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.

Advertisements

Cheap Oil Mania

Pause for a moment and appreciate that the price of oil had dropped below $28 a barrel. Oil has not been this cheap since I was born, and while I appreciate petrol being cheaper at the pump this is having substantial economic and political repercussions.

We are now in the period where everyone pulls out forecasts of the $15 dollar barrel but I feel that this is just where the market momentum is pointing, rather than a real sustainable price for the commodity. With regard to the market we see players like Glencore’s share price tumbling down. But I would argue that this market is ripe for a comeback, with the only direction for the price being up.

I would argue that in the near future the large oil producers are going to cut production, it will be necessary for OPEC to maintain stability, and critically Russia’s economy is taking a hit due to its reliance upon export commodities for growth. Domestic producers in the UK are facing an unparalleled squeeze, and there are signals that operations are going to have to shut down with big firms such as BP shedding workers . Shale oil from the U.S. has changed the scope of demand, and the relative slowdown in the Chinese economy means that brent crude is not the world no. 1 for the moment.

Often it is thought that a drop in oil price behaves similarly to expansionary fiscal policy, there should be more money in peoples pockets right? This might be the case for smaller drops in price, but the extent to which this has occurred and accounting for the global ramifications may mean a drag on global growth. This negative effect may be channelled through all those employed in the fracking industry, and businesses with related operations such as shipping. The going question right now is what prices can non-OPEC producers of oil survive at, and this is going to be what determines when OPEC potentially agree to changes in production, as well as the extent to which this may prove negative for economies.

The Future of Obamacare

Well to some extent it has, regardless of how small a step, it was a step to greater equality in the United States. I am not necessarily the firmest believer in government intervention in regards to healthcare, but equally the position American citizens are put in due to the corporate greed and lobbying power of pharmaceutical and insurance companies is an equal evil.

The Patient Protection and Affordable Care act did not go as far as Obama had wanted it to go. However, it has allowed millions of American cover that they otherwise would not have. One would hope that in the worlds super power economy, people do not have to make a tough decision between putting food on the table for the family or having health insurance.

Moreover, it did not lead to the fears of its opposition, as the cost of healthcare in real terms has not increased. The fear now however is that any foundation laid by the act will be undone by the future policy of the Obama administration, in that the specific protection for the Pharmaceutical lobby.

Stiglitz has pointed out the case of how India was forced to take up patent law in 2005, due to the competition Indian pharmaceutical companies were bringing to drug production, and in that the western pharmaceutical lobby’s fears that competition from the generic market. In the 1970s India abolished pharmaceutical patents, and this lead to an industry, which would be capable of providing some degree of healthcare in the developing world.

The Obama administration is seeking a bi-lateral trade deal with India that will ultimately secure the position of the pharmaceutical companies. Critically, along with Obamacare, it is clear that there needs to be an overriding framework that ensures that care and medicine is affordable. Stiglitz argues that this is not an unintentional outcome of the trade deal, but rather an explicit element of US trade policy. Thus, we come back sadly to a trade off between the US and its desire to keep domestic jobs, and protect a well-lobbied industry.

The argument that the rigorous American patent system is ensuring profits for innovation and development is becoming worn out. Stiglitz gives the example of Hepatitis-C treatment, which in India goes for $1,000 per treatment with profitability, but in the U.S. for $84,000. This chasm in prices shows the degree of monopoly power that the U.S. government grants in the healthcare industry, and this bi-lateral trade agreement will only reinforce this if India strengthens its patent laws.

So it is increasingly clear that healthcare in the United States can be approached from a more critical angle, rather than still trying to force an act through that lobbyists call communist, but your rational person would call equitable.

Growth & Structural Reform

Production Possibility Frontier & Aggregate Supply:

There are many determinants for a shift in aggregate supply; this would mean an increase in real output without an increase in the price level.

Picture2

Some examples of the determinants are:

  • Education: Increased productivity, capabilities, and efficiency of the labour force
  • Innovation/R&D: The product may become more useful or easier to manufacture
  • Government Regulation or Subsidy: Encourages production, or deregulates an immobile market.
  • Transport/Infrastructure: If there was better transport then people could work more often rather than waste time in traffic,  development of infrastructure develops efficiency.

p2


Analysis from Article:

Using Evidence from the Article Explain the Impact of Investment on the UK’s PPF?

