CE Financial Observer: I recently listened to a lecture that you gave, where you presented some surprising analysis results. You indicated that foreign direct investment (FDI) has a negative effect on the development of local entrepreneurship. Can foreign investment have drawbacks?
Saul Estrin: Of course it can. Just like everything else.
But as a rule one usually talks about such investments solely in terms of their advantages.
FDIs can have negative as well as positive consequences depending on the circumstances. Theoretically – on a macro level – FDI could generate capital inflows that a country would not be able to handle. I am referring to the taxation of investors’ foreign revenues. That is an issue more important from the perspective of the state budget. Whereas when it comes to the economy itself, it does seem that the level of local entrepreneurship declines with the increase of foreign investment.
We have to rate foreign direct investments as a whole and not through the prism of their individual advantages or disadvantages. And as I said, even though they also have disadvantages, the general opinion is unequivocal: on the whole FDI is beneficial for the receiving country. It has a positive effect on the level of employment and technological advancement, which leads to an increase in GDP. No serious economist would try to prove otherwise.
But I have met people who argue that some investments are appropriate and some aren’t, and before we let an investor in we should evaluate the situation in that specific instance.
Let’s not forget that nothing is absolutely good and beneficial. Imagine that you find a large gold nugget in a garden. You can either invest it or buy something useful with it, which will increase your quality of life. But you can just as well exchange it for superfluous objects that may make you lazy, and when the money from the gold runs out, you will have nothing left to live on. The same can be the case for various foreign investments. They can be lucrative for the receiving country or ‘spoil’ it. However, this mostly depends on the country and on its institutional solutions, not on investors.
The actual influence of an investment on the economy cannot be wholly assessed until after the fact. Proposals to assess investments beforehand and only allow in the good ones assume a scenario where this selection would be carried out by state authorities, i.e. civil servants. Besides the fact that such a situation would breed corruption, the competencies of civil servants in evaluating what is good for the economy are delicately speaking limited. Imagine a situation where an army of civil servants analyzes case after case, and decides whether each given investment should be allowed or not. This guarantees paralysis. The best option is to create clear criteria for foreign investment and to treat all equally.
In the mid-19th century the United States significantly limited the inflow of foreign investment capital, and that is when it saw the fastest development.
We are talking about another time, about an economy that was different to modern economies and about a situation that is not so clear-cut as it would appear. Comparing modern developing countries to the U.S. in the 19th century makes no sense. For a country like Poland, which continues to need modern know-how, foreign investments are on average definitely beneficial and the example of the U.S. has no place here.
Are there any effective methods for attracting FDI?
I don’t believe in the effectiveness of government policies geared towards attracting FDI. I think that such policies would prove ineffective. If an investor thinks that it is worth investing in a given country then that is where he will invest, irrespective of whether he is advised to do so by some politician or civil servant. Solid institutions are the most important aspect of enticing investors, that is: a well solid legal system, efficient courts and a clear tax code. Likewise, no one will invest in an economically unstable country or one with a high inflation rate.
Weak transport infrastructure also deters investors. And politics – political instability doesn’t help FDI. The case is the same for ‘extreme stability’ in countries such as Belarus for example, which are governed by dictators. Such countries will never have a high FDI. In other words, foreign direct investment will come to countries where nobody is standing in the way of economic development.
I was thinking more about the effectiveness of enticing investors through tax incentives, offering preferential investment loans or the creation of special economic zones. Is this worthwhile?
Tax incentives can sometimes help. When a particular sector within the economy is backward and dominated by a small number of companies it is worth bringing in additional competition, which will force changes and modernization. This will also benefit consumers.
But if we give allowances to foreign investors and not to local entrepreneurs, then this latter group may become slightly indignant, right?
In some cases one has to turn a blind eye to this indignace, because paradoxically it is those irritated parties that benefit from the extra competition. They become better entrepreneurs and will eventually toughen up.
You mentioned special economic zones. I have reserves as to their efficacy. There is a danger that these zones will turn into special enclaves for foreign investors. They will arrive, build factories, produce, make lots of money, but their activity will not permeate through to the local economy and will not be absorbed by it. In effect, apart from an increase in employment in the area, special economic zones will give nothing to the local economy. Additionally, the government has to partly subsidize them because, after all, they are governed by special, preferential conditions the creation of which is expensive for the budget.
How big is the risk that special economic zones will turn into such enclaves?
It is significant. It is better for foreign investors to be surrounded by local companies rather than other foreigners. It is better for them to have full contact with the local economy on an equal basis.
We have some 14 special economic zones in Poland…
Really? And that is in accord with EU law? Amazing! Special economic zones are definitely good for very poor countries that are just beginning their adventure with economic development, African states for example. The zones can act to initiate economic development. I think that in such countries as Poland, which are continuing to develop but that have reached a certain level of advancement – they have their own industry, their own businessmen – special economic zones are unnecessary.
Let’s look for a moment from a more global perspective. The U.S. and European Union plan to sign a free trade agreement. Will this make mutual direct investment easier?
There are those who say that the agreement is a ploy to get rid of regulations that impede huge corporations from making unlimited profit, especially regulations that rightfully protect consumers and the environment.
Who says that? Those aren’t serious opinions. Mutual trade and investment between the U.S. and EU is blocked by many factors, and this is definitely a negative occurrence as it inhibits economic development in the European Union, as well as in the United States. I am talking about limitations on trade in meat, fish and agricultural produce. The details are available in reports from the World Trade Organization. Most of these regulations are the result of economic nationalism, which actually harms those who adhere to it.
Interview by Sebastian Stodolak
Prof. Saul Estrin lectures at the management faculty at the London School of Economics. He specializes in privatization, the growth of developing countries, competition and foreign direct investment.