MPhil-in-Development-Studies-Economics-Foundation-Course by akgame


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									Foreign Direct Investment
 and Emerging Markets
 Prof Valpy Fitzgerald
 University of Oxford

London Business School
   20 February 2007
1. Basic economic principles
2. FDI in practice
3. FDI policy
1 Basic economic principles
       FDI = Intrafirm investment
• Main form of international investment is FDI
  (foreign direct investment) within the multinational
• Control exercised through equity share (> 25%);
  also through technology licensing, internal debt,
  franchising etc.
• FDI involves transfer of production technology
  (process and product) and management skills.
  Spillover depends on degree of local
  modernisation (e.g. subcontracting).
         Capital movement theory
• Without capital flows, capital surplus countries have low
  rates of return (and high wages and full employment);
  capital scarce developing countries have high rates of
  return but low wages and not many jobs.
• „North-South‟ capital flows should raise returns to
  „northern‟ investors, with more jobs and higher wages in
  the „south‟; less wages and employment in the „north‟.
• GDP rises in the south and falls in the north. But both
  gain overall because GNP (after dividend flows) is
  higher in both countries. A distributional political
  economy issue!
Strong expansion of FDI to EMs but
   still a fraction of global flows
 Why doesn’t more capital flow south?
The canonical „Lucas question‟ is: why doesn't all the
  capital flow from rich to poor countries? There are
  many reasons, including:
   – lack of complementary factors (such as infrastructure and
     human capital);
   – inability of foreign investors to capture externalities;
   – sovereign risk arising from political instability and
     governance problems;
   – economies of scale and scope;
   – plus features such as asymmetric information and agency
Public action may be justified to overcome some of these
  problems such as lack of infrastructure and international
  rulemaking; but basic responsibility lies with EM
2. FDI in practice
      Why invest in developing
      emerging markets at all?
• First, traditional motivation is natural resources
  (oil, metals), infrastructure (power, transport) and
  agri-business (tobacco, bananas); tourism a logical
  extension. Still a major motive in e.g. Africa.
• Second motivation is access to large domestic or
  regional markets for manufactures (beer, cars) and
  modern services (banking, telcoms).
• Third motivation is export platform using skilled
  labour at low unit cost (clothing, electronics, call
  centres) and exploiting trade links.
Risk profile is improving
But FDI concentrated in “big 10”
World Bank FDI forecasting model (GDF 2004)
    Key features of WB model
• Lagged FDI = vicious/virtuous circle
• Differential GDP growth = profit
• Export growth and credit rating =
  ability to pay
• G7 growth = supply of capital
  A global direct investment market?

• FDI to emerging markets has grown enormously:
  basically no significant emerging market country
  now imposes legal restrictions on foreign
• But North-South investment flows still only a
  quarter of within-North flows; though South is
  half of world economy.
• Note also capital flows from South to North, as
  large domestic firms globalize (e.g. from China,
  India, Korea, Mexico, Brazil) as well as capital
  flight from domestic risk in unstable countries.
3. FDI policy
              FDI promotion
• All developing countries now actively promote
  foreign direct investment in order to finance
  infrastructure and promote exports. Restricted FDI
  access to „strategic‟ sectors and performance
  requirements now banned under WTO rules.
• Key attractors are skills, facilities and stable
  economic regime. To gain benefits, local linkages
  (subcontracting, skilling etc) should be promoted.
• But poor countries tempted to compete with each
  other for inward investment engage in a „race to
  the bottom‟ with tax holidays, labour or
  environmental exemptions etc.
               FDI „downside‟
• Capital inflow stimulated growth through forex
  availability; but dividend payments a subsequent
  current account burden. However, more risk-
  sharing than with debt.
• FDI includes M&A (vertical and horizontal
  integration) as well as „greenfield‟ new capacity:
  efficiency should improve but not necessarily
  local production.
• The practice of intra-firm „transfer pricing‟ in
  order to shift profits towards low-tax jurisdictions
  a concern for fiscal authorities.
   International investment rules
• While domestic capital markets have developed
  historically within a very strict legal and regulatory
  framework; no international law binds global
  investment or arbitrates disputes.
• In practice only a patchwork of bilateral treaty
  obligations exists and contracts judged in US or UK
  courts. Developing country law does not inspire
  confidence among foreign or domestic investors.
• Thus a number of proposals for a new „international
  financial architecture‟ are under debate, including:
  FDI rules at the WTO, global bank regulation at the
  BIS, bond debt restructuring procedures at the IMF.
               Sources of Data
• World Bank: Global Development Finance
• IMF Global Stability Report 2006
• UNCTAD: World Investment Report 2006
• All available on the respective websites
                     Some reading
Lucas, R.E. (1990) “Why Doesn‟t Capital Flow from Rich to Poor
   Countries?” American Economic Review vol 80
Borensztein, E., J. De Gregorio & J-W. Lee (1998) „How does
   foreign direct investment affect economic growth?‟, in Journal
   of International Economics, vol 45, p 115-135.
De Mello, L.R. (1997) „Foreign Direct Investment in Developing
   Countries and Growth: a selective survey‟, in Journal of
   Development Studies, vol 34, no 1, p 1-34.
FitzGerald, V. (2002) „International Tax Cooperation and Capital
   Mobility‟ Oxford Development Studies 30(3) 251-266.
FitzGerald, V. (2001)„Developing Countries and Multilateral
   Investment Negotiations‟, pp. 35-66 in E.C. Nieuwenhuys and
   M.M.T.A. Brus eds Multilateral Regulation of Investment The
   Hague: Kluwer Law International
Bovenberg, A. „Capital taxation in the world economy‟ in
   V.D.Ploeg (1994) Handbook of International Macroeconomics.
   Oxford: Balckwell
Some theory….
                 FDI theory – 1: returns

Consider a world of two economies (1, 2) with production of the familiar form and no scale
economies for convenience

(1)      Yi  Ai K i L1

We take 1 to be the „developed‟ and 2 the „developing‟ economy, by which we mean

         A1  A2
(2)      K1 K 2
         L1   L2

With no capital mobility then we have the familiar rate of return on capital in each country in
terms of the capital-labour ratio (k)

                Yi         K                   1
(3)      ri          Ai [ i ] 1  Ai k i
                K i        Li

Note that in fact from (2) the relative size of the two rates of return is not unambiguous: it
depends on the parameter values.
               FDI theory – 2: productivity
However, with free capital movements, capital flows the two rates of return must equalise,
and at equilibrium:

(4)                             
        A1 k1 1  r*  A2 k 2 1

Which when rearranged yields the ratio of the capital-labour ratios in the two countries:

              A2 1
(5)         [ ]
         k1   A1

and produces a similar solution for the resulting per capita income levels (y)

         y2   A2 1
(6)         [ ]
         y1   A1

This then is one part of the answer to the Lucas question – capital flows are constrained by
total factor productivity (A) differences, which depend upon institutions, technology etc.
                         FDI theory – 3: risk

However, we cannot even assume that the rates of return, r, equalise because there is an
additional risk premium (ρ) involved, so that in fact at equilibrium

(9)      r2  r1  

Making the small country assumption, we can simply write for our country (2)
         ˆ       A2 1 1
(10)     k2  [        ]
                r * 
In other words, the capital stock resulting from the capital inflow will depend positively on
total factor productivity and capital productivity, and negatively on the world interest rate and
the risk premium. See appendix for an extension to corporate taxation on international
investment, which also drives a „wedge‟ between the host and international rates of return.

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