Foreign direct investment into Latin America

Recommended reading by Professor of International Economics Krohn, with a summary by Erika Tabacniks and me below.

Daniel Chudnovsky and Andres Lopez, ‘Foreign Direct Investment and Development: the Mercosur Experience,’ CEPAL Review #92, August 2007. http://www.eclac.org/publicaciones/xml/0/31920/ChudnovskyLopez.pdf

Ruth Rios-Morales y David O’Donovan, Can the Latin American and Caribbean countries emulate the Irish model of FDI attraction? CEPAL Review #88, April 2006.

 

Foreign Direct Investment into Latin America

Introduction

In 1960 Ireland was one of the world’s poorest nations.  By 2004 it had become of the world’s wealthiest countries in terms of annual income per capita, USD 36,360; it had a large trade surplus of 38.4 billion Euros and a sophisticated economy based on advanced technology and services. Most of this success is considered to be a consequence of long term national development goals and high value added Foreign Direct Investment (FDI) into the country, which resulted in spillovers that were absorbed into the local economy leading to economic growth. In the same period, the Latin America share of FDI went from 14% in the 70s to 6% in the beginning of 2000. The region did not see the benefit of spillover effects into the economy.

 

As Morales and Donovan state, foreign direct investment is regarded as essential to economic development. It can generate employment, enhance exports and can generate positive spillovers among domestic companies within the host country by way of improving the efficiency of suppliers, improving the capacity of personnel, introducing new technologies and better management techniques, marketing strategies and export distribution and production networks. However, empirical studies indicate that FDI per se does not necessarily leads to these benefits. In Eastern Europe, for example, an econometric study highlighted by Chudnovsky and Lopez has shown that the acquisition of domestic firms by transnational firms has caused negative growth. A number of other studies have suggested that growth attracts FDI, rather than FDI causing growth. The studies suggest that the sign (positive or negative) and magnitude of spillovers to local companies vary depending on the capacity of local companies and their responses to the presence of transnational companies, as well as the type of investment made by foreign transnational firms. Much of the FDI going to Latin America, for instance, has been attracted by privatization of the local services sectors, representing a change of ownership and not an increase in the physical production capacity of the Latin American economies, or in jobs or in exports. FDI has, therefore, added little value to Latin American economies.

 

This paper discusses the findings of Daniel Chudnovsky and  Andres Lopez (2007) [1][1] and Ruth Rios-Morales and David O’Donovan (2006) [2][2] vis-à-vis the differences in types of foreign direct investments into Ireland and the Mercosur economies (Argentina, Brazil, Paraguay and Uruguay), as well as the effects of those investments. Part I highlights current trends and issues related to FDI in Latin America and is followed by an analysis of the Mercosur region in Part II. Part III takes us across the ocean to analyze the FDI model adopted by Ireland. Based on those experiences, we wrap up in Part IV with policy recommendations.

 

I.             FDI in Latin America: trends and determinants

Chudnovsky and Lopez note that foreign direct investment into the Mercosur countries (Brazil, Argentina, Paraguay, Uruguay) increased more than tenfold by the mid-1990s since the late 1970s, with the greatest inflows going to Argentina and Brazil. In 2004, FDI as a percentage of GDP was clearly above the global average. Between 1990 and 2004, the Mercosur countries received almost US $300 billion in FDI, making them amongst the largest recipients of FDI among developing countries. Also, a greater number of countries are investing in Latin America; although the US continues to be the largest single contributor, investment from Europe has grown strongly since the privatizations. But while Chudnovsky and Lopez see growth through absolute amounts of FDI, Morales and Donovan see decline in terms of global market share of FDI since the 1970s, when it enjoyed 14% of total FDI. Too, they see that FDI is skewed largely to the large economies of Latin America: Argentina, Brazil, Mexico, as well as Chile because of its macroeconomic stability.

 

One reason for the absolute dramatic increase of FDI has been that the Mercosur economies opened up since the import substitution industrialization era of the 1970s, as they lowered trade barriers, deregulated and privatized in the 1990s, acceding to the Washington Consensus. Coupled with relative macroeconomic stability and growth of domestic markets, foreign direct investment into Brazil and Argentina’s privatized and deregulated services sectors now accounted for the bulk of FDI, where industry, now only accounting for 20% of FDI, had once been the main destination. These reasons also allowed transnational firms to exploit Argentina, Uruguay and Paraguay’s natural resources; almost a third of FDI in Argentina went into natural resources: mining and petroleum. In Paraguay and Uruguay, meanwhile, most FDI went into agriculture and related activities.

