What Can Foreign Investment Really Do for Your Country?

When a respectable multinational company announces a new project in a poor country, it is usually a cause for celebration -- especially when the project won't hurt the environment and won't corrupt public officials. These companies create jobs, pay taxes, and bring badly-needed foreign currency. More subtly, they use better technologies, spread their knowledge, and hire local firms to supply them. This, one hopes, makes everyone more productive, even those that have little or no contact with the newcomers. Think of an international clothing brand coming to your town to set up a factory and export top-end apparel, or a mining giant breaking ground near your village to mine for copper and sell it abroad. They generate benefits that go beyond their own businesses -- in technical jargon, they generate "spill-overs" for the rest of the economy. So, sensible governments do their best to attract "foreign direct investment." But, what evidence do we have that these spill-overs really exist?

A new book edited by Thomas Farole and Deborah Winkler uses a database of some 25,000 firms from 78 developing countries to answer that question. [You can download the book for free here.] What they found is quite surprising: For the average developing country, in the short-term spill-overs exist but are mostly negative! Local firms that are not linked to the new foreign investment tend to suffer from it because they find themselves competing for scarce resources like skilled workers and electricity connections. It is only over time -- two years or more -- that the entry of foreign investors begins to benefit those who do not deal with them directly. Typical case: Workers, especially young workers, train up to the standards demanded by the foreign employers but become available to local industries too.

Of course, not all foreign investment is the same as far as positive spill-overs are concerned. Mining shows fewer of them than agribusiness. Joint-ventures between foreigners and local entrepreneurs unleash greater and faster spill-overs than projects paid and run only by foreigners. So do projects that involve investors from neighboring countries -- they probably know the receiving country better -- and those who seek to create new markets -- they are filling a vacuum. Predictably, countries with less education or larger technological gaps have a harder time extracting spill-overs from the foreign investment they pull in.

This last point hints to the hard truth: what kind of impact foreign investment has on the overall economy ultimately depends on how good or bad your general business environment is. Things like low inflation, open trade, sufficient infrastructure, trainable workers, accessible finance, smart regulation, secure property rights, and a government that treats investors fairly, are all associated not just with more investment but also with more spill-overs. This explains why foreign investments in Chile's mining, Vietnam's agriculture, and Mauritius's apparel have helped raise the productivity of workers and firms that operate outside those sectors.

It gets more complicated. Today, most foreign investment is linked to something called "global value chains." This is the idea that most of the products that consumers buy -- say, cars -- are made up of parts and designs produced in different countries and shipped across borders to a final assembly site. [NB: Now you know why speaking of an "American-," "Japanese-" or "Italian-made car" is no longer that meaningful.] And you can't be part of a production chain if you can't keep up with it. Imagine if your country manufactures the cars' tires but, because of poor port maintenance or unexpected changes in rules at customs, you can't be trusted to deliver the tires on time and on quality. Everyone else's effort along the chain would be wasted. How long before they cut you off? Why would you be invited in the first place?

You see, value chains force countries to rise up to a more-or-less common standard of efficiency. This is the real benefit of foreign investment. But it is also a warning: Foreign investors will put their money into your economy and invite you into their value chains only if your country can offer two conditions. First, there are enough local suppliers who can handle huge orders and can meet precise technical specifications -- that is, there are enough large- and medium-size enterprises. These are not that common in the developing world, so economists advise latching at the section of the chain where it is technologically less challenging, and then "climbing" from there. Second, because these days foreign investment is so closely associated with exports, it tends to go where the government is sold on the merits of international trade, facilitates -- or, at least, does not hamper -- the flow of goods across frontiers, and lets honest businesspeople free to do honest business. In other words, when they decide whether to commit their capital, foreign and local investors think alike.