12:14 PM May 29, 1997


Geneva, May 28 (Kanaga Raja) -- Although globalization of trade and production is now holding the centre stage in the current international economic scene, with world trade exceeding global income growth over much of the post-war period, it is financial globalization which has expanded at an even more rapid pace.

The impact and form of international lending has been varied over time, with syndicated bank lending dominating the 1970s and portfolio flows dominating the 1980s. This current period is being dominated by foreign direct investment (FDI) which is currently considered to carry lower risks than the earlier forms of lending.

An assessment of the risks associated with the increasing reliance of developing countries on FDI and some of the potential difficulties faced by these countries in maintaining domestic economic policy autonomy, exchange rate policy and domestic financial stability has been provided by J.A. Kregel, Professor of Economics at the University of Bologna, Italy in a paper titled "Some Risks and Implications of Financial Globalization for National Policy Autonomy" in the UNCTAD Review of 1996.

The factor that appears to distinguish the rapid international economic integration initiated in the 1980s, says Kregel, is the globalization of finance. It is not uncommon to speak of a 24-hour-a-day global capital market, with financial service providers operating on a continuous basis.

Such cannot be said for manufacturing firms, as there is yet no truly global market for manufactured goods nor truly global production where manufacturers are indifferent to the location of production processes, although some firms have begun to integrate their production processes and sales on the basis of geographical location.

While one can imagine a process whereby each individual step in the production process can be allocated to its most efficient global location, adjusted on a real time basis according to changes in relative costs and prices, that day may be some way off.

One of the reasons for this is that capitalistic production still requires a minimum of fixed capital, which can create certain "inefficiencies" since it is not spatially mobile without cost. Spatial and temporal immobility of physical production capacity has given rise to the rapid growth of financial markets, as they provide an antidote for the "fixity" of productive capacity.

One of the reasons for the increased global dispersion of production facilities is to provide a more flexible response to global changes in interest and exchange rates.

A diversified portfolio of production sites enables a firm to respond quickly to changes in cost conditions as a result of changing interest and exchange rates. In this respect, the advance in computer and telecommunications technology has helped increase the flexibility of production and reduced the adjustment costs associated with the shifting of the global location of production.

Kregel says that, it is the increased variability of international costs and prices due to flexible exchange and interest rates that has been the driving force behind the financial innovations that is currently dominating the globalization process.

The problems associated with the increasing importance that developing countries place on international capital flows are not new. From the experience of the past 20 years, too much foreign capital, in the form of syndicated bank lending in the 70s, is just as bad as too little (the withdrawal of private bank lending in the 80s). What is even worse is one passing rapidly to the other, for example, the rapid reversal of portfolio capital flows in the 90s.

From these experiences, developing countries have found it prudent to avoid private bank lending for medium and long-term financing requirements. Instead, it has been recommended that they rely more on "non-debt-creating" financing. This is in itself an oxymoron, as all financing gives rise to repayment obligations.

"Non-debt-creating" financing refers to private portfolio and foreign direct investment flows. This type of financing is preferable, due to its repayment conditions. With syndicated bank debt comes a foreign-currency denominated fixed interest charge which resets periodically to reflect the international capital market interest rates.

Private portfolio investment flows, however, do not have these characteristics. They are denominated in the currency of the receiving country; the returns payable are variable and are adjusted on the basis of ability to pay and payment is in the domestic currency. Also, the value of the amount invested is a variable determined by domestic assets market and foreign exchange market conditions, where declining prices and/or market illiquidity can act as a deterrent to attempts to enforce payment.

As a result, direct investment is now considered as the preferred alternative source of foreign capital to aid domestic growth. FDI is considered as an investment in "domestic bricks and mortar" which once installed, cannot be easily repatriated and represents a permanent contribution to a country's resources. The Asian development experience is often seen to give support to this impression.

However, in the light of recent Latin American experience with the volatility of portfolio flows, doubts have been raised about the benefits of such flows relative to direct investment.

In evaluating the idea of FDI contributing to a country's growth process, Kregel says, that at one time, bankers considered sovereign country debt as virtually without risk, since a country could not be declared bankrupt. The question that is now to be faced is whether there are similar unanticipated consequences awaiting developing countries as a result of excessive reliance on FDI flows.

For example, if one considers the distinction between portfolio flows and FDI, which was created to distinguish between foreign and domestic control of productive assets, the presumption is that investment for the purpose of controlling the decision-making processes of an enterprise is more or less of permanent character.

The concern about excessive foreign control of domestic production initially related to the question of effectiveness of economic policy on domestic economy and the autonomy of domestic policy makers. A policy measure, for example, to remedy a balance of payments crisis could invariably lead to a foreign owner to close down his plants and move elsewhere. Thus, this could restrict the policy options available and increase domestic difficulties.

