Foreign direct investment drive for development

Introduction

Foreign direct investment (FDI) is an essential part of any economy and key driver for any development. However, for any country to reap the benefits of FDI, countries have to design policies that grant its attractiveness for the foreign investor. There is a fierce competition among countries, especially developing countries to attract more foreign direct investments.

Most of the investments flows are from developed economies to developing ones. Developing countries have increasingly considered FDI as a source of achieving higher levels of: economic development, economic growth and employment (OECD, 2002).

Consequently, most of the developing countries have adopted principles of free market economy and upgraded their investment policies in order to maximize their benefits from FDI.

Egypt pays greater attention towards FDI policies to benefit from FDI positive impacts and throughout this paper, the researcher will shed the light on FDI policies followed by the Egyptian economy during the period from 1980 to 2008 and how these policies effectively impacted the performance of the Egyptian Balance of Payments.

To serve the purpose of this study, the researcher will shed the light on stages of liberalizing the Egyptian economy starting from the 1980s, and the trend of FDI along the period from 1980 to 2008, focusing on the relation between FDI performances and the capital account.

Hence, the paper will be consisted of six main sections. The first section will introduce the basic concepts, and theories of the FDI. Section two will present the determinants of the FDI and the third section will tackle the impact of FDI on the host country. Then, the fourth section will introduce the performance of the Egyptian Economy during the period of 1980-2008 focusing on the main policies of FDI across this period. Followed by the modelling approach i.e. empirical part, in which the researcher will use the regression model to know the effect of the FDI as an independent variable on performance of the Egyptian capital accounts as a dependent variable during the period from 2000-2008, keeping other factors constant. (Check the accuracy of this after stating the model)

Importance of the Topic:

Given the increasing importance of FDI for the well being of countries, especially developing countries, the researcher will shed the light on how effective are FDI policies introduced by Egypt in attracting FDI and consequently on the capital account, and how this creates deficit or surplus.

Methodology:

The Study will depend on the following:

  1. The Descriptive approach: Reviewing FDI policies and the annual data for the period from 1980 to 2008. The analysis will be based on time series data of Egypt across this period on Capital Account, FDI and GDP. Doing so, the researcher will depend on many data references, include but not limited to: Central Bank of Egypt Annual Report, Egypt year book, data of the ministry of investment and ministry of finance.
  2. The analytical approach: The model

Objective of the Study:

The major objective of this paper is studying the impact of FDI on Egypt's Balance of Payments of and in particular the effect of FDI on the Capital account.

The Study is trying to answer the following questions:

  1. How effective are the Egyptian FDI policies offered in attracting FDI
  2. What is the relation between FDI and Capital Account

Section one: Theories of Foreign Direct Investment, Basic concepts

There were reports of FDI (Neumayer & Spess, 2005) being regarded as a "major force in the worldwide allocation of funds and technology". As a result, FDI has a significant value for the majority of countries and the developing ones in particular (Neumayer and Spess 2005, p. 1568). In its report in 2003, UNCTAD asserted that the basic element of the net resources taken by developing countries is represented by the FDI.

For developing countries, FDI plays a significant role not only as a finance and employment source but as an important mechanism for skills acquisition, technology transfer and gain in managerial and organizational practices as well FDI can be seen as one of the most virtuous, if not the most, to developing countries as a stabilized component of flow of capital international investment (Nooerbakhsh et al. 2001).

Finally, according to UNCTAD (2004), FDI stands for sizable proportion of capital formation in the developing countries. Many studies have demonstrated that FDI has positive impacts on developing countries and emerging economies, as it enables developing countries to cover their deficit current accounts, and cover the shortage of financing the ownership of domestic resources and formation of capital (OECD, 2001)

Due to such growing importance of FDI, developing countries are currently in fierce competition for attracting FDI into their economies. In 2007, FDI inflows into developing countries rose by 21% comparing to 2006, to reach a new record level of $500 billion (WIR, 2008).

As defined by Bannock, Baxter and Davis (1998), and explained by Ethier (1995) FDI, according to IMF and OECD is any investment carried on in the host country by the home country which takes place in two ways. Erecting a new production institution is one way. The other is gaining the least possible share of the existing firm (Bannock et al, 1998). This least percentage level or share agreed upon signifying the competence to dominate the firm's management is 10%. On the other hand, if it is less than 10% then it is defined as "portfolio" investment.

