Foreign Direct Investment

            Foreign Direct Investment is often regarded as a critical part of achieving industrialisation in developing countries. Within the framework of classical growth theory capital accumulation has a central role emphasising the need for investment. Foreign Direct Investment (henceforth FDI) goes beyond this role of assisting capital accumulation due to predicted effects such as the diffusion of new technology. It may be formally defined as a “Form of international inter-firm co-operation that involves significant equity stake and effective management decision power in or ownership of foreign enterprises.” (de Mello, 1999). This essay will argue that FDI is part of a successful recipe for industrialisation to a limited extent. The benefits of FDI will be discussed regarding how industrialisation is achieved. These being limited by the threshold conditions an economy must meet for FDI to be successful and the potential negative effects of FDI. This will be supported by evidence from the experience of economies in South East Asia.

Foreign Direct Investment can play a critical role in the industrialisation of a developing country due to its ability to improve growth through enhancing productivity, increasing competition, and enabling the spill-over of skills and technology. The critical element of FDI is the entry into the market of a multinational corporation (MNC) such that they look to produce goods of international quality at competitive prices (Calvo, Leiderman, & Reinhart, 1996). This can have an immediate impact on industrialisation as the MNC may choose to develop local infrastructure and introduce new technologies to support their production. This can involve developing roads, ports, and telecommunications often related to the needs of the relevant industry (Calvo, Leiderman, & Reinhart, 1996). The benefits of FDI go beyond this due to the incidence of technology spill-overs and vertical linkages. Spill-overs may occur as local firms observe and imitate MNCs, employees of MNC join local firms, and how the presence of MNCs may attract other high skilled services such as consultancy. This may enhance industrialisation as local firms gain information on how to more efficiently produce, use new skills, and exploit new information (Calvo, Leiderman, & Reinhart, 1996). The more prominent case for industrialisation through FDI is found in vertical linkages. MNCs have a considerable incentive to introduce technology to local firms that produce relevant inputs. As this enables the local firms to produce more at a lower cost to an international standard quality which can be achieved through training and quality control (Blalock & Gertler, 2008). MNCs will then want to avoid relying upon a single firm as this could lead to hold-ups such that they establish relationships with multiple local firms. This encourages competition amongst the vendors keeping prices lower ensuring sustained profits. The overall impact of this drives forward industrialisation as local firms improve their production techniques, exploit new technologies, and utilise any surplus captured to further enhance productivity. The beauty of this mechanism is that it operates entirely through the market such that policy intervention could be minimised to simply encouraging FDI reducing potential distortions. However, for the mechanism described above to operate such that it has a positive impact on industrialisation there are several threshold conditions which must be met, the issue of absorptive capacity, and then the potential negative effects of encouraging FDI to occur.

FDI may not result in successful industrialisation as a sole strategy due to factors which may limit its impact and quality, suggesting that alternatives must be implemented alongside it. Firstly, the limited impact of FDI on industrialisation may be viewed from the requirement of meeting threshold conditions. This involves matters such as quality over quantity, preparation for receiving FDI, consistency of government policies, promoting linkages, and how trade is facilitated (te Velde, 2001).[1] This case becomes apparent upon examining the success of FDI in promoting industrialisation between Sub-Saharan African economies and South East Asian economies. Considering the accumulated flows of FDI scaled to the size of the relevant economy countries such as Lesotho received more than Singapore (te Velde, 2001), yet they are far less industrialised. This is partially due to FDI being incident in extractive industries focused on the exploitation of natural resources rather than the aim of providing a strong productive base. Emphasising the need for certain types of FDI (the quality improving if incident in industries where there can be substantial technological gains) rather than sheer volume. Countries with poor levels of infrastructure and low human capital may not attract FDI in the first place as MNCs would need to provide this for their operations, such that the developing country must first seek to improve factors such as school enrolment or even telephone lines. Finally, there needs to be an emphasis on the role of the government how policy is practiced and whether there are suitable policies to enhance linkages and facilitate trade. Foreign investors will need assurance that capital controls will not return if they invest. Additionally, the setup of an Investment Promotion Agency (IPA) is critical as it increases the ease of business for MNCs such that they only need to coordinate with one body, and this can help the developing country to target certain kinds of FDI (te Velde, 2001). These factors and ensuring there is some level of existing skills and infrastructure would enhance the absorptive capacity of local firms such that they could reap the benefits of FDI.

