Foreign Direct Investment and Emerging Markets Prof Valpy Fitzgerald University of Oxford London Business School 20 February 2007 Content 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 enterprise. • 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 problems. 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 governments. 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 potential • 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 ownership • 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 2006 • 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 i 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: ˆ k2 1 A2 1 (5) [ ] ˆ k1 A1 and produces a similar solution for the resulting per capita income levels (y) ˆ y2 A2 1 (6) [ ] ˆ 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.