Does Foreign Direct Investment Crowd-In or Crowd-Out Domestic Investment? A Case Study of Emerging Economies

Introduction

Investment is a tool that raises the standard of living for a nation’s citizens and promotes growth. Identifying these factors is one of the biggest challenges in the modern economy. To put it simply, technological knowledge must constantly improve to create new products, markets, or processes that will promote growth. The domestic market comes up with a lot of investment. But after a certain period of time, the domestic investment starts to fade away due to several reasons, where the major reason is the lack of new technology and new skills and implementations. When governments want to grow their domestic economy and drive new technology, business expertise, and capital to their nation, they work to promote FDI.

Source: www.google.com

In economic literature history, there has always been a debate concerning the connection between domestic investment and foreign direct investment, i.e., whether FDI drives domestic investment away or drives it in. The flowchart below (Fig 1) depicts what happens after foreign investment enters the domestic market.

      Fig 1: Crowding-In and Crowding-Out effect of FDI

Source: Own creation 

In order to finance the development of new infrastructure, bring in new machinery and technology, and create jobs for their native workforce, nations have welcomed FDI, as shown in Fig 1. The most obvious benefit of FDI is the creation of employment, which is one of the main reasons a country (particularly one that is developing) will want to entice FDI. FDI increases the manufacturing and service sectors, which leads to job growth and lower unemployment rates in the nation. Increased employment increases earnings and gives the populace greater purchasing power, which strengthens a nation's overall economy. Moreover, employee training and experience-based skills improves a nation's educational system and human resources. It has a cascading effect that trains human resources in other industries and businesses. The introduction of newer and improved technology leads to the diffusion of businesses into the local economy, resulting in increased industrial efficiency and effectiveness. Growing export sales bring in money and profits for enterprises, and through the acceleration effect, this can lead to a rise in capital expenditures. Increased investment boosts a nation's capacity for production, which in turn boosts export potential. For governments with few internal resources as well as those with few chances to raise money on international capital markets, inflow of cash is especially advantageous.

On the other hand, when productivity spill overs occur by the foreign investors, they crowd out the domestic market. FDI aids in the development of a competitive environment and the dismantling of domestic monopolies by allowing the entry of foreign businesses into the domestic market. A good competitive environment encourages innovation by pushing businesses to continually improve their operations and product lines. Additionally, customers have more access to a variety of competitively priced goods. Investors in FDI frequently hold controlling positions in domestic businesses or joint ventures and actively participate in their management. This pushes away the domestic market for the increased want of more lavish foreign goods at affordable prices. Referring to Fig 1, this further leads to a demonstration effect which is the tendency of consumers to copy the consumption patterns followed by others. Foreign companies sourcing locally may cause demand to decline due to stronger competition, or it may rise due to increased competition. The industrial linkage impact calculates how changes in one industry affects other industries' production (mainly the local industries) activity over a specific time period. During this time foreign investors create oligopolies and see at lower prices. International firms when competing with domestic investors tend to provide cheaper costs, better products and services, more options, and more innovation. However, the domestic investors cannot compete with the international investors, in fact the foreign investors start hiring skilled employers from the domestic market as well. This impacts the domestic market over time and the international markets dominate the domestic firm. 

When these FDI’s crowd-in domestic investments, then they act as a complement to each other, which initiates a healthy growth in the economy. Some domestic investments can be complementary because the more FDI’s in the economy, the more domestic investments as well. But as soon as the FDI’s crowd out the domestic investment, they act as substitutes for them. If substitutes rely more on FDI, then it will lead to repatriation of profit back to the origin, and furthermore causes foreign exchange risks to the domestic economy. 

Studies have revealed that since 2000, billions of dollars have been brought back to the United States. According to the Federal Reserve, firms brought back $777 billion worth of cash that had been stashed abroad in 2018. This was mostly caused by the Tax Cuts and Jobs Act, which reduced the transition tax for businesses looking to convert their foreign currency holdings into dollars. Inflows of FDI are frequently seen as an addition to domestic savings that make it easier to finance local investment projects.

 

Trends of FDI and Domestic Investment in Emerging Asia

The table and the graphs below represent the FDI/GDP, DI/GDP, and FPI/GDP in percentage for the South Asia, the South East Asia, and the East Asia regions. 

 

Table 1: FDI/GDP, DI/GDP, and FPI/GDP in percentage

	FDI/GDP (%)		DI/GDP (%)		FPI/GDP (%)
	2000	2020	2000	2020	2000	2020
South Asia
Afghanistan	0.0	0.6	0.0	0.0	0.0	0.0
Bangladesh	0.5	0.4	23.8	31.3	0.0	0.1
Bhutan	0.0	-0.1	50.3	33.8	0.0	0.0
India	0.8	2.4	25.7	27.9	-0.5	-0.6
Maldives	3.6	11.8	0.0	45.5	0.0	-1.8
Nepal	0.0	0.4	24.3	30.4	0.0	0.0
Pakistan	0.4	0.7	17.6	15.0	0.0	0.5
Sri Lanka	1.1	0.5	28.0	25.2	0.3	2.9
SouthEast Asia
Indonesia	-2.8	1.8	22.3	32.4	1.2	-0.3
Philippines	1.8	1.9	15.7	17.4	0.7	-0.5
Cambodia	3.2	14.0	17.5	24.9	0.2	0.4
Lao PDR	2.0	5.1	13.4	0.0	0.0	1.4
Malaysia	4.0	1.3	26.9	19.7	2.7	3.5
Brunei Darussalam	9.2	4.7	13.1	40.6	0.0	9.7
Myanmar	3.7	2.3	0.0	30.0	0.0	0.0
Thailand	2.7	-1.0	22.3	23.7	0.6	2.4
Vietnam	4.2	4.6	0.0	0.0	0.0	0.4
Singapore	16.1	21.6	35.2	22.5	21.9	17.5
East Asia
China	3.5	1.7	33.6	43.4	0.3	-0.7
Hong Kong	41.1	34.1	27.6	19.0	-14.3	19.8
Japan	0.2	1.2	28.4	25.4	0.7	0.7
South Korea	2.0	0.5	32.9	31.9	-2.1	2.6

