Global Policy Forum

by Chakravarthi Raghavan

The report on 'Trade and Foreign Direct Investment', issued last week by the World Trade Organization's secretariat, is perhaps as revealing on the issues it did not address and the studies it ignored, as in those it used to draw a one-sided conclusion, a reading of the report and its bibliography suggests.

The report argues that Foreign Direct Investment (FDI) and Transnational Corporations (TNCs) bring considerable benefits to host developing countries and makes a "compelling case" (in the words of the WTO head, Mr. Renato Ruggiero who previewed it while addressing the UNCTAD Trade and Development Board), for a Multilateral Investment Agreement (MIA), in the WTO. Such an MIA has been proposed by the EU, Canada and Japan, and has been promoted by Ruggiero in a year-long campaign. The three majors want the Singapore Ministerial Conference to begin the process of framing rules at the WTO in this area, by setting up a "working party" and ending with negotiations.

With the WTO membership deeply divided, the promoters of the MIA are using all tactics to persuade the developing countries to fall in line. Apart from several informal meetings convened by them to canvass support, and silence critics, Japan and the EU are reported to be sending out teams to key capitals to pressure.

Japan, is now sending top officials to talk to key delegations here, and also at capitals. Both Japan and the EU are also reported to be planning to send a team to Arusha in Tanzania where a ministerial meeting of the SADC (Southern African Development Community) countries. The WTO Director-General is also reported to be holding bilateral and small group meetings with several African and Asian countries in an effort to persuade them to agree to a "study" process in the WTO -- by establishing a working party to look at the question and report to the 1998 Ministerial meeting of the WTO. The WTO secretariat report, issued in this background, brought a sharp criticism at the General Council last week when India raised the issue of the secretariat interfering on one side of the argument in the informal HOD process where delegations are divided. The secretariat role is also reported to have figured at smaller informal HOD meets.

The report, a chapter in the forthcoming WTO annual report, was pulled out of the report and issued in advance of its publication (expected in November) as a press release. A co-author of the report, the WTO's Director of Economic Research and Analysis Division, Mr. Richard Blackhurst, told the media last week that since WTO members were currently discussing (in the informal HOD process for Singapore) the issue whether or not they should have negotiations, with one group for and another against, the secretariat had felt it necessary to "improve the quality of the debate" by providing timely information.

But the study ignores so much of the available material from serious mainstream economists on the pros and cons of this issue, that it has raised some questions (spilling over into the preparatory processes for Singapore) on the competence and objectivity of the secretariat and its role in servicing the membership as a whole. The paper makes no objective assessment of the benefits and costs of FDI nor of how a multilateral agreement could deal with these. But with a preconceived notion, it argues for a particular position, namely, FDI and TNCs bring considerable benefits and hence there is a very strong case for a multilateral agreement.

In doing this, the paper ignores the negative aspects of TNC practices -- such as transfer pricing and oligopolistic behaviour -- that are used by TNCs to maximise their profits, often cited as proof of their superior 'efficiency'. Rather, the paper suggests, if there are problems associated with FDI, these are due to government interventions, including incentives and requirements placed on investors. The paper ignores the considerable amount of literature dealing with problems associated with FDI -- for both host and home countries -- including a study by M. Feldsten (1994) on effects of FDI on domestic capital stock and the Nomura (Japanese research institute) studies on the effects of Japanese FDI in Japan and in South East Asia.

Even the search, and citation, of studies of international institutions appears to be very selective. The report cites the IMF view that FDI is more stable and less volatile than short-term flows. But it ignores World Bank staff studies (1993, Gooptu in Clessens and Gooptu ed.) that show that both types of flows are indistinguishable in the current structures of the world markets -- since derivatives can be used to erase the distinction.

It cites the UNCTAD World Investment Reports (WIRs), but ignores the UNCTAD Trade and Development Reports (TDRs) that have analyzed the pros and cons of FDI in the context of Development, or the Nomura studies on the effects of FDI on home and host country employment and other effects. An important analytical shortcoming of the paper is that even if one agrees that in practice FDI and TNCs have brought significant benefits, it fails to relate these benefits to the policies pursued by host countries, including regulations and conditions for FDI.

