Working Party on the Social Dimensions
of the Liberalization of International Trade
THIRD ITEM ON THE AGENDA
1. At the 265th Session (March 1996) of the Governing Body, the Working Party on the Social Dimensions of the Liberalization of International Trade decided to consider the effect of foreign direct investment (FDI), including that by multinational enterprises, on labour standards in host countries, and asked the Office to prepare a paper on the issue drawing on existing studies, such as those by UNCTAD.(1) The present paper is submitted in response to that request. It will focus on the two sources that bear most directly on the above topic: UNCTAD's World Investment Report 1996, and the section on foreign direct investment in the OECD report entitled Trade, Employment and Labour Standards (1996).(2) Material will also be drawn from the World Bank's World Development Report 1995: Workers in an Integrating World, an IMF working paper entitled Foreign Direct Investment in the World Economy (June 1995) and a 1995 OECD monograph entitled Foreign Direct Investment, Trade and Employment. The discussion will be organized around four main issues: the growing significance of foreign direct investment in the global economy; the impact of foreign direct investment on economic growth and employment; the link between foreign direct investment and labour standards; and the implications for policy.
2. The UNCTAD's annual World Investment Reports have been a comprehensive source of data on trends in foreign direct investment (FDI) in the world economy, and have documented the very rapid growth in FDI that has occurred since the mid-1980s. Between 1983 and 1987 the outflow of FDI in the world as a whole increased at a rate of 35 per cent per annum. This slowed to 4 per cent per annum between 1988 and 1992 and remained low in 1993 and 1994, but there was a new surge in 1995 when it increased by 38 per cent. Within this overall picture it is significant to note that the inflow of FDI to developing countries has consistently exceeded 15 per cent per annum since 1988, with a peak growth rate of 45 per cent in 1993. Thus, as the 1996 World Investment Report notes "Foreign direct investment has been growing rapidly in the recent past, faster, indeed, than international trade, which has long been the principal mechanism linking national economies".
3. The quantitative significance of these developments is reflected in some key ratios cited in the 1996 report. "The world gross product of foreign affiliates [of multinational enterprises] ... accounted for 6 per cent of world GDP in 1991, compared to 2 per cent in 1982." At the same time the ratio of the stock of FDI to world GDP doubled between 1980 and 1994 (standing at 9.4 per cent in 1994) while the ratio of annual FDI flows to gross domestic investment increased from 1.7 to 3.9 per cent over the same period. These average figures for the world as a whole of course subsume considerable inter-country and inter-regional differences. For example, in 1994 the ratio of FDI inflows to gross domestic investment was as high as 23.5 in Singapore and 24.5 per cent in China.
4. The report highlights two main factors that have driven the rapid growth of FDI. It points out that "particularly since the mid-1980s, the environment for FDI and trade has changed significantly. The most significant changes relate to the reduction of technological and policy-related barriers to the movement of goods, services, capital, professional and skilled workers, and firms. More specifically, technological developments have greatly enhanced the ease with which goods, services, intangible assets and people can be transported, and tasks related to the organization and management of firms implemented over distances ... In the resulting international division of labour within firms, any part of the value-added chain can be located wherever it contributes most to a company's overall performance." This increasingly "means that FDI and trade flows are determined simultaneously. They are both immediate consequences of the same location decision." It also means that "intra-firm trade flows between parent firms [of multinational enterprises] and affiliates and among affiliates assume considerable and growing importance" and that the "structure of trade linked to such FDI involves relatively larger shares of intermediate products and services and intra-industry trade."
5. These developments create both new opportunities and challenges for countries. "The division of labour that results provides potential opportunities for countries to participate in production and trade associated with TNCs, specializing in segments of goods and services production for which they have a comparative advantage." This could be either by actually hosting TNCs or being linked to them "through subcontracting or other arrangements, exporting parts, components, and/or selected products to affiliates and parent companies". This, however, carries the risk that "vulnerability may increase as specialization becomes more narrow, especially when it is susceptible to technological change and locational reorientation".
6. There has been a marked shift in the policy stance towards FDI in many countries across the world since the beginning of the 1980s. As pointed out by the 1996 World Investment Report, "in the 1980s, the earlier post-war approaches to investment, which often stressed restrictions, controls and conditions on entry and establishment of FDI, were reversed ... as a result of the changing perceptions of the role that FDI can play in growth and development ... laws and policies in many developing countries began to change dramatically in the direction of liberalization, protection and promotion of FDI. Liberalization also expanded and deepened in developed countries."
