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PPI | Fact Sheet | April 1, 2020
International Capital Flows, Foreign Investment, and Trade
By Jenny Bates

In the wake of the Asian financial crisis, policymakers, governments, and academics around the world are busy devising ways to reform the global financial architecture. The plethora of articles, speeches, and essays on this topic, however, has failed to produce a consensus on the path that reforms should take, largely because the issue is highly complex. On the one hand, foreign investment brings clear benefits. International investors provide an extra pool of lenders for borrowing nations-- particularly developing countries where capital is scarce--increasing liquidity, lowering the costs of borrowing, and raising output. With foreign direct investment (such as the building of a factory), the host country may also derive benefit from positive spillover effects such as new technologies, ideas, and skills. Even the often-criticized speculative capital flows enable investors to hedge against risk (such as exchange rate fluctuations).

On the other hand, there are some important potential costs associated with international capital flows. When domestic market structures in the recipient nation are anti-competitive or corrupt, foreign investment can involve the exploitation of market power or can increase market failures such as environmental degradation. Similarly, the recent financial crisis has highlighted the destructive effects of "contagion" in emerging markets--when a collapse of investor confidence in one nation (such as Russia) results in capital flight from a seemingly unrelated country (such as Brazil).1

Alarmingly, some commentators have reacted to the recent financial crisis by proposing extreme and ill-conceived measures, such as the imposition of stringent capital controls or the abolition of the International Monetary Fund (IMF). Such measures are based on illogical assertions and would hamper future economic growth and development. In order to identify and counter such misguided proposals, it is essential to have an understanding of the key facts surrounding the international allocation of investment and the key terms of reference for the ongoing debate.

Lessons for Policymakers

  • International flows of capital are a means to an end and not an end in themselves. International capital flows have the potential to bring a wide range of benefits to both the host nation and the country of origin, increasing global output, employment, and wealth. Whether international capital flows bring a net gain depends on the policies pursued by both the recipient and the host country, and whether there are well-designed inernational rules and institutions governing the interaction.

  • Both the volume and the nature of international capital flows have radically altered over the past two decades. After the second world war, foreign aid (or official finance) accounted for a significant portion of international borrowing and lending, particularly for developing countries. With the liberalization of capital and investment controls since the 1970s, the vast majority of foreign capital now comes from private investors, through capital markets (such as sales of bonds and equities) and international investment by multinational companies. Such changes logically require a different system of international rules and institutions and a new policy approach.

  • The United States is the world's number one recipient and provider of foreign direct investment. Indeed, the vast majority of international investment is between developedcountries, such as the United States and Europe, with relatively little flowing to developing or low-wage economies.

    International Sources of Capital

  • International Capital Markets. International capital markets enable domestic firms to sell stocks to foreign residents and national governments to sell bonds to foreign residents.2 International capital flows through stock markets have exploded over the past two decades. They now account for more than half of all flows from developed countries, compared to around 10 percent in 1975. The aggregate figures include both purely speculative activities and sales and purchases by individuals and institutions seeking higher returns or portfolio diversification.

  • Multinational Companies. Foreign firms bring capital into a country either through green field investment (such as the establishment of a factory or an office) or through mergers and acquisitions. In either case, the foreign capital may be human capital--skills, management techniques, etc.--as well as physical or financial. Investment overseas by developed country companies has also increased significantly over the past two decades. (see table below).

  • Commercial Bank Loans. Commercial bank loans refer to lending by foreign private banks. For example, when Citibank makes a loan to a firm in India. This form of international capital flow has faced relative (though not absolute) decline. In the 1970s, bank loans accounted for 45 percent of the capital outflows from the major industrialized countries, compared to less than 10 percent today.

  • Foreign Aid. Foreign aid can be either multilateral (e.g. through the World Bank) or bilateral (e.g. from the United States to Rwanda through US AID). It is most easily thought of as a grant from the donor nation or institution--although it is often a loan on concessional terms.3 Foreign aid has also declined in relative importance (though not in absolute terms) as it has been overtaken by private capital flows. While the United States was the second largest provider of foreign assistance in 1997 (behind Japan), the total value of that aid accounted for only 0.08 percent of U.S. GNP.4

    Capital Flows from the Major Industrialized Countries
    (Billions of U.S. Dollars)
    1975 1995
    Portfolio Investment (Capital Markets) 12.4 330.0
    Direct Investment (Multinational Companies) 34.7 215.0
    Bank Loans (Commercial Banks) 46.2 55.0
    Foreign Aid* (Governments/Multinational Institutions) 13.3 58.9
    Source: Global Public Policy, Wolfgang H Reinicke
    * OECD Data. Only includes flows from OECD countries to developing countries.

    What is Foreign Investment?

