International flow of financial resources to developing countries

Ch. 14 Foreign finance, investment and aid (rough notes, use only as guidance; 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 one country 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 in 2002, $335 bln in 2005 reasons: globalization MNCs but also developing countries opening up 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 is problematic 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 of their 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 were as prominent (see Easterly s ch. 6 for more detail on those times) 3

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 had worldwide sales of more than $150 bln in 2004 (in total larger than the 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 many governments of small LDCs still, remember from fig. 14.1 that most FDIs are directed from developed to developed countries, and (some) competition in virtually all sectors exists 4

Historically, in LDCs these firms were into extracting resources, but more recently 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 may then lead to higher growth (remember the Solow, Harrod-Domar models) 2. alleviate current account deficit (goods imports > exports); generate future exports 3. source of tax revenue 4. perhaps most important in the long-run MNCs can help spread new technologies 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; tariff protection, public subsidies (but whose fault is that?) 4. uneven impact on development mostly urban focus, possible increase in inequality 5. MNCs use their large bargaining and financial power to influence government policies (tax rebates, transfer pricing; tax competition) 6. suppressing local entrepreneurship (but why it didn t develop there before?) 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 those who did not and have reduced poverty due to the beneficial effect of income 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 firms and governments very high returns on investment possible in so-called emerging stock markets (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 the right 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 than aid and portfolio flows); some of this due to improved accounting and recording of financial transactions uneven distribution fig. 14.5 10

3. Foreign aid in theory, all government and resource transfers from one country to another 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 of view 2. should have concessional terms ( below market rates) above definition still controversial e.g. military aid can be both commercial and concessional (thus, often excluded) 11

basically, foreign aid = official grants + concessionary loans (in currency or in kind) Further measurement problems: how to aggregate together (value) different loans and grants with different significance to donor and recipient countries tied-aid: either by source (the country must buy products/services from 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 + multilateral flows (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% in 2005 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 $6perpersoninaid Middle East and N. Africa with well over triple S. Asia s GDP per capita receive 14 times the per capita aid (Table 14.3) Iraq ($750 per capita) and Afghanistan ($93 per capita) are the largest recipients in 2005; vs. India ($2 per capita) 13

1976-2004 Israel (not an LDC) and Egypt were the two countries receiving 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 contain spread of communism) special interests: over the period 1950-2000 US aid patterns switched from 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, former colonies, etc. Economic motives for aid (discussed earlier in the course) 15

based on the financing gap model; aid as supplement to domestic savings in investment zero empirical support for this theoretical model aid uncorrelated with subsequent investment and investment uncorrelated with subsequent growth (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 money be used for what is promised? but a moral hazard problem often exists on the donor s side (especially IMF, World Bank) they need to spend the aid budget no matter what otherwise it may get cut next year hard to impose conditionality many times LDCs take aid because it is readily given and no one is held accountable 17

in fact, by remaining poor you can secure more foreign funds than if you grow (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 and multilateral assistance flows ($1 bln in 1970 to $14 bln in 2005) randomized trials and field experiments new promising methods of policy 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 their implementing packages of reforms triggered by some countries (e.g. Mexico) unable to service their foreign debt by private borrowing idea of adjustment loans money lent on the condition that recipients will adjusts their policies and promote growth (does this remind you of anything?) in 1980s IMF and the World Bank gave an average of 6 adjustment loans to 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

behind these average are some success stories (Ghana improved to 1.6% GDP growth from -1.6%; Thailand, Korea, Peru)...but many failures: Zambia (12 adj. loans in 1980-1994 equaling 1/4 of its GDP yet inflation was over 40% most of the time) countries with triple-digit inflation received as much lending as those with single-digit what happened to the conditionality? similar experience in Eastern Europe in the early, mid- 1990s many loans, little adjustment ; high inflation Aid systematically going to countries with bad policies as indicated by the black market premium (Table 6.1) budget deficits? Cote d Ivoire received 18 adj. loans 1980-1994 while the 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 without showing any improvement 20

corruption and aid Congo/Zaire, Bangladesh, Liberia, Haiti, Paraguay, Guyana and Indonesia were topping the corruption rankings in late 1980s-early 1990s 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 other tricks countries do to justify receiving the next loan governments who are irresponsible before receiving the loan have no incentive to change after receiving it (e.g. cut public goods, road maintenance) governments who eat away at the future by incurring debt find ways to eat away the future in various other ways the who guards the guardians problem no incentives for WB, IMF to do 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 future aid not credible ( lack of commitment or rotten kid problem) since countries with the largest poverty problems get more aid, they have little incentive to improve a little (and get less aid) How to fix this? Paradoxically, the poor would be better off if an agency who did not care about them were in charge of distributing aid (can credibly commit to withhold aid if conditions not met) country departments in IMF, WB and their budgets dependent on loan activities performed if you cut loans, get lower budget next year new loans often given for countries to pay back interest on old loans so that no loans are declared non-performing (bad publicity) 22

Easterly s aid reform proposal: rank countries according to actual policy performance (not promises) and give aid to those higher up the list in the 1980s no correlation between policy performance (measured by standard indicators, e.g. corruption, inflation, black market premia) and aid given reversing the direction from past good policy (improvement) to aid instead of what currently is past bad policies (to be poor now) to aid aid should increase as incomes rise in poor countries, not decrease as now align incentives and help countries by giving them incentives to help themselves. 23

a word on debt-forgiveness debt forgiveness grants aid to those recipients who have best proven their 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 moral hazard problems) in practice (2) above is pretty much impossible to implement politically (see the recent too-big-to-fail debate) 24