FDI and Economic Growth in Developing Countries. A Cross Comparison between Egypt and Turkey’

Table of Contents

1. Introduction

2. Literature Review
2.1. Overview on Foreign Direct Investment (FDI)
2.1.1. Motivations for FDI
2.1.2. Types of FDI
2.1.2.1. Horizontal Outward FDI
2.1.2.2. Vertical Outward FDI
2.1.2.3. Technology- sourcing FDI
2.2. Host Domestic Countries and FDI
2.2.1. Political System and FDI
2.2.2. Economic System and FDI
2.2.3. Transparency and FDI
2.2.4. Eclectic Theory/ OLI Paradigm
2.2.4.1. Ownership Advantage
2.2.4.2. Location Advantages
2.2.4.3. Internationalization Advantages
2.3. Strategies to attract FDI
2.3.1. Investment promotion policies
2.3.2. Fiscal and Financial Incentives
2.3.3. Location Strategic Marketing Strategies
2.4. The Impact of FDI on Host Country
2.4.1. Horizontal and Vertical Productivity Spillovers
2.4.2. FDI and Domestic Economy
2.4.3. FDI and Domestic Trade Balance

3. Research Gap
3.1. Overview on Egyptian Economy
3.1.1. Factors affecting Egyptian Economy
3.2. Overview on Turkish Economy
3.2.1. Factors affecting Turkish Economy

4. Conclusion

5. References

List of Figures

Figure 1: Motives for undertaking FDI..

Figure 2: Model of determinant factors in the key decisions in the internationalization process..

Figure 3: GDP, FDI Inflows Growth in Egypt. Source: ‘‘World Development Indicators, 2013’

Figure 4: GDP, Imports and Exports Growth in Egypt. Source: ‘‘World Development Indicators, 2013’’.

Figure 5: Regional Electoral Volatility and Fractionalization in Turkey 1992- 1995.

Table 6: FDI Inflows Growth in Turkey. Source: ‘‘World Development Indicators, 2013’’...

Figure 7: GDP, Imports and Exports Growth in Turkey. Source: ‘‘World Development Indicators, 2013’’.

1. Introduction

International trade and international investment flows has been a main feature of the globalization era. However, international flows of goods, services, labor, and knowledge among national borders is not a recent phenomenon. Since World War II, most countries attempted to increase the rates of their international trade flows due to the increased impact of foreign firms investing on their economic performance (Tian, 2007). When firms go international, they benefit from the increased international competition, and learn from their global operations. Moreover, these firms can help their domestic economies by providing foreign currency, enhancing domestic productivity, and employment opportunities which positively affect the national trade deficit (Carlos-Pinho, 2007).

Firms can choose from many entry modes when they decide to go international. FDI is one mode of equity ownership in the host country. FDI flows have been widely growing in last couple of years. For example: In 2003, FDI flows within entire world were 560 billion dollars, while exports of goods were about 7.3 trillion dollars, and commercial services’ exports were 1.8 trillion dollars. The sales of multinational corporations’ subsidiaries grew between 1990 and 2001 higher than exports. Moreover, the flow of FDI in services was 950 million dollars in 1990 and increased to 4 trillion dollars in 2002 where services were about two- thirds of the FDI total flows (Helpman, 2006).

Many researchers (Jensen, 2003; Helpman, 2006; Rajan, 2004; Camilla, 2006) stated the benefits of FDI on the host country level; FDI is considered by Helpman (2006) as a feature of productive and larger companies. Jensen (2003) stated that countries especially developing ones cannot achieve economic development without being engaged in FDI; as technology, physical capital, employment, global networks, and marketing policies are all provided by FDI. Therefore, it is a helping factor for countries to realize economic growth by enhancing domestic productivity due to global competition, providing work opportunities for domestic work force, enhancing technological knowledge whether by technology transfer from developed to less developed host countries, or through transferring knowledgeable workers, internationalizing the system of research and development, or through vertical relations with local suppliers and buyers, or horizontal relations to other complementary industries within the host country (Rajan, 2004). These investing firms affect the economic growth in host countries due to their contributions to the economic performance and competition within the host country (Camilla, 2006). Jensen (2003) stated that these benefits are related to foreign currency generated for the host country, increasing employment within the host country; this increase can be direct through employing host country nationals in the firm, or indirectly through establishing local firms operating in industries complementary to the main industry of the firm (Jensen, 2003).

