• Broadly speaking, stages of development as well as timing of investment in terms of stage of industrialization and globalization, affect the development and economic growth dimension in the trade-investment interface. As per Kiyoshi Kojima (1991), the micro-economic interests of MNCs dominate America’s FDI and as a result macro-economic impacts, such as the impact of FDI on patterns of comparative advantage, are largely ignored. On the other hand, the pattern of Japanese FDI has been characterized as the ‘trade-oriented type’ in which macro-economic impacts have been considered either explicitly or implicitly. He adds that Japanese FDI has contributed to the development of host countries with more efficiency than American FDI has in most cases. An industrial country example of managed economic growth through FDI in vertically integrated industries is cited in WIR 96 (page-119) viz. Japan’s early industrial strategy selectively promoted FDI in resource extraction, matching it with liberal import regulations for raw materials, protective policies against competitive FDI or manufactured good imports and export-promotion programmes to assist final product sales.
• Going to the next rung of development, two newly industrialized countries have been studied quite extensively. While FDI contributed significantly to the net private capital inflows in one of them, it was only marginal in the former. But both countries have shown equally gallant strides in economic growth as well as development.
• At the third rung, governments of low-income (as well as other) developing countries are increasingly aware of the potential value of foreign investment. There is, however, a danger of exaggerated expectations of what foreign investment can achieve, particularly of its rôle in resolving a severe foreign-exchange position through net inflows. The limited natural resource endowments and home markets of many low-income countries tend to make these countries particularly unattractive to foreign investors. Thus, without strong ‘fundamentals’ for economic growth and development, investment liberalization may mean little to them.
• Given this wide array of experiences, there is surely a need for a more coherent analysis of implications of investment and trade liberalization on economic growth of countries at various stages of development. The recent South-East Asian crisis adds to the need for further analysis before drawing any firm conclusions on the issue.

The role of FDI

• The implications in this scenario are somewhat ambiguous. Traditional theory suggests that Foreign Direct Investment (FDI) facilitates technology transfer, but numerous studies, starting with WIR 1991, have indicated that countries at lower levels of development are likely to attract FDI only in low-technology sectors. This raises the question of a chicken-and-egg dilemma: should development and economic growth precede FDI to stimulate technology transfers? A study addressing the challenges of technology transfer into low-income countries, as emphasized by Lan and Young in Transnational Corporations (Vol.5 No.1, April 1996), becomes crucial. Undoubtedly, the national policy on this matter is increasingly important for Transnational Corporations (TNCs). To address this, the international community has successfully negotiated several agreements on property rights, with the TRIPs Agreement being the most significant. However, issues related to the global market for technology and the overall benefits to host countries from technology transfer have not enjoyed similar success. Before assuming FDI's conclusively positive role, there is a pressing need to thoroughly examine this issue in the context of development and economic growth.
• Another aspect of this issue is the positive national policy intervention required in order to facilitate transfer of technology through FDI. Joseph M. Grieco (1984) had taken the example of the computer industry and India and suggested that despite initial ‘turbulence’, ‘assertive’ countries can develop closer ties with international firms in high-technology to the domestic industry – a circumstance more conducive to a new and perhaps higher level of international order. It can be said, then, that national policy intervention may be a necessary prerequisite for developing a positive rôle of FDI in transferring intangible assets while ensuring protection of intellectual property rights at the same time.

The relationship between different types of FDI and the development process

• The FDI-trade linkage needs to be studied from the point of view of relationship of development and economic growth with sectoral thrusts in national policies. Grieco’s study (above) shows a symbiotic relationship between sector specific national policy intervention and development. There are numerous such examples that may be collected, collated and studied for their implications. Of particular interest would be to study sectors where comparative advantage lies with the developing countries – such an analysis would help the process of development and economic growth that we wish to achieve through this educative process.
• Two sectors of importance to developing countries are agriculture and textiles. In view of the continuing impediments to developing country access to industrialized countries’ market in agriculture and textiles, despite (or because of) the Uruguay Round agreements on those aspects, investment policy aspects may be studied in these two sectors specifically. For example, it is reported that some obsolete textile machinery is finding its way from industrialized to developing countries through various forms of investments or outright sales, thus blocking precious funds in technologies that may deny comparative advantage to host countries even after the Multi-Fibre Arrangement ends. Secondly, in agriculture, new forms of investments and innovations too often have been seen as a panacea by developing countries whereas there is ample evidence that in some cases the new forms shift risk to host-country producers.
• While such sectoral studies in areas relevant for comparative advantage would be helpful, it is equally essential to study the need for investments in certain sectors for development and economic growth. Core sectors, infrastructure, value added food products, textiles and other sectors have been requiring positive policy intervention. The rôle of industrial policy to encourage investment in such sectors is not denied. How this interfaces with the different types of FDI, and what is the right mix, is not clear though. A study of these issues is more likely to result in a recommendation for sector specific national efforts to facilitate development.

