Cambridge Syllabus Notes

1. Introduction to Foreign Direct Investment (FDI)

Foreign Direct Investment (FDI) is a long‑term investment made by a resident of a home (source) country in an enterprise located in a host (receiving) country. The investor acquires a lasting interest – usually at least 10 % of the equity – and seeks to exercise a degree of managerial control. FDI is a key topic in Cambridge International AS & A Level Economics (syllabus 11.5 Relationship between countries at different levels of development), where it is studied alongside international aid and balance‑of‑payments (BOP) policies.

2. Why FDI Occurs

2.1 Motives for the Home (Source) Country

Motivation	Explanation / Example
Market‑seeking	Access to new consumer markets – e.g., UK retailers entering India.
Resource‑seeking	Acquisition of natural resources or strategic assets – e.g., oil‑field investment in Nigeria.
Efficiency‑seeking	Exploiting lower factor costs (labour, land, capital) – e.g., garment factories in Bangladesh.
Risk‑diversification	Spreading exposure across regions and sectors.
Current‑account improvement	Repatriating profits and dividends to boost the home country’s income balance.

2.2 Motives for the Host (Receiving) Country

Motivation	Explanation / Example
Capital inflow	FDI supplements domestic savings – e.g., Chinese FDI in African mining.
Technology & know‑how transfer	Multinationals bring advanced processes – e.g., Samsung’s R&D centre in Vietnam.
Employment & skill formation	Creation of direct jobs and on‑the‑job training.
Export promotion	Foreign firms often produce for overseas markets – improving the trade balance.
Fiscal gains	Corporate tax, VAT and higher personal‑income tax receipts.

3. Interaction Between FDI and International Aid

3.1 Main Forms of Aid

Form of aid	Typical provider	Key features
Bilateral aid	Individual governments (e.g., UK DFID)	Negotiated directly; often tied to policy conditions.
Multilateral aid	International organisations (World Bank, IMF, UN)	Pooled resources; sector‑specific projects; less political pressure.
NGO/Charitable aid	Non‑governmental organisations (Oxfam, Red Cross)	Humanitarian relief, capacity‑building, community projects.
Humanitarian vs. Development aid	Same providers	Humanitarian – short‑term disaster relief; Development – long‑term structural improvement.

3.2 How Aid Relates to FDI

Aid‑for‑investment programmes: Infrastructure financed by aid (roads, ports, power) lowers transaction costs and attracts FDI.
Conditionality: Aid may require macro‑economic reforms (e.g., trade liberalisation) that create a more FDI‑friendly climate.
Complementarity: Technical assistance improves local firms’ ability to absorb technology spill‑overs from multinationals.
Crowding‑out risk: Generous aid can reduce the incentive for governments to pursue private investment or lead to duplicate projects.

4. Economic Consequences of FDI

4.1 Positive Impacts on the Host Economy

Capital formation: New plant, machinery and infrastructure shift the production‑possibility frontier outward.
Technology spill‑overs: Local firms imitate or adopt new processes, raising total factor productivity (e.g., Toyota’s “learning‑by‑doing” effect in Thailand).
Employment and skill development: Direct jobs plus training raise household incomes and human capital.
Export expansion: Multinationals often produce for export, improving the trade balance and current account.
Fiscal benefits: Corporate tax, VAT and higher personal‑income tax receipts increase government revenue.
Linkages to domestic firms: Backward‑linkage demand for local inputs stimulates upstream industries.

4.2 Potential Negative Impacts on the Host Economy

Profit repatriation: A portion of earnings is sent back to the home country, reducing net capital inflow.
Crowding‑out of domestic firms: Large MNEs may dominate markets, limiting opportunities for local entrepreneurs.
Environmental degradation: Weak regulation can lead to over‑exploitation of resources and pollution (e.g., mining in the DRC).
Wage polarization: High‑skill, high‑pay jobs increase, while low‑skill wages may stagnate, widening inequality.
Dependence on external capital: Sudden withdrawal of FDI can create macro‑economic instability.
Transfer‑pricing and tax avoidance: Multinationals may shift profits to low‑tax jurisdictions, eroding the host’s tax base.

4.3 Effects on the Home (Source) Country

Higher returns on capital for multinational firms.
Potential loss of domestic jobs if production is relocated abroad.
Improvement of the home country’s current account through net income receipts (profits, dividends, interest).
Strengthening of strategic sectors (technology, energy) through global integration.
Possibility of “brain‑drain” if skilled staff move abroad to manage foreign subsidiaries.

