OFDI involves an outflow of capital for a prolonged period of time, preventing these funds being used for investments in the home economy. It can reduce tax revenues in the home economy, especially when investments are aimed at locations with lower corporate and other taxes and are undertaken to evade home-country taxes. In addition, OFDI may facilitate capital flight (Knoerich 2018). All this could be challenging for some low- and middle-income countries with lower capital stock and fewer financial reserves, potentially harming their balance of payments and posing risks of currency depreciation.
Yet, OFDI tends to involve much smaller amounts of capital than international portfolio investments and other cross-border financial transactions, reducing the extent of potential harm from capital outflows. Over time, the financial earnings (see A1) Financial earnings) and repatriation of funds from OFDI could mitigate the unfavourable effects of these capital outflows and eventually even surpass the initial amount of capital that was invested abroad (Knoerich 2017, UNESCAP 2020). OFDI might also induce greater inward investment, which could further offset capital outflows (Goh, Wong, and Tham 2013, UNESCAP 2020).
Key insights
- Because OFDI involves capital outflows, it poses some financial risks (Ameer et al. 2020, Liu, Tsai, and Tsay 2015, Al-Sadiq 2013, Goh, Wong, and Tham 2013, Huang 2013, Herzer and Schrooten 2008, Feldstein 1995). But overall, more empirical studies find a positive relationship between OFDI and domestic investment (see A3) Domestic investment).
- Policy aimed at nurturing positive home-country effects should focus on companies that concurrently invest both at home and abroad.
Interactions
A1) Financial earnings: OFDI is a capital outflow that can reduce finances and tax income in the home country. However, OFDI can also generate financial earnings and result in the repatriation of profits.
A3) Domestic investment: Sometimes, capital outflows associated with OFDI subsequently crowd out domestic investment (Al-Sadiq 2013, Goh, Wong, and Tham 2013, Feldstein 1995), especially in the initial stages after the investment before OFDI starts to yield financial returns (UNESCAP 2020). Yet overall, more studies find a positive relationship between OFDI and domestic investment (Ali et al. 2019, Gondim, Ogasavara, and Masiero 2018, Ameer, Xu, and Alotaish 2017, You and Solomon 2015, Desai, Foley, and Hines 2005, 2009), and some report mixed results (Ameer et al. 2020, Liu, Tsai, and Tsay 2015, Herzer and Schrooten 2008).
C5) Fiscal support: Fiscal HCMs reduce the tax earnings of home countries.
Available Research Findings
Ameer et al. (2020): OFDI made between 1996 and 2017 from developed countries augmented domestic private capital formation but had a negative association with public capital formation. No effect was found in emerging economies.
Liu, Tsai, and Tsay (2015): OFDI undertaken by a sample of 1,084 Taiwanese manufacturing firms between 2000 and 2010 had a favourable impact on domestic investment when it was made in high-wage countries but tended to result in hollowing out when made in low-wage economies. OFDI generally aggravated income inequality.
Al-Sadiq (2013): An examination of 121 developing and transition economies finds that OFDI made between 1990 and 2010 had a negative impact on domestic investment.
Goh, Wong, and Tham (2013): The long-run effect of Malaysian OFDI flows on domestic gross fixed capital formation was negative and inelastic, meaning that the decrease in gross fixed capital formation was proportionally less to the capital outflows. The impact of inward investment was more elastic, meaning it could offset the negative effect of OFDI.
Huang (2013): Taiwanese OFDI undertaken between 1993 and 2008 in both mainland China and the rest of the world was negatively associated with R&D investment of the parent company, especially in the short term.
Herzer and Schrooten (2008): German OFDI had a complementary relationship with domestic investment in the short run but substituted domestic investment in the long run.
Feldstein (1995): OFDI reduces domestic investment.