Sie Ghose Presentation (1)

8/8/2019 Sie Ghose Presentation (1)

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FOREIGN CAPITAL ANDFOREIGN CAPITAL ANDINVESTMENT ININVESTMENT IN

DEVELOPING COUNTRIESDEVELOPING COUNTRIES

Ajit K. GhoseAjit K. Ghose


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Freer capital flow across nationalFreer capital flow across national

frontiers willfrontiers will

Push the investment rate below thesaving rate in developed countries

Raise the investment rate abovethe saving rate in developingcountries


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The reason is thatThe reason is that

Capital is abundant in developedcountries and scarce in developingcountries; so the return toinvestment is much higher indeveloping countries; hencecapital should flow from developedto developing countries


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MoreoverMoreover

Investment in developing countries isconstrained by scarcity of domesticsaving; any availability of foreignsaving, therefore, must add to theinvestment that is financed by

domestic saving; hence investmentmust necessarily rise above domesticsaving


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Figure 2: Net FDI inflow (billion US$)Figure 2: Net FDI inflow (billion US$)

-250

-200

-150

-100

-50

0

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100

150

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2

Developed countries Developing countries


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Figure 3: Net inflow of portfolio equity to developingFigure 3: Net inflow of portfolio equity to developingcountries (billion US$)countries (billion US$)

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1970

1972

1974

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1980

1982

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1986

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1994

1996

1998

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2002


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Figure 4: Net inflow of private debt finance toFigure 4: Net inflow of private debt finance todeveloping countries (billion US$)developing countries (billion US$)

-180.00

-160.00

-140.00

-120.00

-100.00

-80.00

-60.00

-40.00

-20.00

0.00

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002


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Figure 5: Net official inflow to developing countriesFigure 5: Net official inflow to developing countries(billion US$)(billion US$)

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1980

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1989

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1991

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1994

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2002


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Figure 6: Net overall capital inflow to developingFigure 6: Net overall capital inflow to developingcountries (billion US$)countries (billion US$)

-20

0

20

40

60

80

100

120

140

160

1980

1981

1982

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2002


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The broad picture:The broad picture:

Net capital inflow to developing countrieswas small and stable in the 1980s, and wasdominated by official inflow

Net capital inflow to developing countrieswas large and growing in the 1990s (at least

till 1997), and was dominated by FDI inflow


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Capital inflow was highly concentratedCapital inflow was highly concentratedand went to relatively advanced, highand went to relatively advanced, high--

saving countries:saving countries:

Just 6 countries (Argentina, Brazil, China,Indonesia, Malaysia and Mexico) accounted for

78% of the net FDI inflow to developingcountries during 1990-97

Just 6 countries (Argentina, Brazil, China,

Republic of Korea, Pakistan and Thailand)accounted for 85% of the net non-FDI financialinflow to developing countries during 1990-97


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Figure 7: Investment, capital inflow and foreignFigure 7: Investment, capital inflow and foreigncurrency reserve: all developing countriescurrency reserve: all developing countries

0

5

10

15

20

25

30

1980

1982

1984

1986

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1994

1996

1998

2000

2002

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Investment as % of GDP (left scale)

Saving as % of GDP (left scale)

Foreign currency reserve as % of GDP (left scale)

Net aggregate inflow as % of GDP (right scale)


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Figure 8: Investment, capital inflow and foreignFigure 8: Investment, capital inflow and foreigncurrency reserve: Chinacurrency reserve: China

0

5

10

15

20

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30

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1980

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1

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Investment as % of GDP (left scale)

Saving as % of GDP (left scale)

Foreign currency reserve as % of GDP (left scale)

Net aggregate inflow as % of GDP (right scale)


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I/Y = a + b. (SF/Y) + (1 + c).I/Y = a + b. (SF/Y) + (1 + c). (FDI /Y)(FDI /Y)

ID/Y = a + b. (SF/Y) + c. (FDI/Y)ID/Y = a + b. (SF/Y) + c. (FDI/Y)

Where ID (= IWhere ID (= I FDI) is investmentFDI) is investmentundertaken by domestic investorsundertaken by domestic investors

FDI is net inflow of FDIFDI is net inflow of FDI

SF = domestic saving + net inflow of nonSF = domestic saving + net inflow of non--FDI foreign financeFDI foreign finance

Y is GDPY is GDP


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Table 1: Fixed-effect estimates, dependent variable: ID/Y, period:1990-97

Independentvariables

37 developingcountries

15 LAC countries 11 Asiancountries

11 Middle Easternand African

countriesSF/Y 0.165*

(5.445)

0.243*

(4.741)

0.038

(0.527)

0.130**

(2.340)

FDI/Y -0.772*

(-12.838)

-0.625*

(-7.103)

-0.810*

(-7.074)

-0.735*

(-3.973)

ID/Y (-1) 0.256*

(5.750)

0.089

(1.306)

0.355*

(4.442)

0.404*

(4.423)Adjusted R2 0.888 0.743 0.947 0.783

Durban-Watsonstatistic

1.748 1.696 1.387 1.825

Number ofobservations

296 120 88 88

Note: SF is defined as the sum of domestic saving, and net inflows of portfolio equity, private loansand official loans and grants. LAC refers to Latin America-Caribbean.