The paper deals with these benefits as if they came naturally, through an invisible hand -- a proposition that is refuted by experience and the, by now extensive, studies of the successful East Asian development strategies. The paper makes no effort to link these benefits to policies adopted by host countries and does not inquire or analyze the implications of the proposed MIA agreement on the ability of countries to pursue such policies. It not only ignores problems associated with FDI and TNC practices, but fails to suggest how the proposed agreement could deal with these. It concentrates rather on MFN, national treatment and asset protection as the basic tenets of an investment agreement.

The study leaves an uncomfortable feeling: either the economists who did the "systematic research for five months" did not do a thorough job of it or approached it with a view of producing a particular conclusion. Either way this calls into question the WTO as a forum for discussions or the secretariat's role in any wider discussion of the issue in an open forum or its capacity to service impartially an intergovernmental process inside the WTO.

The analysis in the report is premised on a hyper-globalization thesis -- a view of the world economy that has come under critical scrutiny over the last year or more. A critique of this thesis came out early this year in a book by Hirst and Thomson, "Globalization in Question", which received a favourable review even from pro-TNC media like the Financial Times. This book does not figure in the report's bibliography, and has been presumably ignored by the secretariat.

According to this globalization thesis -- in addition to the growing volume of cross-border trade, capital and technology flows -- there are three elements that are changing the structure of the world economy. Firstly, actors responding to the international market signals and international competition have already significantly reduced the role of the national economy as the arena where resources are allocated and processes of wealth creation are organized. Secondly, the rapid abolition of remaining constraints on international flow of goods, services and factors of production is the most desirable policy response of governments in all countries -- regardless of their levels of development and industrialization. Finally, with fewer national impediments, the real winners will be developing countries because they should be better able to attract those increasingly mobile factors, particularly capital.

This entire argument rests on the existence of efficiency enhancing effects of undistorted price signals - an assumption that draws theoretical support from the welfare principles of unregulated markets. However, such an assumption is challenged by the reality that there exists 'market failures' of one type or another. Thus, there are equally strong theoretical grounds that argue against unregulated markets. It is also inappropriate to apply the hyper-globalization thesis to FDI for various reasons.

FDI plays an important role not only because it has been evolving much more rapidly than trade-based integration (of national economies into an international economy), but also because -- and unlike cross-border financial flows which meet with only qualified approval from globalization enthusiasts -- FDI brings with it a package of benefits other than capital. These include, technology, management skills and market networks.

However, TNCs in making their investment decisions do not allocate resources in any economy according to the price signals there, but according to their (centrally planned, within the corporation) overall profitability in their worldwide operations. Therefore, it cannot be argued or assumed, a priori, that a world economy dominated by TNCs would produce the same optimal welfare outcomes as a world where prices are the sole allocator of resources. In contrast to this reality, the policy conclusion of the globalization thesis is that the more FDI a location can attract, the better off it will be. And the fewer the distortions -- including any efforts to manage the FDI - to the flow of FDI, the higher will be the level of global welfare.

In line with their one-sided approach, the authors of the WTO report present some general evidence of FDI flows in the first section of the report. This shows that seven of the leading 20 host countries (between 1985 and 1995) are developing countries. But with the exception of China, all are middle-income countries with rapid growth. This raises a cause and effect issue which the WTO report does not address: is the FDI a source of their economic growth or has the economic growth in these countries pulled in FDI?

The possibility of replicating these experiences of FDI flows through a more open FDI regime is a strong ingredient of the globalization thesis. But how feasible is such a replication? In the case of India for example, where the per capita income is low, some estimations suggest an amount of FDI equivalent to the entire capital invested in the manufacturing industry of the OECD countries would need to be transferred over 10-15 years, for FDI to make a significant contribution.

