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Economic impacts of foreign direct investment

Published 16 Aug 2016

Treasury Staff Insights: Rangitaki article by Mark Holden

In October 2015 the Government published a report, International Investment for Growth, which sets out the benefits of foreign investment for New Zealand.  The analysis in this article informed aspects of that report.

Foreign direct investment (FDI) continues to spark significant public debate, often driven by concerns about the foreign ownership of land.  This article seeks to outline the economic benefits of FDI which are sometimes lost in the public debate.  FDI has a key role to play as a source of capital to support the growth of New Zealand firms, strengthen international connections and support New Zealand’s economic prosperity.  It can also bring other non-financial benefits to firms and the wider economy.

This article explores the economic impacts of FDI which can be grouped into three broad categories (each is discussed in turn below):

  • financial effects
  • non-financial direct effects on recipient firms and their employees, and
  • indirect effects (spillovers) on other firms.

Financial effects

Financial capital is essential for economic growth.  New Zealand’s domestic investment needs persistently outstrip the national savings we have available for investment.  This is reflected in a persistent current account deficit shown in the graph below.

Selected Countries Current Account Balance (% of GDP)
Selected Countries Current Account Balance (% of GDP).
Source: International Monetary Fund, World Economic Outlook Database, April 2016

Covering the shortfall between savings and investment needs requires us to increase our domestic savings, use foreign savings or both.  Foreign savings are likely to make a significant contribution to meeting New Zealand’s investment needs for some time.

FDI can be complementary to other forms of foreign funds and in some cases may even be preferable (even leaving aside the other direct and indirect effects of FDI discussed later).  This is because:

  • FDI provides different risk sharing options for firms and investors and thickens capital markets, thereby supporting a more efficient cost of capital.
  • FDI can offer greater stability of funding for firms as it is a less liquid form of investment which means that investee firms are less exposed to rollover risk.  Debt to direct investors may also have favourable terms.  These characteristics can reduce the vulnerability of the wider economy to economic shocks as they mean that FDI can help to reduce risks to macroeconomic stability.
  • A FDI can increase the chances of further investment into New Zealand as the investor either reinvests earnings into the existing investment or into other firms.

Other (non-financial) direct effects on recipient firms and their employees

A reasonable starting assumption is that FDI has a net positive impact on firms (otherwise they would not opt into the transaction).  The following firm level effects can be identified in international and New Zealand research:

  • Effects on firm productivity - research consistently shows that firms with foreign investors outperform domestic firms on a range of metrics including firm size (employment), productivity, and average wages.[1] A frequently cited explanation for this is that FDI has direct positive effects on firm performance. Although there are other plausible explanations – for example foreign investors may simply purchase the highest performing firms or may crowd out domestic investment.  Empirically, a mixture of these explanations is likely to apply.
  • Effects on firm employees - The direct effects of FDI can also flow through to employees through higher wages and the opportunity to gain skills and opportunities which might not be available in domestically owned firms.[2]
  • Exit opportunity for entrepreneurs - FDI provides an exit opportunity for entrepreneurs who may not have the resources or the desire to continue to grow their business beyond a certain point.  The ability to sell all or part of the business to a foreign investor enables entrepreneurs to gain the greatest possible return from their investments.

While direct benefits accrue primarily to the firms concerned, they also represent a potential benefit to the whole economy, by drawing resources to more productive uses, increasing total output and productivity (and taxable profits), and providing employment and higher incomes for New Zealanders.

Other indirect effects (spillovers)

Not all of the economic impacts of FDI are captured by the recipient firm or foreign investor.  Some benefits can “spill-over” to other firms in the New Zealand market and /or to employees and consumers.  Spillovers are a key difference between FDI and other forms of foreign investment.  The following spillovers can be identified:

  • Spillovers by observation: Domestic firms may be able to learn from and mimic the productivity enhancing features of foreign-owned firms.  The ability of firms to benefit from observational spillovers is likely to be conditional on their existing capability and closeness to the technological frontier (absorptive capacity).[3]
  • Transaction-based spillovers: Downstream firms (those purchasing inputs from the foreign-owned firm) may benefit from transaction-based spillovers such as improved access to technology or customised products or services.  In turn, upstream firms (those supplying inputs to the foreign-owned firm) may benefit from additional demand for their products.  On the other hand, the entry of foreign firms can in some cases reduce transaction numbers or values for domestic firms.
  • Product-market spillovers (competition):  Foreign owned firms can provide competition, spurring innovation and improving consumer welfare.  These competition effects are likely to be important in small markets such as New Zealand, particularly in the non-tradeables sector.  While competition from foreign owned firms could lead to the closure of less efficient domestic firms, this can ultimately improve allocative efficiency in the economy (though there will be some shorter term adjustment costs).
  • Labour market spillovers: Foreign owned firms can bring increased skills and expertise to the New Zealand market which can spill over to other firms via labour mobility and improve agglomeration of skills in New Zealand.  Regardless of foreign investment, there will be some situations where as New Zealand-based firms grow some jobs will be relocated offshore.  However, in certain cases, this risk will be heightened in cases when existing firms are acquired by foreign owners.[4]

Conclusion

FDI is an important source of capital for growing New Zealand firms and will continue to be so for the foreseeable future.  It provides wider non-financial benefits to the economy, including to other firms, employees and consumers.  The size of these wider economic effects will vary for individual investments as the effects can be can be complex, inter-related and may differ on a case-by-case basis.  Overall, FDI has a positive net impact for the economy and evidence shows it raises the productivity of host firms and the wider economy, as well as contributing to increased job numbers and wages and other broader spillovers.

Notes

  • [1] See for example Greenaway and Kneller, 2007; Hayakawa et al, 2010; Sanderson 2004; Fabling et al. 2008; Fabling and Sanderson, 2011.
  • [2] Sanderson and Fabling (2011).
  • [3] Iyer et al (2010).
  • [4] Sweet and Nash (2007).

 

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