Foreign Direct Investments

Foreign direct investment (FDI) can have important positive effects on a host country’s development effort.1 In addition to the direct capital financing it supplies, FDI can be a source of valuable technology and know-how while fostering linkages with local firms, which can help jumpstart an economy. Based on these arguments, industrialized and developing countries have offered incentives to encourage foreign direct investments in their economies. FDI can convey great advantages to host countries, such gains might differ across primary, manufacturing, and services sectors. UNCTAD World Investment Report (2001:138), for instance, argues, “in the primary sector, the scope for linkages between foreign affiliates and local suppliers is often limited.... The manufacturing sector has a broad variation of linkage intensive activities. [In] the tertiary sector the scope for dividing production into discrete stages and subcontracting out large parts to independent domestic firms is also limited.” More recently, the theoretical work on linkages, by Rodiguez- Clare (1996), shows that multinationals’ intensive use of intermediate goods enhances production efficiency in host economies. In this framework, increased demand for inputs leads to a positive externality to other producers owing to an increase in variety. Greater varieties of inputs, however, seem to be more relevant to the manufacturing than to the agricultural sector. Likewise, Markusen and Venables (1999) analyze the effect of foreign firms on the development of domestic firms in the industrial sector. In their model, foreign companies compete with domestic producers while creating additional demand for domestically produced intermediate goods through linkages with local suppliers. This can lead to domestic firms entering into the intermediate goods sector, which can result in lower costs that, reflected in lower final prices that increase demand, can benefit domestic firms producing final goods.