Foreign Direct Investment

Multinational enterprises are at the centre of policy debates in low- and middle-income countries. As some of the most productive and innovative firms in the world, which are at the core of global supply chains, multinational enterprises (MNEs) can accelerate development in the countries hosting them, both directly with their presence, and indirectly through linkages to local economic actors. At the same time, when MNEs operate in lower-income countries, they are often blamed for environmental degradation (especially in extractive sectors), crowding out productive local firms, undermining good governance, and having lax labour standards.

This VoxDevLit reviews the effects of MNEs with a particular focus on their implications for lower-income economies. We comprehensively examine the impact of MNEs on income and innovation at the country level; the linkages of multinationals with local firms in host countries; their effects on the environment and climate; the role of multinationals in sectors devoted to natural resource extraction; and the impacts on workers and their wages and labour standards in low- and middle-income host countries. We highlight key conclusions from each chapter in this summary.

Foreign Direct Investment: Presentation of key takeaways

At our launch event, Stefania Garetto, Nina Pavcnik and Natalia Ramondo joined us to present the key takeaways from this VoxDevLit, highlighting policy relevant results from recent research on the economics of foreign direct investment.

Multinational enterprises and the macroeconomy

• It is important to evaluate the gains from multinational production at the country-level and in a quantitative framework that incorporates product and factor markets, many industries and many countries. This setting includes multiple channels that can help governments to better understand the overall consequences of their policies. For example, lower tariffs achieved by a free trade agreement will impact not only trade flows but also the geographical structure of multinational production across countries.
• MNEs increase the real income of countries, primarily through enhanced productivity of production in host countries through technology transfers and the sharing of management knowledge from parent companies. The size of these gains depends on country-specific conditions, including the degree of technology transfer to local affiliates, the use of local and home-country factors of production (and country’s comparative advantage), and the role of barriers such as trade costs, tariffs, RTAs, domestic infrastructure, governance, and corruption, in attracting FDI.
• Lower-income nations experience lower gains in real incomes from MNEs because lower shares of their production are led by foreign companies, highlighting their higher impediments to cross-border investments (relative to high-income countries). Low-wage countries with convenient access to consumers, both domestically and in third markets, coupled with lower discount rates for using MNE’s home technology, emerge as the favoured hubs for multinational corporations.
• Multinational production has drastically shifted the organisation of firms, separating the creation of ideas from the manufacturing process. While the literature that quantifies the implications of  multinational R&D is still small, it suggests that R&D by MNEs can benefit even lower-income host countries. Host countries with a well-developed manufacturing sector tend to be more attractive for foreign R&D because of the importance of co-location between R&D and production. In addition, cultivating a suitable workforce in targeted industries can be effective.
• While MNEs are likely the largest players in the global value chains, data constraints have limited studies of the specific role of MNEs’ supply chains for the transmission of events, such as financial crises and natural disasters, across developed and developing countries. Nonetheless, existing studies already find evidence on their importance for international business cycle synchronisation.

