These flows are not just volatile, they tend to come in and go out exactly at the wrong time.When economic prospects in a developing country are considered good, too much foreign financial capital may enter. This can temporarily raise asset prices (e.g., prices of stocks, real estate prices) beyond their real value, creating asset bubbles.When things get bad, often because of the bursting of the very same asset bubble, foreign capital tends to leave all at the same time, making the economic downturn even worse. Such ‘herd behaviour’ was most vividly demonstrated in the 1997 Asian crises, when foreign capital flowed out on a massive scale, despite the good long-term prospects of the economies concerned (Korea, Hong Kong, Malaysia, Thailand and Indonesia).[10]
Of course, this kind of behaviour – known as ‘pro-cyclical’ behaviour – also exists among domestic investors. Indeed, when things go bad, these investors, using their insider information, often leave the country before the foreigners do. But the impact of herd behaviour by foreign investors is much greater for the simple reason that developing country financial markets are tiny relative to the amounts of money sloshing around the international financial system. The Indian stock market, the largest stock market in the developing world, is less than one-thirtieth the size of the US stock market.[11] The Nigerian stock market, the second largest in Sub-Saharan Africa, is worth less than one five-thousandth of the US stock market. Ghana’s stock market is worth only 0.006% of the US market.[12] What is a mere drop in the ocean of rich country assets will be a flood that can sweep away financial markets in developing countries.
Given this, it is no coincidence that developing countries have experienced more frequent financial crises since many of them opened their capital markets at the urge of the Bad Samaritans in the 1980s and the 1990s. According to a study by two leading economic historians, between 1945 and 1971, when global finance was not liberalized, developing countries suffered no banking crises, 16 currency crises and one ‘twin crisis’ (simultaneous currency and banking crises). Between 1973 and 1997, however, there were 17 banking crises, 57 currency crises and 21 twin crises in the developing world.[13] This is not even counting some of the biggest financial crises that occurred after 1998 (Brazil, Russia and Argentina being the most prominent cases).
The volatility and the pro-cyclicality of international financial flows are what make even some globalization enthusiasts, such as Professor Jagdish Bhagwati, warn against what he calls ‘the perils of gung-ho international financial capitalism’.[14] Even the IMF, which used to push strongly for capital market opening during the 1980s and especially the 1990s, has recently changed its stance on this matter, becoming a lot more muted in its support of capital market opening in developing countries.[15] Now it accepts that ‘premature opening of the capital account … can hurt a country by making the structure of the inflows unfavourable and by making the country vulnerable to sudden stops or reversals of flows.’[16]
The behaviour of international financial flows (debt and portfolio equity investment) is in stark contrast with that of foreign direct investment. Net FDI flows into developing countries were $169 billion in 1997.[17] Despite the financial turmoil in the developing world, it was still $172 billion per year on average between 1998 and 2002.[18] In addition to its stability, foreign direct investment is thought to bring in not just money but a lot of other things that help economic development. Sir Leon Brittan, a former British commissioner of the European Union, sums it up: foreign direct investment is ‘a source of extra capital, a contribution to a healthy external balance, a basis for increased productivity, additional employment, effective competition, rational production, technology transfer, and a source of managerial knowhow.’[19]
The case for welcoming foreign direct investment, then, seems overwhelming. FDI is stable, unlike other forms of foreign capital inflows. Moreover, it brings not just money but also enhances the host country’s productive capabilities by bringing in more advanced organization, skills and technology. No wonder that foreign direct investment is fêted as if it were ‘the Mother Teresa of foreign capital’, as Gabriel Palma, the distinguished Chilean economist who is my former teacher and now a colleague at Cambridge, once ironically observed. But foreign direct investment has its limitations and problems.
