econ 355w - a. karaivanov lecture notes ch. 14 foreign ...akaraiva/ch14notes.pdf · econ 355w - a....

Econ 355W - A. Karaivanov Lecture Notes

Ch. 14 Foreign finance, investment and aid (rough notes, use only asguidance; more details provided in lecture)

International flow of financial resources to developing countries

1. Foreign direct and portfolio investment

2. remittances of earnings by international migrants

3. public and private (NGO) foreign aid

1


1a. Private foreign direct investment (FDI)

• past few decades — fast growth of multi-national corporations (MNC) —firms that conduct and control productive activities in more than onecountry

• accompanied with growth of private FDI to developing countries

— annual FDI rate of $2.4 bln in 1962 to $35 bln in 1990 to $147 bln in2002, $335 bln in 2005

— reasons: globalization — MNCs but also developing countries ‘openingup’

• high variance of flows over different regions and times

— e.g. out of $335 bln in 2005; $118 went to China (incl. Hong Kong)— Africa receives only about 3% of global FDI (remember, this isproblematic for the Solow model)

2


• total world FDIs peaked in 2000, still not recovered — Fig. 14.1

• Fig. 14.2 — FDI inflows to developing countries remain small fraction oftheir total investment

— note, however, FDI may be qualitatively different investment (e.g.hi-tech, management know-how, etc.)

• Fig. 14.3 — FDI have become the largest source of foreign funds to LDCs(72% of all flows in 2003)

• sharp contrast with the late 1980s- early 1990s when official flows wereas prominent (see Easterly’s ch. 6 for more detail on those times)

3

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 14-4

Figure 14.1 FDI Inflows, 1980–2008


Figure 14.2 FDI Inflows to Developing Countries in Relation to Domestic Investment,1990–2003


Figure 14.2 Net Capital Flows to Developing Countries,2000–2009


Multinational corporations

• two defining characteristics: large size and high fraction of foreign trade

— 350 largest firms account for more than 40% of world trade— size: 8 of the top 10 non-financial MNCs ranked by assets hadworldwide sales of more than $150 bln in 2004 (in total larger thanthe combined GDP of Sub-Saharan Africa and India)

• most are global brands, immediately recognizable (Ford, BP, Honda,Nestle, Siemens, etc.)

• their great size often yields high negotiating power with manygovernments of small LDCs

• still, remember from fig. 14.1 that most FDIs are directed from developedto developed countries, and (some) competition in virtually all sectorsexists

4


• Historically, in LDCs these firms were into extracting resources, but morerecently into manufacturing and services to use cheaper labor

• MNC controversy — mostly not about the economic impact but other(social, equity, etc. reasons)

• Economic arguments in favor of FDI:

1. supplementing domestic savings to create higher investment which maythen lead to higher growth (remember the Solow, Harrod-Domar models)

2. alleviate current account deficit (goods imports > exports); generatefuture exports

3. source of tax revenue

4. perhaps most important in the long-run — MNCs can help spread newtechnologies and management techniques (eventually these ‘leak out’)

5


• Stories/arguments against private FDI

1. inhibiting domestic firms, crowding out other investment

2. profits repatriation , royalties, etc. may not benefit the host nation

3. tax contributions are low due to concessions from government; tariffprotection, public subsidies (but whose fault is that?)

4. uneven impact on development — mostly urban focus, possible increasein inequality

5. MNCs use their large bargaining and financial power to influencegovernment policies (tax rebates, transfer pricing; tax competition)

6. “suppressing” local entrepreneurship (but why it didn’t develop therebefore?)

6


Reconciling the debate

• markets vs. governments as driver of the development process

• growth vs. inequality

• hard to generalize but overall facts speak for themselves — countries that‘opened up’ to MNCs and trade have growth at higher rates to thosewho did not and have reduced poverty due to the beneficial effect ofincome growth

7


1b. Portfolio investments (see fig. 14.3 again)

• a rising factor (at least up till 2008) in financial flows to LDCs

• consists of investment in stocks, bonds, commercial papers of LDCs firmsand governments

• very high returns on investment possible in so-called ‘emerging stockmarkets’ (e.g. 39% in L. America 1988-1993)

• but also high risk and volatility

• frequent crises: Mexico (1994-95); East Asia (1997-98) and Russia(1998); Argentina (2001-02)

• for investors: capital flows to productive uses; diversification

• possible instability in economies with structural weaknesses (e.g.fixed/controlled exchange rates)

8


• Lesson: MNCs and portfolio investors often follow growth so put theright pre-requisites for it and the flows will come

