Capital Flows and Foreign Investment MBAW6 Dermot McAleese

FROM TRADE TO CAPITAL MOBILITY Trade Better access to credit spurs trade Traders need to hold or borrow foreign exchange; trade imbalances need to be financed International finance Deregulation Domestic institutions demand relief form rules; regulation ever harder to enforce Access to foreign capital markets Range of financial products expands Domestic financial firms are forced to compete Innovation

OUTLINE  Trends in capital flows  Analysis of capital flows  Basic model  Capital mobility and taxes  Extensions  FDI and multinationals  Trends in FDI  Why invest abroad?  Effects of foreign investment

Table. 1 Savings, investments and lending, (% GDP) Source: IMF, World Economic Report (October 1999)

Table. 2 Inward and outward stock of foreign-owned capital (US$bn) Source: United Nations, World Investment Report, 1991, 1999 (1999 figures are author’s own estimates)

TRENDS IN CAPITAL FLOWS  1990s – ‘the decade of equity finance’  Increased level of integration  International bank lending has risen to ½ of GDP in industrial countries  Increasing share of government bonds held by foreigners  Increasing orientation of the foreign private sector issuers of bonds and securities to the international markets  Proliferation of different types of mobile investment funds  Demand and supply factors of increasing capital mobility

BASIC MODEL Gains form capital mobility Rate of interest (R) World capital stock (K) OnOn OnOn KK* R* RnRn RsRs A C B D E Rate of interest (R) MP n MP s

TAXING CAPITAL IN THE CAPITAL-MOBILE WORLD Rate of interest (R) Capital stock (K) DkDk O KoKo T R G E SkSk tax Rate of interest (R) Capital stock (K) DkDk O K1K1 R T F D SkSk tax E World rate of return K0K0

EXTENSIONS Positive effects:  capital inflows represent critical part in development of some countries  capital inflows create spill-over effect – macro management  capital mobility allows risk spreading through portfolio diversification Adverse effects:  international capital flows can be very volatile  capital inflows can cause unsustainable inflationary pressures  capital flows can lead to short term misalignment of the exchange rate  capital mobility can weaken country’s tax base by forcing governments to offer excessive enticement to investors

FOREIGN DIRECT INVESTMENT

Table. 3 Stocks of FDI (% GDP) Source: Computed form J.H. Dunning, The Globalisation of Business (London: Routledge, 1993) and World Investment Report (United Nations, various years)

Table. 4 Regional distribution of FDI inflows and outflows (%) Source: UNCTAD, World Investment Report (1999).

WHY INVEST ABROAD? - OLI PARADIGM Ownership advantages  Intangible assets  Economies of size Location advantages  Labour costs and other inputs  Availability of skilled labour  Market size, growth of market  Government  Other costs Internalisation advantages  ’Failure’ in markets for final goods and inputs  Monopoly power  Product differentiation

EFFECTS OF FOREIGN INVESTMENT  Multinationals generate externalities  Multinationals create more jobs  Foreign investment generates tax revenues  Foreign investment generates foreign exchange

TO MAXIMISE SPILLOVERS HOST COUNTRY NEEDS TO DEVELOP:  An integrated policy approach  Targeted incentives  After-care policies  Support for indigenous industry