As a result of such concerns, the definitions of FDI have become synonymous with the degree of control being exercised by a foreign investor, rather than with the permanence or physical mobility or volatility of an investment.

The IMF defines FDI as "the category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy" and the OECD defines it as "investment that involves a long-term relationship reflecting a lasting interest of a resident entity in one economy (direct investor) in an entity resident in an economy other than that of the investor. The direct investor's purpose is to exert a significant degree of influence on the management of the enterprise resident in the other country"

The definitions of FDI however, do not take into account the rapidly increasing facility with which developed country investors obtain and discharge control of companies through mergers and acquisitions. Companies themselves have become commodities to be traded daily in the markets for corporate control.

Even if FDI were to be redefined to include only investments deemed to be more of a quasi-permanent nature, it does not mean that FDI would have a substantially different effect on capital flows and exchange rate management than other types of flows.

Innovations in financial markets have come a long way to eliminating the concept of a "permanent" investment in plant and equipment in much the same way that the concept of "maturity" of a financial investment has been done away with.

For example, purchasers of 30-year US government bonds were considered to be permanent or "long-term" investors, but at the hands of financial wizards these days, a 30-year bond can be re-engineered to produce 61 zero coupon bonds with maturities of 6 months to 30 years.

Thus, the purchase of a long-term bond need not mean a "long-term" holding and the holding can be converted into any desired time horizon without selling the original long-term bond.

Other examples are futures and options contracts where investors are allowed to hold ownership of long maturity assets but reduce permanence of the investment as well as exposure to market risks and sale and repurchase (Repo) markets, which allow investment positions to be maintained with minimal commitment of their own funds.

Can the same be applied to FDIs?

According to Kregel, an investor can continue to own the bricks and mortar without retaining the foreign country risks, foreign exchange risks and so on, associated with their "permanent" or immobile nature. Most financial assets today don't move, being located in central depositories or as electrical charges in computers.

A recent World Bank study also notes this point: " Because direct investors hold factories and other assets that are impossible to move, it is sometimes assumed that a direct investment inflow is more stable than other forms of capital flows. This need not be the case. While a direct investor usually has some immovable assets, there is no reason in principle why these cannot be fully offset by domestic liabilities. Clearly, a direct investor can borrow in order to export capital, and thereby generate rapid capital outflows"

When hedging the risks of any investment, the financial intermediary providing the risk coverage would have to engage in direct foreign exchange or capital market transaction at some point in time and the coverage is usually the highest where the uncertainty over stability of exchange rate or of domestic financial conditions is the greatest.

Home country firms keep balance sheets in their domestic currency and foreign investments represent currency risks in the same way as any other use of company funds and this will be hedged in the same way. The risks covered would produce cross-border flows that puts further pressure on the foreign exchange market or domestic money market.

The benefit of the absence of scheduled interest and principal repayments, is another aspect of FDI investments that is overlooked. This gives rise to the impression that no payments need to be made to foreigners and therefore no drain on the foreign exchange reserves. However, foreign direct investors do not invest without the expectation of being repaid, with profit. FDI is not an unconditional gift to a developing country but is an investment against the expectation of profit earnings and eventual repatriation or relocation of the investment.

From the point of view of a lender of funds, the highest risks are those associated with FDI, and the lowest with bank-syndicated sovereign lending. This is not due to the permanence of the FDI investment, but due to the fact that they are less standardized and thus more costly to hedge. A combination of factors contributes to the higher risk, that is the reduced amount of information regarding the assets; difficulties in operating in foreign cultures; and the fact that investors prefer to keep their investments at home where they can keep an eye on them.

Consequently, the lender's risk premia attached to the FDI will normally be the highest among the alternative forms of lending and investors will expect to be compensated for the higher risks.

The implication of this is that FDI is certainly the most costly method of borrowing capital, especially from the South's point of view.

Indeed, most international companies apply an implicit hurdle rates of return in the range of 20 to 25% per annum over a relatively short recoupment period. It seems a contradiction that while developing countries are being recommended FDI as the least risky form of foreign borrowing, the foreign lender considers it as the most risky. Instead, developing countries should assess borrowing in terms of risk-adjusted cost of capital.

Kregel adds that another aspect of FDI that is overlooked is the problems associated with a range of assets included in the FDI measures. Statistics suggest that in most countries that have benefitted from foreign investment, the greatest proportion of FDI is from the reinvestment of profits from prior FDI.

Although FDI does not represent a charge on foreign exchange reserves, the reinvested profits however, would represent a claim on reserves as they are recorded as current account outflow, which is offset by an entry into the capital account as an FDI inflow.

While the recipient country may regard these profit reinvestment as equivalent to direct investments, the foreign investor may consider them to be a delayed return on the original investment. Thus it may instead be invested by the foreign owned subsidiary in highly liquid domestic financial assets in anticipation of future repatriation. Although they are recorded as FDI flows, they may take the form of short-term portfolio investment. As a consequence, it may prove difficult to assess the condition of a country's balance of payments.

