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FDIs: Is the Left right after all?

T C A Srinivasa-Raghavan | August 20, 2004

It is hard to stop laughing at economists when you read this outstanding paper*.

One the one hand, it shows how little they agree with each other, probably because for every piece of empirics someone trots out, someone else wheels in an equal but opposite set of empirics.

On the other hand, it shows that the Left could have been right all along -- you really don't need large dollops of foreign investment to get growth going.

Joshua Aizenman, Brian Pinto and Artur Radziwill set out to see if foreign direct investment makes any difference to the rate of growth. It turns out that it doesn't.

"There is no evidence," they write, "of any 'growth bonus' associated with increasing the financing share of foreign savings. In fact, the evidence suggests the opposite: throughout the 1990s, countries with higher self-financing ratios (the share of domestic capital that was financed by domestic savings) grew significantly faster than countries with low self-financing ratios."

Not just that. It also turns out that, "on average, 90 per cent of the stock of capital in developing countries is self-financed, and this fraction was surprisingly stable throughout the 1990s."

And, to follow the Shourie writing style, not just that either. "Higher volatility of the self-financing ratios is associated with lower growth rates and better institutions are associated with lower volatility of the self-financing ratios."

And then the knock-out punch, "Financial integration may have facilitated diversification of assets and liabilities, but has failed to offer new net sources of financing capital in developing countries."

In other words, not only does it not matter very much if you don't have FDI, it can actually make things worse if you have too much of it.

This paper is so amazingly well argued, and provides such a comprehensive review of the literature, that it should become a must read for all students of economics. It takes apart the case for FDI nut by shiny nut, bolt by stubborn bolt.

Thus, it finds that there has been little change in the pattern of financing ratios of developing countries. In fact, the critics of foreign investment have been bang on because "greater financial integration has resulted in inflows of foreign saving financing outflows of domestic saving, with little net impact on financing ratios."

There is also the one number that, hard as you might try, you cannot ignore -- on average, 90 per cent of the stock of capital in developing countries is self-financed and it has remained stuck at that level, never mind the tide of financial liberalisation.

So what does FDI achieve then? Two things, it seems.

One, it improves the "quality of growth", presumably because of the accompanying inflows of technology. Two, it results in greater financial asset diversification, meaning it forces national governments to adopt policies that provides for diversifying risk.

What are the welfare gains from these two fallouts?

No one really knows, say the authors and add that "welfare effect of diversification is mixed in the presence of political polarisation, where capital movements are motivated by the attempts to reduce the tax base available to future administrations."

One may, therefore, legitimately ask: how did this hype about FDI come about? The major part of the answer lies in the US pumping dollars after it walked away from the Bretton Woods system in 1971.

These dollars have always needed investment destinations. It is this that has driven globalisation, the demand for capital account convertibility and the liberalisation of FDI rules.

Economists, such as the right wing Martin Feldstein, who heads the National Bureau of Economic Research, gave the demand respectability by clothing it in the intellectual garb of savings-investments "correlations as a measure of capital mobility."

The brat pack then followed with the chorus. A hundred one-sided flowers bloomed.

Sovereign power, which naturally seeks to protect domestic capital, then came into the game by blocking foreign capital. The owners of global capital have since then sought to devise ways and means (including persuading influential economists to hold forth) to further the cause of FDI.

Without stating things in such a crude (but accurate) manner, the authors have nevertheless blown a huge raspberry at the prevailing orthodoxy. It is likely that the large number of economists who have made a career out of pushing FDI will ignore it.

More is the pity because closed minds in open economies run the risk of looking ridiculous.

*Sources for Financing Domestic Capital -- Is Foreign Saving a Viable Option for Developing Countries? NBER Working Paper No. 10624, June 2004.



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Number of User Comments: 12




Sub: DFI band left view

atlast the voice of sanity and reason is being understood.We need overall better ecpnpmic management rather just flow of FDI.


Posted by arif siddiqui





Sub: Shape economy differently

FDI or no FDI the economy has to expand at a 10% rate perhaps for the next 15 years to eradicate poverty from this country. ...


Posted by prakash





Sub: Yah yah

Fine everybody. Let's go back to the good old pre-nineties. Only Fiat or Ambassador cars. Let's all be be happy in those good old days.


Posted by Paritosh Uttam





Sub: Some FDI s are needed

I dont agree with the research report in all sense..though I do belive that you need to protect your industry and domestic capital ( which ...


Posted by Indian Lover





Sub: Good one

One of the better articles on economy. Rediff always reports Left front as an evil. For once they justified left stand on FDI, it is ...


Posted by Sunil Chandrashekharan




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