Is Foreign Investment Beneficial to the Developing Countries ?

Types of Foreign Investment and its Implications for Developing Countries

With the opening of the economies of the world, there has been a concomitant increase in the flow of investment from the west to the east.

As capital from the west started flowing into the developing countries in search of better yields, these countries are experiencing the effects of such investment.

While there are many benefits to the flow of foreign investment to the developing countries, there are downsides as well. Before delving into these effects, it would be useful to consider the categories of foreign investment that flow into the developing countries.

First, there is the FDI or the Foreign Direct Investment, which comprises the flow of capital into sectors that are opened up to foreign investment. This form of direct investment into these sectors usually is done through the setting up of plants, factories, and establishments either through joint ventures or through wholly owned subsidiaries.

The second form of foreign investment is the foreign institutional investors who invest in equity markets and bond markets of the developing countries as a policy of investment that is indirect. The crucial difference between these two types of foreign investment is that whereas FDI is longer term and less prone to capital flight in emergencies, the flow of foreign money into stock markets is what is known as “hot money” or money that can exit the country at short notice.

The Benefits of Foreign Investment

Hence, the fact that FDI is preferred more by developing countries become clear when one considers the deep and the longer-term nature of these flows. However, this does not mean that investments in equity and bond markets are not welcomed. This is because many developing countries run large current account deficits, which have to be financed with dollars.

In other words, current account deficits are the difference between the imports and the exports that a country does and since many developing countries import more than they export, there needs to be a mechanism through which the deficit is financed. This is made possible by the investment in bonds and equities.

On the other hand, FDI is suitable for generating jobs and creating conditions for future prosperity. Moreover, FDI comes with the added advantage of technology and knowledge transfer, which is beneficial to the developing countries. Therefore, as can be seen from this explanation, both FDI and hot money are attractive in terms of the usefulness they have to developing countries.

The Downsides of Foreign Investment

However, the downsides of these investments are that whenever there is a crisis like the recent economic crisis and the Asian financial crisis of 1997, there tends to be outward flows of foreign capital as panicky investors flee the developing countries markets lest they lose out in the process of the crisis eroding their investments. This is the key downside of foreign investment.

Further, even FDI or capital investment can flee the developing countries if they have full capital account convertibility or the provision for the foreign companies to quickly convert their holdings in domestic currencies back to their home currency, which in many cases is the United States Dollar.

Hence, the implications of FDI and Hot Money have to be clearly understood by policymakers before they commit themselves to opening up their economies.

Indeed, as the experiences of China and India illustrate, the gradual opening up of the economy and the careful monitoring of flows of hot money are needed for developing countries to withstand currency shocks and liquidity crunches.

Closing Thoughts

Finally, in this globalized world, no country can be immune to the flow of foreign capital from the West. Hence, prudence and caution must be exercised before committing one’s economy to be open to foreign capital.

If there are any lessons to be learnt from the Asian Financial crisis of 1990s, it is that foreign capital is as fickle as it is fun to have and hence, when the party is over, it would be the first to leave.