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Guest Article: Foreign Direct Investment in the United States

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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RACHEL MCCULLOCH

Rosen Family Professor of Economics at Brandeis University in Waltham, Massachusetts

As a consequence of the investment boom of the 1980s, foreign companies now play a prominent part in the daily lives of Americans. When a US consumer buys a new car, shops in a department store, or checks into a hotel, chances are increasingly good that the supplier will be the local subsidiary of a company based in Europe, Japan, or Canada. The same is true when a US business rents office space, purchases components, or applies for a bank loan. This article discusses the reasons for the growth of foreign direct investment in the United States, the concerns raised by the increase, and its impact on the US economy.

What happened?

The rapid inflow of direct investments (those providing foreigners with at least 10 percent ownership in a US business) during the 1980s occurred in the context of an explosion in international trade in all types of assets. For several decades, US investors had dominated international financial markets as both lenders and borrowers, with a modest net capital outflow in most years.

In the 1980s, the United States abruptly became a net borrower on a scale that was unprecedented for any nation. However, only a fraction of the rise in total capital inflows came in the form of direct investment. Even in 1989, when direct investment inflows reached a peak of more than $70 billion, this constituted less than a third of total capital inflows for the year (Table 1).

Table 1.Foreign investment in the United States

Balance of payments inflows

(billion dollars)

TotalForeign direct

investment (FDI)
FDI as percent

of total
19602.30.313.7
19706.41.523.0
197221.50.94.4
197434.24.813.9
197636.54.311.9
197864.07.912.3
198058.116.929.1
198183.025.230.3
198293.713.814.7
198384.911.914.1
1984102.625.424.7
1985130.019.014.6
1986221.634.11S.4
1987218.558.126.6
1988221.459.426.8
1989216.570.632.6
199086.337.243.1
Source: Survey of Current Business. August 1991 and earlier issues.Note: Percentages calculated from unrounded flow data.
Source: Survey of Current Business. August 1991 and earlier issues.Note: Percentages calculated from unrounded flow data.

The impact on US economic performance of increased foreign ownership and control is different from that of other capital inflows (a major part of the total was purchases abroad of US Treasury securities and increased foreign deposits in US banks), and the motive for direct investment is likewise different. The flood of direct investment into the United States is thus a phenomenon that needs to be examined separately from the much bigger rise in US net borrowing.

Most economists see the rise in net borrowing as the result of overall macroeconomic forces; when aggregate US saving (private saving less the government deficit) falls short of aggregate domestic investment, the nation necessarily borrows the difference abroad. In contrast, direct investment is basically a microeconomic phenomenon driven by competitive conditions in particular markets. To understand the causes of the surge in inward direct investment, we must therefore examine the motivation of individual companies.

Why foreign direct investment?

To understand why foreign firms have been buying and building US operations, it is helpful to look at direct investment as an integral part of a firm’s overall strategy for global production and sales. At one level, it should not be surprising that successful firms expand their operations. When that expansion crosses a national boundary, it becomes—by definition—foreign direct investment. Yet many firms sell abroad without undertaking direct investments, and in any case, investment abroad is not necessarily the most profitable avenue for increasing foreign sales. In fact, a foreign firm is almost always at some disadvantage in operating away from its home base. A company’s decision to invest in the United States thus raises two questions: (1) why does the firm choose direct investment over other strategies, and (2) how is the foreign firm able to compete successfully with US companies already established in the domestic market?

Modern theories of foreign direct investment suggest that a firm will want to establish a US subsidiary only if it enjoys a firm-specific competitive advantage over its rivals and if that advantage is most profitably exploited through managerial control over operations in multiple countries. Direct investment in the United States can be a viable strategy only if the advantages outweigh the disadvantages vis-à-vis established US-based competitors. The rapid growth of US imports and of inward direct investment can thus be viewed as two aspects of a single phenomenon—both reflect the increased global competitiveness of corporations in Europe, Japan, and Canada relative to their US-based rivals.

