Multinational Corporations and Economic Development

In this article we will discuss about the role of multinational corporations in the economic development of a country.

Foreign capital plays a very important role in the growth and development of most countries, at least in the early stages. Such capital is of two types, viz., foreign direct investment and foreign (international) portfolio investment.

FDI is the recorded capital movement resulting from the investor (usually a firm) in one nation acquiring control of a firm in some other nation via acquisition or establishment. (Increases in retained earnings in the acquired or established firm, under balance-of-payments accounting, are usually counted as FDI flows.

Foreign direct investment (FDI) comes through multinational corporations (MNCs). Such a corporation has headquarter (decision-making centre) in one country but production centres at different countries. An MNC includes any firm which controls operations in a nation other than that which constitutes the firm’s principal market, even if these operations are very small rela­tive to its domestic operations.

Most scholars, however, consider a multinational corporation to be a large firm for which non-domestic operations account for some significant portion of total firm revenues. Most US and Japanese companies are multinationals.

For example, Ford pro­duces motor cars not only in the USA but also in India, Western Europe and Japan. After World War II (1939-1945), Direct Foreign Investment (DFI) was increasing associated with the ex­pansion of very large firms, mostly, but not entirely from the USA.

The role of MNCs has figured prominently in both development economics and interna­tional economics. The most commonly used measure of economic development are per capita income, rates of growth, changes in the sectoral distribution of activity, and distribution of income (including employment). All of these may be very much affected by the operations of MNCs in both home (capital exporting) and host (capital receiving) countries.

Moreover, the important policy issues raised for home countries are very similar to those raised by any out­flow of capital and technology and restrictions on the expansion of their firms abroad may have results similar to those of protectionist trade measures. It is against this backdrop that we discuss the role of multinationals in developing countries like India.

MNCs not only supply the much needed real capital to less developed countries (LDCs) but also act as a vehicle for the transfer of technology across national borders. The capital exporting country is called the home country and the capital receiving country is called the host country.

Reasons for International Movement of Capital:

There is considerable mobility of capital in the world today. The main reason is that financial capital is the most mobile of all factors and it has an extra temptation to go abroad in search of higher return. After all, owners of financial capital, like other factor owners, seek to maximise the return on their resource. They seek to reach an optimisation goal, viz., obtaining a higher return on capital over time.

Other reasons for the international movements of capital are:

1. To take Advantage of Large and Growing Markets:

Firms invest abroad in response to large and rapidly growing markets for their products— mainly food and textiles. Take, for example, the case of Adidas, Lee, McDonalds, Burger King, etc. Empirical studies find a strong positive correlation between GDP (and its rate of growth) of a capital receiving country and the inflow of foreign direct investment. Firms in developed countries seem eager to move to India or China because of their sheer size.

2. High Per-Capita Income:

Since manufacturing and service production in developed countries is catering increasingly to high-income tastes and wants, developed-country firms will invest overseas if the recipient country has a high per-capita income. Thus, foreign firms producing modern sophisticated consumer goods are more interested in investing in countries where PCI is high (such as Singa­pore) rather than in countries where GDP is high but PCI is low (such as China).

3. Worldwide Sourcing:

Another reason for direct investment in a country is that the foreign firm can seek access to mineral or raw material deposits located there and can then process the raw materials and convert them into finished goods for sale to Third World countries. For example, an US MNC can buy iron ore from India or China, produce finished steel from Korea and sell steel to Ger­many or Japan.

4. Overcoming Trade Barriers:

Many foreign firms set up their production units in host countries just to overcome various tariff and non-tariff barriers to trade. This is why many US and Japanese firms had set up factories in Europe in the 1960s, immediately after the European Economic Community (Common Market) was formed, with its common external tariff on imports from the rest of the world.

5. Low Wages:

Many foreign firms set up production units in host countries to take advantage of low wages in such centres. It is a real attraction for MNCs to set up factories in labour abundant countries where the wage rate is invariably low in spite of the presence of trade unions and government intervention in the form of a minimum wage. Most Japanese firms take advantage of low wages in developing countries like India, Korea and Taiwan by being engaged in international sub­contracting business.

They adopt the production process which can be broken up so that capital- intensive or technology-intensive production of components takes place within developed countries while labour-intensive assembly operations that use the components takes place in developing countries.

6. Risk Spreading:

Many firms invest abroad as a means of risk diversification. Firms often wish to distribute their real investment assets across industries or countries. Like an individual investor, a company also finds it judicious to follow the policy of not putting all the eggs in the same basket.

It is unlikely that there will be recession or downturn in all markets (where a firm operates) or industries (in which a firm invests) at the same time. Moreover, the nature and seventy of recession is unlikely to be the same.