FDI is done through many ways. One way for carrying out FDI is through receipt of shares no matter if they are cash funds or assets. Another way is to reinvest the earnings. Another method can be the long financial transactions occurring between linked firms. Compared to, foreign bank lending (FBL), and foreign portfolio investment (when citizens, firms or public entities invest in instruments and tools of foreign finance), the main feature distinguishes FDI from the latter two terminologies, is the long term relation-ship between the home and host countries and the obvious influential level by the home country's direct investor in managing the host country's firm (IMF, 1993).

A direct investor may be an individual, a firm, a multi-national company (MNC), a financial institution, or a government. FDI is the essence of MNCs - they are so called because part of their production is made abroad. Furthermore, MNCs are the major source of FDI - they generate about 95% of world FDI flows (United Nations, 2002).

Historical Background:

The roots of foreign Direct Investment dates back to the beginning of mankind. A fact to be mentioned is that, many activities similar to modern day FDI's activities occurred in the ancient times (Wilkins, 1970, p.1). Prior to the Great War, FDI was an actively less important than FPI. In 1914, this latter accounted for 90% for all international capital movements (FBL, FDI, FPI, government loans, grants).

The major providers who invested abroad in 1914 were Great Britain (43%), France (20%), and Germany (13%) (Kenwood and Longhead, 2000).

The main recipients of these funds were other developed countries in North America and Europe. The only main determinant of international capital movement was interest rate differentials. Investments (especially portfolio investments) were made in countries offering high interest rates (Lipsey, 2001).

The depression of 1929 and World War II caused downturns in international business activities. After the Second World War, official gifts and loans, followed by direct investments made up the most important international capital flows (Sodersten and Reed, 1994, ).

In the early 1960s, the term MNC was introduced in the economic literature to refer to those firms operating in more than one country. At the same time, the frontier between FDI and FPI was drawn (Hirst and Thompson, 2000).

Types of FDI:

There are several types of Foreign Direct Investment. The first with high importance as referred to by Lawler and Seddighi (2001) is Greenfield investment, which is the establishment of a new site abroad and it is financed out of capital raised in the direct investor's country, (Lawler & Seddighi, 2001). The use of the term Greenfield investment covers any investment abroad, whether there has been transfer of payments from the investor country to the host country. The second type is Merger and Acquisitions (M&A), which refers to the transfer of ownership of a local productive activity and assets from a domestic to a foreign entity (United Nations, 1998).

In the short-term, a country may benefit more from a Greenfield FDI than from a M&A FDI. Because it affects directly, immediately, and positively employment and capital stock. Where the installation of a new industry in the foreign country adds to the existing capital stock and entails job creation. Moreover, Kendwood and Louhheed believe that Profits of M&As are kept in the host country to finance future projects instead of being recorded in the home country (Kenwood & Louheed, 2000).

In addition to Greenfield investments and M&A investments, there are other two types, known as: Vertical and Horizontal investments. Vertical FDI is vertical extension backwards of the activities of the firm, which refers to an export oriented FDI, either by extracting raw materials or manufacturing component parts or finished goods at a cost lower to the investor's home country, while Horizontal FDI which is often known by import-replacement FDI (i.e. the local production of goods and services for sale in the host country) (UNCTAD).

A government - initiated FDI is a subsidized investment set by the host country, to enhance employment, shorten disparities within the recipient country's regions, as well as lowering the balance of payment deficit (UNCTAD).

FDI incentives involve some market considerations, including FDI's size and the host country's comparative advantages. From these considerations that foreign investors might be attracted with is stability, as well as significant economic growth. Achieving progress in macroeconomic reforms is another sight of attraction. Another area of attraction is independence from foreign exchange restrictions, as well as Openness, transparency and accessibility of the local and regional markets (UNCTAD).

Fiscal and financial incentives play a great role as determinants of FDI. The most popular used fiscal policies include: income tax, sales tax and stamp tax exemptions, in addition to, establishing free zones where there no trade barriers. For financial incentives, they include: direct government loans or loan guarantees, export financing or debt/equity conversion possibilities (UNCTAD).

Thus, any serious investor will consider all reasonable alternatives for greater or equal return and minimize risks before deciding whether and where to invest.