FDI can potentially harm the industrialisation of developing countries, and at times government policy aligned to encouraging further investment may be less effective than alternative policies. FDI could lead to investment in industries where without the MNCs there would be no operations, this is especially problematic with resource extraction based investment where there is the repatriation of profits and then firms leave (Rodrik & Subramanian, 2009). MNCs would also look to limit any horizontal linkages to protect their rents, this may mean that even if industrialisation to a factor such as utilities occur it may no longer be worthwhile as people cannot afford to use them. There is also the potential for balance of payment related crises to occur given the financial mechanism of FDI which will be elaborated further regarding the South East Asian crisis. Alternative strategies can be used to directly target desired industrialisation namely in the form of import substitution industrialisation (ISI) and export promotion. The main advantage of these alternative strategies is their independence from foreign perceptions of the domestic economy, and are then not subject to sudden reversals. FDI may be beneficial as part of a larger industrialisation strategy but there are conflicting policy areas with alternative strategies (Rodrik & Subramanian, 2009). For example, ISI would suggest limits on importing capital goods from abroad, while an FDI strategy may require allowing an MNC to import capital goods from their supply chain.

The success of South East Asian countries in industrialising is often cited as strong evidence for the benefits of following FDI based strategies. This was to an extent dispelled by the South East Asian Crisis in the late 1990s. There was a boom in FDI in South East Asia in the early 1990s, largely based around countries committing to policies suggest by the Washington Consensus such as financial liberalization. Indonesia is a prominent example of successful industrialisation since the “New Order” market reforms enacted by the Suharto regime in the 1970s (Blalock & Gertler, 2008). Notably the economy went from strong capital controls to complete financial and trade liberalization. One issue with this transition was that industrialisation varied substantially by region, as seen in the value added by region map of Indonesia (Blalock & Gertler, 2008).

Picture1

FDI leading up to the crisis had led to substantial welfare and productivity gains alongside a surge in industrialisation with some estimates of productivity gains around 2%. Critically, the conditions which allowed for successful industrialisation through FDI contributed to the crisis in South East Asia. Financial market liberalization and the relaxation of capital controls led to huge capital reversals, and critically for Indonesia much of their borrowing was in dollars due to linkages with various MNCs. When the Rupiah came under speculative attacks its devaluation had substantially increased the effective debt burden. Indonesia lost approximately 13.5% of its GDP in 1998 (Aswicahyono, 2010). This had long lasting effect on growth and industrialisation with evidence suggesting that there was fewer small firms’ upscaling production, and output growth depended on existing firms which had benefitted from the initial period of positive FDI (Aswicahyono, 2010).

FDI is an undeniably effective largely market based approach in encouraging industrialisation in developing economies. The incidence of positive spill-overs emphasises the power of foreign investment provided there is the transfer of technology, and operational skills. However, it has been argued that FDI is only one element of achieving successful industrialisation. This is because of certain threshold conditions which must be met in order enable useful FDI, and ensure that local firms have an absorptive capacity of new technology and skills. These limitations are well evidenced with the Sub-Saharan experience with FDI and limited industrialisation. There are dangers to FDI being used as the ultimate solution as at times some capital controls are important for economic protection, the experience of many South East Asian economies is testament to this. Currently, the case for FDI is a direct strategy for achieving industrialisation remains ambiguous noting the failure of some globalization related policies.