9


2. Remittances

• in 2007 there were 200 mln migrants worldwide

• huge differences in incomes between HICs and LDCs

• fig. 14.4 — steep growth in remittances after 1990 (currently higher thanaid and portfolio flows); some of this due to improved accounting andrecording of financial transactions

• uneven distribution — fig. 14.5

10


Figure 14.3 Sources of External Financing for Developing Countries, 1990–2008


Table 14.1 Major Remittance-Receiving Developing Countries, by Level and GDP Share, 2008


3. Foreign aid

• in theory, all government and resource transfers from one country toanother

• measurement issues:

— e.g. how to value preferential trade tariffs— private flows should be excluded (not aid)

• so, in practice, foreign aid defined by 2 criteria

— 1. should have non-commercial objective from the donor’s point ofview

— 2. should have concessional terms (‘below market’ rates)

• above definition still controversial — e.g. military aid can be bothcommercial and concessional (thus, often excluded)

11


• basically, foreign aid = official grants + concessionary loans (in currencyor in kind)

• Further measurement problems:

— how to aggregate together (value) different loans and grants withdifferent significance to donor and recipient countries

— tied-aid: either by source (the country must buy products/servicesfrom the donor) or project (funds can only be used for specific purpose)

— nominal vs. real values

12


Data on public aid (Tables 14.2 and 14.3)

• the official name of ‘foreign aid’ is official development assistance(ODA) = bilateral grants + loans + technical assistance + multilateralflows (e.g. IMF, WB)

• grew from $5 bln in 1990 to $100 bln in 2005 (nominal values)

• as % of developed countries GDP, fell from 0.5% in 1960 to 0.33% in2005

• “ODA is allocated in some strange and arbitrary ways” (not really)

— S. Asia where more than 50% of the world’s poorest people live receives$6 per person in aid

— Middle East and N. Africa with well over triple S. Asia’s GDP percapita receive 14 times the per capita aid (Table 14.3)

— Iraq ($750 per capita) and Afghanistan ($93 per capita) are the largestrecipients in 2005; vs. India ($2 per capita)

13


Table 14.2 Official Development Assistance Net Disbursements from Major Donor Countries, 1985, 2002, and 2008


Table 14.3 Official Development Assistance (ODA) by Region, 2008


— 1976-2004 Israel (not an LDC) and Egypt were the two countriesreceiving the most of US foreign aid; now Iraq

— obviously the allocation of aid is mostly politically (militarily)determined, not by need

14


Why donors give aid?

• primarily because of political, strategic, or economic self-interest

• very little ‘humanitarian’ reasoning (mostly disaster relief)

• Political motives:

— the Marshall Plan (restart the economies of Western Europe to containspread of communism)

— special interests: over the period 1950-2000 US aid patterns switchedfrom S. Asia, S-E. Asia, L. America, Middle East, Central America,Eastern Europe, Middle East again

— similar patterns in the aid by other major donor countries like Japan,Britain, France — mostly propping up ‘friendly’ regimes, formercolonies, etc.

• Economic motives for aid (discussed earlier in the course)

15


— based on the ‘financing gap’ model; aid as supplement to domesticsavings in investment

— zero empirical support for this theoretical model — aid uncorrelated withsubsequent investment and investment uncorrelated with subsequentgrowth (remember Easterly, ch. 3)

16


Why developing countries accept/ ask for aid?

• LDCs willing to accept aid even under seemingly stringent terms

• the economic rationale — aid as supplement to domestic resources...

• LDCs would like less tied-aid or strings attached and longer-term loans

• a moral hazard problem — if no conditions attached, would this moneybe used for what is promised?

• but a moral hazard problem often exists on the donor’s side (especiallyIMF, World Bank) — they need to spend the aid budget no matter whatotherwise it may get cut next year — hard to impose conditionality

• many times LDCs take aid because it is readily given and no one is heldaccountable

17


• in fact, by remaining poor you can secure more foreign funds than if yougrow (see more in Easterly ch. 6 and below)

• military aid — accepted/given for security/strategic reasons

• role of NGOs — growing but small-scale relative to bilateral andmultilateral assistance flows ($1 bln in 1970 to $14 bln in 2005)

• randomized trials and field experiments — new promising methods ofpolicy evaluation (but can these small-scale results be scaled up?)

18


The loans that were, the growth that wasn’t (Easterly ch. 6)

• 1980s — push for aid/loans to developing countries conditional on theirimplementing packages of ‘reforms’

• triggered by some countries (e.g. Mexico) unable to service their foreigndebt by private borrowing

• idea of adjustment loans — money lent on the condition that recipientswill adjusts their policies and promote growth (does this remind you ofanything?)