Some researchers (Seyoum and Manyak, 2009; Tian, 2007; Musila and Sigue´, 2006) believe that developing countries can mostly benefit from FDI; they stated that FDI for developing countries is more than just an economic tool helping them realize economic growth. FDI is a means to reduce poverty, enhance their international trade; helping them access advanced technological knowledge. Moreover, FDI is a major financing source for domestic investments in these developing countries. In addition, FDI is an accompanying feature of privatization processes occurring in developing countries (Seyoum and Manyak, 2009). Kosack and Tobin (2006) mentioned that FDI in low and middle income countries had an annual growth rate of 17% in the period between 1995 and 2000. These developing countries consider FDI as the most stable external funding source (Kosack and Tobin, 2006).

Tian (2007) mentioned that FDI has been considered by many firms to be an effective means to realize economic growth like the four Asian tigers ‘Hong Kong, Taiwan, Singapore, and Korea’ which had set some policies to attract FDI into their countries through tax reductions and rebate (Tian, 2007). Moreover, Musila and Sigue´ (2006) stated that African countries adopted FDI as a means to face the financial constraints which hinder their development. FDI refers to the process of purchasing or creating a firm in a country by foreigners (Musila and Sigue´, 2006).

The goal of this paper is to examine the relationship between FDI and economic growth in developing countries. The paper focuses on Turkey and Egypt as special cases worth of considering. The paper consists of five main sections; the first section is the introduction including basic information about the importance of international investments, trade flows among countries and how FDI affects the host countries especially in Africa, Asia and The Middle East. The second section; literature review introduces an overview on firms’ motives to become international, why firms might choose to engage in FDI rather than other non-equity modes. The three types of FDI, factors affecting FDI and three major strategies to attract FDI are described. The literature then reviews some country- related factors which affect the FDI like: political, economic environment and transparency levels in the host country. Then the impact of FDI on the host country in economic terms is explained. The third section of the paper is the research gap section; it lists some shortcomings in the previous literature, providing an overview of Egyptian and Turkish economies and factors which affected their economic performance. Then the fourth section which the conclusion is providing a brief summary about the entire paper, and finally references.

2. Literature Review

The following section provides an overview on FDI; motivations of firms engaging in FDI and types of FDI are explained in details. Afterwards, some factors affecting FDI are discussed, then some strategies which attract FDI flows are discussed and finally the impact of FDI on host countries is discussed.

2.1. Overview on Foreign Direct Investment (FDI)

Foreign market entry mode refers to the institutional arrangements taken by the firm to facilitate the movement of its resources, products, and technology into a foreign host country (Carlos-Pinho, 2007). When firms decide to go international, they have to decide which foreign market to enter, and how to enter it. Firms have three strategic choices to select from. These choices are: FDI, exporting, and licensing. The firm can keep its operating advantages internalized if it selected FDI or exporting, it can also engage in either FDI or exporting either independently or by joining other collaborative ventures. However, risk is generally high for firms engaging in FDI although the high control degree they have over foreign operations. While for licensing, the firm externalizes its operating advantages by granting the host country’s firm the usage rights of its operating procedures and technical knowledge; this means lower control degrees over marketing and operational activities and higher risks (Riportella and Cazorla-Papis, 2001). The same aspect was previously discussed by Erramilli and E.D’Souza (1995) who mentioned that firms can choose either FDI or non-FDI entry modes. The decision is based on the degree of resource commitment which the firm intends to make by having fixed investment. Generally firms prefer FDI modes if uncertainty is low in the host country; when the host and home countries are culturally proximate, sharing similar cultures and languages, firms will have high levels of resource commitment in the host country (Erramilli and E.D’Souza, 1995). Moreover, resources of the firm affect its preferred entry mode; as firms with special technological knowledge and capabilities would prefer ownership modes which help them protect their knowledge from being disseminated by local host countries (Blesa and Ripolle´s, 2008).

