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Chapter Two

Theoretical Perspective of the Terms

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2.0 Introduction

It is generally believed that foreign capital plays a vital role in promoting economic

development of a country especially the Less Developed Countries (LDCs). The growth

of output of any economy generally depends on capital formation, and capital formation

requires investment and an equivalent amount of saving to match it. Therefore two of the

most important issues for developing countries are how to stimulate investment, and how

to bring about an increase in the level of saving to fund increased investment. The

analysis of these issues leads to the concept of Dual-Gap i.e. ‗the saving-investment gap‘

and ‗the trade gap‘ or ‗the foreign exchange gap‘ which usually exist in a developing

economy. Foreign capital has played an important role in the economic development of

many economically advanced countries of today. For example, between 1870 and 1914

the ratio of capital inflow to gross domestic capital formation was about 40 per cent in

Canada. The same ratio for Australia was about 37 per cent between 1861 and 1900, and

for Norway it was 29 per cent between 1885 and 1914 and 31 per cent between 1920 and

1929 (Hagen, 1975). Even in countries like Japan and the USA, where such ratios were

lower during their early stages of economic development, foreign capital played a

significant role.

In order to understand these terms in greater detail, each term has been discussed in

detail. Accordingly the chapter has been divided in two parts. In Part-I, various concepts

and terms which are part of the present study and will be used extensively later in the

study will be discussed. These terms are as follows:

1. Savings and saving rate

2. Investment and Investment rate

3. Foreign capital1- The Dual-Gap Analysis

4. Transfer of technology

5. External Debt

1 Here the term foreign capital is essentially referred as foreign resources or in the sense of foreign

borrowing. But ultimately they will take the form of capital.

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Whereas in Part-II various theories of FDI will be discussed as the present study has

primarily based on the concept of FDI, therefore it is imperative that we discuss the

theory of FDI in detail.

PART-I

2.1 The concept of Savings2

The understanding of the concept of saving is very important at this moment as in the

coming chapters we‘ll be using this term extensively. Therefore it is imperative to explain

the term in detail.

Meaning: Any income that is not spent is saving. In other words savings are that part of

income which is not spent on consumption. Ultimately savings are the source of the

investment in the economy. Therefore we can say that

S= Y-C (1)

Here S refers to savings, Y refers to Income and C refers to Consumption.

2.1.1 Types and Determinants of domestic saving: There are three broad groups in

society that save viz. (i) The Household sector, (ii) The Business sector and (iii) The

Government sector. The Household sector saves out of personal disposable income i.e.

personal saving, the business sector saves out of profits, and the government can save out

of tax revenues but only when it spends less than what it receives on current expenditure.

Household and business saving taken together referred as private saving, while the

government saving is known as public saving. There are basically three types of private

domestic saving, each with their own different determinants. They are as follows:

(i) Voluntary savings: Voluntary savings are those savings that arise through voluntary

reduction in consumption out of disposable income for household and companies out of

profit. Therefore both household and business sector may be a source of this type of

savings.

2 The present analysis of saving has been drawn extensively from Thirwall (2003).

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(ii) Involuntary savings: These are savings that brought about through involuntary

reductions in consumption. All forms of taxation and schemes for compulsory lending to

governments are forms of involuntary saving.

(iii) Forced saving: These savings are the result of rising prices and the reduction in real

consumption that inflation involves if consumers cannot (or do not) defend themselves.

Rising prices may reduce real consumption for a number of reasons. Firstly, people may

suffer money illusion. Secondly, they may want to keep constant the real value of their

money balance holdings, so they accumulate more money and spend less as prices rise

(the real balance effect). Thirdly, inflation may redistribute income to those with a higher

propensity to save, such as profit earners. Inflation initiated by monetary expansion will

certainly redistribute income to the government as the issuer of money. This is the notion

of the inflation tax (Keynes, 1923).

Determinants of Voluntary Savings: Voluntary savings depends on the (a) capacity to

save and (b) the willingness to save.

The capacity to save depends on three main determinants,

(i) The level of per capita income: Keynes (1936), for the first time link, consumption

(and therefore saving) to the level of income through the concept of the consumption (or

savings) function. The relationship between savings and income is part of the Keynesian

absolute income hypothesis3. According to which, the consumption or savings function

is non-proportional; that is, that the rich (people or countries) consume proportionately

less, and save proportionately more, of their income than the poor. This idea can be

expressed is to start with the following savings function4:

(2)

Here is the level of savings per head of population (P), and is per capita income. The

negative constant term means that the marginal propensity to save is above the average,

3 This idea is based on Keynes‘s Psychological Law of Consumption, according to which, consumption of

an individual increases as his income increases but not with the same proportion.

