Foreign Direct Investment

How much does an economy benefit from the possibility of shifting production across borders? By choosing to establish a production facility overseas to serve foreign markets or secure intermediate inputs for their production processes, multinational enterprises (MNEs) can have a significant impact on their host economy.

Countries interact in many ways, two major ones being trading goods and services, and firms producing internationally using a mix of their home and local technologies, including ‘’green" or ‘’brown" technologies, local and home suppliers, and local and home factors, including labour and physical capital.

While international trade has enabled nations to specialise based on productivity and factor cost differences, sparing them from producing their entire consumption basket domestically at a much higher cost, the possibility of producing outside the home country allows firms to raise global output and welfare by allowing technologies, managerial abilities, and other forms of organisation and knowledge capital to be transferred to foreign locations.

Understanding the sources and magnitude of the effects of multinational activity is especially relevant for developing countries, and it is one of the main topics at the centre of economic research and policy debate. Being the most productive and innovative firms in the world, and at the same time, at the centre of the web of global supply chains, MNEs can accelerate development in the countries hosting them, both directly with their presence, and indirectly through linkages to local economic actors.

But at the same time, when MNEs operate in less developed 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 article is aimed at reviewing key aspects of the activity of MNEs with a particular focus on their effects for developing economies.

Section 3 of this review is dedicated to MNEs and the Macroeconomy. The increased focus on global firms and the inherent complexities surrounding their geographical decisions in an open and integrated world economy highlights the need for quantitative models to handle MNEs’ responses to cost reductions, government incentives, deeper integration agreements, and an array of other frictions.

Section 3.1 reviews the literature that quantifies the aggregate impacts of the activity of MNEs, often measured as the gains in real income stemming from shifting away from scenarios where firms face prohibitively costly barriers to producing in foreign countries.

The ever-changing barriers to MNE activities—together with barriers to trade in goods and services—as well as the mobility of capital and labour, international and national regulations, intellectual property rights protection, and government interventions, not only shape the location of production across the globe, but also the location of innovation. Recent trends indicate that MNEs are increasingly establishing innovative activities in middle-income countries. Section 3.2 focuses on the presence of MNEs in research and development (R&D) activities across the globe, a less discussed, but no less important, aspect of the activities of these firms. The chapter reviews the recent empirical evidence as well as general equilibrium theories on the subject.

The activity of MNEs, and the related trade flows, creates complex links between countries, the so-called global supply chain. These linkages, in turn, facilitate the transmission of shocks, such as financial crises and natural disasters, from one economy to the other. Section 3.3 reviews the literature on the role of MNEs in the transmission of shocks.

One of the main reasons why governments want to attract MNEs to their territories, offering multi-million packages (‘’mega deals") to compete with other nations, is that MNEs not only create local jobs, tax revenues, and new transactions in the local economy, but also ‘’spillovers". Central to the attraction of MNEs is the idea that these firms can transfer their expertise, technologies, and know-how to economic actors in the local economy. More concretely, the presence of MNEs in an economy may act as a catalyst for more and higher-quality jobs, better and greener technologies, higher-quality products, and more developed financial markets, benefiting local firms.

Section 4 is dedicated to reviewing the literature and policy implications of the various channels through which the MNE transfers knowledge to the host economy. We focus on supplier and buyer transactions with local firms, high-skilled migrants, and the finance channel.

Section 4.1 focuses on firm-to-firm linkages, including both links where the MNE is the supplier to local buyers and links where the MNE is the customer to local suppliers. The recent empirical evidence reviewed in this section is made possible thanks to the availability of datasets tracking transactions between firms, many of which are from developing countries.

Multinational activity is deeply interconnected with the movement of workers across borders. Workers flows may accompany the flows of FDI and trade across countries, helping to reduce communication and information frictions between their home country and the country they migrate to, as well as helping with the transfer of technologies, managerial ability, and know-how from the home to the host country. Section 4.2 is dedicated to the analysis of migration flows, with a special emphasis on high-skilled migrants, and their effects on the activity of MNEs.

Finally, Section 4.3 reviews the literature analysing the link between finance and technology adoption. Well-developed financial markets play a pivotal role in encouraging FDI and facilitating the establishment of MNEs. At the same time, financial markets serve as critical catalysts for enhancing firms’ productivity and facilitating technology adoption in developing countries, with MNEs playing an active and central role.

