is no panacea for South's economic woes
THE TDR-99 notes that with the decline in official financing
and instability of private financial flows, FDI has come to be
increasingly seen as a solution to the problems of resource
gap and external financing. The significant upturn in FDI
flows to developing countries in the 1990s, the success of
some in attracting large amounts of FDI, and the 'relative
stability' of FDI in the aftermath of the East Asia crisis,
TDR-99 notes, have led to predictions that FDI is a more
stable form of capital flow linked to an emerging
international production system, and is likely to offer new
and, on some accounts, unprecedented growth opportunities to
But on a closer examination of recent inflows, including their
size, distribution, sources and utilisation, and an assessment
of their contribution to the balance of payments (BOP), TDR-99
presents a more sceptical assessment.
The report notes that the average annual growth of FDI inflows
has risen from 15% in the 1980s to 28% in the 1990s -
reflecting in part structural and policy changes in potential
southern hosts. And the share of world FDI received by
developing countries has risen from around 16% in second half
of 1980s to 28% in the 1990s.
But, it notes, these flows are increasingly concentrated in a
small number of locations - with 10 leading emerging-market
economies accounting for three-quarters of all FDI flows to
the South and with China, Brazil and Mexico alone accounting
for almost one-half of the total flow. Even adjusting the
flows to a per capita basis does little to diminish their
highly uneven distribution.
'The recent FDI-led integration' of developing countries is
thus a highly selective process, TDR-99 says.
Data on FDI are not always up-to-date and reliable. FDI flows
are usually distinguished under three different sources:
equity capital, undistributed profits and loans from parent
companies to affiliates. Empirically, equity capital is
defined as 'investment made to acquire a lasting management
interest (usually at least 10% of voting stock) in an
enterprise operating in a country other than that of the
investor, whether in a new or existing firm. Acquisitions
below 10% are considered portfolio investment.
TDR-99 points out these are somewhat arbitrary definitions and
raise conceptual problems - nor do the definitions always
accurately reflect national practices in classifying FDI.
Thus defined, while total FDI inflows into developing
countries have been growing steadily, total portfolio equity
inflows have shown considerable instability since their
emergence in the mid-1980s.
Undistributed profits are a relatively important proportion of
measurable FDI flows - though the share of reinvested earnings
in total FDI in developing countries has been declining in
favour of equity and loans during the 1990s.
For example, more than half the total outflow of what is
labelled FDI from the US consists of earnings of foreign
subsidiaries retained by them and not remitted to the US. Some
studies have questioned the validity of contending that such
FDI is functionally indistinguishable from fresh capital
inflows, as if these reinvested earnings are a flow of foreign
resources crossing the borders of two countries.
TDR-99 says that clearly such reinvestments do not involve any
cross-border flows and their treatment as a one-way inflow
item in the capital account of the BOP is not admissible. But
the difficulty is resolved by showing the profit as a payment
abroad on the current account, and the reinvested profits as
an FDI inflow on the capital account.
Difficult to evaluate
However, existing statistical measures cannot always
distinguish between retained earnings being used for
investment in equity capital, on the one hand, and for
acquisition of other financial assets such as government
bonds, on the other.
Together with many other changes in global financial markets
that have facilitated capital mobility, such features of FDI
make it difficult to evaluate its stability.
Another issue that has a bearing on stability and
sustainability and on the impact on the BOP of FDI relates to
whether the inflows are utilised for mergers and acquisitions
(M&A) or so-called greenfield investment.
While conventional analysis has usually treated FDI as if it
consists essentially of additions to the real capital stock of
the host country, and though long-term considerations may play
a role, M&A may also be greatly influenced by prospects of
quick capital gains, particularly during periods of crisis.
In practice, TDR-99 points out, data do not allow independent
estimation of these two components of FDI. But since the data
on cross-border M&A are available, greenfield investments can
be estimated as a 'residual' - the difference between total
FDI and M&A.
Cross-border M&A has accounted for between one-half and two-
thirds of total world FDI flows Ð a figure that is higher for
developed countries and lesser for developing, probably mainly
because of the smaller role for M&A in China.
If China is excluded, the share of M&A in cumulative FDI in
1992- 1997 turns out to be 72%, up from 22% during 1988-1991.