7. This positive view of the role of FDI is to some extent supported by recent empirical evidence on the subject. But it is important to point out that applied economic research on the subject is beset by methodological and data problems. There is lack of agreement on how to model the overall effects of FDI, and the data necessary to establish causal relationships is often not available.(3) This is significant because, in principle, "FDI and MNCs can have both positive and negative effects on host countries. Positive effects come about largely through the transfer of technology and other intangible assets, leading to productivity increases that improve the efficiency of resource utilization and ultimately lead to higher per capita income."(4) These positive effects include "both direct benefits brought about by linkages between MNCs and local firms (e.g. suppliers and distributors) and indirect benefits, whether created by increased rivalry or via the generation of external benefits." At the same time negative effects "can arise from the market power of the MNC and the ability of an MNC to use this power to generate supranormal profits and transfer this to its shareholders, who presumably are not residents of the host country." Similarly, there can be both positive and negative effect for the home (or FDI exporting) country. Outward FDI can reduce employment if it crowds out the exports of parent firms or displaces employment which would have otherwise come about. However, outward FDI could increase employment if it leads to a net increase in home-country exports (e.g. through increased demand for intermediate products and capital goods from foreign affiliates) or if the transfer of low-skilled activities helps to maintain high-skilled jobs at home. "There is no reason why, in principle, the positive effects should be dominated by the negative effects or vice versa. This indeterminacy is, perhaps, why debate over the MNC has long been lively and subject to 'sea change'".(5) Thus, as noted earlier, there has been a broad shift towards a positive view of the effects of FDI, but there has also been concern in some industrialized countries over the employment-reducing effects of the outflow of FDI or "delocalization". Similarly "when FDI into the United States began rapidly to rise during the late-1980s, many politicians began to question the benefits of this influx and some restrictive measures have been passed." (IMF 1995).
8. In reviewing the available empirical evidence, most of the reports conclude that the positive effects of FDI predominate. The UNCTAD report notes that "some empirical studies suggest, indeed, that the trade-creating effect of FDI in manufacturing tends to outweigh the trade-replacing effect for the home country" and that "on balance FDI leads to more trade. The result therefore is an intensification of international economic interactions." Similarly, the IMF study concludes that "outward FDI seems to be positively associated with trade expansion" and that with inward FDI "the overall effect would be increased growth and increased capital formation resulting initially from increased efficiency of use of capital, and sustained by a 'virtuous circle'". The OECD study on the employment effects of FDI in the industrialized countries is, however, more cautious on this specific issue. It takes the position that "no general conclusion has evolved either regarding the sign of the employment effects or their magnitudes. The broad range of results is a reflection of both the complexities of the analysis and methodological shortcomings, combined with the generally poor data availability in most countries."
9. The OECD study on Trade, Employment and Labour Standards contains a short section which discusses the economic links between FDI and core labour standards (defined as the standards related to the elimination of child labour exploitation, prohibition of forced labour, freedom of association, the right to organize and bargain collectively, and non-discrimination in employment).(6) It "addresses two key questions:
10. The study sets out the "conceptual issues" surrounding each of these questions and then examines the empirical evidence. On the first question of the link between core labour standards and investment decisions, the report points out that "Labour standards could influence the decision on the location of investment -- in which country to invest and where in the country". Labour standards impact on labour costs "either directly, where, for example, prohibition of forced labour or child labour translates into higher labour costs, or indirectly where freedom of association and collective bargaining provides the opportunity to employees to negotiate wages and working conditions." Therefore, "labour standards could be a variable in the decision of investors trying to minimize labour costs."However, the report also points out that "while in a static view lower labour standards may in fact translate into lower labour costs, the relationship could be reversed in a dynamic perspective" since "higher labour standards may work as an incentive to raise productivity through investment in both human and physical capital, thus contributing in the longer run to greater cost competitiveness of companies."(8)
11. In reviewing the empirical evidence the report notes that "the bulk of FDI -- 73 per cent in 1993 -- is directed to OECD countries where compliance with core labour standards is by and large guaranteed in law and practice."(9) The issue is thus reduced to that of the extent to which FDI flows to non-OECD countries have been influenced by labour standards. On this it points out that "the multitude of factors that determine investment flows and the lack of data ... render it difficult to isolate the relevance of core labour standards. The variety of countries, their investment conditions and the legal and practical situation regarding core labour standards in these countries also prevent clear-cut answers to the question."(10) Its overall assessment is that "while core labour standards may not be systematically absent from investment decision of OECD investors in favour of non-OECD destinations, aggregate FDI data suggest that core labour standards are not primary factors in the majority of investment decisions of OECD companies. None the less, some governments in non-OECD countries have restricted labour rights in the belief that doing so would help attract inward FDI from both OECD and non-OECD investors. Inward FDI from non-OECD countries, some of which have had problematic records of respecting core labour standards, has also increased. According to reports by MNEs from OECD countries, core labour standards are not considered a factor in assessing investment opportunities in a potential host country. In these circumstances, host countries may be able to enforce core labour standards without risking negative repercussions on FDI flows."(11) This assessment is shared by the World Bank's World Development Report 1995: Workers in an Integrating World, which noted that "although many countries have indeed offered tax breaks and other enticements, and some authoritarian governments have repressed labour, these are not the primary attractions for capital, and over the long term they are more likely to reduce net capital inflows".(12)
