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Explaining Foreign Direct Investments
Foreign Direct Investment (FDI) is a cross-border transfer of funds made by an entity to a foreign economy of interest. It is an influx of capital from a foreign source to be invested in the domestic economy in order to develop a particular sector of the latter’s economy. It is believed that FDI spurs growth, especially in developing economies, because of the economic activities generated by the inflow of capital from a foreign source, as well as productivity spillovers that happen when new foreign technology is introduced to the domestic economy.
However, there is growing academic literature and research that refutes this belief. Some go as far as saying that FDI, in the long term, is harmful to the economy. FDI itself might not be harmful to the domestic economy, but overdependence on FDI to spur economic growth is as these economies will develop under the influence of foreign interests instead of developing organically. Domestic politics will be influenced in favor of foreign entities, and gains from the FDI will be extracted instead of being used in the domestic economy.
In 2021, Non Fungible Tokens (NFTs) and Play-To-Earn blockchain games rose in popularity as gamers started earning simply by interacting with the game. But when the bear market in 2022 started, gaming economies started seeing dips in their token prices as investors looked to cut their losses, or extract value while they could. For blockchain gaming economies, the purchase of gaming assets to interact with the protocol can be considered FDI by either venture capitalist firms or average players, who act as foreign investors in this economy.
Countries and protocols function similarly since both are marketplaces where the transfer of value occurs. This article aims to apply the research revolving on FDI and its impact on regional economies to blockchain gaming economies to inform those developing similar projects.
Short-Term Impact of FDI On Economies
The general belief is that the accumulation of capital through FDI benefits the economy through stimulating economic activity leading to economic growth. In reality, FDI’s overall impact is still up for debate according to different academic research done. However, the influx of capital brought about by FDI does have some short term benefits to the economy through job creation, increased productivity, and increased exports.
Jobs are created when foreign entities enter the domestic market. Foreign multinational firms looking to expand in the region would need domestic workers in order to start their operations. They would hire accountants, lawyers, managers, analysts, and other positions before they can establish a presence in and compete for a share of the domestic market. Another example is when foreign entities fund domestic development projects, like road, bridges, and expressway construction. These activities require laborers from the domestic market to build. The jobs created by FDI become a source of income that can be used for consumption within the domestic economy. The increased consumption, in turn, has a positive effect on the domestic economy’s growth.
The domestic economy’s productivity increases due to two factors, a spill-over effect, and increased competition within the industry where the FDI will be spent. When foreign firms enter a domestic market, they bring with them technology and best practices from their developed economies to use in the domestic market they’re investing in. The spill-over effect is when this knowledge and technology is transferred to the domestic market as a result of its use. Local firms also become more competitive in the market when a new player tries to capture some of their market share. These domestic businesses need to find a way to compete with the foreign firms or they will lose some of their clients. The increased competition is a positive sign for the economy, the industry, and the consumers.
It is also good to note that the country of origin of the investment plays a role when FDI impacts labor productivity. Research done on foreign acquisitions in Hungary shows that acquisitions from lower income economies have a less significant impact on labor productivity when compared to acquisitions from countries with a higher income than Hungary (TŐKÉS, 2019).
Another positive impact on the domestic economy that FDI can bring is through an increase in exports. The business environment in developing economies is usually favorable to multinational firms, either through cheaper wages, low barriers to entry, or other incentives. These firms produce goods and services that are demanded globally and can be exported from the domestic market the multinational firm enters. Another reason for the increased export could be through the developed infrastructure that connects regions within the economy. The better the transportation network an economy has, the faster goods reach ports, the more goods can be exported.
Long-Term Risks Of FDI Dependence
While there are some benefits to FDI in the short term, researchers argue that long term dependence on this method of capital accumulation exposes the domestic economy to some risks. (Bornschier and Chase-Dunn, 1985) The inorganic growth of the economy (Amin 1974, and Frank 1979), the crowding out of domestic investors (Aitken and Harrison, 1999), and the export of resources, skilled manpower, and profit (Agosin and Mayer, 2000) are some of the potential risks of an over dependence on FDI. Some also argue that the spillover effect does not occur, especially in developing economies (Görg and Greenaway, 2004).