FDI according to Jensen (2003) is a flow of private capital from a home- country firm to another host foreign country. These capital flows might be in form of reinvestment of firm’s earnings, equity capital, and inter-firm debt. FDI has a long term span and that is why it is adopted by firms willing to penetrate some local markets and use their available resources. The parent company should have more than 10 percent managerial control over the subsidiary to be FDI (Jensen, 2003). About one third of FDI flows into developing countries take the form of Mergers and Acquisitions rather than Greenfield investments. This is due to the effect of government and corporate transparency which highly affect business decisions by foreign investors. However, in 2006 the FDI into Asian countries was more than 68 percent of FDI total flows into developing countries, and this reflects the fact that FDI is unevenly distributed among developing countries. The share of developing countries in global FDI in 2006 was 448 billion $. Moreover, the FDI had the largest share of total flows of resources into developing countries (Seyoum and Manyak, 2009).

2.1.1. Motivations for FDI

Motivations for FDI include the desire of the firm to access available opportunities in the host country like lower labor costs, cheaper factors of production, less transportation costs and accessing new markets with new customers (Elli and Fausten, 2002). Rajan (2004) stated that the firm’s motivations might be related to resource acquisition, market positioning, operational efficiency and strategic motives (Rajan, 2004). More specifically, the following table by Camilla (2006) summarizes motives of firms undertaking FDI in host countries. It shows there are four objectives that each firm might be looking for; the firm might be seeking natural resources which are abundant in the host country, seeking new markets for its products and services especially if there is an opportunity to build networks, customer relations and product adaptation. Some other firms might be seeking operational efficiency which would help them cut their costs; this can be realized through hiring low wage labor, or having product mandate. And finally, there are firms which seek strategic assets such as firm-specific benefits like brand names, R&D (Camilla, 2006).

illustration not visible in this excerpt

Figure 1: Motives for undertaking FDI

Source: (Camilla, 2006: 885)

2.1.2. Types of FDI

There are three major types of FDI; horizontal outward FDI, vertical outward FDI and technology seeking FDI. They are discussed below.

2.1.2.1. Horizontal Outward FDI

The horizontal outward FDI is also called market-seeking FDI which occurs when the foreign firm penetrates a foreign market by producing there and operating within many countries. This type of FDI results in replacing the domestic production by foreign production in the domestic market. However, this replacement is short term due to the fact there is no absolute horizontal production; this is because the firm might rely on its headquarters to provide it with some services or assets to operate within domestic markets although the finished product might be produced within the domestic market or within the parent country. Moreover, both foreign and home production could be integrated to achieve benefits related to cost savings for both parent and host country. This means higher revenues realized by the host country and thus domestic production increases (Herzer, 2010).

2.1.2.2. Vertical Outward FDI

Vertical outward FDI refers to an investment which is affected by the price differences in production factors; when firms relocate their production processes and stages in many locations where factors of production can be obtained at less cost. When firms restructure their chain of production and operate more efficiently, they are improving their market competitiveness and domestic production especially on the long run; the firm can realize cost savings and increase efficiency when it imports from its foreign affiliates some of intermediate goods at fewer prices (Herzer, 2010).

2.1.2.3. Technology- sourcing FDI

Technology- sourcing FDI refers to the acquisition of technology, know-how techniques, management practices, and market knowledge by foreign affiliates when the firm sources its technology base; this is achieved through either buying another foreign company or building facilities for R&D by having foreign excellence centers. When the affiliate has this knowledge, it benefits the parent country company which realizes gains in terms of increased productivity (Herzer, 2010).

2.2. Host Domestic Countries and FDI

There are some host-country related factors which affect the flows of FDI into this country; these factors are the political system, economic system, public sector transparency and private sector transparency.

