Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 14 Foreign finance, Investment, and aid: controversies and opportunities

14-2 The international flow of financial resources. A country’s international situation and its balance of payments depends not only on its current account balance (trade), but also on its balance of capital account (net inflow or outflow of financial resources). In this chapter we examine the international flow of financial resources.

14-3 The international flow of financial resources. Three sources: Private foreign direct and portfolio investment. -Foreign direct investment (FDI) by large multinational corporations -Foreign portfolio investment in LDC financial markets by private sector. Remittances of earnings by international migrants. Public and private development assistance (foreign aid).

14-4 Private Foreign Direct Investment and the Multinational Corporation (MNC). Definition: A MNC is an enterprise that conducts and controls productive activities in more than one country (i.e. Nike, Toyota, etc.). The growth of private foreign direct investment (FDI) in the developing world has been extremely rapid in recent decades. – 1962: $2.4 billion – 1990: $35 billion – 2002: $147 billion Global FDI trends are largely determined by: Expected returns. Perceived safety.

14-5 Figure 14.1: FDI Inflows (1980–2005)

14-6 Figure 14.3: Total net resource flows to developing countries ( )

14-7 MNCs: Transfer of not only capital, but also know-how, tastes and preferences, business practices, etc. Size: very large. $150 billion in sales in More in sales revenues than combined income of sub-Saharan Africa in 2004 Ownership: concentrated in the developed economies. General Electric, Ford, Wal-Mart in US. France Telecom, Nestle in France. Honda, Toyota, Sony in Japan. Deutsche Telekom, Volkswagen in Germany. Private Foreign Direct Investment and the multinational corporation

14-8 Private Foreign Investment: pros and cons for development. Traditional argument in support of FDI: FDI helps fill in the gap between domestically available supplies of: (1) Savings. (2) Foreign exchange reserves. (3) Government tax revenues. (4) Management / human skills.

14-9 Economic argument against FDI: FDI may lower domestic savings rate (thus investment) by: – Limiting domestic competition via exclusive agreements. – Failing to reinvest much of profits in local economies. – Generating incomes for groups with lower propensity to save (i.e. rich in LDCs) FDI may reduce foreign exchange earnings by: – Repatriation of earnings (i.e. profits, interests, loyalties, management fees, etc.) worsen the capital account in the long run. Private Foreign Investment: pros and cons for development.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Economic argument against FDI: Net return to host LDC may be low due to large economic and political concessions. – Excessive protection – Tax rebates or investment allowances – Cheap provision of factory sites and utilities MNCs can avoid (minimize) local taxation through transfer pricing – Shifting profits from affiliates in high-tax countries to those in low- tax countries. Private Foreign Investment: pros and cons for development.

14-11 Private portfolio investment: boon or bane for LDCs? In addition to FDI, the most significant component of private capital flows has been in the area of portfolio investments. What is portfolio investment? – Foreign purchase of the stocks (equity), bonds, certificates of deposit, and commercial papers of LDCs Emerging-country stock markets. – High returns – But also high volatility – Exchange rate (depreciation) risk

14-12 The international flow of financial resources. Three main sources: Private foreign direct and portfolio investment. Remittances of earnings by international migrants. Public and private development assistance (foreign aid).

14-13 The role and growth of remittances Definition: Earned income transferred by international migrants from host to home country. Reason for international labor mobility. Wage level differences between LDCs and MDCs.

14-14 Figure 14.4: resource flows to developing countries ( ).

14-15 The role and Growth of Remittances Reason behind rising trend: Improved accounting of remittance flows. Rising number of migrants. Reduction in transaction costs.

14-16 Figure 14.5: top 20 remittance recipient countries (2004)

14-17 Foreign Aid: The development assistance debate Definition: Any flow of capital to LDCs that meets the following criteria: Its objective should be non-commercial from the viewpoint of the donor. It should be characterized by concessional terms; i.e. interest rate and repayment period should be softer than commercial loans.

14-18 Foreign Aid: The development assistance debate Amounts and Allocations: Official development assistance includes: - Bilateral and multilateral grants (i.e. direct transfers). - Loans (i.e. IMF loans). - Technical support (i.e. assistance in policy related areas).

14-19 Table 14.2: Official Development Assistance (ODA) disbursements from major donor countries, 1985, 2002, and 2005.

14-20 Table 14.3: Official Development Assistance (ODA) by region (2005).

14-21 Foreign Aid: The development assistance debate Why donors give aid? Political Motivations: Most aid programs focus on: – Ensuring national security – Keeping friendly governments in power U.S. used Marshall Plan to reconstruct Western European economies after WW2 to contain the spread of communism.

14-22 Why donors give aid? Economic Motivations: Donor countries tend to direct aid to economies where they have large private investments. Expansion of trade. – Trade follows aid: aid is spent on goods and services from the donor country (i.e. Japan, U.K.) Foreign Aid: The development assistance debate.

14-23 Why LDC recipients accept aid? Economic reasons: Aid is an essential ingredient to the development process: – Supplements scarce domestic resources – Helps transform the economy structurally. – Contributes to faster economic growth. Foreign Aid: The development assistance debate.

14-24 Why LDC recipients accept aid? Political reasons: Aid is seen as political leverage for incumbent to suppress opposition. Assistance includes transfer of not only financial resources but also military and intelligence support domestic security reinforcements. Foreign Aid: The development assistance debate.

14-25 Effects of Aid: Traditionalists argue: Aid promotes growth and structural transformation. Critics say: Aid delays economic growth by lowering domestic savings (thus investments) and worsening LDC balance of payment deficits. Foreign Aid: The development assistance debate.

14-26 Conclusions: toward a new view of foreign aid. Dissatisfaction among donors and recipients may create the possibility for new aid arrangements. Future aid is likely to be linked to market reforms and institutional capacity-building.