7. Outperforming Domestic Firms:

Foreign businesses may find investing in a host country to be profitable because of its superior management skills or an important patent which enables it to outperform the domestic busi­nesses of the host country. In truth, the opportunity to generate a profit by exploiting this ad­vantage in a new setting induces the foreign firm to make the investment.

Potential Benefits and Costs of Foreign Direct Investment to a Host Country:

Whether MNCs raise the level of welfare in the nations in which they operate is debatable. The truth is that there are both benefits and costs to the home country from capital outflow.

The benefits from an inflow of FDI are:

1. Increased Output:

Capital is not only a productive factor. It also makes other factors productive. The inflow of foreign capital to work with labour and other resources is likely to enhance the total output as well as output per unit of input used in the production process (i.e., an increase in total factor productivity).

2. Increased Wages:

If labour productivity rises wages are bound to rise in host countries. Moreover, a portion of the profits of the MNCs may be shared with the workers for motivating the workers. In the context of MNCs we often find the application of the efficiency wage theory. MNCs often pay higher than the market clearing wage even during recessions so that their efficient workers do not quit and join domestic firms.

3. Increased Employment:

Most developing countries are labour surplus countries, due to population explosion. So opera­tion of MNCs creates new employment opportunities in such countries.

4. Increased Exports:

Some export-oriented units, set up with foreign capital, enables the home countries to earn foreign exchange which is a scarce resource in such countries. This additional foreign ex­change serves a twofold purpose. Prima facie, it can be used to import the much needed capital goods and/or materials which assist in meeting a country’s development goals, viz., rapid in­dustrialisation. Secondly, the foreign exchange can be used to pay interest or repay a portion of the country’s external debt.

5. Increased Tax Returns:

The profits and other increased incomes originating from the foreign direct investment projects are a source of new tax revenue for the host country. Such revenues can be used for developmental projects. However, this is likely to happen when the tax measures are effectively implemented i. e when there is not much tax evasion and tax avoidance).

Furthermore, the host country has to spend the tax revenue wisely and should not impose too high a rate of tax on the foreign firm as this might cause the firm to leave the country (by creating an incentive problem).

6. Realisation of Economies of Scale:

The foreign firm might enter an industry in which there is scope for more production and thus realisation of both economies of scale and economies of scope (or returns within scale) for at least two reasons:

(i) Wider market; and

(ii) Use of modern sophisticated technology (which reduces cost per unit).

Domestic firms might not be able to raise necessary capital to achieve the cost reductions associated with mass production. If the foreign firm is able to realise econo­mies of scale by being able to produce for the mass market, consumers will also be able to derive the benefits of lower price.

7. Provision of Technical and Managerial Skills and of New Technology:

Since the skills are among the scarcest resources in developing countries, a crucial bottleneck is broken when foreign capital brings in the much needed human capital in the form of skilled managers and technicians. Furthermore, the new technology can widen the host country’s pro­duction possibilities.

8. Weakening Power of Domestic Monopoly:

With the arrival of a foreign firm, a domestic monopolist faces new competition. This forces the domestic firm to increase its output and to reduce its price in order to survive (or remain competitive). Thus, international capital movement in the form of inflow of DFI through a foreign firm can act as an antitrust policy.

Costs of FDI:

Some alleged disadvantages to the host country from a foreign capital inflow are:

1. Adverse effects on the Host Country’s Commodity Terms of Trade:

It is often alleged that if foreign investment is made in export-oriented industries, then in­creased exports drive down the prices of imports. This implies that the commodity terms of trade (i.e., the price of a country’s exports divided by the price of its imports) will deteriorate due to the inflow of foreign capital.

2. Transfer Pricing:

Many FDI projects have a negative impact on the economic welfare of the host country. The main reason for this is the lack of competition in input and output markets in which the foreign firm operates. When foreign firms are given monopoly rights-to operate in protected domestic markets they often—though not always—misallocate resources, generate less employment, induce smaller productivity gains, and transfer less technology, making the host (capital im­porting) country worse-off than it would have been in the absence of FDI.

3. Fall in Domestic Savings:

The inflow of foreign capital may cause the domestic government to relax its efforts to gener­ate greater domestic savings. If it is very difficult to implement the tax measures, the govern­ment of the host country may give tax concessions to the poor people since the foreign firm is providing necessary funds for financing investment projects. The foregone tax revenues are likely to be used for consumption rather than for saving.

4. Fall in Domestic Investment:

The foreign firm may also raise funds from the host country’s capital market. And, due to its goodwill, any new issue of equity shares will evoke tremendous public response in a develop­ing country. This action can push up interest rates in the host country by creating shortage of funds and lead to a fall in domestic investment through a ‘crowding out’ effect.