Section 5 turns to the role of MNEs on climate change. This topic may be of central importance for developing countries, which are particularly vulnerable to the adverse effects of higher temperatures. MNEs have the potential to exert a positive influence throughout their supply chains and through their direct presence in these countries. But while MNEs offer a potential avenue to enhance the access of developing countries to cleaner technologies, either by using the same cleaner technologies they use at home in the host country or by transferring those technologies to local firms, they may also shift emission-intensive production to regions with less stringent environmental standards so that developing nations become recipients of environmentally harmful production facilities.

Section 5.1 is dedicated to reviewing the evidence on how MNEs, with operations spanning multiple countries, can influence global emissions. Section 5.2 explores the relevance of MNEs for innovation in clean technologies. Finally, Section 5.3 summarises the economic literature on the adaptation of MNEs to climate risks, both physical and transition risks.

Section 6 discusses a very important but less studied aspect of the activity of MNEs: their role in sectors devoted to natural resource extraction. This topic is particularly important for less developed economies, which host key natural resources, such as agricultural land, water resources, fossil fuels, and other types of mining. These resources are sometimes seen as a “curse" to development, due to food security, specificity of supply, price fluctuations, monopsony power, weak institutions, and violence. At the same time, these sectors constitute a key source of income for countries, are linked to large infrastructure projects and can generate local positive spillovers.

While Section 6.1 explores the quantitative literature linking international trade, MNEs and the market for natural resources, Section 6.2 reviews the empirical literature that relates the activity of MNEs in those sectors to development.

We conclude with Section 7, dedicated to advances in the literature on MNEs and their effects on labour markets. As mentioned above, policymakers make costly efforts to attract MNEs, one of the main reasons being the creation of jobs, and in particular, higher-quality ones. The effects are not circumscribed to workers employed by the MNEs themselves, but they extend to other workers in the receiving economy. However, the effects on workers become more nuanced and can have very undesirable consequences in less developed countries with lax labour standards. The key question is whether the arrival of MNEs improves labour standards or if these firms engage in a “race to the bottom” in order to keep low labour costs. While Section 7.1 reviews recent advances, both empirical and theoretical, on the direct and indirect effects of MNEs on workers, Section 7.2 explores the literature on the effects of MNEs on the adoption of (or lack-of) labour standards.

Our review complements existing surveys of MNEs and global value chains such as Antràs and Yeaple (2014), Antràs (2020), and Antràs and Chor (2022). These surveys are predominately organised around theory models of MNEs and global value chains. Our survey is organised around topics of interest and pays particular attention to issues of MNEs in lower-income settings. 

Definitions

• We refer to a Multinational Enterprise (MNE) as an entity consisting of a parent or head- quarter firm and at least one foreign affiliate firm owned with a share of 10% or more. These are sometimes also known as Multinational Corporations (MNCs).
• Multinational production (MP) refers to the activities of parents and foreign affiliates, such as sales, employment, trade, and innovation.
• Foreign Direct Investment (FDI) refers to a financial category of the Balance of Payment of countries. FDI consists of financial flows related to parent and affiliates of MNEs (equity flows, reinvested earnings, and intra-firm debt). FDI can be established in two ways: Greenfield FDI, whereby the foreign affiliate is a new firm; and Merger and Acquisitions (M&A), whereby the foreign affiliate is an existing firm that is acquired by the parent firm.
• Outward (Inward) FDI refers to the FDI flow that a country sends abroad (receives from abroad).
• We refer to a host country as the country of operations of the MNE affiliate, and source, origin, or home country as the country of ownership — where the parent or headquarter company is located.
• Horizontal MNE activities refer to activities directed to the host market of operations of the affiliates (e.g. horizontal sales are sales directed from the affiliate to its host market of operations).
• Vertical MNE activities refer to activities of the affiliate directed to the parent company and other affiliated parties (e.g. sales to the parent and other affiliated parties).
• Export-platform activities refer to activities of the affiliate directed to other markets other than its host market (e.g. affiliate exports).

References

Antràs, P (2020), “Conceptual Aspects of Global Value Chains”, World Bank Economic Review 34(3): 551-74.

Antràs P and D Chor (2022), Chapter 5 - Global Value Chains. In Gita Gopinath, Elhanan Helpman, and Kenneth Rogoff, editors, Handbook of International Economics, Elsevier 5:297-374

Antràs, P and S R Yeaple (2014), “Multinational Firms and the structure of international trade” in Gopinath, G, E Helpman, and K Rogoff, eds, Handbook of International Economics 4. Elsevier.