As the Group of 7 Finance Ministers met to discuss the global financial crisis, the debate intensifies on whether governments should intervene in the flawed markets, or whether the markets are sound and should be left alone whilst governments change their flawed policies. However, before deciding what actions (if any) are needed, a proper understanding is needed of the types of international flows of capital, and their effects. This article deals with foreign direct investment and portfolio investment. A subsequent article deals with other types of foreign capital.

By Martin Khor

March 1999

The big debate on what to do to prevent future financial crises continues.

At the level of the Group of 7 rich countries, there is a division between the United States that insists markets should be left alone (and countries should improve their economic policies and financial systems) and several others (including France, Germany and Japan) which advocate greater government intervention to curb market excesses.

From several press reports, it looks as though Europe and Japan are ready to initiate some modest action, such as having the dollar, yen and euro float within a band to be defended by government intervention.

But the US believes the financial markets are sound and should not be regulated or interfered with. Instead governments have to strengthen their national systems to attract positive responses from the market players.

This position seems to be the biggest stumbling block to international regulation or reform of the markets. As long as there is no consensus between the three giants (the US, Europe and Japan), there will be the steam of debate but no international action.

Then there are many developing countries, led by Malaysia, that feel vulnerable to the sudden and sometimes unpredictable inflow and outflow of foreign funds.

Although some of these countries have been castigated by many pro-market analysts as the culprits which deserve punishment for wrong policies and weak or corrupt financial institutions, they feel they are the victims of a fundamentally flawed market manipulated by a few giant players.

The view that East Asian countries and Brazil are victims rather than culprits is now gaining more and more credence with senior academics and some policy-makers, even in the West and Japan.

However, the debate on what (if anything) should be done to reform the global financial system can be properly conducted if more focus is put on how and why funds flow across borders.

It is well known that foreign exchange valued at US$1-2 trillion is transacted across borders daily, and only very little of that (1-2%) is due to payment for trade and services.

The bulk is 'foreign investment' and short-term capital flows as well as speculative capital taking positions on the markets.

It is very important, especially for vulnerable developing countries, to establish a policy framework to deal with international capital flows.

In doing so, the first task is to distinguish between the various types of foreign funds, and their impact on recipient countries. The next step is to consider measures to manage these different types of capital flows.

This is of course a tall order, but it is a good starting point for seriously tackling the global financial crisis, and for developing countries like Malaysia to better prevent or manage future shocks.

One of the critical aspects to look at is the potential effect of different types of funds on foreign exchange and the balance of payments.

That's because in the present financially open system that most countries subscribe to, a country with inadequate foreign reserves or with a deteriorating balance of payments can be subjected to panic withdrawal of funds, speculative attacks and currency depreciation, the kind of 'market behaviour' that sank the East Asian countries.

Foreign Direct Investment

Firstly, there is foreign direct investment (FDI), usually considered the best kind of foreign funds. Even here, however, distinctions have to be made between different types and their different effects.

A large part of FDI comprises foreigners or foreign firms purchasing equity in local companies, or financing mergers and acquisitions, that may not result in new productive activity.

Then there is the more commonly thought of FDI, where foreign firms do start new production, such as opening or expanding factories, and engage in plantation, mining and service activities.

FDI is usually very much sought after, because it can have many benefits, including inflow of long-term capital, technology and marketing networks. However, some FDI can also have negative effects, such as displacement of local firms, net foreign exchange outflow and adverse social impacts.

The overall effects of FDI should thus be analysed, especially on the balance of payments. Foreign firms are known to have high imports of capital goods and inputs. They also earn and can repatriate high levels of profit.

These can be a drain on foreign exchange. Indeed because of these factors, there is often a tendency for FDI to cause a deterioration in the balance of payments.

If the foreign firm produces mainly for export, the export earnings may help offset this tendency. Still, estimates should be made on whether there is a net foreign exchange gain from this more 'ideal' form of FDI.

However, if the foreign firm produces mainly for the local market, and especially if it displaces the products and services of local firms (rather than replacing imports), then it is likely to have a significant negative effect on foreign exchange and the balance of payments.

Developing countries have tried to get firms to use more local inputs, and thus reduce the drain on foreign exchange caused by imported capital and inputs.

But this policy will be harder to implement in future because of the World Trade Organisation (WTO) agreement on trade-related investment measures, which prohibits 'local content' requirements on investors.

The potential problem with even the good forms of FDI is that the outflow of profits can be rather or even very high, and as stocks of FDI increase, so too does overall profit outflow. This can be a big drain on the balance of payments.

From the above, it can be seen that even for FDI, a country needs to have a good assessment of the effects (especially on the balance of payments) and thus a good policy that manages the balance-of-payments effects by increasing the export earnings, retaining as much of the revenue within the country, and minimising the outflows of foreign exchange.

Foreign Portfolio Investment

Then there is foreign portfolio investment, or foreign purchases in the local stock market. A distinction could theoretically be made between the 'serious' investors who plan to stay for some time (and might therefore be encouraged) and the short-term speculators looking for quick profits and are likely to exit when enough is made, or at the first sign of trouble.

In reality, such a distinction may sometimes be hard to make. In a panic situation, as was seen in Asia, any portfolio investor may acquire the herd instinct and quit fast, leading to an overall large exodus of funds.

Developing countries should decide how much they need to open up their stock markets, and what measures can be taken to reduce the volatility.

In particular, they should be on the lookout for (and prevent) manipulative moves, such as deliberate short-selling to push a market down, or the kind of double play on the currency market and the stock exchange futures market that Hong Kong experienced (and countered through massive government purchase of shares) in 1998.

In any case, proper management of foreign portfolio investment is vital to prevent manipulation, excessive speculation, excessive surges of inflows, and the potentially devastating herd-type massive panic outflows.

To prevent excessive inflows of portfolio investment, Chile introduced a policy requiring a percentage of all foreign funds (excepting FDI) entering the country to be deposited interest-free for a year with the Central Bank. The percentage has gone as high as 30% (when there was too much inflow, in recent years) and as low as zero (as of now, when the country wants to attract more inflow due to a shortage of funds).

Malaysia's initial move of September 1998 requiring portfolio investment funds to remain in the country for a year, and the subsequent revision of this to an exit tax (with variable rates depending on length of stay) are also interesting examples of measures to discourage the speculative forms of portfolio investments.

The effect of these measures will be closely watched by other countries. - Third World Network Features

About the writer: Martin Khor is Director of the Third World Network.