A. ADIR 2017

Bibliography

Aswicahyono, H. (2010). Industrialisation after a Deep Economic Crisis: Indonesia. The Journal of Development Studies, 46(10), 1084-1108.

Blalock, G., & Gertler, P. J. (2008). Welfare Gains from FDI Through Technology Transfer to Local Suppliers. Journal of International Economics, 402-421.

Calvo, G. A., Leiderman, L., & Reinhart, C. M. (1996). Inflows of Capital to Developing Countries in the 1990s. The Journal of Economics Perspectives, 123-139.

de Mello, L. R. (1999). Foreign Direct Investment Led Growth: Evidence from Time Series and Panel Data. Oxford Economic Papers, 133-151.

Rodrik, D., & Subramanian, A. (2009). Why Did Financial Globalization Disappoint. IMF Staff Papers, 56(1), 112-138.

te Velde, D. W. (2001). Foreign Direct Investment for Development: Policy Challenges for Sub-Saharan African Countries. London: Overseas Development Institute.

[1] This is not an exhaustive list of perceived baseline requirements for FDI, rather an emphasis on key factors.

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The Perils of Africa

The development of global institutions had heralded an era of globalization. Politicians and economists had made promises that this would be a positive force of globalization which will see markets emerge and support weak national economies. For a time this was true, and to a degree it had worked. Globalization had effectively integrated the developing world to the developed. What was distinct in this “first round” of globalization was the wealth of knowledge which the developing world could now acquire.

Stiglitz makes it clear that this worked both ways, and uses some straightforward examples to explain the benefits of open markets and global recognition of issues. One example being the opening up of the Jamaican dairy market to U.S. imports in 1992 which saw the price of milk drop so that even poor children could access it. To sound cliché it was a double-edged sword; it was clear that opening a market to foreign firms could undermine state-owned enterprises but then again also provide new technologies and greater productive efficiency.

What was becoming clearer during the 90s was the increasing gap in income equality, between increasing proportion of the population living in poverty in regards to total world income (adjusted for inflation) increasing by an average of 2.5% annually. As globalization began to be criticised it was quickly associated with American style capitalism, which Stiglitz argues is still progress. He is undoubtedly a capitalist, an American, and a neo-Keynesian economist and already there is an assumption that capitalism is a form of progress for all. However, on this point I struggle to find a suitable replacement. Stiglitz highlights the manner in which free market and capitalist reforms were imposed on African nations and how he would have done it differently to ensure success. What quickly arises is often the issue in economics is that you don’t actually know what would have been more successful as you only chose one method in the end – you hope (but inevitably) there is no “next time”. As Friedman often says when choosing a specific economic policy following a certain line of theory you are ultimately deciding upon a lesser evil.

I believe one of the most significant points that Stiglitz raises was the question of to what degree did developed nations benefit relative to the degree that developing nations benefitted? From my position in 2013 you can see that the boycott and protest surrounding the trade and national conferences of the time, was as a result of the people perceiving globalization to be far more advantageous to developed countries. Here Stiglitz takes the perspective that the inevitable existence of special interest and the connection between the IMF and Washington would have always ensured irrespective of the policy decisions made that the end result would benefit them. Such is human nature and sadly a system of “good faith” cannot be depended upon.

One of the first examples Stiglitz employs is of Ethiopia and the handling of macro policy by the IMF. The first issue he raises sets the tone for what becomes an inherent aspect of IMF policy and instructions. The Ethiopian government had two sources of revenue, foreign aid and taxes. The IMF argued that their “budgetary position would be solid” if their expenditures would be based only on taxes and within this line of thought aid should be kept in reserves for that inevitable ‘rainy day’. The IMF logic was flawed, as foreign aid was contributed with the interest of developing and sustaining schools and health clinics. The IMF argued that foreign aid was not as stable as tax revenue, and this perspective may have worked for a country which was lingering between developing and developed. But Stiglitz statistical analysis showed that foreign aid was far more reliable than taxes, often coinciding with the economic situation and the institutions of the nation. Furthermore, the IMF often acted as a barrier to progress rather than an enabler.