• in 1980s IMF and the World Bank gave an average of 6 adjustment loansto each country in Africa; 5 to each in L. America; 4 in Asia.

• result: figure 6.1 — ‘much lending, little adjustment and little growth’(only some E. Asian countries grew)

19

Easterly, William. Elusive Quest for Growth : Economists' Adventures and Misadventures in the Tropics.Cambridge, MA, USA: MIT Press, 2002. p 103.http://site.ebrary.com/lib/sfu/Doc?id=10229607&ppg=118

Copyright © 2002. MIT Press. All rights reserved.May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S.or applicable copyright law.

Elusive Quest for Growth : Economists' Adventures and Misadventures in ... http://site.ebrary.com.proxy.lib.sfu.ca/lib/sfu/docPrint.action?encrypted=...

1 of 1 12/3/2010 8:46 AM


— behind these average are some success stories (Ghana improved to1.6% GDP growth from -1.6%; Thailand, Korea, Peru)

— ...but many failures: Zambia (12 adj. loans in 1980-1994 equaling 1/4of its GDP yet inflation was over 40% most of the time)

— countries with triple-digit inflation received as much lending as thosewith single-digit — what happened to the conditionality?

— similar experience in Eastern Europe in the early, mid- 1990s — manyloans, little ‘adjustment’; high inflation

• Aid systematically going to countries with bad policies as indicated bythe ‘black market premium’ (Table 6.1)

• budget deficits? Cote d’Ivoire received 18 adj. loans 1980-1994 whilethe country’s budget deficit ran at 14% of GDP 1989-1993; Pakistan —still receiving loans to adjust its budget deficit (which is not adjusting)

• negative real interest rates, Table 6.2 (huge signal for a non-growing,badly functioning economy) — continuing recipients of aid withoutshowing any improvement

20




1 of 1 12/3/2010 8:47 AM




1 of 1 12/3/2010 8:48 AM


• corruption and aid

— Congo/Zaire, Bangladesh, Liberia, Haiti, Paraguay, Guyana andIndonesia were topping the corruption rankings in late 1980s-early1990s

— together these countries received 46 adj. loans from IMF and WB,including dictator Mobutu Sese Seko of Zaire with 9 loans

• pretending to adjust — Easterly goes over various accounting and othertricks countries do to justify receiving the next loan

— governments who are irresponsible before receiving the loan have noincentive to change after receiving it (e.g. cut public goods, roadmaintenance)

— governments who eat away at the future by incurring debt find waysto eat away the future in various other ways

• the ‘who guards the guardians’ problem — no incentives for WB, IMF todo due diligence on their loans

21


Foreign aid — a plethora of badly aligned incentives

• if donors did care about the poor this makes threats of cutting off futureaid not credible (‘lack of commitment’ or ‘rotten kid’ problem)

• since countries with the largest poverty problems get more aid, they havelittle incentive to improve a little (and get less aid)

• How to fix this? Paradoxically, the poor would be better off if an agencywho did not care about them were in charge of distributing aid (cancredibly commit to withhold aid if conditions not met)

• country departments in IMF, WB and their budgets dependent on loanactivities performed — if you cut loans, get lower budget next year

• new loans often given for countries to pay back interest on old loans sothat no loans are declared ‘non-performing’ (bad publicity)

22


Easterly’s aid reform proposal:

• rank countries according to actual policy performance (not promises) andgive aid to those higher up the list

• in the 1980s — no correlation between policy performance (measured bystandard indicators, e.g. corruption, inflation, black market premia) andaid given

• reversing the direction from past good policy (improvement) to aidinstead of what currently is past bad policies (to be poor now) to aid

• aid should increase as incomes rise in poor countries, not decrease asnow

• align incentives and help countries by giving them incentives to helpthemselves.

23


• a word on debt-forgiveness

— “debt forgiveness grants aid to those recipients who have best proventheir abilities to misuse the funds”

— debt-relief may only work if (1) there has been a proven change (i.e.need to wait and see) in government to one with good policies and (2)it is a one-time measure that will never be repeated (to avoid moralhazard problems)

— in practice (2) above is pretty much impossible to implement politically(see the recent ‘too-big-to-fail’ debate)

24

econ 355w - a. karaivanov lecture notes ch. 14 foreign ...akaraiva/ch14notes.pdf · econ 355w - a....

Documents