5. Balance‑of‑Payments (BOP) Effects of FDI

5.1 How FDI Appears in the BOP

Capital (financial) account: Recorded as a capital‑inflow, improving the financial account balance.
Current account:
- Short‑run: Export earnings from the new plant increase the trade surplus.
- Medium‑run: Profit repatriation, interest and royalty payments generate a current‑account outflow.

5.2 Policies to Correct BOP Disequilibrium (Syllabus 11.5.1)

Policy type	Objective (expenditure‑switching / expenditure‑reducing)	Typical instruments	Illustrative FDI‑related example
Fiscal policy	Expenditure‑switching (if current‑account deficit)	Tax incentives for export‑oriented FDI; higher corporate tax on repatriated profits	South Africa’s “investment‑promotion tax allowance” for green‑technology projects.
Monetary policy	Expenditure‑reducing (to curb excessive capital inflows)	Interest‑rate hikes; open‑market operations to tighten liquidity	Brazil’s policy‑rate increase in 2015 to limit speculative inflows.
Exchange‑rate policy	Both – can make imports more expensive (expenditure‑reducing) or exports cheaper (expenditure‑switching)	Managed float, foreign‑exchange controls, sterilised intervention	China’s managed renminbi to balance FDI inflows with export competitiveness.
Supply‑side measures	Expenditure‑switching (enhance export capacity)	Infrastructure investment, skills‑training programmes, easing of business licences	Vietnam’s “Industrial Zones” scheme to attract electronics FDI.
Protectionist tools	Expenditure‑reducing (if FDI threatens domestic firms)	Local‑content requirements, import quotas, anti‑dumping duties	India’s “Make in India” policy requiring a minimum percentage of local inputs.

5.3 Evaluation of Policy Choices

Fiscal incentives can attract desirable FDI but may trigger a “race to the bottom” in tax rates, reducing government revenue.
Higher corporate taxes on repatriated profits improve the current account but could deter future investment.
Monetary tightening limits volatile inflows but raises borrowing costs for domestic firms, possibly slowing growth.
Exchange‑rate appreciation makes imports cheaper (reducing inflation) but can make export‑oriented FDI less attractive.
Supply‑side improvements (infrastructure, education) generate sustainable gains without distorting market signals, though they require time and fiscal resources.
Protectionist measures protect nascent industries but risk retaliation, reduced foreign‑investment attractiveness, and inefficiency.

6. Development‑Level Specific Outcomes of FDI

Development level	Typical benefits	Typical risks / challenges
Low‑income	Basic infrastructure (roads, power); initial technology transfer; sizable job creation; improvement of the BOP.	High profit repatriation; weak regulatory capacity; environmental damage; possible crowding‑out of small firms.
Middle‑income	Advanced skill formation; integration into global value chains; diversification of export base; higher tax revenues.	Wage inequality; displacement of domestic SMEs; need for stronger environmental and labour standards.
High‑income	Access to new markets; acquisition of strategic assets; innovation synergies; higher returns on capital.	Offshoring of manufacturing jobs; de‑industrialisation of certain sectors; possible over‑dependence on foreign profit streams.

7. Diagrammatic Representation (Exam Guidance)

When asked to illustrate the effects of FDI, draw a simple flow diagram:

Arrows **into** the host country: capital, technology, managerial expertise, direct employment.
Arrows **out of** the host country: profit repatriation, interest/royalty payments, import of intermediate goods.
Label the impact on the current account (trade surplus vs. income outflow) and the capital account (FDI inflow).
Optionally add a short‑run vs. long‑run note (e.g., trade surplus initially, later income outflow).

8. Summary of Key Points

FDI is a major driver of growth for low‑ and middle‑income economies, but its net effect depends on the host’s ability to capture spill‑overs and to manage adverse side‑effects.
International aid can complement FDI by improving infrastructure and institutional capacity, yet excessive aid may crowd‑out private investment.
FDI improves the capital account but can generate a current‑account deficit through profit repatriation; governments have a suite of fiscal, monetary, exchange‑rate, supply‑side and protectionist tools to correct any disequilibrium.
Policy design should aim to maximise positive externalities (technology, jobs, exports) while minimising negative outcomes (crowding‑out, environmental harm, inequality).

9. Exam‑Style Question

“Discuss the likely impact of a large multinational corporation establishing a manufacturing plant in a low‑income country. In your answer, consider both short‑run and long‑run effects on the host economy, and evaluate the role of government policy and international aid in shaping those effects.”

consequences of FDI