Canada has long had a love/hate relationship with foreign direct investment (FDI). FDI brings economic activity and jobs but conjures up fears of foreign takeovers, especially by the United States.
A dispassionate analysis of the evidence shows that the benefits of foreign investment far outweigh any real or imagined drawbacks. Foreign firms operating in Canada are more innovative and productive than their Canadian counterparts, and they pay higher wages. More importantly, they import significant amounts of technology from their parent companies, and the benefits of these technologies spill over to domestic firms. In addition, though the stock of inward FDI did increase somewhat as a share of GDP in the late 1990s, it has held steady since then at just over 30 percent — the same share as in 1970.
Worries about corporate takeovers and the “hollowing out” of high-value head office functions in Canada are also misplaced. Foreign takeovers have actually increased head office activities in Canada in recent years, because foreign firms typically find it to their advantage to keep such activities geographically close to their Canadian operations.
Despite these benefits, Canada has been losing its attractiveness as a destination for foreign investment, particularly in the wake of continental free trade. Canada’s share of global inward foreign investment has fallen since the mid-1980s, because firms are increasingly locating their production facilities in the United States or Mexico to serve the entire North American market.
The debate about foreign investment in Canada ignores the fact that Canadian multinationals have quietly become major players in the global marketplace. Canadian direct investment abroad has exploded in the past 30 years, and Canadian firms now own more foreign operations (in terms of dollar value) than foreign companies own in Canada. Far from exporting jobs, this investment abroad serves primarily as a beachhead for market expansion, stimulating domestically produced exports and high value added head office activities such as engineering and design. ...
Canada has moved from being predominantly a host economy for foreign investment to being an important source economy. These investments into the global economy, for the most part, have opened foreign markets for Canadian exports, and have thus stimulated Canadian domestic investment and employment. Furthermore, outward FDI increases demand for domestic head-office activities that go beyond straight “exports” (such as engineering and design). ...
There is a stark difference between the environment today and that of 1970. Expressed as a share of GDP, Canada’s inward FDI is about the same as it was in 1970, but outward FDI is much higher. This means that the cost of “protecting” the Canadian economy by further restricting inward FDI is much higher than before in the sense that any retaliatory restrictions by other countries would have very large adverse effects on the growing stock of Canadian investment abroad. ...
[A]ny reductions in FDI designed to avoid tariffs were overwhelmed by the expansion of trade and investment flows brought on by the globalization of supply chains that broader continental free trade agreements enabled.
In addition to these trade effects, the industry-level analysis also yields important findings with respect to corporate taxation and R&D intensity. The results indicate that R&D is robustly important in attracting inward FDI into Canada. This has important policy implications, because it indicates that a fertile innovation environment is important for attracting foreign investment, which in turn leads to additional technology transfer to Canada in a positive feedback loop. Industries that have a high R&D intensity both attract more inward FDI and undertake more outward FDI.
Industry-specific Canadian corporate tax rates are found to be unimportant statistically for inward FDI, suggesting that they are not an important criterion for determining the location of FDI. However, corporate tax rates appear to have a negative effect on outward FDI. ...
With the takeover of many “iconic” Canadian firms, there has been extensive discussion of restricting foreign investment into the Canadian economy. However, restricting foreign investment would have several adverse effects.
First, it would remove the discipline imposed on managers of Canadian firms that accompanies the threat of takeover by large foreign companies. When management of any publicly traded company deteriorates, shareholders express disapproval by selling its shares. If share prices fall sufficiently, the company becomes a prime target for a takeover. With the falling stock market value, new owners can buy a controlling stake in the company and replace the management team that has been performing poorly with new managers. When foreign investment is restricted in an economy of relatively small size such as Canada’s, this threat of takeover is very much muted, and with it the discipline of managers. Investment restrictions would have a detrimental impact on the quality of management in Canada, especially in large and influential companies.
Second, limitations on investment would constrain the amount of capital available within the Canadian economy, thus raising the cost of capital. There is in fact a positive relationship between inward FDI and domestic investment. The majority of domestic credit is sourced locally, but a growing proportion comes from international sources, in the form of FDI or mergers and acquisitions. The ratio of inward FDI flows to domestic fixed capital formation has risen rapidly in Canada, and reached 34 percent in 2007. This is significantly higher than in the United States, where the corresponding proportion is less than 10 percent.
Third, FDI restrictions reduce spillover benefits from foreign companies. We have already seen that in Canada, foreign firms tend to have higher productivity than domestic firms, and in their presence, domestic firms benefit from the advanced technology and management techniques employed by foreign firms operating locally. In order for foreign operations to overcome the hurdles of going international and operate profitably when faced with competition by local firms, they must be more competitive. The domestic economy also benefits from the increased amount of competition that comes with the presence of foreign firms. These spillover effects are significant: some estimates say the spillover benefits that come from FDI are twice those of spillovers associated with trade alone