The main issue with IMF policy of the time was the extensive use of conditionality. It was clear that Ethiopia had a government capable of handling their economy, but still needed IMF support (in regards to actual monetary aid) as the economy was developing. Ethiopian sentiment was that the IMF acted in a neo-colonial manner, forcing the government to implement certain strategies. The IMF felt that this was procedure, and an integral part of their covenant. Stiglitz points this failure at special interests, and the failure of the IMF to apply different methods to differing situations. What becomes clear in the Ethiopian example is as Stiglitz notes is that the means are often confused with the ends. Here enters the IMF’s infamous devotion to “liberalising markets” and “opening-up banking systems”. There is no conspiracy here, the IMF genuinely thought that through these means credit instruments would be more accessible and at more competitive rates. Ethiopia is not the only example of this IMF policy prevailed with devastating effects, following along were Botswana and Kenya. Market liberalisation had led onto liquidity crises in Botswana continuing as they hoped the IMF would support them, and opening the banking systems had only led to credit being unobtainable for local firms, as they were high-risk as judged by foreign banks and investors.

To summarise the IMF’s involvement in Africa throughout the late 20th century it was clear that they were not creating policy that suited transitioning and developing economies. The “one size fits all” approach did not work, and it had bred corruption in the nations with diamonds, and had allowed warlords such as General Amin of Uganda to come into power. The issue being ultimately that the IMF saw nations they were assisting as “client countries” when it should have been the other way around. Stiglitz goes far in blaming the IMF for the perils of Africa, however I think that it must be put into perspective that local militias had existed during colonial rule as well, and at the time many African nations were still to a degree divided into tribes within a country – making having one government difficult and ground for civil wars and corruption. Ethiopia is a frustrating example, as the countries potential was clear, and the IMF was a barrier to progress rather than a partner.

Globalization & Its Discontents

My aim here is not to simply provide a summary of the book, nor regurgitate what has already been written and argued. My aim is to examine some of the examples used, and the merit of Stiglitz argument relative to the economic situation of the time.

Joseph Stiglitz has become a renowned economist, notably winning the Nobel Prize for Economics in 2001. He has had a wide experience, serving on the Council of Economic Advisors under Bill Clinton, and also as chief economist and vice-president of the World Bank. He was fortunate to witness the transition of Russia into a free market, and also the peril of South-East Asia.

Globalization & Its Discontents provides a critique of not only the IMF but “Washington” in the policy making that threatened and created economic disaster. The book is unique by maintaining Stiglitz’s academic nature, but delivering a narrative of events which develops a convincing argument for the negligence and malpractice of the IMF and coinciding “special interests”.

Just to save explaining in the following posts, globalization is not only defined as the spreading of “western” culture like finding a McDonalds in Beijing. But instead a definition of economic globalization which sees the breakdown of trade barriers, free market transitions, opening new markets, and handling macro level economic policy of developing nations.

I will break the book into three sections, which will be published separately in order to appreciate the vast economic ground Stiglitz covers.

  1. The Perils of Africa
  2. South-East Asian Crisis
  3. Who Lost Russia?
  4. The Nature of “Global” Economics

Command Economy Vs. Free Market (Round 3)

Video

The Crisis of Capitalism, are we really using the right system? Capitalism has been the champion of the free market system, but is there an issue with the foundation of our system.

David Harvey talks about the inherent failures of our system, but is there really a better alternative?

I personally believe that in this video David Harvey is  biased against the capitalist system.  He does make a point of taking a Marxist point of view to address the issue of barrier points that capitalism may face, and this sets the tone for his perspective. From my understanding Harvey is in favour of more regulation, as he spoke about financial ingenuity and innovation he basically slandered the movement from manufacturing & industry to finance. Due to his bias I believe he failed to develop the point that this change had been positive at the time and lead to substantial economic growth. I assume that Harvey’s stance would be towards a command economy, due to the several factors he mentions.

