The role of foreign direct investment, or FDI, as an accelerator of economic growth of the receiving, i.e. the host, country is difficult to dispute (although, as there are always exceptions to every rule). These benefits include the increase in the level of investment, higher wages, transfer of technology, transfer of know-how, etc. Therefore, it is in the best interest of a country to attract such investments. This is especially true for developing economies. One of the reasons is because it is much more efficient to buy or receive new technologies than to develop them on your own.
In order to attract FDI, the economy has to first satisfy several conditions. These conditions depend on the reason for an investor to be interested in the host economy. Generally, in the literature on FDI, there are four main reasons: searching for new markets, searching for resources, searching for strategic assets and searching for efficiency. The last one involves such aspects as low-cost labour.
Wages and foreign direct investment relationship
It is important to note that investors are not looking at the final cost of labour, but rather at what is the lowest price for which they can purchase a specific set of skills. Therefore, it is reasonable to assume that a foreign investor will not invest in a host country with inexpensive labour if this labour does not have the required set of skills. Furthermore, it is reasonable to assume, that the only time an investor is willing to pay a high price for a unit of labour is when this labour is of high quality, e.g., it is highly educated or overall represents a high level of human capital.
Taking the above into consideration, it is possible to construct a 2x2 matrix. A host economy will begin in the lower-left corner (let us call this Stage I), where its labour does not have high human capital therefore it cannot request a high wage. In time, the labour’s human capital increases and becomes more and more attractive for foreign investors. Now the economy is moving to the bottom-right corner (Stage II), where the low-cost labour is a source of a competitive advantage in attracting inward FDI. As more investments are made, the workforce is even further increasing in human capital; therefore, it is justifiably able to charge higher prices for its services. Eventually, the host economy will find itself in the top-right corner (Stage III), where its high human capital labour is a source of competitive advantage in attracting inward FDI. If the host is located in the top-left corner, then (a) it is possible that the high cost of labour is not paired with the high quality of the workforce or (b) labour is not one of the key drivers attracting FDI (see other reasons mentioned earlier).
Of course, it is possible for a host economy to move directly from Stage I to Stage III, but this would require that each investment in the human capital of the host’s workforce to be immediately recognised and acted upon by the foreign investors in a form of higher FDI. Given that each FDI decision bears significant involvement costs and therefore risk, such a path is less likely than the Stage I-II-III (“curved”) path.
It is also possible for a host to move horizontally from Stage I to Stage II, which would mean that there is no change in the cost of labour. In other words, either this workforce is not increasing its human capital (e.g., skills; this can be due to a lack of absorptive capacity of the said workforce), or they are doing so, but are artificially keeping labour costs relatively low to remain the leading low-cost labour destination for foreign investors. The problem with such a strategy in the long term is that a second, cheaper alternative is going to arrive on the investment map and the host using this strategy will lose its competitive advantage. To avoid such a situation, the analysed host can allow for labour costs to increase in order to match the increasing skills of its workers, but then (as is shown on the graphic) there would be no or very little change in inward FDI presence or (as is not shown) the FDI involvement would decrease. It is important to note that the above scenario, called the “reversed L path”, does not look at the type of investment. Therefore, the analysed host could, while increasing labour costs, be substituting low-technology FDI for high-technology FDI.
Wages and FDI – Implication for Polish and Ukrainian Policy
When examining how Poland moves on the wage-FDI plane, it is interesting to see that when compared to the Czech Republic, for example, which appears to follow the curved path, Poland’s shifts are rather horizontal. This puts it right next to both the Czech Republic and Slovakia which after following a horizontal path has suffered from a significant drop in FDI. This means that Poland is simultaneously competing with the Czech Republic when it comes to both costs and quality of labour force and with Slovakia when it comes to the costs of the workforce. Such a situation can be called the “middle host trap” as the hosting economy is stuck between being a low-cost and being a high-quality workforce host. This situation is very hard from the policy standpoint as there is a substantial opportunity cost of focusing on one of the two sources of competitive advantage related to the labour force when attracting inward FDI. Therefore, this decision needs to be long-term in nature with a supporting ecosystem being put in place. For instance, a decision to compete on the quality basis without proper investment, e.g. in the educational system, can prove to have opposite effects to those that were set out.
Looking at the movement in Ukraine, it can be said that relative to other examined economies, low-cost labour is not a source of competitive advantage when it comes to attracting inward FDI. Given the situation of Ukraine a recommendation can be made that in order to attract foreign investors (and to some degree to compensate the risks involved in investment in Ukraine rather than in Slovakia that is an EU member) wages, despite eventual increases in human capital, should be kept low which obviously requires other parallel policies in order to attract FDI. Once the competitive advantage of Ukraine’s workforce in terms of low costs is achieved, then it should focus on substituting low-technology inward FDI for high-technology inward FDI. Without this, Ukraine could share the shifts seen in Slovakia. In other words, Ukraine should take the harder reversed L path.
Tomasz M. Napiórkowski is an assistant professor at the Warsaw School of Economics in Poland and a lecturer at Lazarski University. He is an expert at the Schumpeter Centre for Creative Destruction.
This text is part of the series titled: “Intermarium in the 21st century” based on the conference held on July 6-7 2017, Lazarski University in Warsaw.