And when the residual is treated as the greenfield component
of FDI, its absolute annual level during 1992-1997 was
consistently below the level reached in 1991.
'Thus,' says TDR-99, 'the recent boom in FDI flows to
developing countries has, with the exception of China,
consisted predominantly of M&A, largely in the services
The surge in M&A, especially in the services sector, is
closely linked to privatisation programmes adopted in 1990s in
which transnational corporations (TNCs) have played a
prominent role. According to World Bank data, during
1990-1997, privatisation via foreign investors amounted to 12%
of total FDI inflows into the developing world except China.
Owing to consequent, frequently drastic, falls of exchange
rates and declines in asset prices, financial crises in
emerging markets have also created opportunities for highly
profitable M&A. In 1998, for example, while total FDI flows to
the five Asian countries affected by the crisis declined by
$1.5 billion, cross-border M&A in those countries is estimated
to have risen to more than $3 billion.
The shift of FDI towards acquisition of ownership rights over
existing assets is associated with changes in sectoral
composition. FDI in the primary sector has been declining for
some time, though still a relatively more important component
of total FDI in developing than in developed countries. The
secondary sector still accounts for the largest share of total
FDI in many developing countries, but the pattern in the 1990s
has definitely involved a shift away from manufacturing to
tertiary sectors where much M&A activity has taken place.
'Not a sound basis'
There has been a rising share of non-tradable sectors in total
But clearly the stocks of assets of the host country, in the
public and private sectors, for M&A are finite and their
limits are even tighter in poorer countries. FDI attracted by
privatisation of public assets is of a one-off nature. As for
FDI involving acquisition of existing private equity, the
presence of non-residents in the stock markets of many
emerging markets is already at high levels, and for foreign
acquisitions to grow, the stock market equities have to grow
'These considerations suggest that any simple projection of
recent FDI trends may not be a sound basis to assess the
sustainability of such flows.'
As for the BOP impact, the issue could be viewed in terms of
net transfers (comparing FDI inflows with associated payments
abroad, including profit remittances, royalties, licence fees
and wage remittances as well as interest paid on net loans of
parent company to subsidiary). This was a prominent issue in
the early literature on FDI, but is no longer so. Countries
with long history of TNC involvement Ð hence a large stock of
foreign capital Ð usually had negative net transfers, which
remained negative until 1988, when China was excluded.
'But it is the boom in FDI, rather than stagnation in profit
remittances, that has reversed the situation in favour of
developing countries in the 1990s. In fact, profit remittances
continued to increase at an average rate of 10% per annum from
1988 to 1998.'
Data limitations prevent any comprehensive analysis covering
all developing countries of the broader concept of net
transfers - taking account of royalties, licence fees and
interest payments to parent companies.
But UNCTAD estimations of royalties and licence fees for
Argentina (1986-1996), Mexico and Thailand (1987-1996) give a
total outflow of $9.9 billion for these items, or over 10% of
FDI inflow for these countries.
Viewing it in a broader approach, and including the effect of
FDI on exports and imports in addition to net transfers,
UNCTAD has some conclusions from a few country studies
available. In the case of Malaysia, the total impact of the
trade balance of foreign firms and their income flows on
Malaysia's current account had been negative in every year
during 1980-1992. The impact on the trade balance became
positive during the late 1980s owing to a strong export
expansion. But as exports became more import-intensive, this
And the net foreign exchange outflows on the current account
were offset by new FDI inflows on the capital account only
after the late 1980s, but the cumulative payments impact
during the whole period was negative.
A similar picture emerges for Thailand, where FDI,
particularly from Japan, surged after 1986. It had a positive
impact on investment and growth, and partly explained the rise
in the export/GDP ratio from 29% in 1987 to 36% in 1992. But
it was also the cause of a stronger rise in imports because
the associated investment and production was import-intensive.