4 This saving function has been discussed by Thirwall (2004).

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so raising the average as rises. To convert this function so that the savings ratio is the

dependent variable, multiply both sides of the equation by P and divide by Y. This gives:

(3)

where the savings ratio is a non-linear function of per capita income i.e. as rises,

rises but at a decreasing rate to the asymptote . We usually observed this relationship

between saving and income in various countries (Hussein and Thirlwall, 1999). The poor

countries has lower saving ratio than the rich countries and the relation is not linear. It

increases at a diminishing rate and then levels off (at approximately 25 percent of

national income).

(ii) Growth of income: The other important determinant of the domestic savings ratio,

apart from the level of per capita income, is the growth of income. This has been

suggested by the life-cycle hypothesis of saving (Modigliani, 1970) Figure- Life Cycle

Hypothesis

Figure 2.1: Life Cycle Hypothesis

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Thirwall (1999) explained the process of this hypothesis in the following manner.

Individuals and households attempt to spread out consumption evenly over their lifetime.

A typical pattern of behaviour as per this hypothesis would be dissaving in youth,

positive saving in middle-age, and dissaving in retirement and breaking even on death (on

the assumption of no legacy). Now if income is rising over time, it means that the life

earnings and consumption of each successive age group will be higher than the preceding

one. If each successive age group is aiming for a higher level of consumption in

retirement, the volume of saving of the active households will exceed the dissaving of the

currently retired households with a lower level of lifetime consumption. The savings ratio

will then tend to rise with the rate of growth of income because the higher the growth

rate, the greater the gap between the target levels of consumption of the current

generation of working households and the dissaving of retired people from a less

prosperous generation. Thus, countries with higher growth rates might be expected to

have at least higher personal savings ratios than countries with lower growth rates.

(iii) Distribution of income: Another potentially important factor determining the

capacity to save is the distribution of income. According to Thirlwall (2004), if the

propensity to save of the rich is higher than that of the poor, the aggregate savings ratio

will be positively related to the degree of inequality both in the personal distribution of

income, and also in the functional distribution between wages and profits on the

assumption that the propensity to save out of profits is higher than out of wages. The

transformation of countries from traditional agricultural economies through Rostow‘s

‗take-off‘ stage to maturity is bound to be accompanied in the early stages by widening

disparities between individuals, and a rise in the share of profits in national income. Some

individuals are more enterprising, and more adept at accumulating wealth, than others.

On the other hand, the willingness to save depends upon:

(i) The real rate of interest: The real rate of interest will affect saving positively i.e. there

is positive relationship between real interest rate and saving rate in the economy. As we

know the real rate of interest is adjusted to inflation rate i.e.

. (4)

Where r = real rate of interest, Nominal rate of interest and = rate of inflation

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(ii) The existence of financial institutions: The willingness to save also depends upon the

existence of the financial institution and the efficiency of the financial institutions in the

economy. It also indicates that how much the financial sector is developed in the

economy. Apart from these factors the willingness to save also depends upon

(iii) The range and availability of financial assets, and

(iv) The rate of inflation.

.

The above discussion was a brief introduction of the concept of saving. Now we would

focus on the next important term i.e. Investment.

2.2The concept of Investment

Keynes (1936) defined investment as the increment of capital equipment, whether it

consists of fixed capital, working capital or liquid capital. In other words investment

refers to capital formation – the acquisition or creation of resources to be used in

production. As such, it captures the production side of inter temporal

consumption/savings decisions. This approach to investment is also known as the

neoclassical approach.

2.2.1 Investment function: Investment mainly dependent on interest rate. It has negative

relationship with the interest rate. As the interest rate increases, the investment demands

falls and vice versa.

I= I0-h (i) (5)

Here I0 refers to Autonomous investment level i.e. that amount of investment which

remains constant or fixed irrespective of interest rate. The term h refers to marginal

propensity to invest

2.2.2 Types of Investment: We can distinguish between three groups of investment

types:

(i) Pure investment which enlarges the productive power, and increase to the stock of

capitalized commodities sometime also referred as capital formation.

(ii) Total investment which includes both the new capital, and the replacement capital

(known as Investments of Replacement).

(iii) Investment of Replacement which keeps the capital in value, size and quality.

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2.2.3 Determinants of Investment: Following are the main determinants of Investment

(1) Marginal Efficiency of Capital (MEC): MEC refers to the final profit or the

anticipated revenue (calculated taking into account the net profit and price of interest). If

the net profit is bigger than the price of interest, he will proceed investment, but if the

anticipated net profit is equal to the price of interest, the investor‘s decision depends upon

himself.