First, foreign direct investment flows may have been very stable during the financial turmoil in developing countries in the late 1990s and the early 2000s, but it has not always been the case for all countries.[20] When a country has an open capital market, FDI can be made ‘liquid’ and shipped out rather quickly. As even an IMF publication points out, the foreign subsidiary can use its assets to borrow from domestic banks, change the money into foreign currency and send the money out; or the parent company may recall the intra-company loan it has lent to the subsidiary (this counts as FDI).[21] In the extreme case, most foreign direct investment that came in can go out again through such channels, adding little to the host country’s foreign exchange reserve position.[22]
Not only is FDI not necessarily a stable source of foreign currency, it may have negative impacts on the foreign exchange position of the host country. FDI may bring in foreign currency, but it can also generate additional demands for it (e.g., importing inputs, contracting foreign loans). Of course, it can (but may not) also generate additional foreign currency through exporting, but whether it will earn more foreign exchange than it uses is not a foregone conclusion. This is why many countries have imposed controls on the foreign exchange earnings and spending by the foreign companies making the investment (e.g., how much they should export, how much inputs they have to buy locally).[23]
Another drawback with foreign direct investment is that it creates the opportunity for ‘transfer pricing’ by transnational corporations (TNCs) with operations in more than one country. This refers to the practice where the subsidiaries of a TNC are overcharging or undercharging each other so that profits are highest in those subsidiaries operating in countries with the lowest corporate tax rates. And when I say overcharging or undercharging, I really mean it. A Christian Aid report documents cases of underpriced exports like TV antennas from China at $0.40 apiece, rocket launchers from Bolivia at $40 and US bulldozers at $528, and overpriced imports such as German hacksaw blades at $5, 485 each, Japanese tweezers at $4, 896, and French wrenches at $1, 089.[24] This is a classic problem with TNCs, but today the problem has become more severe because of the proliferation of tax havens that have no or minimal corporate income taxes.Companies can vastly reduce their tax obligations by shifting most of their profits to a paper company registered in a tax haven.
10
The Asian crises are well documented and analysed by J. Stiglitz (2002),
11
In 2005, the US stock market was worth $15, 517 billion. The Indian market was $506 billion. http://www.diehardindian.com/overview/stockmkt.htm.
12
In 1999, the Nigerian stock market was worth a mere $2.94 billion, whereas that of Ghana was a mere $0.91 billion. http://www.un.org/ecosocdev/geninfo/afrec/subjindx/143stock.htm
13
B. Eichengreen & M. Bordo (2002), ‘Crises Now and Then:What Lessons from the Last Era of Financial Globalisation’, NBERWorking Paper, no. 8716, National Bureau of Economic Research (NBER), Cambridge, Massachusetts.
14
This is the title of chapter 13 of J. Bhagwati (2004),
15
The new, more nuanced view of the IMF is set out in detail in two papers written by Kenneth Rogoff, a former chief economist of the IMF (2001–2003), and three IMF economists. E. Prasad, K. Rogoff, S-J. Wei & A. Kose (2003), ‘Effects of Financial Globalisation on Developing Countries: Some Empirical Evidence’, IMF Occasional Paper, no. 220, International Monetary Fund (IMF), Washington, DC, and Kose et al. (2006).
16
Kose et al. (2006), pp. 34–5. The full quote is: ‘premature opening of the capital account without having in place well-developed and well-supervised financial sectors, good institutions, and sound macroeconomic policies can hurt a country by making the structure of the inflows unfavourable and by making the country vulnerable to sudden stops or reversals of flows’.
17
World Bank (2003),
19
L. Brittan (1995), ‘Investment Liberalisation: The Next Great Boost to the World Economy’,
20
For example, one study by a group of IMF economists shows that, for a sample of 30 poorer developing countries during 1985–2004, FDI inflows turned out to be
21
P. Loungani & A. Razin (2001), ‘How Beneficial is Foreign Direct Investment for Developing Countries?’,
22
In addition, with the increasing importance of collective investment funds that I discussed previously (note 5), there is also shortening of time horizons for FDI, which makes such ‘liquidizing’ of FDI more likely.
23
These include local content requirements (where TNCs are required to buy more than a certain share of inputs from local producers), export requirements (where they are forced to export more than a certain proportion of their output) and foreign exchange balancing requirements (where they are required to export at least as much as they import).
24
Christian Aid (2005), ‘The Shirts off Their Backs – How Tax Policies Fleece the Poor’, September 2005.