Developing economies who build a dependence on FDI do not grow organically due to the external influence these foreign firms have over the domestic economy. Be it predatory lending terms, the fear of capital flight, or enticing corrupt officials, foreign firms have some degree of influence over policies of interest in the domestic economy. This leads to a principal-agent problem where the ruling elite might prioritize the foreign entity’s interests over that of the domestic community. An example could be keeping minimum wage low to keep foreign firms’ costs low at the expense of income generated for citizens of the domestic economy.
Foreign influence connects to the second risk of having an over dependence on FDI, the crowding out of domestic investors. Developing countries create policies that favor foreign investors to attract FDI, giving foreign firms a competitive advantage over domestic firms. As foreign firms look to capture a share of the domestic market, giving them too much of an advantage may force domestic firms that can’t compete with multinational companies to just exit the market. This takes away the possible increase in labor productivity, which happens when domestic firms improve in order to compete in the industry.
The capital accumulation coming from foreign entities are investments, meaning that these stakeholders would want to make a return on what they gave out. Profits that come from these businesses are likely not to be used on the domestic market and would rather export their earnings to their home countries. Additionally, firms that operate in the domestic market have access to scarce resources of the domestic economy, and to talented members of the domestic workforce. Both these can also be exported to their home countries instead of staying in the domestic economy.
The spill-over effect to the domestic economy, a short term benefit of FDI, has also been critiqued by researchers. Even if the foreign entity brings their advanced technology to the domestic economy, the domestic market will only benefit from the spill-over effect if they have the means to adopt that technology. This is not the case in most developing countries as their technology is too far behind that the local market cannot use it. Local firms may not have the resources to invest and adopt that technology. Even if they do, most multinational firms would safeguard their trade secrets and technology to keep their competitive advantage.
An over dependence on FDI exposes the domestic economy to risks in the long term. A study of GDP data from 1940 to 1990 of about 89 countries found that countries with a higher dependence on Foreign Direct Investments exhibit slower economic growth than that of countries who do have a lower dependence on FDI (Kentor, 1998).
FDI Equivalent In Blockchain Gaming
Blockchain technology integrated into games created a whole new ecosystem that allowed for asset ownership and earning potential for playing and interacting with games. Since regional economies and blockchain gaming economies function in a similar way as a venue where the transfer and creation of value exists, the same economic forces that govern countries can be translated to blockchain games. For FDI, the three main components are the domestic economy, the foreign entity, and the actual investment.
The domestic economy will be your blockchain gaming protocol. As explained earlier, this is where the transfer and creation of value happens. Players will interact with the different mechanisms inside the game’s metaverse, and build using the game’s assets. This is where capital accumulates through foreign investments.
The foreign entities in this market are your venture capitalist firms, yield guilds, and blockchain gamer. These market players are considered foreign entities because they are external agents from the protocol and are the source of value that enters the gaming economy. Think of venture capitalists as institutions that invest in infrastructure of an economy, yield guilds as multinational companies, and blockchain gamers as your private investors.
Lastly, FDI in the blockchain gaming economy is in the form of the value that these foreign entities bring. Venture capitalists invest in a gaming economy during the early seed investment rounds so the ecosystem has the funds to build out the infrastructure of the game. Yield guilds bring their expertise in gaming, their network of players, and invest some capital to help the gaming economy function. Blockchain gamers purchase game assets in order to interact with the game.
FDI Impact On Blockchain Gaming Economies
Now that we know what the different aspects of FDI are in blockchain gaming economies, the next step is trying to understand how the literature mentioned earlier applies to blockchain gaming economies. The impact can be classified into two categories, short term gains and long term risks.
Positive Gains Brought by FDI
Similar to regional economies, blockchain economies also benefit from capital accumulating within their economy. One of the more direct benefit comparisons is the creation of jobs in blockchain gaming economies. Jobs, in this sense, are your profit sharing scholarship programs where players interact with the game using assets owned by a guild or manager and yield will be split accordingly. Jobs also open up as a result of capital invested in the early stages of game development. These jobs come in the form of talent that the development team can now hire to further improve the infrastructure of the gaming economy.
Another benefit is an increase in productivity within the blockchain gaming economy. Market players bring their best practices with them and share it with other players in the economy. This manifests in the form of content created by members of the community that focus on the best strategies to navigate the design of the game. Tools are created that help with guild management, or give game analytics to improve performance. Educational content is also created that helps with the onboarding of new players.