    Not all of the above capital flows constitute investment. Economists define investment as expenditure on productive, as opposed to expenditure on consumption. Hence, foreign investment is defined as the purchase of assets in Country A by residents of Country B. It is usually divided into two categories:

  • Foreign Direct Investment (FDI). This refers to investment where the foreign investor (from Country A) owns or controls the assets (in Country B).5 Examples include the building of a factory in the United States by a Japanese car manufacturer or a foreign takeover of an American firm. (For example, Burger King and Pillsbury are both owned by the British company Diageo).

  • Foreign Portfolio Investment. This refers to investment where a foreign resident provides the capital, but the activity is owned and operated by domestic residents. An example would be the purchase of a small number of shares in Microsoft by a Canadian investor or the purchase of U.S. government bonds by a British pension fund.

    Where the Foreign Direct Investment Comes From.....and Goes To

  • The United States is the world's largest recipient of foreign direct investment. In 1997, $90 billion worth of foreign direct investment flowed into the United States. This was far more than the next largest recipients of foreign capital, China ($42 billion) and the UK ($30 billion).6

  • The United States is also the world's number one provider of foreign direct investment. In 1997, the United States invested $115 billion overseas. This was double that of the next largest overseas investor, the United Kingdom.

  • The vast majority of international direct investment (60 percent of inflows and 85 percent of outflows) flows between developed countries with similar (high) standards and wages. Take, for example, the United States (see table below). Europe and Canada together receive two-thirds of U.S. overseas investment and provide three-fourths of the foreign investment coming into the United States. Indeed, high levels of overseas investment--in both directions--are often the result of open, transparent, and liquid capital markets and highly competitive, dynamic domestic economies.

  • In contrast to the claims made by many globaphobes (Ross Perot's "great sucking sound"), a similar pattern is true for manufacturing investment. In 1997, U.S. manufacturers allocated 65 percent of their FDI to countries with high wages and mature labor markets--a percentage that has remained stable over the past 10 years. Roughly one quarter of this investment goes to Canada alone.

  • The vast majority of investment flowing to the developing world is received by a few countries. China receives roughly one-third of these investments, and significant amounts also flow to the eight Asian Newly Industrialized Countries (NICs), Brazil, Mexico, and Argentina.7 Together, these twelve countries receive three-fourths of all FDI flows to developing countries.

    Major Direct Investment Partners of the United States (1997)
    Top 10 Recipients of U.S. Investment Millions of U.S. $$ Top 10 Providers of Investment to the United States Millions of U.S. $$
    1. United Kingdom 22,435 1. Germany 10,712
    2. Netherlands 14,329 2. Netherlands 10,274
    3. Canada 10,734 3. Japan 9,430
    4. Brazil 6,545 4. Canada 9,411
    5. Mexico 5,933 5. France 8,728
    6. Ireland 4,539 6. United Kingdom 8,582
    7. Hong Kong 3,770 7. Switzerland 8,255
    8. Singapore 3,676 8. Ireland 3,948
    9. France 3,166 9. Sweden 3,478
    10. U.K. Islands, Caribbean 3,008 10. U.K. Islands 3,444
    Source: Bureau of Economic Analysis, United States Department of Commerce

    Foreign Investment in Perspective

  • Globaphobes often imply that foreign investors are taking over the American economy--for example, the displacement of American car manufacturers by foreign companies. In fact, domestically sourced investment far exceeds foreign investment as the main source of capital formation in the world. In the United States, foreign direct investment accounts for only 5 percent of gross domestic investment and only 1 percent of GDP.

    Conclusion

  • Foreign investment has the potential to bring net benefits to lenders and borrowers in both developing and developed countries. Yet, whether the benefits are realized depends both on the market structures of the countries involved and the existence of international rules and institutions governing capital flows across national borders. Many of our current rules and institutions need to be reformed and updated to properly manage the new reality of significantly increased flows of capital reaching an increasing number of countries, at an increasingly rapid pace. When doing such redesigning, it is important to bear in mind that increased capital flows are a means to an end and not an end in themselves--the ultimate goal being increased output, employment, and wealth.

    Notes

    1. International contagion, however, may be rational from an individual investor's point of view--as he or she withdraws capital from the next riskiest or most liquid asset to minimize current losses.

    2. Note that residents may be individuals, firms, or governments.

    3. The OECD definition of aid is any loan with at least a 25 percent grant element.

    4. As a group, the OECD countries spent only 0.22 percent of their combined GDP on official development assistance in 1997.

    5. A controlling share is usually defined as an equity capital stake of 10 percent or more. In practice, the distinction is somewhat arbitrary.

    6. 1996 figures.

    7. The eight Newly Industrialized Countries (NICs) are Hong Kong, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan, and Thailand.

    Jenny Bates is the trade and economics policy analyst for the Progressive Policy Institute.



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