(2) Technological advancement: This factor is considered very important for ventures

tending to keep their competitive position in the markets. They always endeavor to

improve these positions, through keeping pace with the technological advancement which

leads to rising up the productivity in the project.

(3) Future anticipations of Demand: These anticipations play a great role in determining

the project investment, as the investor who expects more demand on his productions in

the future, will be more willing to invest, compared to the investor who expects low

demand on his productions.

(4) Profits rate: the expected profit of any project in any period of time is considered a

very important indicator for the demand situation of the products of the project. If we

look at the profits on the economic level as a whole, we find that they are closely linked

with the income, since the high rates of profits in projects are coupled to high level of

income. Here the total investment is considered as (Income Function) instead of the

function of profits accomplished in the projects.

2.2.4 Components of Investment: There are basically four components of investment

(i) Business fixed investment

(ii) Gross public investment

(iii)Residential construction investment

(iv) Inventory investment

But it is usually business fixed investment which form major part of our discussion.

2.3 Foreign Capital: Capital in financial sense refers to those funds which are used for

investment. In physical sense, capital means all capital equipment, plant, machinery etc.

which is to be used for production process. Therefore finances are to be raised through

savings and used for buildings, plants and equipments for use in production. It means that

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savings and investment are the two acts which create capital. When domestic saving gets

converted into investment, capital thus created is called domestic capital and is owned by

the residents of the country. But investment is made either directly by the non-residents,

institutions or governments, this is called foreign capital and it is owned by the non-

residents. Thus, for example, Reliance Industries represents domestic capital whereas

PepsiCo represents foreign capital.

2.3.1 Types of foreign capital: The flow of foreign capital can be in many forms. First, it

can come in the form of aid; there are institutions (e.g. OXFAM, War on Want etc.)

which provide grants to many countries to alleviate the after-effects of a natural disaster

such as famine, flood or earthquakes. These aids need not be repaid by the recipient

countries, nor do they carry any interest charges. These grants are genuine ‗aids‘ but they

are tiny fraction of the total inflow of foreign capital. In fact this kind of aid not

necessarily part of the typical meaning of capital. Second, the foreign capital can come in

the form loan given mainly by the international lending agencies (e.g. the World Bank,

Asian Development Bank etc.) at interest rates which are lower than those in the market.

In this case the foreign capital is on ‗soft‘ terms which reflect a desire to ‗aid‘ the

receiving countries. However when the foreign capital comes in the form of foreign

private investments in the LDCs they are not exactly ‗foreign aid‘ as they are made on

commercial terms. Foreign private investment usually carries commercial interest and

does not stem from altruistic motives. Foreign private investment usually forms a

significant proportion of the total inflow of foreign capital. Sometimes, several

governments could set up a consortium to provide capital to a country or countries (e.g.

Aid-India or Aid- Pakistan Consortium). Such lending could carry commercial terms; but

frequently these loans are provided at concessionary rates and they have to be repaid after

a long period. Sometimes, grace periods are offered to relieve the burden of debt

repayments. It seems clear that all FR are not ‗aid‘ or charities, some parts of them being

international lending on a commercial basis. In nutshell we can say that the international

capital flows to developing countries may be consist of:

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1. Official flows from bilateral sources and multilateral sources (such as the World

Bank and the International Finance Corporation) on concessional and non-

concessional terms.

2. Foreign Direct Investment.

3. Commercial Bank Loans( including export credits)

2.3.2 The Dual Gap analysis-Reason behind the requirement of foreign capital:

Every country aspires to achieve greater growth rate especially the developing nations.

But growth requires investment goods, which may either be produced domestically or be

purchased from abroad. The domestic provision requires savings as savings gets

converted into investment5. The foreign provision requires foreign exchange. It is also

true to a large extent that a certain type of capital goods can only be procured from

abroad or can be invited in the form of foreign direct investment. Traditionally, the role

of foreign capital has been seen as countries as supplement to domestic to bridge an

investment-saving gap and achieve faster growth. Therefore a minimum amount of

foreign exchange is always required to sustain the growth process6. However, the

concept of dual-gap analysis, which was pioneered by Hollis Chenery and others, shows

that foreign borrowings may also be viewed as a supplement to foreign exchange if, to

achieve a faster rate of rate of growth and development, the gap between foreign

exchange earnings from exports and necessary imports is larger than the domestic

investment-saving gap, and domestic and foreign resources are not easily substitutable for

one another. Foreign capital must fill larger of the two gaps if target growth rate is to be

achieved. This process through which this can be explained is known as Dual-gap

analysis. In order to explain the dual-gap analysis it is necessary to discuss a bit of

growth theory as ultimately the dual-gap analysis is related to the growth of the economy.