The view of the 'pro-competitive' effects of TNCs is sought to be buttressed in the report by a rather dated study by R.E. Caves (1974). However, several recent examples suggest that in many regions of recent TNC activities (Latin America and East Europe, and even countries like India) the entry of FDI is associated with closure of domestic competing enterprises (by buyouts etc).

The study is also weak on the technology transfer issue. It brings together in an ad hoc way firm, industry and national level evidence on technology spillovers, linkages and economic growth. This one-sided view of technology spillover benefits seems to be based on the research work of a limited number of scholars like Swedish economist Magnus Blomstrom -- though a careful reading of the work of the scholars may be needed to decide whether they have actually been as definite (as the report makes out) or more nuanced and that the nuance may have been lost in summarising.

Most explanations of why firms undertake overseas production dwell on whether the ownership advantages of the firm (which allow it to create monopoly rents) offset the adverse domestic costs of doing business in an unfamiliar territory. But in the context of linking FDI to growth and development, such an analysis may result in imposing a static logic to a dynamic situation. Over time, the impact of TNCs in a host country will depend on the pace at which the TNCs learn to operate in their new environment - thus reducing the costs of unfamiliarity - and their capacity to retain control over their specific ownership advantages and the rents that go with it.

On what actually happens in a country, much depends on the development policy and the approach taken. The earlier emphasis by TNC theorists like S.H. Hymer about 'market power' as a source of 'exploitation' by TNCs is now viewed as too one-sided by many current theorists of TNC behaviour. But the potential conflict of interest originally identified (and which many current studies show still face policy makers), has been replaced in the WTO report by a one-sided emphasis on the assumption of automatic spillovers from hosting FDI. This is on the implicit assumption that technology is a public good -- an assumption long rejected by economists of technological change.

Some recent surveys, including by authors cited (Blomstrom and Kokko, 1996), and studies of Sanjaya Lall, Lynn Mytelka and others suggest that FDI is no substitute for domestic technological capacity building. FDI, in several of these works, is seen as at best a complement where appropriate policies are in place, and not something with an automatic spillover effect. As many studies show, successful integration of a country into the world economy requires a strong domestic industrial base. Among the many reasons for this are those having to do with economies of scale and scope. Within a host economy, FDI may enhance firm-level performance, but without strengthening such domestic linkages. The TNCs may even weaken them.

Some comparative studies on East Asia and Latin America (such as by the ECLAC economist Michael Mortimore comparing the Korean and Mexican experiences in the automobile industry) bring this out clearly. The WTO secretariat has not "searched" this at all. There is also the danger that the TNC/FDI route, without any state policy and guidance, may lock a developing country into a perpetually lower end of the development scale.

While this danger is often discussed in terms of the primary sector (TNCs engaged in primary production and exports, either of commodities or minerals), it is also important in the manufacturing sector. Since the TNCs are now able to slice up particular production segments of their chain of operation, they can locate them around the globe. The implications of this have been discussed by Sylvia Ostrey (no opponent of TNC-led integration) and by several others like Peter Evans about the computer industry. The TDR 1996, in the East Asian experience, has also discussed this. All are again ignored by the WTO secretariat report.

In linking growth and FDI, without establishing a causal link, the WTO suggests that the FDI is the variable that explains the differing growth experiences. But the econometric correlation is based on the experience of a few East Asian economies -- which have used differing strategies and policies to enhance the benefits of FDI. However, with the exception of Hong Kong, none of them followed a laissez faire approach.

A number of studies (Deepak Nayyar, 1995; Bairoch and Kozul-Wright, 1996 and some others) show that experience in the globalization episode of the last century does not really make out a case of laissez faire and free capital flows having promoted development. Rather it shows uneven global development associated with such flows.

In any event it is clear that an analysis based on linkages between firms and their affiliates cannot be generalized into a relationship between FDI and Development overall, let alone be the basis of a policy conclusion.

Worst of all, such a biased and non-objective report of the WTO secretariat cannot be the basis for a "compelling case" for WTO to host a negotiation on a multilateral investment framework or agreement. On the contrary it provides a good reason why the WTO is an inappropriate venue for a comprehensive and balanced discussion on such a complex and critical issue.

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