There are five general points developed, Harvey makes a notable reference to Alan Greenspan’s comments on the crisis (many people had blamed him to be a contributing factor to the sub-prime mortgage crisis) as Greenspan notes that it is human nature that lead to the failure (human frailty). This is in reference to qualities such as greed and instinct for mastery, on this point I would have to agree with Greenspan as no matter what system is used we are a big factor in contributing to error (impossible to have a perfect free market, purely theoretical). The second point is the obsession with false theory; at this point I believe that Harvey establishes him to be against free market economics. Harvey considers that peoples false belief in the efficiency of markets is what contributed to crisis, and mentions Hyman Minsky’s theory of the inherent instability of financial activities. To an extent I would agree that absolute belief in the efficiency of markets can only lead to systemic failure, as free markets are prone to speculation and the development of bubbles.  I believe that Minky’s theory is a fair while analysing economic trends, as instability at certain periods of time is almost unavoidable.

I personally believe that an error of free market economics that led up to the financial crisis was the driving up of the credit economy, which was a result of wage repression after the 80’s. The development of the credit economy let people live beyond their means (increase in effective demand). However there was a vast accumulation of debt, and In the U.S. it was concentrated in the housing market this was a contributing factor to the crisis. In Minsky’s theory he mentions that a mechanism that pushes towards crisis is the accumulation of debt by non-government sectors. I believe that too often the 2007-2008 financial crises is blamed on poor policy and institutional failure and not enough on the fact that the people are to blame as well as those in power.

I fully appreciate David Harvey’s perspective, however I believe whether it is a capitalist system (free market) or a socialist one (command economy) failure and crisis is inevitable part of economics, a part of human nature. We attempt to apply theory to reality, and in that is the digression of successful economies.

Command Economy Vs. Free Market (Round 1)

Winter Is Coming, and The Soviet Cupboard Is Bare

http://www.businessweek.com/stories/1991-11-03/winter-is-coming-and-the-soviet-cupboard-is-bare

International Business

WINTER IS COMING, AND THE SOVIET CUPBOARD IS BARE

Tensions are running high at Moscow’s sprawling Gastronom food store near Byelorussia Railway Station. With coupons ready, two dozen people are lined up at the counter to get sugar rations they were supposed to have had three months ago. Management claims there’s no sugar–but it turns out that 20 sacks of sugar have been hidden in the back. For hours, the angry crowd refuses to leave, forcing police to clear the store when closing time comes at 8 p.m.

As winter approaches, such scenes are becoming common. The question being asked in capitals from Brussels to Washington is: How bad will it get in the former Soviet Union? Mass starvation is unlikely. But a combination of poor harvests and breakdowns in food distribution will mean pockets of serious shortages throughout the country. The repercussions are being felt on world commodity markets. Plans are afoot for the U. S. to extend $1 billion in emergency food credits and aid, prompting American grain prices to shoot up.

Across the Soviet Union, cities loom as the most vulnerable spots. Perm, an industrial town in the Urals, already witnessed major protests when sugar supplies dried up. In Moscow, frustrated tipplers ransacked a liquor outlet that had no vodka. In Alma Ata and St. Petersburg, bread is running short. Most at risk are retirees, who struggle along on pensions of 140 rubles a month and can’t afford the plentiful but expensive food in private markets.

The biggest immediate threat is a poor grain harvest, which many expect to come in at 170 million metric tons–down 22% from last year. Of that amount, about 70 million metric tons were to have been sold to state distribution agencies run by Moscow. But in the aftermath of August’s failed coup, central authority has all but evaporated, allowing state and collective farms to sell what they please. By Oct. 1, they had sold only 35.4 million metric tons to the government.

