Arguments for or against PFI are of a relatively recent date. In classical economic theory, capital movements were generally considered to benefit both the host, as well as the investing country. In the traditional approach, international capital movements imply a flow of investment funds from countries where capital is relatively abundant to countries where capital is relatively scarce. It could also be said, that investment moves from countries with low marginal productivity to countries with high marginal productivity of capital. The host country in this situation benefits from the foreign investment, to the extent that the productivity of the investment and the income created is higher than what the foreign investor takes out in the form of profits and interest. The investor country benefits to the extent that the rate of return on its foreign investment, through profit and interest receipts, exceeds the rate of return on domestic investment.
In this approach international capital movements are to the benefit of the world economy and to all of the individual parties participating.
The classical theory of distribution of gains between recipient and donor countries of PFI has increasingly been questioned on many grounds. H.W. Singer came to the conclusion that “by and large direct private investment have been very beneficial to investing countries, but have had no effects, or even negative effects on the host countries.”
The following statement illustrates how foreign capital, once invested can prove to be beneficial for the investor. Hence, reinforcing Singer’s conclusion that private investment is likely to be more beneficial to the investor, than the host;
“If foreign capital in a single enterprise causes an increase, directly and indirectly, in value added to total output in all sectors greater than the amount appropriated by the investor, then its social returns exceed private returns and its impact is said to be beneficial.”
Recently much interest has been shown in measures that might promote PFI and allow it to make a greater contribution to the development of recipient countries.
“In an attempt to stimulate larger flows of private capital to developing nations, several capital-exporting countries have adopted a range of measures that include tax incentives, investment guarantees, and financial assistance to private investors. International institutions are also encouraging the international flow of private capital…”
It has however, been stated that the policies employed by the capital-recipient countries are more effective than the measures adopted by capital-exporting nations or even the international organisations themselves. Controls exercised by the host country over the conditions of entry of foreign capital, regulations of the operation of foreign capital and restrictions on the remittance of profits and the repatriation of capital are far more decisive in determining the flow of foreign capital than any policy undertaken by the capital-exporting country.
It is essential that the recipient country devise policies that will succeed in both encouraging a greater inflow of private foreign capital and ensuring that it makes the maximum contribution feasible toward the achievement of the country’s development objectives.
The tasks of development require both more effective governmental activity and more investment on the part of international private enterprise. However, private investors must be aware of the developmental objectives and the priorities of the host country and understand how their investments fit into the country’s development strategy. Therefore, private investors evidently play a vital role in the development process of ‘host countries’, nevertheless, it is important that governments realise that if risks are too high or the return on investment too low, PFI will be inhibited from making any contribution at all.
From the perspective of national economic benefit, the essence of the case for encouraging an inflow of capital is that the increase in real income resulting from the act of investment is greater than the resultant increase in the income of the investor. If the value added to output is greater than the amount appropriated by the investor, social returns exceed private returns. Provided that foreign investment raises productivity, and the investor does not wholly appropriate this increase, the greater product must be shared with others, and there must be some direct benefits to other income groups. These benefits can accumulate to
- Domestic labour in the form of higher real wages,
- Consumers by way of lower prices,
- The government through higher tax revenue,
- Indirect gains through the realisation of external economies.
An increase in total real wages may be one of the major direct benefits from an inflow of foreign capital. For a developing country, the inflow of foreign capital may be essential in not only raising the productivity of a given amount of labour, but in also allowing a large labour force to be employed.
A shortage of capital in heavily populated poor countries limits the employment of labour from the rural sector to the advanced sector, where wages are higher. An inflow of foreign capital may in this case, make it possible to employ more labour in the advanced sector. The international flow of capital can, therefore, be interpreted as an alternative to labour migration from the poor country.
The social benefit from the PFI in the advanced sector is then greater than the profits on this investment, as the wages received by the newly employed, exceed their former real wage in the rural sector and this excess should be added as a national gain.
Domestic consumers are also likely to benefit from FDI. When the investment is cost reducing in a particular industry, consumers of this product may gain from lower product prices. If the investment is product improving or product innovating, consumes will benefit from better quality products or new products.
The fiscal benefit derived from PFI is evident from the fact that the share of government revenue in the national product of countries that have received sizeable foreign investment is considerably higher than in most of the other low-income countries.