Empirical studies show that direct investment activity in manufacturing is clustered in industries where research and development (R&D) and advertising expenditures are important—examples for the United States include electronics, chemicals, pharmaceuticals, and processed foods, as well as the much-publicized automobile industry. R&D and advertising expenditures presumably create competitive advantages that allow firms to operate profitably in a foreign environment. But firms’ competitive advantage can in many circumstances be better exploited through exports from the home country. An additional requirement for setting up US operations, therefore, is that it must offer some locational advantage. Otherwise, the potential investor is likely to choose exporting over the more costly and risky option of establishing a US subsidiary. During the 1980s, increased protection and a decline in the relative cost of US labor helped to tip the balance in favor of a US location for Japanese auto producers. Previously the same markets were served by exports. The Free-Trade Agreement between the United States and Canada that went into effect in 1989, as well as its pending expansion to include Mexico in a North American Free Trade Area, have given further boosts to the region’s advantages as a production location.

Even given a competitive advantage and a locational advantage, the investing firm must also anticipate an organizational advantage from extending its managerial control across a national boundary. The underlying motives for foreign direct investment are essentially the same ones that promote expansion at home. But because international expansion is typically more expensive, the anticipated benefit needs to be large enough to offset the higher cost. Otherwise the firm will prefer an arm’s-length alternative such as licensing.

Enhanced opportunities for tax avoidance are a much-cited potential benefit of multinational operations, although the size of the benefit is difficult to gauge. The key tool here is the transfer price—the bookkeeping price at which a good or service is “sold” by one unit within the firm to another. Firms use advantageous transfer prices to increase global after-tax profits by shifting reported profits between tax jurisdictions. This is a longtime practice of US-based multinationals. Now the counterpart activity of foreign companies operating in the United States has begun to attract attention. Some officials charge that foreign corporations are benefiting from access to the US market without paying an appropriate share of US taxes. Through stricter enforcement of US tax laws, the Clinton administration hopes to raise taxes collected from foreign corporations by as much as $45 billion over four years. However, tax specialists believe a crackdown on abuses of transfer pricing would yield only a fraction of that, and also runs the risk of discouraging new investors.

US worries

While the domestic economy was strong, the United States worried mainly about large, but somewhat vague, consequences of increased foreign ownership. Heading the list was loss of control over domestic economic activity—loss of economic sovereignty, in the usual phrase—and an associated potential threat to national security. These large issues have remained contentious in the 1990s environment of low growth and high unemployment, but the debate has refocused on specific concerns of those directly affected.

The prominent issue is jobs—more precisely, what happens to American employment and wages when a foreign company gains control of a US business. Less often raised explicitly but intimately related is what happens to profits of US-controlled companies.

The United States also worries about the nation’s trade. As with competition from imports, beleaguered domestic firms are apt to label activities of their foreign-controlled US rivals as unfair and detrimental to the national interest. Just as the recession of the early 1990s brought forth new calls for aggressive trade policies, critics of foreign direct investment found a host of new reasons to limit the role of foreign companies within US borders.

But the recession also increased the zeal of those who favor an open-door policy toward new foreign investment. Indeed, with trade performance sagging and many US regions and industries experiencing near-record unemployment, states and cities dispatched missions abroad in active pursuit of investors who would, it was hoped, create jobs and boost industrial competitiveness. The competition to attract foreign investors has, in fact, spawned a new worry. With so many states and cities bidding for investments with special incentives, the benefits might well be shifted in favor of foreign firms and away from US workers, investors, and taxpayers.

Another concern is how these investments affect America’s technological edge. Does foreign ownership help to boost US productivity and restore the vigor of US business, or, on the contrary, do direct investments aid foreign companies in their quest for access to US technology in leading-edge products like computers and aircraft?

Impact on US capital and labor

From a global perspective, unimpeded movement of capital (unfettered competition between foreign-based and US-based firms), like free trade, is desirable because it promotes an efficient allocation of productive resources worldwide. But Americans are increasingly fearful that a laissez-faire policy toward investment may create benefits abroad at the expense of economic well-being at home.