The rest is being hoarded by farmers in hopes of selling it privately later at higher prices. Since spring, for example, grain prices have jumped from 900 rubles to 2,000 rubles a ton. And with the ruble losing value by the day, farmers are using grain to barter for consumer goods, cement, or other items they need.

Yet state and collective farms do not have adequate storage facilities and may face big grain losses, as Vladimir A. Tikhonov, a Soviet agricultural expert, told an Oct. 18 conference at the Geonomics Institute of Vermont’s Middlebury College. The resulting shortages could touch off food riots by spring, he says.

RUMBLING BELLIES. In Russia, the most populous republic, food supplies are tight. Meat purchases for the first nine months of the year were down 20%, and dairy sales sank 15%. In more than 50 Russian cities, meat, butter, and vodka are being rationed.

Finding additional supplies will be difficult. Now that they’ve declared their independence, such food-producing republics as Moldavia, the Baltic states, the Ukraine, and Kazakhstan are reluctant to ship food to Russia, since they want to feed their own people first. Russian cities in the heavily industrial Urals region, for example, used to get livestock from the Baltic states. But shipments have fallen off dramatically. The republics are supposed to adhere to their commitments to sell food or pay penalties in hard currency. But, says Tikhonov, “a period has come when no agreements can be relied upon.”

Western countries, fearful of the chaos that food shortages could spawn, are gearing up with emergency plans. The U. S., Japan, the European Community, and Saudi Arabia have earmarked $10 billion in aid and credits primarily for food. But last year, when the situation was less than dire, the Soviets cried wolf: Much of the emergency food aid sent by the West ended up wasted or absorbed by the black market. The question now is figuring out how to send help when it’s really needed–and before it’s too late. Rose Brady in Moscow and Peter Galuszka in Middlebury, Vt.

Questions:

How is the basic economic problem being handled by the use of coupons? Why might this be less successful than money?

The coupons are in a way a different form of currency for the people and businesses, since the coupon is being exchanged directly for a given product. Through the use of coupons there is the elimination of opportunity cost, as a coupon only entitles you to one given product. The reason this may be less successful than money is because the value of the product may increase as there is a shortage of supply, but a coupon entitles the person to the same amount of the product as before. This encourages those with the product to hoard it and sell it on the black market for immediate monetary gains and a greater profit then would have been received if the coupons were taken.

Suggest reasons why there may be a shortage of sugar?

  • The main reason there is a shortage of sugar is because the producers are hoarding the sugar. There are two markets in existence the black market and the coupon market. The producers rather sell in the black market to increase profit rather than sell in the coupon market, therefore the creation of shortage.
  • Another possible reason is that product is being used to barter for other product, this direct trade skips the use of coupons or the black market therefore not establishing a supply.
  • The final reason for a drop in supply would be the independence of former Soviet Union states not exporting their product

Use demand and supply diagram to explain why there is a shortage of some foodstuff.

Use a demand and supply diagram to demonstrate the surge in the price of food.

Does the article demonstrate the failing of the command or free market based solutions to the basic economic problem?

To an extent the article highlights what occurs when there is an economic transition from one system to another. The main issue that the article highlights is the undermining of the command economy system with the use of the black market. In essence the black market is a free market without regulation but with similar aspects such as equilibrium and price signals. The article mentions an immediate threat with the poor grain harvest, and the resulting surge in prices; this is not entirely an issue that only a command economy would face but also a free market economy. An example of this occurring in free markets can be noticed often when there is scarcity of a resource, what a command economy attempts to do by rationing is to reduce the issue of scarcity.

What can be noted about the transitioning economy is the behaviour of the sellers of commodities. Since there is no longer the regulation forcing them to give their produce to the government they are free to do with it as they like. So immediately they go for the short-term positive personal gain, rather than thinking about the greater community. This is why the black market prospers at this time, because the profit margin for selling in the black market is much greater than the margin in the transitioning economy; this relates back to the issue of the coupons.