 

Unfortunately for the Mercosur economies, FDI did not come with the purpose of exploiting regional efficiencies as it did in Mexico, where low labor costs and demonstrated success in the manufacture of automobiles, textiles and electrics attracted capital for the purpose of exporting higher-value goods outside of the region.

 

Other than extraction of natural resources, FDI in the Mercosur economies came primarily with the intention to access local markets, with the market share of transnational subsidiaries amongst the highest in the world. Chudnovsky and Lopez would have expected otherwise: “in the 1990s FDI should have been much more oriented towards international trade, with local subsidiaries incorporating more of the logic of the production chains of each transnational company”.

 

II.            The effect of FDI on Mercosur economies

Reviewing the available econometric literature, Chudnovsky and Lopez find that FDI has had little effect, either positive or negative, on Mercosur economies, although growth may have had an affect on attracting FDI into Uruguay and a weaker effect into attracting FDI into Argentina.

 

Positive spillover effects on domestic firms from foreign subsidiaries have come, to an extent, in productivity increases in human capital, modern management techniques and technology. In Brazil, demanding foreign subsidiaries have given their suppliers technical assistance to improve their quality, price and delivery-time, from which their downstream horizontal competition will also have benefited.

 

Against their competition, foreign subsidiaries, try to keep away positive spillovers, but Chudnovsky and Lopez found that positive horizontal spillovers in Brazil occurred in the form of increased productivity of domestic firms with large productivity gaps, and in Argentina, where domestic firms had a high “absorptive capacity” to learn. In Brazil too, it was found that spending on research and development was increased among domestic firms in order to keep up with the innovation being imported by subsidiaries from their parent companies, although the extent of this effect was probably not as great as first thought, reflective of Chudnovsky and Lopez’s overall finding of the latest econometric research into the positive effects of FDI on domestic companies. One explanation was that foreign firms may be acquiring companies that already had the greatest productivity.

 

Also, the hypothesis that the presence of foreign subsidiaries reduce the cost of acquiring information on export markets was found to not hold true on aggregate, although it had a very small positive effect in Brazil, unless this was negated by the increased competition against slightly less productive domestic firms.  This was because Mercosur subsidiaries were not found to export a great deal outside of Latin America, and especially not export higher-value goods; intra-firm trade accounted for as much as 63% of exports, with the subsidiaries importing higher technology than they exported back to their parent companies in the USA, Canada or Europe.

FDI has limited negative spillovers on domestic firms associated with it. In Brazil, domestic companies which were only a little less productive than their foreign subsidiary competition lost business to their marginally superior competition, hence lost economics of scale and hence lost productivity. The same happened in Uruguay, when FDI was used to gain access to the domestic market, as well as for the world at large, with local exporters losing productivity as a result of losing foreign clients

 

The type of foreign direct investment that the Mercosur nations will want more of are the two lower ones in table below: greater efficiency-seeking FDI, as mentioned above in the case of Mexico, and FDI into technology, as will be explained now using the example of Ireland.

 

The types of FDI inflows into Latin America, according to Morales and O’Donovan

Goods

Services

Details

Access to natural resources

petroleum, gas, mining

Tourism

Most are exported as raw materials: little value added, high price volatility

Market expansion

automotive, chemical, food industry, beverage, tobacco

finance, telecom, retail commerce, electric power, gas distribution

Spain is a large player in services

Greater efficiency

automotive, electronics, clothing

back-office

Only in Mexico (NAFTA) and the Caribbean Basin

Technological assets

Not significant

 

 

III.           FDI Across the ocean – the Irish experience

The success of the Irish model of FDI attraction is a consequence of historical developments and strategic policies.

 

The first historical development was the Great Famine that took place in the country which resulted in many Irish living in the USA, thus tightening the relationships between both countries. As a consequence, many Irish that live in the US provided investments in Ireland. A second important development is that the country adopted a free trade regime in 1966. Thirdly, its entry into the European Union in 1973 provided an increase in trade relations and financial assistance, mainly used towards infrastructure developments.