-1 indicates lag of one period

* indicates significance at 1%, and ** indicates significance at 2.5%

Figures in parentheses are t-statistics


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Two conclusions:Two conclusions:

Foreign capital crowds out domestic capital.FDI crowds out investment by domesticentrepreneurs. Financial inflow displacesdomestic saving as investment finance. This

crowding-out explains why capital inflow hasan insignificant effect on investment butleads to accumulation of foreign currencyreserve.

Capital inflow to developing countries islargely exogenous.


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Further evidence on the exogenous nature of capital inflowFurther evidence on the exogenous nature of capital inflowto developing countries:to developing countries:

Not particularly sensitive to the degree of capital accountopenness of developing countries

Sensitive to business cycles, macroeconomic policychanges, behaviour of institutional investors, etc., in

developed countries

The literature on multinational firms shows that FDI is market-seeking and efficiency-seeking rather than profit-seeking . Location decisions are governed bystructural characteristics (such as factor endowment,level of infrastructure development, etc.) of countriesrather than by their current policies

Official inflow is inversely related to private financialinflow


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Stylised facts:Stylised facts:

Capital inflow is exogenous from theCapital inflow is exogenous from therecipient countries point of viewrecipient countries point of view

Capital inflow crowds out investmentCapital inflow crowds out investmentfinanced by domestic savingfinanced by domestic saving

Capital inflow leads to accumulation ofCapital inflow leads to accumulation offoreign currency reserve by theforeign currency reserve by therecipient countriesrecipient countries


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Y = C(DY) + Id(r) + If + G [M(Y,q) X(q)], If= Sf.e/Pd

+ - + - +

MS + Sf. e = Pd. L(Y, r) + Sf. e, 0 1

+ -

Y output, C private consumption, DY disposableincome, Id investment financed by domestic saving, r

nominal rate of interest, If investment financed byforeign saving, G government consumption, M imports, q (= e. Pf/Pd) real exchange rate, X exports, Sf

foreign saving, MS money supply when there is noinflow, - index of sterilisation


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1. For given capital inflow and domestic price level, a depreciation ofthe nominal exchange rate (i.e. a rise in the value of e) increasesboth the output and the interest rate. The output increases because

exchange rate depreciation reduces the trade deficit. The interestrate rises because increased output means increased demand formoney.

2. For given nominal exchange rate and domestic price level, a rise incapital inflow increases both the output and the interest rate. Theoutput increases because the increase in investment exceeds the

increase in trade deficit. The interest rate rises because increasedoutput means increased demand for money.

3. For given capital inflow and nominal exchange rate, a rise in thedomestic price level lowers the output but has an uncertain effecton the interest rate . Output declines because higher domestic pricelevel causes appreciation of the real exchange rate, which increases

the trade deficit. The interest rate movement is ambiguousbecause, on the one hand, lower output reduces the demand formoney and, on the other hand, higher price level increases it.


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Given fixed nominal exchange rate anddomestic price level, the positive effectof an increased inflow of foreign capital

on output grows weaker and thepositive effect on the interest rategrows stronger as the degree ofsterilisation rises i.e., as the value of

declines from 1 toward 0.


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FCR.e/Pd = Sf.e/Pd [M(Y,q) X(q)] = S(Y) Id(r)

+ - + + -


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Developing countries need stable realexchange rate in order to pursue export-oriented industrialisation

An exogenous increase in capital inflowposes a rather awkward problem: pre-emption of nominal exchange rateappreciation requires substantial expansionof money supply, which threatensaccelerating inflation

The standard response is sterilisation, whichcrowds out investment financed by domesticsaving


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An exogenous increase in capitalinflow, therefore, ends up generating or

increasing excess domestic saving ,which is accumulated by thegovernment in the form of foreign

currency reserve

In effect, capital inflow induces capital

outflow so that national investment isaffected only marginally


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The main benefit of capital inflow lies inmodernisation and restructuring of the

capital stock in recipient developingcountries

To benefit from foreign capital, therefore, a

developing country must already possess asubstantial capital stock

Developing countries with little capital stockand low saving cannot expect to derive muchbenefit


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If a developing country pursues anexport-oriented industrialisationstrategy with the help of foreign

capital, its macroeconomic policieshave to be geared to counteringthe fluctuations in capital inflow;

to this extent, there is a loss ofpolicy autonomy

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