Thursday, February 5, 2009

Is Presence Of Multinationals Desirable In LDCs?

Multinationals: companies that operate in more than one country

Economic reasons to go multinational:

(1) The local market has become saturated & possibly there is not much space for further growth

(2) To make larger supernormal profit by basing in developing countries which have increasing number of middle income households such as China & India

(3) To exploit economies of scale when they produce in larger volume

(4) To take advantage of ease in obtaining natural resources in developing economies

(5) Producitvity of labour is increasing & yet they are able to endure long working hours. Also they hardly ask for higher pay

(6) Easy to press local government to pass on laws that favour MNCs e.g. extension period of tax holidays, investment allowances & cheap provision of factory sites

(7) Avoiding legal compliance in developed world which actually increase their production costs e.g. health & safety standards

Benefits of multinational in LDCs

(1) Filling the savings gap. According to Harrod-Domar, savings which are later channeled to investment is the main driver of economic growth. With greater investment spending, there will be more capital goods & human capital produced, thus increasing the productive capacity of economy. This then enables output & income to grow, which in turn generates larger saving & then larger investment. The system will be self-sustained. Somehow in many LDCs especially African regions, unemployment is high, those employed have decent wages & many that do not trust their financial institution. As such it is very difficult to kick start any investment due to lack of funds

Therefore inflow of foreign capital may help to patch the savings gap & enable a country to achieve targeted level of investment spending

(2) Filling the foreign exchange gap. Many LDCs are facing the problem of current account deficit. To pay, they will need lots of foreign currency such as dollar, euro or pound. But the problem is, LDCs which are mainly primary sector driven suffer all these years from the fall in world commodity prices & the worsening of Terms of Trade (ToT). These attribute to lower foreign exchange earnings

With large influx of foreign capital, LDCs will have more foreign currency in their reserves. Also once established, goods produced & exported will help to minimise the current account deficit

(3) Tax revenue. LDC government may also expect to be able to collect tax revenues from both MNC in the form of corporation tax & income tax that resulted from employment created. As such there will be more available funds to meet development projects. There will be more schools, hospitals, upgrading of roads, setting up proper communication system etc that can increase the standard of living of its people

(4) Employment & skills to local. Remember under the Lewis model, large scale rural-urban migration has caused industries unable to absorb surplus of labour force. As such increasing number of multinationals in LDC is invaluable in solving problems like urban poverty resulted from unemployment. Also there will be transfer of skills, knowledge about technology & management experience that can be gained through training & the process of learning by doing. MNCs can educate local managers on how to establish contacts with oversea banks, locate alternative source of supply & become flair with international marketing practices

In time there may be positive externalities. As workers become more marketable, they may leave MNCs to work in local companies, or use their knowledge to start their own businesses


(1) Harm domestic firms. Local companies may not be able to compete directly with multinationals that possess everything e.g. management skills, tendency to be more productive efficiency (producing at lower part of LRAC), marketing strategies etc. As such, they could be out of business & this may result in bankruptcies which surface along with unemployment. Also local suppliers of raw materials, capital goods etc may be worse off if these MNCs decide to buy them from overseas

(2) Crowing out effect. Although MNCs provide capital, large numbers of them do raise financial needs domestically. In LDCs, available funds for investment are already limited. With the presence of MNCs, competition for limited amount of fund will eventually bid up interest rates, thus crowd out local investment & private consumption. From macroeconomic perspective, although AD in theory is said to increase due to investment by foreign firms, somehow it is offset by the fall in both local investment & consumption. AD & therefore economic growth may not increase that much after all

(3) Worsen both current account & financial account. Although the initial impact of MNC investment is to improve the foreign exchange position of recipient nation, its long run impact may reduce foreign exchange earnings on both current & capital accounts. The current account may deteriorate as a result of substantial import of intermediate products & capital goods. Meanwhile, capital account may worsen because of the repatriation of profits & other funds back to their home country

(4) Contribute little to tax. Although MNCs do contribute to public revenue in the form of corporation tax, their contribution is considerably less than it should be due to liberal tax concessions, excessive investment allowances & practice of transfer pricing. Transfer pricing is a situation where MNCs inflate the price it pays for intermediate goods bought from overseas affiliates. In this case, overseas affiliate will register higher profits while that MNC will register lower profits. This is because that MNC could be operating in a high-tax LDC & while its affiliate operating in a low tax LDC. As such it’s like some sort of ‘profit-transferring’

(5) Unemployment not solved. Since most MNCs originate in more-developed countries, they tend to use technology that suits the conditions with which they are familiar. In many cases, these will tend to be relatively capital-intensive, which may not be wholly appropriate for LDC factor endowments e.g. large pool of labours. As such employment may not be created or perhaps limited to relatively low-skilled jobs

(6) Limited spillover effects. Those MNCs may make use of local unskilled labour but hire expatriate skilled workers & managers. As such there could be of minimal spillover effects to local economy. Another possibility is that, MNC may pay wages that are higher than necessary to maintain good public image & to attract best local talents. This is fine for workers lucky enough to land on such job, but it can cause great difficulties to local companies to maintain their best workers. Yes, they could increase the wages but at the expense of increase in production costs

(7) Worsen rural-urban migration. MNCs tend to locate in urban areas, usually the capital city of LDCs, unless they are purely resource seeking in which the case they may be forced to locate near the supply of natural resources they are seeking. Locating in urban areas may aggravate the rate of migration. This will potentially cause 2 major problems. First, if the job expansion cannot keep up with the high migration rate, we will witness urban unemployment which leads to other problems like shanty towns. Secondly, higher incomes earn in urban may result in the widening of income inequality between urban-rural areas

There are other problems as well. Powerful MNCs may exert their power so as the government bows to their need e.g. more favourable tax rate, greater investment allowances etc. Also MNCs may produce growing number of higher income groups with high propensity to buy imports & low propensity to save domestically

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