Private Foreign Investment

Private foreign investment (PFI) can take various forms, firstly, private portfolio investment, which includes an acquisition of securities without associated control, flows of money capital enabling flows of real capital. ‘Bank sector lending’ is an important aspect within portfolio investment in contemporary circumstances. Secondly, direct private foreign investment (FDI), which involves purchasing power to exert control over decision-making processes. FDI involves the participation of large multinationals and usually requires more than money capital. Thirdly, private export credits, which should be of more than 1 year’s duration.

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This is often in the form of medium-term credit to importers of particular types of goods, preferably capital goods. Another form of PFI is through technical collaboration agreements, where the sale of technology and know-how by a particular firm are exchanged for specified royalties and technical fees. Joint ventures are also a form of PFI; where previously firms had 100% control; they would now be required to act in accordance with local ownership regulations. The last form taken by PFI is under management contracts. These contracts are agreements by foreign firms to supply packages of skills and techniques for a specified fee.

The first three forms of PFI described above are often regarded as the most significant.

Foreign direct investment (FDI) is the investment by a multinational company in establishing production, distribution or marketing facilities abroad. Sometimes FDI takes the form of ‘Greenfield investment’, with new factories, warehouses or offices being constructed overseas and new staff recruited. Alternatively, FDI can also take the form of takeovers and mergers with other companies located abroad. Foreign investment in financial assets, also known as portfolio investment, in particular by institutional investors such as unit trusts and pension funds is undertaken primarily to diversify risk and to obtain higher returns than would be achieved on comparable domestic investments.

FDI differs from overseas portfolio investment by financial institutions, which generally involves the purchase of small shareholdings in a large number of foreign companies.

The 19th century saw a great expansion of private investment in developing countries, especially in the United States, Canada, Australia and Argentina, as well as in Brazil, Mexico and India. It is important to establish the changing composition of private capital flows; beginning from the pre-1914 period. During this period private portfolio investment was the essential form of investment, contributing to 90% of total PFI, direct investment by the progenitors of the multinationals made up some of the remaining 10%. During the inter-war years, 1919-1929, the previous position continues. However, it is important to note that PFI was gradually expanding during this period. The collapse of the world monetary system in 1930 brought about a dramatic change within PFI; portfolio lending virtually disappeared, leading to the ‘march of the multinationals’.

The relative decline of direct investment and rise of portfolio investment between 1956 and 1980 can be explained by the efforts of poor countries to restrict direct investment, therefore, stagnating aid and domestic investment programmes now supported by the portfolio bond market. In the 1970’s oil price shocks led to a dramatic increase in bank sector lending. The 1970’s also saw a significant rise in direct investment. The 1980’s experienced a notable decline in total PFI. A decline in export credits and portfolio investment was a result of the debt crisis in 1982. Direct investment rose steadily over the 1980’s and by the late 1990’s FDI contributed approximately 50% of total foreign investment.

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.”2

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.”3

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…”4

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

1. Domestic labour in the form of higher real wages,

2. Consumers by way of lower prices,

3. The government through higher tax revenue,

4. 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.