 

The strategic policies were divided into two main groups, industrial and macroeconomic policies. The first group included having a long-term strategic focus, based on job creation and education. Human capital allowed the country to be in a good competitive position. Essential to its success was the fact that Ireland targeted high-value added sectors, such as information technology, the pharmaceutical industry, and internationally traded services. According to Morales and O’Donovan, the main cause of its success was the creation of an institutional framework for investment promotion. To that end, three institutions were organized: the Industrial Development Agency, focused on marketing policies; Enterprise Ireland, to provide support to new company start-ups and to create linkages between multinationals and local industry; and the  Science Foundation of Ireland, which gave substance to Ireland’s brand image  of being a “knowledge economy”.

 

The second group of policies consisted of sound macroeconomic performance and prospects, including low inflation, surplus in the government budget and balance of trade, grants and subsidies for FDI promotion and low taxes. In addition, Ireland had an open market economy which helped create a propitious economic environment that was stimulated by financial incentives (investment and training grants, low-interest loans) and fiscal incentives (low taxes 12.5%). Important to the success of these policies was a national consensus in the form of agreements on taxes and wages between government, employers and unions.

 

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IV.           Policy Recommendations

Latin America can learn from Ireland how to attract more foreign direct investment.  At the same time, according to Morales and O’Donovan, a short-term macroeconomic “the more the better” approach to FDI is not going to attract quality investment, and for this reason, investment in natural resources or acquisitive investment in privatized service sectors, which transfer the ownership of what already exists, add little value to Latin American economies. What is needed is Greenfield investment, which creates jobs by improving production capacity, and this comes when transnational firms seek efficiency gains from a host country’s low-cost labor force, or highly educated workforce to develop technology.

 

What is also needed is the sort of investment that leaves positive spillovers for domestic firms.

 

To attract more and better quality investment, Morales and O’Donovan recommend that Latin American countries make available low-cost labor, a skilled and educated workforce and quality physical infrastructures. They may also want to consider, like their competition, the use of low taxes, grants and loans for foreign investors, and perhaps even monopoly rights to lure investment. Whatever Latin American countries can do to eliminate investor risk, ensure political and macroeconomic stability – in the long-run, the tight monetary and fiscal policies employed by most Latin American countries may win the, the confidence of investors (as opposed to Asian competitors which pursued growth-enabling macroeconomic policies) –  keep trade open (by use of regional and bilateral agreements), maintain property rights and fight corruption will also attract export-oriented and efficiency-seeking investors. They should also seek the investment of European nations whose heritage they share, as well as the upcoming Asian powers.

 

In order to maximize the spillovers from foreign subsidiaries, Chudnovsky and Lopez recommend that the Mercosur nations boost the capacity of small and medium sized enterprises to absorb the technological and business management gaps between local firms and transnational subsidiaries, whether they be  horizontally or vertically related; that the Mercosur governments incentivize research and development for both subsidiaries and domestic companies; that they persuade transnational firms to locate more of their strategic activities at the Mercosur subsidiaries, from which they develop products for global export; and that they help local companies integrate with the foreign subsidiaries.

 

V.             Critique of Morales/O’Donovan

Although Ireland may be tempting to draw comparisons to because of its success in attracting FDI, it must be remembered that the small country is being compared to a large and diverse continent which has a different set of circumstances: Latin America does have large domestic markets, and it does have natural resources.

 

Secondly, the financial data in the article ends in 2004, but it was only published in 2006. After 2004 FDI inflow to Ireland was reduced and FDI outflow to the US increased. Also, there is no evidence and no numbers on the linkages and spillover effects in the country. As far as the policies adopted to attract FDI, fiscal policies reduce government revenues and should be carefully analyzed. Furthermore, a review of how sustainable Ireland’s growth was in light of its economy’s collapse in 2008 following Lehman Brothers and the accusation that it was a ‘glorified hedge-fund’ is warranted.

 

Much of the country’s unprecedented growth is a function of a unique confluence of historical  events impossible to replicate, as well as its main language and its geographical location to a large northern market.
Relevant FDI calculations to host countries and to corporations


[1][1] Daniel Chudnovsky and Andres Lopez, “Foreign Direct Investment and Development: the Mercosur Experience”, CEPAL Review #92, August 2007.http://www.eclac.org/publicaciones/xml/0/31920/ChudnovskyLopez.pdf

[2][2] Ruth Rios-Morales and David O’Donovan, “Can the Latin American and Caribbean countries emulate the Irish model of FDI attraction?” CEPAL Review #88, April 2006. http://www.eclac.org/cgi-bin/getProd.asp?xml=/revista/noticias/articuloCEPAL/7/26317/P26317.xml&xsl=/revista/tpl-i/p39f.xsl&base=/revista/tpl-i/top-bottom.xslt

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