5 Investment is not constrained by prior saving; but ultimately saving must match planned investment for

real capital accumulation to take place.

6 It is not true in the case of FDI. It is because of this very reason developing countries prefers FDI form of

investment than importing capital goods from abroad, as they usually face the shortage of foreign

exchange.

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Mathematically, the growth of output (ΔY/Y) can be expressed as the product of the ratio

of investment to national output (I/Y) and the productivity of investment (ΔY/I), i.e.

(6)

As per the definition this is true, and identical to Harrods‘s growth formula for the actual

rate of growth

(7)

where g is the growth rate (ΔY/Y); s is the savings ratio (S/Y), and c is the incremental

capital-output ratio (I/ΔY) i.e. the amount of investment or increase in the capital stock

required to increase the flow of output by one unit (which is the reciprocal of the

productivity of investment, ΔY/I). The Harrod formula for the actual rate of growth is

definitionally true since in the national accounts (ex-post) saving (S) and investment (I)

are always equal. It is clear, for example, that given the capital output ratio for a country,

the ratio of saving and investment to national income can be calculated for any target rate

of growth stipulated. Suppose a country wishes to grow at 5 percent per annum, and the

capital-output ratio is 3, it can be seen from equation (2) that it must save and invest 15

percent of its national income. If it saves less, growth will be slower, unless the country

can somehow reduce the incremental capital-output ratio or raise the productivity of

investment. If there is a difference between the actual savings ratio and that required to

achieve a target rate of growth, there is said to exist a savings-investment (S-I) gap. In the

example given above, if the required savings ratio is 15 percent and the actual ratio is 10

percent, the S-I gap is 5 percent. This needs to be filled if the target growth rate is to be

achieved. This can be done by either attempting to raise the domestic savings ratio or by

borrowing from abroad i.e. by foreign saving. The relation between savings and growth

in a closed economy can be explained with this simple yet powerful framework.

In the case of an open economy the growth rate can be expresses as the product of the

incremental output-import ratio (∆Y/M) and the ratio of investment goods to income

(M/Y) Symbolically

∆Y/Y = ∆Y/M *M/Y (8)

i.e. g = m‘I (9)

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Here m‘ = ∆Y/M and I = M/Y

Now in the open economy case i.e. with foreign trade, not even 5 percent foreign

borrowing may be enough if the difference between the import requirements for growth

and export earnings is more than 5 percent of output. In this case, a dominant export-

import (X-M) gap is said to exist which would need to be financed by foreign capital

inflows of various types. This leads to the concept of dual-gap analysis, originally

pioneered by Chenery and Strout, 1966, which argues that foreign borrowing will be

necessary to fill whatever is the larger of the two gaps if the target rate of growth is to be

achieved. In other words, if the X-M gap is the larger (or the dominant constraint) foreign

borrowing has a dual role – not only to supplement domestic saving, but also foreign

exchange. If there is a lack of substitutability between domestic and foreign resources,

growth will be constrained by whichever factor is most limiting- domestic saving or

foreign exchange. For example, the growth rate permitted by domestic saving is less than

the growth rate permitted by the availability of foreign exchange, growth would be

―saving-limited‖ and if the constraint is not lifted, a proportion of foreign exchange will

go unused. On the other hand, growth will be ―foreign-exchange limited‖ if growth rate

permitted by the availability of foreign exchange is less than the growth rate permitted by

the saving rate and a proportion of domestic saving will go unused. In both cases, there

will be resource waste as long as one resource constraint is dominant. Most developing

countries fall into this category. If foreign exchange is the dominant constraint, ways

must be found of using unused domestic resources to earn more foreign exchange and/or

raise the productivity of the imports. If domestic saving is the dominant constraint, ways

must be found of using foreign exchange to argument domestic saving and/or raise the

productivity of domestic resources. The whole process of dual gap analysis can be

explained with the help of following example.

Suppose, a country sets a target rate of growth, r. the required saving ratio s*= r c [As g =

s/c] and the required import ratio i*= r/m‘ [equation 4]. If domestic saving calculated to

be less than the level required to achieve the target rate of growth, there is said to exist

investment- saving gap equal at time t, to

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It-St = s* Yt= (r c) Yt- sYt (10)

Similarly, if minimum import requirements to achieve the growth target are calculated to

be greater than the maximum level of export earnings available for investment purposes,

there is said to exist an import-export gap equals at time t, to

Mt –Xt = i*Yt – iYt = (r/m‘) Yt – iYt (11)

Where i is the ratio of imports to output that is permitted by export earnings. If the target

growth rate to be achieved, foreign capital flows must fill the largest of the two gaps. The

two gaps are not additive. If the import-export gap is larger, then foreign borrowings to

fill it will also fill the investment-saving gap. If the investment saving gap is the larger,

foreign borrowings to fill it will obviously cover the smaller foreign exchange gap.