12. On the second question that is addressed by the OECD report on trade, employment and labour standards, that is, the impact of MNEs on core labour standards, it notes that MNEs could either improve the situation by functioning as a "role model ... with respect to business ethics and core labour standards" or they could contribute to a deterioration by "engaging in efforts to lobby governments to change labour legislation to a more 'investor friendly' environment". It also notes that where MNEs have a positive impact on economic growth in the host country this would be "an important ingredient for countries to raise labour standards." The discussion on empirical evidence is very brief, since very little information is available. The report notes that there is no published evidence that MNEs lobby governments to change labour standards and that "there is little evidence that foreign investors from OECD countries employ child labour or are guilty of exploiting child labour; similarly, violations of standards for forced labour and discrimination have not been documented. However, there have been a number of published accounts of MNE subcontractor violations, particularly with respect to child labour." On the behaviour of MNEs with respect to freedom of association rights in non-OECD countries the report observes that "the radically lower degree of unionization in EPZs in comparison with the domestic economy as a whole could suggest that MNEs do not contribute to the improvement of the practical situation of unions." The report also makes a guarded reference to the role of MNEs from non-OECD countries in noting that "some are of the view that an increase in the potential for downward pressures [on labour standards] may be expected in response to growing competition from investors from non-OECD countries, where core labour standards are not (fully) respected".(13)
13. A basic implication for policy that emerges from the various reports is that the growing importance of FDI flows in the world economy is a positive development that should be sustained. It creates new economic opportunities for countries at all levels of development and contributes to higher economic growth. The UNCTAD report discusses the issue of whether, as part of the policy response, there should be a move towards a multilateral framework for foreign direct investment. It notes "that the question has been raised whether current international arrangements have been overtaken by global economic reality and, therefore, a 'catching up with the market' is necessary. The vigorous growth of bilateral and regional investment agreements, the inclusion of certain FDI-related issues in the Uruguay Round agreements and the beginning of negotiations on a Multilateral Agreement on Investment in the OECD suggest that many governments believe that this is indeed the case."(14) It further notes "that widespread recognition is emerging on the principal issues that need to be addressed in the FDI area" and these include the "general standards of treatment of foreign investors; questions relating to entry and establishment and operational conditions; protection standards, including dispute settlement; issues relating to corporate behaviour; and other issues such as the promotion of FDI." Nevertheless, it recognizes that a diversity of views exist as to how existing arrangements guiding FDI should be further developed. It also states that "members of the WTO are discussing a proposal for a decision to be taken at the WTO's first ministerial conference in Singapore in December 1996 to create a body to conduct a work programme on trade and investment. If such a decision were taken, it is likely to provide for exploratory work rather than the immediate launching of actual negotiation of a set of investment rules."(15)
14. In terms of national policies it is clear that the attraction of FDI offers new opportunities for raising economic growth, increasing exports, expanding productive employment, and improving productivity. But, as highlighted in the UNCTAD report, FDI flows have so far been very unevenly distributed. The ten largest developing country recipients received 76 per cent of the annual flow of FDI into developing countries between 1993 and 1995. "In the short and medium term, poorer countries that generally attract little FDI may ... indeed be further marginalized unless there are strong national and international efforts for development."(16) The national efforts in question will need to emphasize investment in infrastructure and human resources. According to the World Bank report the key attractions to investors are "good infrastructure, a reliable and skilled workforce, guarantees of their right to repatriate both income and capital, and social and political stability".(17) As mentioned earlier, neither the World Bank nor the OECD reports consider it to be sound policy to offer concessions to investors in the form of compromises on core labour standards. In addition, the role of core labour standards in contributing to higher productivity and the capture of longer-term dynamic benefits from FDI is mentioned in the OECD report. A final policy issue highlighted in the UNCTAD report is the need for closer coordination of trade and FDI policies. It points out that "national trade and FDI policies have typically evolved separately, frequently influenced by different goals, and administered by distinct, often loosely coordinated agencies" and warns that "inconsistent policies risk creating an environment in which trade and FDI policies may neutralize each other or could even prove counterproductive." In contrast, "when formulated and implemented coherently, national trade and FDI policies become mutually reinforcing in support of national growth and development."(18)
15. The Working Party may be interested to know that it is the intention of the Office to take into account gaps in knowledge on the implications of foreign direct investment for employment and social policy, as identified in the present paper and as may emerge from the Working Party's discussions, in formulating its future research programme.
Geneva, 28 October 1996.
2 See also the paper submitted to the Working Party under the second item on its agenda: Reports of the Organisation for Economic Cooperation and Development on trade and labour standards, GB.267/WP/SDL/2, which reproduces in an appendix the introduction to this report.