Multinational enterprises and linkages with local firms

• Governments frequently support MNEs, with the idea that these firms can transfer their expertise, technologies, and know-how to economic actors in the local economy.
• Horizontal linkages are those between MNEs and their domestic competitors (typically in terms of their outputs). The increasing importance of MNEs in an industry can both negatively and positively affect domestic firms’ performance. We have yet to reach a consensus on the aggregate effects of horizontal linkages.
• Research on spillovers from MNEs has emphasised the shared-supplier linkages as a channel through which MNEs can affect their domestic competitors. By increasing the demand for inputs, a final-good firm helps bring forth a greater variety of specialised inputs, thus generating a positive externality to other final-good producers. The externalities to domestic competitors are affected by potential technological incompatibilities between foreign and domestic technologies.
• The availability of within-country firm-to-firm transaction data has allowed researchers to zoom in on the domestic firms that establish linkages with MNEs.
• Research shows that firms supplying MNEs tend to experience substantial productivity improvements and gain better access to markets. First-time suppliers to MNEs experience a series of interdependent improvements in efficiency, product scope, quality, and reputation.  However, the productivity gains are not explicitly shown to arise as externalities.
• MNE affiliates tend to be heavy importers, which limits the opportunities for domestic firms to start supplying to these firms and experience the benefits documented above. More research is needed on the extent to which MNE affiliates actually rely on local supply chains, the reasons behind their low reliance, and the scope for policymakers to intervene to increase this reliance.
• While there is some degree of substitution between migration and offshoring, in the long run, migrants increase connections across regions through trade and FDI. Information asymmetries play a notable role in MNEs’ investment decisions. Studies have found that immigration can persistently diminish information barriers and thereby boost FDI. However, the academic research on this area has focused predominantly on the effects for the receiving economies and not sending countries.
• Competition for FDI is intense among low- and middle-income countries. Studies find that one of the more successful policies promoting FDI is capital account liberalisation. Another promising way to promote FDI and attract MNEs is to promote the expansion of multinational banks because they offer an established network of financial services and expertise, reducing information asymmetry and transaction costs for both investors and firms looking to expand into foreign markets.
• Trade liberalisation can promote FDI and the expansion of MNEs through boosting incentives for mergers and acquisitions of firms and greenfield investment.
• Likewise, investment promotion initiatives are also associated with attracting FDI through reducing information asymmetries through targeted outreach and international image building.

Multinational enterprises and the environment

• Given their size and overwhelming share of world output, MNEs are the largest emitters. The Word Bank reports that the 157 MNEs surveyed by the Carbon Disclosure Project and their networks of affiliates account for 10% of direct emissions and an additional 50% through their value chain. Around half of these MNEs operate in the energy sector (electricity utilities and oil and gas).
• Environmental outcomes tied to MNEs are not uniform. Evidence shows that MNEs often use advanced and cleaner technologies and are more energy efficient than domestic firms.
• Evidence is mixed about whether MNEs from countries with stricter environmental regulations reallocate their dirtier production to countries with laxer policies. More research is needed about the environmental spillovers of MNEs to domestic firms.
• Carbon leakage is an important concern, particularly in industries that are both trade-intensive and energy-intensive. Mechanisms like carbon border adjustment taxes and coordinated international agreements can encourage MNEs to align their operations with environmental goals, but they face political challenges.
• The transition to a clean(er) global economic system provides an opportunity for innovators of low-carbon technologies to emerge from lower-income countries. The leadership of Chinese firms in both Electric Vehicles (EVs) and solar energy points to the possibility that relatively poor countries can leapfrog developed economies and quickly become leaders in low-carbon technologies. Moreover, the Chinese examples show that FDI into emerging economies, as well as FDI from those economies, are central factors on the road to carbon superstardom. However, China is a special case in many respects and it is not clear whether the Chinese example is replicable elsewhere, especially with regards to the involvement of MNEs.  More research is needed to evaluate other cases.
• Climate risks will only become more severe over time. Yet, there is still a substantial knowledge gap in terms of how MNEs are exposed to these risks and no consensus as to how they have reacted so far and might react in the future. Based on existing evidence, we cannot rule out the possibility that there will be a significant reallocation of FDI due to climate risks.