Suppose, initially Investment – Saving gap is the larger of the two gaps, so that foreign

borrowing must be sufficient to meet the shortfall of domestic saving below the level

necessary to achieve the target rate of growth. We want to consider the size of the initial

gap that must be filled by foreign borrowing and the determinants of the size of the gap to

be filled in future years by foreign assistance. If the gap is to narrow, and foreign

borrowing is to be terminated, the presumption must be that additional increments to

saving out of the increases in national income generated are greater than the increments

of investment. For any target rate of growth, r, the required foreign assistance in the base

year (F0) is:

F0 = I0 – S0

= Y0 cr – Y0 s (As we know g=s/c)

= Y0 (cr – s) (12)

where I0 is investment in the base period, S0 is the savings in the base period, Y0 is

income in the base period, r is the growth rate, c is the incremental capital output ratio

and, s is the savings ratio( S/Y).

If the M – X gap is the larger of the two gaps, the foreign assistance required to cover the

foreign exchange gap in the base year is:

F0 = M0 – X0

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= Y0 m – Y0 – Y0 x

= Yo (m – x) (13)

where M0 is imports in the base period, X0 is exports in the base period, Y0 is income in

the base period, m is the average import coefficient, and x is the average export

coefficient.

In many economies especially in the developing economies while constructing a

development plan models, a target level of investment is specified to achieve a certain

rate of growth of income and then an estimate of planned savings is made. When the

planned investment (Ip) exceeds planned savings (Sp), it leads to Investment-saving gap

in the economy. This gap is sought to be made up by foreign capital. The shortage of

domestic saving in the LDCs is supposed to fill by the foreign capital. Generally, the

difference between planned investment (Ip) and planned saving (Sp) is taken as an

indication of the foreign capital (F) that are necessary to attain a target rate of economic

growth. In other words, F = Ip−Sp. i.e. the saving gap in the economy. In this ‗savings

gap‘ of analysis, the implicit assumption is that all foreign capital would be used for

domestic investments. This need not always be true and as discussed earlier it is possible

to have a ‗foreign exchange gap‘ or ‗trade gap‘ (M-X) along with a ‗savings gap‘. The

equilibrium relationship between the ‗savings gap‘ and the ‗trade gap‘ can be expressed

as

Ip − Sp=M−X (14)

These two gaps need not be equal ex ante, though ex post they must be equal because of

the method of national accounting7. Any excess of investment over savings could only be

financed by an excess of imports over exports ex post. It is contended that where the trade

gap predominates over the savings gap, a supply of foreign resources could have a

positive effect on growth and as such foreign resources should be provided after careful

estimation of these two gaps (McKinnon 1964; Chenery and Strout 1966). Third, the

other criterion which is sometimes advocated is known as ‗absorptive capacity‘

7 Further, The national income equation from expenditure side can be written as Y= C+I+X-M, and S= Y-C

= I+X-M therefore implying that I-S= M-X

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(Rosenstein- Rodan 1961). There are some difficulties in the actual estimation of

‗absorptive capacity‘ as the concept is not usually regarded as very clear. Basically, it

means a country‘s ability to absorb capital and to use it in a productive way. Such

‗productive‘ use of capital is measured by positive ‗reasonable‘ rates of return on total

investment. It means, ‗absorptive capacity‘ would depend upon the level of income and

its growth rate, the supply of skill and the level of average and marginal rates of savings.

It may be mention that the absorptive capacity of an economy depends, inter alia, upon

the nature of the infrastructure of an economy. An economy with a poor system of

transport and communication, with managerial skill handicapped further by lack of

proper training and educational facilities, is likely to have a low absorptive capacity

(Ghatak, 1995).

Evaluation of the dual-gap model: Dual-gap models have been criticized on two

grounds. The model is criticized either because of its assumed adjustment mechanism or

because of its assumptions which have engendered the idea of two separate types of

constraints, or both. It is attempted to meet the first criticism by relaxing the assumption

regarding saving and the work of Maizels has been mentioned in this connection. But

such modifications do not destroy the existence of the two gaps.