The determinants of the locational decisions of multinational enterprises

• These determinants, as identified by UNCTAD and elsewhere, have already been referred to in the introduction. The most important factors influencing the location decisions are concerned with the structural features of the host economy. Important positive determinants could be the level of prosperity, market size, growth rates, extent of industrialization and quality of infrastructure, and negative determinants could be high rates of inflation, current account deficits and political instability. Degree of openness of the economy, investment incentives and liberalization are not significant determinants. 
• In fact, many investors prefer a protective régime so that they can bar the entry of potential competitors once they have jumped the tariff wall. Requirements of investment protection and dispute settlement are already being taken care of through bilateral agreements. Rather, as was evident in the recent UNCTAD expert meeting, even bilateral investment agreements have little effect on FDI flows. Given such conclusive evidence, determinants of locational decisions of TNCs have little implication for the trade-investment interface, and for this reason, there appears no reason to study their impact on development and economic growth. What is perhaps required is policy stability, which depends on domestic factors like political stability and economic fundamentals.

Conclusion

• The term FDI is currently employed in a broad sense, referring to the increase in the net worth of investments in one country held by investors from another country, with these investments being under the managerial control of the investors. It's important to clarify that the term "investment" is somewhat misleading in this context because not all reported values of FDI flows imply an addition to the host economy's stock of capital or capital formation. For instance, takeovers do not contribute to the increase in capital. Therefore, it is crucial to collect empirical data from the outset on the volume of takeover-related FDI flows and other forms of FDI to analyze the relative significance of these flows in terms of fostering development and economic growth.
• The recent South-East Asian case demonstrates the unsustainability of large trade and current account deficits and profligacy induced by distorted trade and investment patterns. It shows how it has affected the value and level of domestic savings, fiscal position and balance of payments of these countries. Although more study and analysis may be required by taking stock of recent developments in that region, it can prima facie be concluded that FDI when channelled in the right way and in desirable sectors can positively contribute to economic growth and development. This may call for progressive and prudent liberalization and management of their trade regimes by developing countries so as to calibrate their impact on macro-economic stability.
• The Trade and Development Report (1997) indicates that trade, investment- and technology-led globalization has posed a major challenge to employment generation, income and wealth distribution within and among countries. That shows the importance of making international trade and investment policies more conducive to employment, income and wealth generation in developing countries commensurate with their natural, human, entrepreneurial and other resources. There should be both value creation and value realisation of their resources by developing countries in the context of international trade and investment flows.
• Competitiveness, transfer of technology and managerial skills are important benefits of trade and investment for development and economic growth. However, much would depend on how the investing firm actually transfers relevant and state of the art technology, shares managerial skills and competitive advantages such as global marketing and distribution networks and brand image. It is not sufficient for liberal trade and investment policies to be in place to ensure maximum positive impact on development and economic growth of developing countries in all their dimensions. Unless some responsibilities are also taken by investing firms, the positive nexus between trade and investment on the one hand, and development and economic growth on the other, may not materialize. Hence, the need for any international debate on the FDI issue to insist that these parameters be consciously provided for in terms of governmental policy as well as the investors responsibility and behaviour.
• Domestic markets of developing countries are generally moving towards larger indigenous enterprises, alone or in collaboration with foreign enterprises capturing market shares in a large spectrum of goods and services. SMEs are facing a crisis of competition and survival. This issue of a level playing field for domestic enterprises of developing countries in the context of their globalization is an issue that must be addressed in this Working Group, as well as that on trade and competition policy.
• Finally, mobility of all factors of production needs to be studied for a comprehensive educative process on this issue. Thus, mobility of labour should be inextricably linked with the discussions on trade-investment linkage if the WTO is to go beyond looking at delivery systems to look at production systems.