Source: Own calculations from World Bank Indicators

According to Table 1, Maldives among the South Asian countries (Fig 2) and Singapore amongst the South East Asian countries (Fig 3) have a higher growing FDI/GDP percentage of 11.8% and 21.6% respectively. India has a declining FPI/GDP percentage in 2000-2020 (Fig 4). The graph in Fig 2 depicts the various South Asian countries, where the FDI/GDP %, and the DI/GDP% is highest in Maldives in 2020, but the FPI/GDP% declines in the same year. Sri Lanka has the highest FPI/GDP% of 2.9 in 2020. Sri Lanka has the highest FPI/GDP% of 2.9 in 2020. The South Asian region in 2020, overall has an FDI/GDP % that lies in between 0-12, the DI/GDP% lies between 0-50, and the FPI/GDP% lies between -2 to 3. In Fig 3, The Southeast Asian region in 2020, has an FDI/GDP % that lies in between -1 to 22, the DI/GDP% lies between 0-40, and the FPI/GDP lies between -1 to 18. Thailand has a declining FDI/GDP% in 2020. On an average, China has the highest DI/GDP% in 2020, which indicates a total of 43.4% shares of investment.

 

Fig 2: FDI/GDP, DI/GDP, and FPI/GDP of South Asia (in %)

Source: Own calculations from World Bank Indicators

 

Fig 3: FDI/GDP, DI/GDP, and FPI/GDP of Southeast Asia (in %)

Source: Own calculations from World Bank Indicators

 

Fig 4: FDI/GDP, DI/GDP, and FPI/GDP East Asia (in %)

Source: Own calculations from World Bank Indicators

Summary 

So far, the empirical literature does not draw clear conclusions about the effect of foreign direct investment on domestic investment. Some studies find negative effects on domestic investment, while others show positive effects. Moreover, several experts believe that FDI inflows have no influence on domestic investment.

The data and evidence depict that the FDI in the economies demonstrates a favourable trend of investment, which ultimately leads to a rise in the GDP and the growth of the nation. FDI is necessary for DI to improve. If foreign investors hire qualified workers from the domestic market, that is one form of crowding out as well, since FDI establishes oligopolies and sells at cheaper prices yet they are unable to compete. The FDI and Domestic Investment growth period of most of the countries has been between 2011-2020. The data collected and processed until now depicts that India has the highest FDI and DI among the South Asia countries, whereas China highest FDI and DI among the East Asia countries. Among the Southeast Asian countries, Singapore and Vietnam have the highest FDI and DI respectively. Maldives and Singapore have a higher growing FDI/GDP percentage. India has been showing the highest domestic investment throughout the span of 40 years. Between 2011-2020, the highest FDI CAGR is depicted by Philippines with a rate of 13 and Lao with a rate of 12.4. The South Asian region in 2020, overall has an FDI/GDP % that lies in between 0-12, the DI/GDP% lies between 0-50, and the FPI/GDP lies between -2 to 3; whereas, the Southeast Asian region in 2020, has an FDI/GDP % that lies in between -1 to 22, the DI/GDP% lies between 0-40, and the FPI/GDP% lies between -1 to 18. China has the highest FDI among all the countries and has received four times more investment than India. China's development is mostly driven by domestic investment and consumption rather than exports. Countries such as Malaysia, Myanmar, Afghanistan, and Sri Lanka have a negative Compound Annual Growth Rate from 2011-2020 which depicts that over a certain amount of time, their foreign investment has declined rather than risen, and indicates losses. Japan has a domestic investment of approx. twice that of India over the span of years. During times of uncertainty like the year 2020, countries with a high amount of FPI such as Hong Kong and Singapore experienced increased market volatility and currency upheaval.

 

References

Hayes, A., (2022). General Information on FDI. https://www.investopedia.com/terms/f/fdi.asp#:~:text=FDI%20can%20foster%20and%20maintain,jobs%20for%20their%20local%20workers.

Javorcik, S., (2004). Does Foreign Direct Investment Increase the Productivity of Domestic Firms? In Search of Spillovers Through Backward Linkages. American Economic Review https://www.aeaweb.org/articles?id=10.1257/000282804146460

Markusenab, J.R., & Venables, A.J., (1999). Foreign direct investment as a catalyst for industrial development. European Economic Review. https://www.sciencedirect.com/science/article/abs/pii/S0014292198000488

Murphy, C.B., (2020). General information on Repatriation. Investopedia. https://www.investopedia.com/terms/r/repatriation.asp#:~:text=The%20term%20repatriation%20refers%20to,nationals%2C%20refugees%2C%20or%20deportees

WTO (1990-2020) World Trade Report

Ms. Aryaa Parida, B.A. Honors Economics (batch 2020-23), Department of Economics, Faculty of BEhavioural and Social Sciences (FBSS), Manav Rachna International Institute of Research and Studies (MRIIRS), Faridabad, Haryana. Written under the supervision of Dr. Durairaj Kumarasamy, Associate Professor and Head, Department of Economics, Faculty of Behavioural and Social Sciences (FBSS), Manav Rachna International Institute of Research and Studies (MRIIRS), Faridabad, Haryana.  aryaaparida@gmail.com