More serious criticism of dual-gap analysis could be made on the grounds that such a

model is based on the assumption that FR cannot be regarded as a substitute for domestic

savings (Joshi 1970). To the extent that FR are substitutes for domestic savings, only one

gap exists. Next, some of the assumptions about fixed savings and capital-output ratios in

the dual-gap analysis cease to be valid if FR can alter the composition of output of the

recipient country in a manner which would reduce the capital-output ratios. But if the rate

of transformation of FR into domestic capital is zero or takes a long time, then two gaps

exist.

2.4 Transfer of Technology

The direct benefits from the transfer of technology by the multinational corporations

(MNCs) to the LDCs can be summarized as follows:

1. Increase in productivity and better quality of output available to host countries;

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2. Higher wages and salaries of local workers;

3. Higher tax revenue for the host government from the investment income which

can be utilized for development purposes.

The indirect gains from the transfer of technology can be summarized as follows:

1. transfer of skills, know-how management and marketing techniques;

2. supply of information about larger markets and cheaper sources of inputs;

3. provision of access to the international capital markets where funds are usually

supplied on the basis of complex negotiations and bargaining.

However, all these benefits should be measured against costs to reach final judgement

about the net benefits. It is suggested that one of the major reasons for the expansion of

the MNCs is their possession of intangible assets, e.g. the new cost-minimizing

technology or better quality products, patented processes or design, knowhow and

marketing skill. When an MNC puts an intangible asset to work in its subsidiary abroad

‗it is in a sense making use of an excess capacity in its roster of assets‘ (Caves 1982).

Such a theory has received considerable support in statistical studies.

2.4.1 Private foreign investment and the transfer of technology: One of the crucial

factors in promoting economic growth in the LDCs is technology. In one sense, here the

LDCs of the present time have an advantage over the LDCs of the past because they can

now choose from a ‗menu‘ of technology available to them from past inventions and

innovations. On the other hand, the availability of the menu of technology could pose

problems for the LDCs. At the outset it is very important to decide the ‗appropriate‘

technology for different LDCs. According to some economists, such appropriateness has

to be judged in the light of the relative factor endowments and factor price ratios of the

LDCs. Others have pointed out that such an argument would simply reinforce the static

theory of comparative cost. Also, the existing factor prices may not reflect the true social

costs and benefits because of distortions in the product and the factor markets. Next, it is

necessary to analyse the effects of such a transfer of technology on the level of wages,

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employment and balance of payments of the LDCs. Fourth, the impact of transfer of

technology on the pattern of income distribution of the LDCs should be examined

carefully.

Fifth, the transfer of technology may have important socio-political implications which

could influence the power structure of the LDCs (Vernon 1971; Vaitsos 1974). Sixth, the

transfer of technology has to be analysed along with the transfer of the product. It has

been suggested that the choice of ‗consumption‘ technology cannot be discussed in

isolation from the problem of choice of product (Stewart 1974; OECD 1974; UNCTAD

1976b). It is true that where the final product is imported the foreign exchange cost can

often be a heavy burden on LDCs. Where the technology is imported there may often be

fears that technology ‗dependence‘ is fostered and this could only be explained by the

theory of imperialism (Radice 1975). Thus, considerable debate has recently been

observed about the transfer of technology and the role of MNCs regarding the net social

benefits of such transfers to LDCs. It should be remembered that the transfer of

technology and the role of the MNCs are two very complex issues. Notice that all MNCs

are not involved in transfer of technology. It is equally noteworthy that since the

technology-supplying industries, and even the final product-supplying industries, are so

often oligopolistic and multinational in character, technology dependence raises the

further issue of the relationship between nation states and the giant corporations (Vernon

1971).

2.4.2 Types of transfer of technology: The transfer of technology can assume different

forms. To summarize the major ones, we have:

1. Initiative: Where the LDCs construct plants chiefly imitating the technology in

the DCs;

2. Contractual: Where an LDC obtains capital and know-how usually through

licensing;

3. Joint Venture: Where foreign firms collaborate with the home industries and

could agree with minority holdings in assets;

4. Subsidiaries: Where the foreign companies set up wholly- or partly owned

subsidiaries with the host country exercising little or some influence;

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5. Turn-key projects: Where the whole plant is transferred along with all the

different stages of production to the point of final consumption through the

marketing and distribution of the final products.