The most significant contribution of PFI is likely to come from external economies. FDI, for example, brings not only capital and foreign exchange to the recipient country but also managerial ability, technical personnel, technological knowledge, administrative organisation and innovations in products and production techniques, all of which are in short supply. This ensures that a project involving PFI will be adequately formulated and implemented, unlike the situation that has frequently confronted public economic aid when the recipient country has not had the talent or inclination to undertake adequate feasibility studies and devise projects that might qualify for public capital. The pre-investment survey, act of investment and operation of the investment project are ensured in PFI.
One of the greatest benefits to the recipient country is the access to foreign knowledge that PFI may provide, for example, knowledge that may help overcome the managerial gap and technological gap. The provision of this knowledge is often referred to as “private technical assistance”. The rate of technological advancement in a poor country is therefore, extremely dependent on the rate of capital inflow, as well as on private technical assistance. Poor countries are also beneficial in the sense that new techniques also accompany these private capital inflows, and by the examples they set, foreign firms promote the diffusion of technological advance in the economy. Foreign investment can also lead to the training of labour in new skills, and the knowledge gained by these workers can be passed on to other members of the labour workforce.
It is possible that PFI may act as a stimulus to additional domestic investment in the recipient country. This is particularly likely through the creation of external pecuniary economies. If the foreign capital is used to develop the country’s infrastructure, it may directly facilitate more investment. Even if the foreign investment is in one industry, it may encourage domestic investment by reducing costs or creating demand in other industries. This may lead to a rise in profits and eventually, expansion into these other industries. Due to the scarcities in poor countries, it is common for investment to be of a cost-reducing character by breaking bottlenecks in production. This stimulates expansion by raising profits on all under-utilised productive capacity and by allowing the exploitation of economies of scale that had been restricted. When the foreign investment in an industry makes its product cheaper, another industry that uses this product benefits from the lower prices. This creates profits and stimulates an expansion in the second industry.
Although the host country benefits greatly from PFI, in the form of economic development, there are also many costs that it may incur, such as, adverse effects on domestic saving, deterioration in the terms of trade, and problems of balance-of-payments adjustments.
In order to encourage foreign investment, the government of the host country may have to provide special facilities, undertake additional public services, extend financial assistance or they may even have to subsidise inputs. Tax concessions may also be offered and may have to be extended to domestic investment because the government may not be able to discriminate, for administrative and political reasons, in favour of only the foreign investor. Once foreign investment has been attracted it should be expected to have an income effect that will lead to a higher level of domestic savings. This effect may, however, be offset by a redistribution of income away from capital if the foreign investment reduces profit in domestic industries. The consequent reduction in home savings would then be another indirect cost of foreign investment.
It is possible that foreign investment may also affect the recipient country’s commodity terms of trade through structural changes associated with the pattern of development that results from the capital inflow. If the inflow of capital leads to an increase in the country’s rate of development without any change in terms of trade, the country’s growth of real income will then be the same as its growth of output. If the terms of trade deteriorate, then, the rise in real income will be less than that in output and the worsening terms of trade may be considered another indirect cost of the foreign investment. Whether the terms of trade will turn against the capital-receiving country is problematic, depending on various possible changes at home and abroad in the supply of and demand for exports, import-substitutes, and domestic commodities. It is unlikely, however, that PFI would cause any substantial deterioration in the terms of trade. If an unfavourable shift resulted from a rising demand for imports on the side of consumption, it would probably be controlled through import restriction. If it resulted on the side of production, from a rising supply of exports owing to FDI in the export sector, the inflow of foreign capital would diminish as export prices fell, thereby limiting the deterioration in the terms of trade. If the deterioration comes through an export bias in production, it is still possible that the factoral and income terms of trade might improve even though the commodity terms of trade worsen, as the capital inflow may result in a sufficiently large increase in productivity in the export sector. Raymond Vernon made some interesting comments regarding the arguments relating to terms of trade;
“…the terms of trade by which the less developed countries exchange their goods with the advanced countries and acquire their foreign exchange are adverse, both in the static and in the dynamic sense. Because of high import restrictions in the advanced countries, the less developed areas are obliged to accept poor prices for their exports. And the terms of trade grow progressively worse…”
The balance-of-payments adjustments are often the most serious factor concerning the costs of PFI. Pressure on the balance-of-payments may become intense when foreign debt has to be serviced. If the amount of foreign exchange required to service the debt is greater than the amount of foreign exchange being supplied by new foreign investments, the transfer mechanism will have to create a surplus on current account, equal to the debit items on account of the payment interest, dividends, profits and amortisation on the foreign borrowings. When a net outflow of capital occurs, a reallocation of resources becomes necessary in order to expand exports or to replace imports. To accomplish this, the country may have to endure internal and external controls or experience currency depreciation. The adverse effects of these measures of balance-of-payments adjustments must then be considered as indirect costs of foreign investment, to be added to the direct costs of the foreign payments.