Because ownership of US operations is a way for highly competitive, foreign firms to enter the US market, its most predictable effect is to reduce profits of other firms (domestic and foreign) already in that market. But new entry can also affect profits of firms that do not compete directly, through changes in demand for intermediate goods and productive inputs, and through changes in tax revenues and public expenditures. In the longer run, foreign ownership can even influence the legal structure within which the industry operates, as new owners lobby on legislative and regulative issues.

Increased employment is the benefit most eagerly sought by host regions, yet the impact of direct investment on employment and earnings is complex. Direct investment influences aggregate employment and earnings mainly through enhanced productive efficiency. Both theory and empirical evidence suggest aggregate employment effects are minor, although there may be larger sectoral or regional impacts.

Localities want foreign investment because it creates “new jobs.” But overall demand for a given product is unlikely to rise significantly as a consequence, even when foreign investment entails construction of new plants. Any new jobs, therefore, mainly replace others lost either abroad or at home, depending on whether output from a new plant substitutes chiefly for foreign or for other domestic production. If foreign jobs are replaced, employment in that US industry might rise, but as displaced foreign workers move into other sectors, global demand for other US products will tend to fall.

Even in a given industry, substitution of jobs will not be one for one if the investor’s competitive advantage includes higher efficiency in production. Empirical results suggest that foreign owners in the United States pay roughly the same wages as domestic owners in the same industry but have higher output per worker. The number of jobs in the industry nationwide is thus likely to fall unless much of the new production replaces US imports or augments exports. And even if total US production in the industry rises, on average foreign-controlled producers use a higher percentage of imported intermediate inputs. This can mean job losses for workers in the domestic industries that produce these inputs.

“From a global perspective, unimpeded movement of capital (unfettered competition between foreign-based and US-based firms), like free trade, is desirable because it promotes an efficient allocation of productive resources worldwide.”

Although the effect on US labor is complex, at least wages and employment can be observed directly. This is not true for technology. Developing countries’ efforts to attract foreign investments reflect a presumption that multinationals provide a channel for transfers inward of advanced technology from abroad. The same hope is expressed by many US officials and corporate leaders. The problem is that technology transfer is a two-way street. Critics of a laissez-faire policy toward inward direct investment worry that investments can serve as listening posts, facilitating the dissemination to foreign-controlled companies of proprietary US technologies. The Clinton administration has promised tougher scrutiny of proposed investments in high-technology sectors.

What role for the United States?

The greatly increased extent of two-way foreign direct investment has blurred the distinction, at least among industrial nations, between host and source countries. In the 1960s, the United States was the preeminent and indeed quintessential source country. It was thus also the most conspicuous potential beneficiary of international limits on nationalistic policies of host countries. Today, the United States remains a major source country as well as the strongest voice for international action to regulate investment policies. Yet it has also become the world’s most important host to direct investment, with all the political pressures that role entails. Correspondingly, the European Community, as well as Canada and Japan, have gained a stake in placing limits on host-country investment policies, particularly those of the United States.

A key policy question for the United States in the 1990s is therefore analogous to the one raised by the national debate on trade policy a decade earlier; that is, whether it remains willing and able to champion global goals even when this requires some sacrifice of perceived national needs. More specifically, is the United States willing and able to continue its leadership role in combatting investment policies that achieve narrow sectoral objectives at the expense of global efficiency? Or will it instead join other host countries in yielding to interest-group pressure and xenophobia?

Table 2.Foreign direct investment in the United States

Balance of payments inflows for major investing countries

(billion dollars)

Total, all

countries
United

Kingdom
JapanNetherlandsCanadaGermanySwitzerland
198519.04.73.42.80.92.32.7
19B634.110.87.34.42.52.01.4
198758.125.38.88.53.74.43.0
198859.421.017.35.81.22.40.8
198970.618.917.47.33.23.84.7
199037.23.717.37.10.0-0.9-1.0
Source: Survey of Current Business, August 1991 and earlier issues.
Source: Survey of Current Business, August 1991 and earlier issues.

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