Contractual agreements, joint ventures and direct foreign investments are usually the

major avenues of technological diffusion. Although direct foreign investment is probably

the major route (UN 1975), contractual agreements also figure prominently as such

agreements account for about 85 per cent of total foreign investments in India, 87 per

cent in Korea and 66 per cent in Brazil. However, these data could be overestimated as

the minority foreign equity participations are also included in the agreements. Joint

ventures (with majority or minority participation) are also very common in LDCs as they

account for 71 per cent of total foreign investments in Sri Lanka and 48 per cent of such

investments in Columbia. Foreign direct investment (FDI) is probably the most important

way to affect transfer of technology and its impact is largely felt in the manufacturing

sector. From the point of view of the technology-supplying country, FDI is preferable to

other methods of transfer of technology if the nature of the product is important and

durable, if the resources are available and if transfer of technology through other methods

could give away secret information to potential rivals. The recipient country, usually

anxious to be economically independent of the DCs, prefers collaborations or joint

ventures usually with minority participation in the equity capital by the foreign

companies. However, there are major problems in joint ventures and collaborations

regarding division of operations, management and profits. Also, foreign firms apply

export restriction clauses more to joint venture firms than to those wholly owned by them

(Vernon 1971, pp144). Nor do joint ventures rely less heavily on imports relative to their

total needs than wholly-owned subsidiaries. Thus, whether the local equity interest gives

the recipient country any more effective control is sometimes doubted. Similarly, the

technical collaboration agreements do not always offer clear advantages

(Balasubramanyam 1973, pp35). For instance, foreign companies in the technical

collaboration agreements rarely adjusted their production techniques in line with the

Indian factor price ratios. It was only in joint ventures where the foreign firms had an

equity interest that they modified technology to some extent. Interestingly enough, the

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Indian firms did not change the techniques either. From the point of view of the donor

country, lack of control in management reduced the incentive to alter technology to the

economic conditions of the LDCs. It could be argued that only a few LDCs have the

administrative skill to choose ‗appropriate‘ technology. But this is not always true

(Streeten 1971). On the other hand, Singer and Campo (1970:12) have advocated the

establishment of an International Development Fund to support an agency which will

help the LDCs in choosing an ‗appropriate‘ technology. These different points of view

highlight the necessity to undertake realistic appraisal of the difficult alternatives through

a social cost-benefit analysis (Streeten 1971). Such a study could be facilitated by looking

at the following benefits and costs of transfer of technology by MNCs.

2.5 External Debt

External debt (or foreign debt) is that part of the total debt in a country that is owed

to creditors outside the country. The debtors can be the government, corporations or

private households. The debt includes money owed to private commercial banks,

other governments, or international financial institutions such as the IMF and World

Bank. According to IMF, ―Gross external debt, at any given time, is the outstanding

amount of those actual current, and not contingent, liabilities that require payment(s) of

principal and/or interest by the debtor at some point(s) in the future and that are owed to

nonresidents by residents of an economy". (IMF, 2003). The key elements of External

debt are as follows; (a) Outstanding and Actual Current Liabilities: Here debt liabilities

include arrears of both principal and interest. (b) Principal and Interest: This definition

does not distinguish between whether the payments that are required are principal or

interest, or both. (c) Residence: To qualify as external debt, the debt liabilities must be

owned by a resident to a nonresident. Residence is determined by where the debtor and

creditor have their centre of interest. (d) Current and Not Contingent: Contingent

liabilities are not included in the definition of the external debt. These are defined as

arrangements under which one or more conditions must be fulfilled before a financial

transaction takes place.

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Classification of External Debt: Generally external debt is classified into four heads i.e.

(i) public and publicly guaranteed debt, (ii) private non-guaranteed credits, (iii) central

bank deposits, and (iv) loans due to the IMF.

External debt sustainability: Sustainable debt is the level of debt which allows a debtor

country to meet its current and future debt service obligations in full, without recourse to

further debt relief or rescheduling, avoiding, accumulation of arrears, while allowing an

acceptable level of economic growth. World Bank and IMF hold that ―a country can be

said to achieve external debt sustainability if it can meet its current and future external

debt service obligations in full, without recourse to debt rescheduling or the accumulation

of arrears and without compromising growth.‖

2.5.1 Indicators of external debt sustainability: There are various indicators that can be

used to determine a sustainable level of external debt. The indicators include, (a) debt to

GDP ratio, (b) foreign debt to exports ratio, (c) government debt to current fiscal revenue

ratio etc. This set of indicators also covers the structure of the outstanding debt including

the (d) share of foreign debt, (e) short-term debt, and (f) concessional debt in the total

debt stock. The extent of external debt sustainability is widely discussed and debated in

literature. There are different perspectives to debt sustainability. Some of them are: (i)

optimising models- where the marginal benefit equals the marginal cost of borrowing. (ii)