The multinational enterprise (MNE), with facilities in many countries and responsive to a common management strategy, has gained much prominence as an instrument for PFI in developing countries. While the capital, technology, managerial competence, and marketing capabilities of an MNE can be utilised for a country’s development, there is also fear that the MNE may dominate the host country or even impose excessive costs upon the host country.
The distinguishing feature of an MNE is that the range of its major decisions is based on the opportunities and problems that the MNE confronts in all countries in which it operates. In utilising its ‘global scanning capacity’ to determine its investment plan, world-wide sourcing strategies, and marketing based on expectations of returns and risk factors, the MNE concentrates on the total net worth of the investor’s interests, not on that of an individual subsidiary alone.
Analysing why a MN undertakes FDI, John Dunning, presents an eclectic theory incorporating locational advantages, owner-ship specific advantages and internationalisation advantages. Locational advantages usually occur from foreign investment that seeks lower costs in the foreign country, a supply of natural resources as an input, lower transportation costs, or a ‘tariff factory’ if the foreign country raises tariffs, thereby inducing investment to ‘skip over’ the tariff wall for production in the ‘protected market’.
Ownership advantages allow the foreign firm to appropriate rents if it innovates and produces differentiated product, giving the firm a monopolistic element, or if the firm has some propriety knowledge that others may not be able to duplicate.
Internationalisation advantages arise because the markets for human capital, knowledge, marketing and management expertise have high information and transaction costs. Therefore, it is administratively better to take out of the market those transactions that the market performs imperfectly and use an internal administrative method of allocation within the firms, instead of having to rely on the external market. The internationalisation of markets across borders leads to FDI. Compared with external markets, the firms linkages, integration, transfer pricing and economies of centralisation allows costs to be reduced through FDI.
Based on the advantages that are mentioned above, FDI allows the investor to profit from a comparative advantage in creating, exporting, and capturing private returns on information and new technologies.
BIBLIOGRAPHY
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Handbook of Development Economics, Vol. II, H. Chenery & T.N. Srinivasan, 1989, Elsevier Science Publishers B.V.- ‘Foreign Private Capital Flows’, E.A. Cardoso & R. Dornbusch
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Handbook of Development Economics, Vol. II, H. Chenery & T.N. Srinivasan, 1989, Elsevier Science Publishers B.V.- ‘Transnational Corporations & Direct Foreign Investment’, G.K. Helleiner
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Private Foreign Investment in Developing Countries, H.C. Bos, M. Sanders & C. Secchi, 1974, D. Reidel Publishing Company
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Leading Issues in Economic Development, 4th edition, G.M. Meier, 1984, Oxford University Press- ‘Benefits & Costs of Private Foreign Investment’
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Leading Issues in Economic Development, 4th edition, G.M. Meier, 1984, Oxford University Press- ‘Transnational Enterprises & Linkages’, S. Lall
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Leading Issues in Economic Development, 4th edition, G.M. Meier, 1984, Oxford University Press- ‘Multinational Enterprises in Developing Countries’
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Finance & Development, June 2001, ‘How Beneficial is Foreign Direct Investment for Developing Countries?’-
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Economics of Developing Countries, Lecture Notes- 07/03/2002
Taken from lecture summaries, ‘Private Foreign Investment a) Nature, Forms, Size and Purposes, Economics of Developing Countries, 14/03/2002
Pg. 473-85, ‘The Distribution of Gains…’, 1950, American Economic Review
Pg. 1388-1439, ‘Foreign Private Capital Flows’, E.A. Cardoso & R. Dornbusch- Handbook of Development Economics, Vol. II, H. Chenery & T.N. Srinivasan, 1989
Pg. 247-59, ‘Private Foreign Investment- Benefits & Costs of Private Foreign Investment’- Leading Issues in Economic Development, G.M. Meier, 1995
Pg. 24, R. Vernon cited in ‘PFI in Developing Countries’, H.C. Bos, M. Sanders & C. Secchi, 1974