Multinational enterprises and natural resources

• Natural resources, such as agricultural land, water resources, fossil fuels, and other minerals, are of significant macroeconomic importance for low- and middle-income countries, accounting for a high share of exports and value added.  A small number of large MNEs often operate in these sectors, so it is important to consider the role of MNEs for host economies.
• MNEs in these sectors can generate important streams of income by bringing technology, investment, and means of integration between suppliers and consumers within the global supply chains. However,  MNEs can exacerbate existing domestic market failures, such as the overexploitation of natural resources such as forests, water, and fisheries.
• Existing evidence suggests that MNEs in the extractive sector are linked to corruption, violence, and environmental degradation in lower-income countries.
• Another major concern is the extent to which the economic gains from trade and investment are shared with local economies. Existing research provides limited insights about which factors drive partitions of profits in these sectors between MNEs and local economies. Yet, some recent evidence from several African economies suggests that FDI can also bring positive local development impacts, especially in boom times. Large mines can spur local economic activity and reduce poverty, creating jobs and generating long-lasting effects.
• What policies can increase the benefits being shared with local economies? Field experiments suggest that providing citizens with information about substantial oil and gas discoveries can increase local mobilisation and counter the resource curse. Evidence suggests that monitoring MNE corruption in their origin countries can change corporate behaviour.
• Considering both benefits and costs of MNEs in developing countries, the most effective policies (based on the scant evidence so far) appear to be those that promote the growth of MNEs as part of a comprehensive strategy, which includes addressing local market distortions and improving distributional inefficiencies.
• It is important that research (and policy discussions of the role of MNEs in these sectors) continues to incorporate economic features that are ubiquitous in these markets, including oligopoly and market power, the investment decisions for expanding supply chains under uncertainty, vertical linkages and investment in downstream industries (such as processing and manufacturing), and optimal policy design to maximise the potential local benefits of MNEs. 

Multinational enterprises and labour markets

• Policymakers make costly efforts to attract MNEs, one of the main reasons being the creation of jobs, particularly higher-quality ones.
• The current body of research suggests optimism on the ability of MNEs to positively impact workers, both directly and indirectly, through higher wages and employment, although the evidence varies across countries. It is reasonable to expect significant benefits in developing countries, where labour markets often lack MNE-like domestic employers.
• The discussion of the effects of MNEs on labour markets in lower-income contexts needs to pay close attention to interactions with the informal sector, which employs a large share of workers in lower-income settings. We currently do not know whether MNEs trigger reallocations towards or away from the informal sector, and whether workers in informality see higher or lower wages when MNEs grow in importance.
• While the focus on wages and employment is relevant, job creation in itself should not be a measure of success. It is important to consider how MNE jobs influence economy-wide employment in the context of unemployment or underutilised workers that MNEs, directly or indirectly, help employ.
• To the extent that MNEs provide higher-quality jobs, we need further evidence to understand the complementarities that trade policy or other types of industrial policy can have with MNE job creation.
• In theory, MNEs could deteriorate labour standards by inducing a race to the bottom between governments vying for their presence. Alternatively, their production or sourcing activities could raise labour standards, through increasing local incomes and enabling governments to pass some of the cost of improved labour standards to foreign countries.
• The evidence on MNEs’ impacts on labour standards is growing, but it remains underdeveloped, especially in light of the continued push of policymakers in wealthy destination countries toward regulating sustainability in global supply chains.
• The impact of MNEs on labour standards also depends on the quality of institutions that govern labour markets. As a result, even when strong de jure labour standards exist, de facto, domestic firms may face very little enforcement. A recent field experiment suggests that improved enforcement by MNEs increases suppliers’ compliance with the mandates.
• A growing body of evidence documents that monopsony power of exporters, combined with other market frictions, is another important characteristic of labour markets and agricultural value chains in many developing countries. This suggests that, at least in certain value chains, MNEs may play an important role in influencing workers’ and farmers’ gains from exposure to international trade.
• Weak institutions that result in contracting problems and market power along the value chain often lead parties to rely on long-term trading relationships. Scholars have argued that MNEs’ efforts to privately enforce labour standards on third-party suppliers can be understood through the lens of relational contracting, in which the future value of trade provides MNEs with the incentive and opportunity to monitor.
• It is important to also understand the overall impact of responsible sourcing policies on workers in developing countries. The predicted welfare impacts are ambiguous, and depend on whether MNEs face consumer demand that values these practices, on the potential monopolistic market power of MNEs relative to their domestic suppliers, and on suppliers’ potential market power over workers.

Editor's note: The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.