2.2.1. Political System and FDI

The political environment affects the tendency of multinational firms to invest in various countries; instable countries in terms of political regimes are unattractive for foreign investors who are threatened by changing laws and declining profits in those countries as it means higher internalization costs for the foreign firm. These degrees of political risk affect the entry mode of foreign firms who prefer contractual agreements with domestic firms rather than ownership agreements when there is high political risk (Jensen, 2003).

Some researchers state that there is a positive relationship between democracy and economic growth; as democratic nations tend to consume more, also democracy is about respecting property rights which in return encourage economic growth, but democracy is also a threat to investors who fear the pressures imposed by public on the agreements (Jensen, 2003). Democracy was described by Alesina et al (1996) as a political system which has at least two parties represented in the free elections conducted. In a democratic system, interest groups represent a source of pressure on governments. These pressures sometimes lead to opportunistic behaviors by policy makers who attempt to increase their likelihood of being reelected (Alesina et al, 1996). The concept of political freedom was further described by Hann and Siermann (1998) who stated that political liberty/ freedom is evident when citizens are allowed to take part in the political process in their country; they have the rights to vote, decide who to present them in elections, and many parties are existing (Hann and Siermann, 1998).

However, democratic regimes are a source of credibility to their countries; when there is political stability, foreign investors do not fear changing policies which might make them lose their ownership and profits through events like: nationalization, expropriation of revenues, changing taxes or tariffs, and currency devaluations. On the other hand, autocracies do not respect property rights and therefore they pose a threat to investors. Meanwhile, investors might prefer to invest in authoritarian regimes as they believe they might obtain attractive agreements due to lower wages for low paid workforce. This low cost labor force is an attractive fact for investors (Jensen, 2003). This was confirmed by Verma and Brennan (2011) who stated that governmental policies highly affect the economic performance of the country and the inward and outward FDI flows; government is the main influencer of macroeconomic variables like: inflation, economic growth and trade barriers (Verma and Brennan, 2011). Political insatiability was defined by Alesina et al (1996) as the tendency of the executive power represented in the government to change and collapse. This change can be attributed to either unconstitutional or constitutional factors. Economic growth is negatively affected by political instability which implies uncertainty and risk to potential investors who would either invest abroad or withdraw their investments from the local unstable environment (Alesina et al, 1996). This instability results from the given up governmental autonomy due to the imposed contractual policies; as citizens might negatively vote while evaluating their governments’ performance. This instability is due to changes in policies related to macro-policy or towards foreign investments; as host country’s government might be willing to increase foreign investments to exploit them (Jensen, 2004).

2.2.2. Economic System and FDI

FDI was considered as one of necessary tools to achieve economic growth by some transition countries like Spain and Ireland which were followed by many countries from Eastern European and other developing countries. These transition countries attempted to realize an economic structural change from a socialist strict system into capitalism. These countries benefited from the flow of capital, knowledge and technology. However, these benefits are heavily depending on the host country’s initial conditions at the time of investment. Developing and transition countries have few alternatives to substitute the foreign capital flows which would be generated by FDI. However, transition countries are considered relatively industrial than developing countries and this makes the case different between two groups. However, some transition industrial countries do not necessarily indicate existence of entrepreneurship and innovative activities; as most of these transition countries were based on the socialist strict system which forcefully used to transfer and exploit resources, this socialist system led to under-investing in new industries and services, and this refers to having zero innovation rates in some of these countries due to the lack of free entry and exit opportunities for firms (Camilla, 2006). Privatization is an important tool in economic transition from socialism to capitalism; it positively affects long term economic growth as it enhances the economic efficiency and property rights. Moreover, it facilitates market entry and exit for new investors due to wider absence of governmental intervention (Camilla, 2006). Hamar (1994) further mentioned that liberalizing FDI- related laws positively affects flows of capital into host countries; these capital inflows increase by a quadrant rate (Hamar, 1994).

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