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FDI and Sustainable Growth

FDI and Sustainable Growth

 President Hassan Rohani has regularly reminded foreign companies of the investment attraction of Iran because of its massive market. Just recently, the government announced major tax breaks for foreign companies if they export at least a third of their products. The government has sent warm invitations to bring Foreign Direct Investment (FDI). The question is how to prepare for the coming guests to achieve a sustainable economic growth?

There is no doubt that FDI and gross domestic product (GDP) of a country are positively correlated. Although it is not clear whether the FDI and GDP relationship is unidirectional or bidirectional, Rohani’s government seems to assume FDI causes economic growth perhaps via knowledge transfers and adoption of new technologies and increases in export. Hence, the government is working on introducing new policies to increase our GDP by making investment laws more liberal and ignoring the other economic and non-economic variables which influence GDP.

The good news is the condition of the tax break that tries to promote tax relief while preventing a consumption boom in the country. However, with the high tendency of Iranians towards foreign products and their comparative advantages, 33% which sets the standard for the rest of the deals might not be of great help. The government’s aim of converting threats to opportunities is in favour of foreigners and the opportunities are yet to be used while there are new threats ahead of us.

FDI impact on our national welfare will highly depend on the type of investment carried out. The effect can be significant by creating new production capacities, new working places, increase in export, enhancement in international liquidity that helps to stabilize the exchange rate and so on. However, FDI leads to an increase in the effective demand (consumption) as well. This in turn will increase GDP only if national producers can meet the quality/price requirements of buyers. Otherwise, imports will grow instead. Moreover, if national production cannot grow, firms will decide to raise prices, vanishing effective demand with inflation. In this situation, the government’s economic team would prescribe the closure of domestic industries that cannot keep up with foreign companies. This signifies a crucial decrease in the number of jobs. Moreover, FDI is correlated with negative externalities such as an increase in energy consumption.

Generally the increase in consumption will cause higher prices that will increase the interest rate. While this will decrease the domestic investment, it will promote FDI as interest rate differentials exert a strong effect on the attraction of foreign capital. At the same time more FDI means more demand for rial, which in turn leads to rial appreciation that will lead to more rounds of imported consumption and less revenue for the government. Thus, causing deficits in current accounts and balance of payments. If FDI increases consumption more than capital formation we should question the purpose of accumulating debt in order to consume and not to invest and grow.

As the relation between FDI and GDP is bidirectional, Iran will experience greater inflow of foreign capital that leads to demand-led growth, which in turn, attracts more FDI.  To prevent the potentially unhealthy growth, the government should promote FDI that finance investment and not consumption, and attract FDI in deficient sectors and not in retail.

 An economic growth based on demand/consumption is always easier to put into place than a growth based on supply. However, in order to achieve sustainable growth, policies should be designed to attract FDI destined to increase supply and productivity. Only then we can hope for FDI help to bring excessive enthusiasm originated in its association with economic growth.

 

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