Truths about FDI

With investments worth $2 trillion and growing, it is no exaggeration to say that multinational investment in the developing world is now a fact of life.

Yet, few governments have been able to develop a coherent or consistent policy towards them. Should they be restricted so that local economic interests are protected? Or should they be given incentives to invest?

Neither, suggests a recent study from the McKinsey Global Institute titled 'The truth about foreign direct investment in emerging markets,' excerpts of which were published in the latest issue of the McKinsey Quarterly.

"[B]oth the incentives used to attract foreign direct investment and the restrictions placed on it are largely ineffective. Worse, they are frequently counter-productive, costing governments millions of dollars annually, protecting inefficient players, and lowering living standards and productivity," say authors Diana Farrel, Jaana K Remes and Heiner Schulz.

Much of the dichotomy over attitudes and policies towards foreign direct investment (FDI) stems from uncertainty over its benefits, a confusion well displayed by the existence of equally strong reform and anti-reform proclivities within India's ruling political spectrum.

This study unequivocally establishes the fact that FDI actually benefits economies and consumers, regardless of the policy regime.

In support of their contention, Farrel, Remes and Schulz have calculated the impact of foreign direct investment on 14 manufacturing and service industries in Brazil, China, India and Mexico.

In each of these sectors "" which range from automobiles and consumer electronics to banking, IT and BPO "" the study looked at industry dynamics, sector productivity, output, employment and prices before and after multinationals entered these markets.

To provide some random examples of benefits to consumers, the study says the price of passenger cars in China dropped more than a third between 1995 and 2001 after Ford, General Motors and Honda entered the market.

In India, too, prices of consumer durables "" from TVs to air-conditioners "" dropped steadily after foreign companies entered.

As for the automobile industry, today the fact that at least 30 car models are sold in India, up from just eight at the end of the eighties, has seen prices drop steadily in all segments by 8 to 10 per cent a year.

If consumers have benefited, so have economies, and India's BPO story and its spin-off benefits are referred to several times. The authors note that "wages in India's business-process-outsourcing sector...are 50 to 100 percent higher than in other white-collar sectors requiring similar skills."

They also point out that in the Chinese auto industry, "foreign producers offer unskilled line workers more than twice the going rate for unskilled manufacturing jobs."

As for incentives, the study suggests that give-aways are sometimes extended for investments that would have been made anyway "" India's tax breaks for companies that shifted BPO operations to the country being a case in point.

Ironically, interviews with IT executives showed that this was the least important influencer in decision-making; they said they would have been happier had the government focused on local infrastructure.

In fact, if there is a central message to this study, it is that developing countries "must strengthen the foundations of their economies".

Stronger infrastructure, sound judicial and regulatory frameworks and levels of competition would do far more to attract FDI in a productive and optimal way than opaque incentives and protective domestic policies.