Increasing the quality of university education and teachers may mean that the workforce becomes more efficient and productive. The article highlights the need to invest in human capital. This would lead to an outward shit for the PPF because there is a greater potential for production. If this potential were to be realised there would be a shift to the right for the aggregate supply curve.

The article mentions that the government should target investment towards equipment rather than property, increasing government investment into R&D and general innovation. The lack of innovation is identified through the lack of patents submitted. The issue surrounding R&D and capital investments are the long pay-off periods, whereas financial products pay-off in the short term. If more money were to be invested in long term research and development projects there is an outward shift for the PPF as there is a higher possibility of products being manufactured with greater efficiency.

Finally, the article recognises that British infrastructure is considered “mediocre” being ranked 24th in the world. It relates this to government failure, and the amount of time it takes to get energy bills through and the time it takes for projects to come to fruition. If there were to a boost in infrastructure spending, then there is the potential for an increase in productivity leading to an outward shift in the PPF.

Evaluate the Argument That Structural Investments Alone Are Not Enough to Stimulate Growth?

There are many theories and manners of approaching how best to stimulate growth, the article heavily leans toward the Salter Cycle. This can be summarised as an increase in productivity and efficiency, resulting in reduced inputs of land, labour, and capital while achieving a great output. This what the article highlights as structural investment, i.e. improving education, improving transport, and stimulating research and development. This does work to stimulate growth however it must be realised that humans can only ever be so efficient or productive, and that factors such as capital and land become scarcer in developed countries.

It is true that the government needs to stimulate development within Britain; it is unacceptable to continue supporting financial institutions that don’t contribute to growth. Energy and energy efficiency are two factors which are integral to stimulating growth within an economy, simply because when there is a greater quantity of energy and at a cheaper price more is used. This is where the American government unlike the British government took a lead and has effectively introduced shale fracking to slash gas prices down and increase consumption. The British government has been slow to develop supporting infrastructure and R&D for the implementation of fracking, when a recent geology report displayed the abundance of shale formation across Britain. This highlights the need for structural investments, but into sectors that have optimistic prospects for the future.

The other methods of approaching growth stimulus can be equally as effective. There is the classical approach of increasing free trade between countries, and the development of trade agreements to stimulate production resulting in general economic growth. In the article there is a display of a real GDP per person graph, it shows that Britain had the highest real GDP in 1870. This was a time when Britain had abundant trade from its colonies (without restriction due to naval dominance and to an extent exploitation), and the expansion of trade into the “new world”.

Structural investment will assist Britain in re-modernising; however it can be argued that it is best suited to developing economies that still have a greater abundance of land, labour, and emerging capital. One possible route is the development of military infrastructure; this would mean creating more aircraft carriers and submarines. This has worked to an extent to help stimulate American growth as it announced that two new aircraft carriers are going to be developed, and the roll out of the successor to the F-22 Raptor.

Another possible approach to growth stimulation is to induce a state of semi-isolationism which had worked for East-Asian economies in the 90s. The crash for the East-Asian economies can be attributed to the liberalization of markets which had stifled growth due to speculation. Creating a state of semi-isolation reduces the inefficiency of market speculation, and makes a country more self-dependent, and this may be realised through structural investment. Overall, it can be recognised that structural investment are a necessity, but it must be coupled with a new economic approach to achieve not only growth but sustainable growth.

 

 

Monopoly – Theory of The Firm

Monopoly Abnormal profit

The above diagram represents the existence of a monopoly, due to the abnormal profit shown. The firm operating at this point is profit maximizing, and abnormal profit means that they have more profit than they need to break-even at the point of normal profit.

Through this graph it can be noted that the firm is not a maximum productive efficiency, as the condition for a firm to at maximum productive efficiency would be to produce at the lowest point of average total cost.  It can be noted that the firm is operating just above the lowest point of average total cost. The reason this represents maximum productive efficiency is because all of the costs of the firm are being met by revenue generated by the sold products.

Furthermore, the firm is not operating at the point of maximum allocative efficiency. This can be identified through the fact that the price at the point of profit maximization is not equal to marginal cost. This lack of allocative efficiency represents a type of market failure (in this case the existence of monopoly), this is shown by the dead-weight loss which is the highlighted triangle in the graph.