Foreign Direct Investment
Trade linkages

Total annual world flows of foreign direct investment (FDI) grew from around $50 billion in 1985 to almost $200 billion in 1989. Persistent US external and internal imbalances induced sharp rises in interest rates which, together with increasing fears of protectionism, induced short- and long-term capital flows into the US, while the appreciation of the yen raised investment by Japanese transnational corporations (TNCs) in the US and South East Asia, and the 1987 signing of the Single Market Act raised FDI flows into and out of Europe. By 1989, the EC, the US and Japan accounted for over 80% and 45% of the total outward and inward stocks of FDI respectively, while the share of FDI into LDCs had correspondingly fallen.

In Discussion Paper No. 687, Research Fellow Louka Katseli examines the links among FDI, trade and competitiveness. The concentration of FDI reflects international firms' strategies to entrench their home market positions, penetrate each others' markets and reap economies of scale and scope through enlargement and regionalization. The liberalization of capital markets and services has enhanced incentives for service-related FDI in the large developed-country markets. The global recession and the likely reductions to excess savings from Japan and Germany in the 1990s will probably slow FDI growth and make it even more difficult for the LDCs to increase their relative shares of inflows.

Katseli maintains that risk and uncertainty, low capital productivity, high production costs and `thick-market externalities' have impeded FDI flows into LDCs. With mobile factors such as capital, both comparative and absolute advantage determine production and exchange, and the latter plays a greater role for more expensive commodities. Almost all `successful' LDCs that have attracted and sustained FDI inflows display an `evolutionary' pattern of FDI-trade interlinkages: they used the initial proceeds from resource-exploiting or -extracting FDI to upgrade their human and physical infrastructure and to develop networks to create the locational advantages that attract FDI for more sophisticated sectors.

Katseli examines empirical evidence from seven developing countries that confirms the strong pro-trade effects of FDI in Singapore, South Korea and Mexico. Domestic income growth is a key determinant of FDI in countries with large domestic markets, which then contributes to export growth, while small markets' export growth prompts FDI inflows following the `evolutionary' pattern. Countries likely to receive FDI in the 1990s are those whose forward-looking development policies have allowed TNCs to expand both trade and also technological and productive capacities to initiate a `virtuous circle of development'. Katseli concludes that the geographic concentration of FDI in a few developing countries is a by-product of their policies designed to match ownership with locational advantages.