Looked at from a different side, supplies of funds in the developing country may supply the much-needed financial capital to the foreign firm than to local enterprise because of perceived lower risk. This diversion of funds will make it difficult for the host country to use its limited capital in those areas which could be more valuable to its economy.

5. Instability in the Balance of Payments and the Exchange Rate:

With the inflow of FDI, a developing country receives foreign exchange. This improves the balance of payments. As a result, the currency of the host country appreciates in the foreign exchange market. However, when the foreign firm imports inputs or when it sends a major portion of its income to its home country, there is a pressure on the balance of payments of the host country.

As a result, the currency of the home country depreciates in value. Thus, the operation of a foreign firm introduces a certain degree of instability in the host country and makes it difficult for it to engage in long-term economic planning.

6. Loss of Control Over Domestic Policy:

Large foreign firms can exert enough economic-cum-political power in more ways than one. So the host country is no longer truly sovereign in the sense that it cannot take decisions inde­pendently. It is under pressure from a foreign firm as far as formulations of economic policies are concerned.

This point has been highlighted by Harvard University’s Raymond Vernon (in his book- Sovereignty at Bay). In this context, a quote from E. Penrose is quite relevant- “Large economic institutions inevitably have a political significance which cannot be ignored in con­sidering their overall impact on the society.”

7. Growing Unemployment:

The operation of foreign firms in developing countries explains this very clearly. This is known as the ‘technology paradox’; the use of capital intensive techniques of production by a labour abundant country. The foreign firm usually brings its own capital-intensive techniques into the host country.

However, such techniques are not appropriate for a labour-abundant country. So, the foreign firm hires very few workers and displaces many others by forcing many domestic firms to close down their business. Thus, the presence of MNCs is a double blow to developing countries. The MNCs lead to deindustrialization and labour redundancy at the same time. They do not normally absorb the displaced local workers.

8. Establishment of Local Monopoly:

No doubt one of the presumed ‘benefits’ of FDI is that it breaks up a local monopoly. On the ‘cost’ sides, due to its cost advantages (originating from the use of modern technology), a large foreign firm may force several domestic firms to leave an industry. Then the firm will exist as a monopolist, with all the abuses of monopoly.

9. Inadequate Attention to the Development of Local Education and Skill Formation:

Most MNCs reserve the jobs that require expertise and entrepreneurial skills for the head office in the home country. Jobs requiring low level of skills and ability are offered to workers of host country who are engaged in branch offices or subsidiary operations. Since the local workers and managers remain engaged in routine management operations, rather than creative decision making, they do not get an opportunity to acquire new skills and management techniques.

There is wide disagreement over the problems over the problems raised for host govern­ments in developing countries, not only because they are less powerful to adequately prevent monopolistic and certain other deleterious practices—particularly tax evasion through transfer pricing—but also because of the effect of the introduction of ‘inappropriate’ technology on the structure of production and of ‘inappropriate’ tastes on the composition of demand. Ill-advised on the policies in both developed and developing countries are often the principal source of the disadvantages created by MNCs for both the governments of host countries and the MNCs themselves.

Partly for the above reasons and partly because they are often treated as instruments of foreign domination, MNCs have often been attacked, restricted, excluded and even expropri­ated in a large number of developed as well as developing countries.

They may come to domi­nate not only important industries (ranging from mining and oil to pharmaceuticals, electronics and other high technology industries) but, at times, also the entire economy of small countries dependent on a narrow range of exports.

The political as well as economic power they some­times possess is, at times, used to the disadvantage of host countries. Dislike and fear of foreign domination and end of ‘monopoly capitalism’ generally leads to many-sided attack on MNCs individually and collectively.

It is not possible to make an overall assessment of the MNCs in the context of developing countries in terms of benefits and costs because these cannot always be quantified. However, both developed and developing countries try to formulate and implement policies that will improve the ratio of benefits to costs associated with a foreign capital inflow.

For this reason, performance requirements are often placed on the foreign firm, such as stipulating a minimum percentage of local employees, a maximum percentage of profits that can be repatriated to the home country and a minimum percentage of output that has to be exported to earn the much needed foreign exchange.

Furthermore, the output of the firm may be subject to domestic con­tract requirement on inputs, or foreign firms may be banned altogether from certain industries of strategic importance to the home country.

However, some progress towards eliminating such distortionary performance requirements has been made in the last round of trade negotiations of the GATT, viz., the Uruguay Round which included in 1994 and led to the emergence of the WIO (1995).