Compilation of FDI flows:

The available statistics on FDI flows between a country and the rest of the world are classified into two main categories; FDI inflows and FDI outflows.

Based on the guidelines set by IMF in (1993), a home country should register foreign investment as an outward FDI flow and host country as inward FDI flow investment provided that the foreign investor holds a minimum percentage of 10% of the normal shares.

This process is not an easy on, since the governments' main obstacle, is not possessing an efficient machinery of collecting the adequate statistics (South Centre, 1997). Moreover, accounting conventions of several countries differs from the IMF (1993) guidelines. Hence, these facts illustrate the variations between World FDI inflows and outflows as they should be normally equivalent.

Section Two: Determinants of FDI

In general the theories of FDI are classified into two main categories; Macro-economic theories, and Micro-economic theories. In this section Macro-economic theories of the FDI will be presented.

Exchange Rate:

Keeping other factors constant, the relationship between FDI inflows and the host country currency is negative. For Aliber (1993) when the currency of the host country depreciates, foreign direct investments to the country increase as a result.

Aliber (1993) argued that foreign investor is motivated to invest in the host country as long as its currency is depreciating considering it a low-cost place in comparing to other countries that have currencies appreciation.

Economic Growth:

According to (Lipsey, 2000) as well as (Salvatore, 2001), the relationship between FDI and economic growth is positive. The positive relation between FDI and economic growth was argued by Aliber (1993) that stated that countries with lower rate of growth are experiencing capital outflows comparing to those with higher rates of economic growth.

Market Size:

According to Scarperlanda and Mauer (1969) the market size is an influential factor, the greater the market in terms of population, the more FDI in it.

Other Determinants:

Statements and views made out by Holland and Pain (1998); Lansbury, Pain and Smidkova (1996); Wheeler and Mody (1992) as well as the United Nations (1998) show that, the more is the country towards applying free market economy regime, the more available determinants of FDI, which includes: trade openness, privatization. In addition to other factors like: macro economy stabilization cost of labour and effectiveness of FDI policies (Holland and Pain, 1998).

Section Three: Impact of the FDI on the host country (positive and negative aspects):

Many economic studies tackled the impact of FDI on the host countries exploring FDI pros and cons. In all the cases, this will depend on the type of the investment, whether it is Greenfield or M&A, horizontal or vertical.

a. Economic Growth:

Many economic studies demonstrated that FDI has a positive impact on the economic growth, as it contributes to increasing the capital formation of the host country that may be induced by transferring technology and/or creating new jobs. However, Lipsey (2000) pointed out that the effect of FDI on increasing capital formation doesn't apply for all the countries. Therefore, it can't be generalized. In addition to that, the impact of FDI on the economic growth of the host country depends on the type of FDI as stated by (Borensztein, De Gregorio and Lee, 1998). As said in the first section, international M&A does not add, at once, to the host country's capital stock where as Greenfield FDI does.

b. Balance of Payments:

As said in the first section, there are two types of investments that are renamed under export oriented FDI, which is known as Vertical Investment and import replacement which is known as horizontal investment. These two types affect the host country balance of payment. However, their impacts on the balance of payments are ambiguous. Therefore, in this study, the researcher will try to explore more the impact applying to the Egyptian case.

From a theoretical point of view, Dunning (1969) stated that FDI decreases host country imports, keeping other factors constant, and as a result improves balance of payments performance. However, if the inputs used by the investor are imported from abroad, the balance of payments performance may not be improved.

For vertical investment or export oriented as Dunning (1969), whether the investor sold the produced goods and services in the same host country or just aiming at extracting raw materials, both of the two activities will have a positive impact on the host country balance of payments.

Moreover, Dunning (1969) asserted that the financing of investment and repatriated profits affect the balance of payments of the host country, as if the financing source of the investment is the home country and the repatriated profits are kept in the host country, this will have positive impacts on the host country balance of payments.

c. Other Impacts:

The other impacts of FDI on the host country includes but not limited to: cultural, environmental, political and social impacts. However, these impacts depend on the sector or industry which the investment is in, in addition to the power influence of the foreign investor on the market. As FDI in the media sector affects the cultural of the host country, may weaken national culture and dominance of investor's home culture. For production sector, some foreign industries may cause negative externalities, e.g. pollution. Moreover, the influence of some MNCs over policies in host countries cause conflicts in host countries.

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