Given that there are no actual goods produced in blockchain gaming economies, exports in this ecosystem are the entry of new players as this represents value entering the economy. The earning opportunity attracts new gamers to enter the ecosystem. Educational content also facilitates an easier onboarding process as these gamers will research about the game before entering. The more gamers that enter the economy, the more economic activity happening within that metaverse.
Risks of Overdependence on FDI
We’ve seen blockchain gaming economies grow exponentially as their user base grew with them. A growing user base allows for capital accumulation within gaming economies. New gamers entering are a source of FDI for blockchain games, and an overdependence on FDI harms the economy in the long run, as mentioned earlier. The bear market of 2022 also showed us that reliance on this model of capital accumulation isn’t sustainable for the gaming economy.
The first risk mentioned in the article is about the inorganic growth as brought about by foreign influence in policy making. In a blockchain gaming economy, venture capitalist firms, yield guilds, and gamers may have different interests. This long term risk comes into play when the decision makers prioritize the interests of a select few over the general community or betterment of the game because these agents made a bigger investment than others. In particular, the formation of Decentralized Autonomous Organizations (DAO) should be carefully crafted to mitigate this risk.
Crowding out can also happen to these gaming economies, particularly when there are high barriers to entry, or when there is a poor competition environment. Gaming economies need gamers to have a healthy economy. But these gamers are the ones crowded out by larger entities who have the financial capital to enter or stay in the economy. High barrier to entry can be in the form of high prices for assets needed to enter the economy, while poor conditions are the policies that the development team implement that do not favor the gamers.
The over extraction of resources, particularly the utility or rewards token of the blockchain gaming economy, is a risk of an overdependence on FDI. Because blockchain gaming economies have the ability to earn, market agents that enter this economy would like to make a return on their investments while they are interacting with the ecosystem. An economy that has too many agents that extract value from is not sustainable. We see this happen in a lot of popular blockchain gaming economies where sell pressure has pushed the prices of their tokens down as more and more users exit the ecosystem.
The last risk pertains more to how members of the ecosystem absorb new knowledge similar to the spillover effect in the previous paragraphs. Members of the ecosystem that focus on value extraction will not pay attention to other aspects of the gaming economy. The bigger picture of blockchain technology, economic sustainability, and community building is not in their interest and will entertain the idea. It can also be that these members cannot comprehend the information and just opt to play the game to extract value as a result.
What Protocols Should Keep In Mind
Those looking to create a blockchain gaming economy should keep in mind that the short term positive impact of having FDI to stimulate growth also has long term risks associated with an overdependence on it. In the short term, FDI helps create jobs through scholarship programs and new hires to the development team, improve productivity through the content and tools created, and increase export by attracting more players to enter the economy through its earning potential or fun gameplay.
Policy makers, in the form of the gaming economy’s development team, should keep in mind that being dependent on FDI for growth has some risks as well. Inorganic growth, possibly through a principal-agent problem, the crowding out of gamers, and over extraction of value are some of the risks to keep in mind. Some ways to mitigate these risks start with the choice of venture capitalist firms and large scale yield guilds that the game partners with. The development team should make sure that the long term goals of their partners are aligned with what the developers are planning to build, and any DAO that the protocol will form will take into account any financially large players in its decision making mechanics in order to avoid a principal-agent problem in the future.
Second, protocols should make it a point to cater to its community. This comes in the form of clear communication of what the team plans to do, be transparent with what is happening to the protocol, and create ways to educate the community on the bigger picture of blockchain gaming and what the protocol is trying to achieve. Going back to the formation of the DAO, a governance model should be heavily evaluated to make sure that the majority of the community gets a say rather than just those with a large stake in the game.
Lastly, and the most important and difficult to achieve, is to make sure that the economy is not dependent on player growth, or FDI. The development team should entice “foreign investors” to “migrate” into the domestic ecosystem, meaning that players must be immersed in the game to a point where they consider themselves part of the “domestic economy”. This can be achieved by promoting value retention inside the ecosystem through the design of the game loop. Additional revenue sources can be used to buy back game assets in an effort to relieve some of the sell pressure on those assets.
But most importantly, blockchain gaming developers should focus on building a game that their community will fall in love with and continue playing. Earning from playing the game should be secondary motivation and the core gameplay mechanics should be fun, challenging, and addictive enough that gamers will stay inside the economy beyond the financial incentives.
An Article by Lorenzo Martin | Junior Associate at Economics Design
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