This situation can be further complicated if the FDI flows are used to finance investments in productive facilities requiring large proportion of specialized imported capital goods and semi-finished goods for domestic assembly and sale to the domestic markets. While the creation of additional exports, re-export of assembled finished goods or recorded reinvestment of profits may offset these imports, it may still prove to a net drain on reserves since the portion of FDI flows created by reinvested profits des not represent actual foreign currency inflows

Therefore, the proper assessment of impact of FDI depends on factors such as the proportion of reinvested earnings in current FDI flows, the destination of these earnings, the proportion of imports in FDI and the proportion of exports in the output of foreign affiliates.

Kregel adds that one of the greatest potential difficulties associated with FDI, will be related to the reinvestment of the current cash flows from operations (representing not only accounting profits but also accruing depreciation allowances) of FDI investments as they will be accumulating at compound rates over time. For example, if you consider a country with tiger-like growth rate of 10% per annum and an initial once and for all net FDI inflow of 10% of national income and full reinvestment of profits, if the FDI returns the expected 25% per annum, after 18 years it would have an accumulated stock of FDI representing foreign claims equal to its national income!

If a country which has settled into an equilibrium on its external accounts and accommodates the assumed FDI inflow in the form of a current account deficit, any national or international event which causes foreign investors to stop or reduce the levels of FDI inflows will be sufficient to provoke a foreign exchange crisis. Unless FDI flows are truly permanent -- where neither profits nor principal are repatriated -- the more successful a country is in attracting FDI and the FDI is in terms of generating returns, the greater the risk of FDI flows producing fragility in a country's current account position and thus on its foreign exchange rate.

The difficulty arising for a developing country is in assessing what proportion of FDI flows is indeed permanent, and what the short and long-term impact on trade flows and foreign exchange reserves will be. The higher the return on investment and the higher the proportion of reinvested earnings in the total FDI stock, the less permanent the FDI stock will be and thus the greater the threat to the balance of payments and exchange rate stability.

Thus, FDI flows could have both a short and longer-term structural influence on the country's external payment flows. Accumulated foreign claims in the form of accumulated FDI stocks may create a potentially disruptive effect on any domestic or external policy goals.

This was evident in countries such as Germany in the 1960s and 70s, where direct controls was placed on capital inflows in order to prevent disruption of exchange rate stability.

The impact of FDI flows on economic policy is independent of the problems arising as a result of the response of short-term portfolio flows to traditional stabilization policies.

A successful reduction in the inflation rate usually involves an appreciation of the real exchange rate, causing domestic producers difficulties in adjusting to foreign competition and also causing a deterioration in the trade balance.

If there has been a good deal of indexing, the fall in inflation rate may cause consumers to attempt to take advantage of what may appear to be a temporary lull in inflation. Consumption expenditures may rise thus putting pressure on domestic prices and bringing in additional imports.

Therefore, Kregel says, a too rapid short-term improvement in inflation may thus impede the longer-term process of adjustment of productive capacity to a more open and competitive market environment. These factors may be aggravated if the increase in interest rates together with an improving fiscal and inflation outlook attract portfolio capital inflows.

Although this will also aggravate the foreign balance but may temper the negative impact of rising real interest rates, this will be countered by an upward pressure on the exchange rate. If the central bank intervenes to stabilize the exchange rate, it will have to do this by purchasing foreign assets and this will be accompanied by increased money base growth. The effects associated with purchase of foreign assets can create an endogenous deterioration in government accounts, increasing the interest burden and offsetting policies to restrict government deficits.

The foreign balance may continue to deteriorate, while little real adjustment takes place. Part of this adjustment should be increasing investment at the expense of imports and consumption, however, this is made doubly difficult because imports are subsidized by the improving exchange rate and investments are penalized by both financing costs and decline in foreign competitivity. This is more or less referred to as the Tequila syndrome.

This syndrome is particularly telling when a crisis hits, as in the case of Mexico, it was estimated that no more than 20 to 30% of Mexico's production could be re-oriented towards export markets. The restructuring as a result of domestic stabilization policy in 1989 did not get under way till after the collapse of the exchange rate in 1994.

In Mexico's case, the government clearly lost control over monetary policy, after voluntarily relinquishing control over fiscal policy as a result of the stabilization programme.

It should be noted that it was the government that adopted globalization as the integral part of its stabilization programme and while increased globalization of the economy has without doubt, sharply reduced policy autonomy, the loss of sovereignty is not due wholly to the impact of globalization. It is also due in part to the acceptance of a particular type of economic stabilization, based on market liberalization and monetary targeting, that has increased volatility in both money and foreign exchange markets.

Therefore, if the money supply target has been set as part of a stabilization programme, this may force the government or central bank to sterilize capital inflows.