It has been estimated that 90% of all machinery and equipment
used for FDI projects and 50% of raw materials were imported
and thus FDI had a negative impact on the trade balance in the
late 1980s and early 1990s. This was reinforced by the rising
payments abroad for royalty and licence fees and rising profit
remittances. 'These features appear to have contributed to the
external imbalances that played an important role in the
As for the recent surge in FDI into Brazil, TDR-99 cites UN
Economic Commission for Latin America and the Caribbean
(ECLAC) studies that because of an upward trend in associated
remittances, increased concentration of FDI in non-tradeable
sectors and gradual exhaustion of privatisation-linked FDI, in
the near future there will be a significant deterioration in
BOP (due to activities) of TNCs in the Brazilian economy.
According to ECLAC, the TNC-led restructuring of the
automotive sector has been an important factor behind the
renewed FDI flows into the region, and has worsened the trade
balance in both Argentina and Brazil because of the import
dependence of such FDI - whereas in Mexico the impact has been
However, even when FDI-linked activities may incur
foreign-exchange deficits, such investments may still improve
the BOP if they create significant externalities enhancing the
export potential of the economy, TDR-99 says. There may be net
benefits still if there are significant technological
spillovers from FDI and the presence of TNCs.
'Nevertheless, such benefits are not spontaneous and may not
compensate for additional foreign-exchange deficits if FDI
predominantly takes the form of M&A in non-traded sectors.
'In any case if the payments outcome of TNC-related activities
is constantly a deficit, the economy would need to generate
net foreign exchange elsewhere, since meeting such a deficit
by simply relying on a new inflow of FDI would mean engaging
in an unsustainable process of Ponzi financing.'
Examining and comparing the relationship between export growth
and FDI inflows during the 1980s and 1990s in South and East
Asian countries, the Bank for International Settlements has
singled out 'significant weakening of the relationship between
FDI and the growth of exports in the 1990s' as a factor
contributing to the factor payment problems and the crisis in
East Asia. The BIS also notes that prospects had become
'dimmer that the initial deterioration of the current account,
brought about by the imports of capital goods associated with
foreign direct investment, would eventually be corrected by
new export activity generated by the increase in capacity.'
UNCTAD notes that the same comparison for a larger number of
developing countries, including several in Latin America,
shows that this weakening of the link between FDI and exports
is widespread in the developing world. The same inflows of FDI
were associated with less rapid expansion in exports during
1991-1996 than in 1985-1990 in both Asia and Latin America.
'Notwithstanding other possible influences originating from
global economic conditions, such as increased competition in
world markets, slow growth and adverse price movements, the
increasing concentration of FDI in services sectors seems
likely to have played an important role in the weakening of
the link between FDI and export growth.'
While TDR-99 refrains from drawing the necessary conclusion,
this line of reasoning based on empirical evidence raises the
question whether developing countries, in further negotiations
on services, should call a halt to opening up their markets
for service exports from the North through capital and
investment as a mode of supply or in further financial
services liberalisation of their banking and insurance sectors
and stock markets.
In a final chapter, devoted to 'Rethinking Policies for
Development', TDR-99 says that attracting FDI to obtain
foreign technologies and secure other advantages associated
with the international production network of TNCs can offer a
faster route to establishment of competitive industries.
'However, the benefits from hosting TNCs are not automatic,
and the policy objectives of the host country in such matters
as local content, technological upgrading and BOP stability
may clash with the commercial interests of corporations....
replacing the high import content of TNC activities in
manufacturing with domestic production remains an important
objective in many countries. Equally, the potential
technological and other spillovers, particularly for
middle-income economies and in sectors where specific
knowledge and capital equipment are closely knit together,
still require that host governments preserve their ability to
bargain effectively with TNCs.'
The TDR analysis presents perhaps the most effective case
against any negotiations for a multilateral framework of rules
on investment at the WTO, even one providing for
post-establishment MFN and national treatment and other
privileges for foreign investors.
Perhaps the UNCTAD analysis of FDI could be summed up as: FDI
is an acronym for foreign direct investment that may be
foreign but could also be round-tripping domestic capital
(that flows out legitimately or illegally and then brought
back); not always direct inflows as it could be reinvestment
and loan capital that is debt-creating; and not necessarily
investment and capital accumulation but consumption. - (Oct/Nov 99)
The above article first appeared in the South-North
Development Monitor (SUNS- issue no. 4513) of which
Chakravarthi Raghavan is the Chief Editor.