Non-Optimising model- It is also known as growth-cum-debt model and ‗debt dynamics‘

approach. In this mode, the external borrowing is used to fill the gap between domestic

savings and investments, as uin the two gap model (Chenery and Strout, 1966). In this

approach the condition for solvency requires that the rate of the growth of the economy

must be greater than the rate of interest (the cost of borrowing). Whereas the ‗debt

dynamics‘ approach looks at the external solvency and at the export rate of growth which

must exceed the interest rate. (iii) Fiscal space modes- it is due to reduced public

expenditures and because of debt service. But lack of infrastructure and public

expenditure will have an adverse affect on private investment which ultimately leads to

slower growth rate. (d) Disincentive effects- It refers to a situation where a large stock of

debt undermines economic performance through the debt overhang effect, which is

related to the tax disincentive and to macroeconomic stability. In the first case, which

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explains the basic idea of debt overhang theory, a large stock of debt discourages the

investments because taxes on future income are expected to be used to serve the debt

payments. In the second case, the disincentives are related to the possible creation of

macroeconomic instability, due to: (1) exchange rate depreciation, (2) increase in fiscal

deficit, (3) monetary expansion and inflation (4) uncertainty due to exceptional financing.

2.5.2 Effect of external debt on economic growth: The most important determinant of

debt sustainability is economic growth. External debt allows a country especially a

developing country to invest and produce more than what it could otherwise produce.

Through external borrowings it can finance capital formation by tapping savings from

capital surplus countries for example many East Asian economies greatly benefited from

external debt. An increase in the rate of growth of GDP makes affordable a higher level

of debt. Traditional neoclassical models and some endogenous growth model imply a

positive relationship between external debts and economic growth of an economy.

However the key assumption of perfect capital mobility is unrealistic and, when dropped,

lower debts are associated with higher growth. The debt overhang hypothesis considers

the investment channel and the disincentive effects on government policies that lead to

poor macro policies. The importance of external debt lies not in its absolute value, but in

its proportion of GDP. Additionally, large debt stocks lead to capital flights, high tax

rates and continuous over-borrowing, with a negative effect on growth. There are three

main channels through which the debt affects the economic growth:

(1) The debt overhang effect- The debt overhang is defined as a situation in which the

creditors do not expect to be fully repaid because of the presence of a large stock of debt.

Krugman (1988) asserts that ―A country has a debt over hang problem when the expected

present value of potential future resource transfer is less than its debt‖. The presence of

this stock of debt changes the incentive of both creditor and debtor and debt relief could

benefit both of them. The debt-Laffer8 curve shows the possibility of this double benefit.

When the debtor country is on the right side of the curve, a debt reduction increases the

likelihood of the repayment. So, as long as the stock of debt is higher then the critical

value D* (Figure 2.2), both the creditors and the debtor will be well off after debt relief.

8 The debt-Laffer curve represents the expected repayments as a function of the face value of the debt

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Figure 2.2: The Debt-Laffer Curve

Source: Adapted from Cathrine Pattillo et al., ―External Debt and Growth‖, Finance and

Development, June, 2002

The theoretical background of the debt overhang hypothesis can be used for a broader

interpretation of the negative effects of debt on growth, which include the disincentive

that a high stock of debt has on other type of investments namely human capital and on

the government‘s willingness to adopt structural reforms and fiscal adjustments.

(2) The Liquidity Constraint: The negative effect of debt on growth works not only

through the impact of the stock of debt, but also via the flows of service payments, which

are likely to crowd out public investment (Cohen, 1993). The rational behind the negative

impact of debt payment on investment is that, if the debt obligations are expected to be

met, the service payments could affect investment decisions, depending on the efficiency

of the rescheduling strategy; on the other hand, if a debtor country is not expected to

repay its debt, as a result of a known rescheduling rule, then investment should not be

crowed out. Therefore, a decreasing level of debt service payment is the crucial

determinant for investment and growth.

(3) The Effect of the Uncertainty- It is generally believed that a large debt burden

increases the uncertainty about how much of the outstanding debt will be actually repaid.

The third channel through which a large external debt could affect the economic

Expected

value of

repayment

Stock of

Debt D*

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performance concerns the uncertainty about future aid and resources inflows and about

debt-service payments, together with their effects on macroeconomic stability. On the

other hand debt reduction reduces the uncertainty and increases the confidence in the

debtor country‘s government.

PART-II

2.6 Theories of FDI

In this part various theories of FDI will be discussed so as to understand the rationale

behind FDI. A number of attempts have been made to develop a theory that try to explain

why MNCs indulge in FDI, why they choose one country in preference to another to

locate their foreign business activity. Some of the theories try to explain outward FDI,

whereas others try to explain inward FDI. Theories of FDI may be classified under the

following categories. (Lizondo, 1991) and (Agarwal, 1980, pp740)

1. Theories assuming Perfect Markets

2. Theories assuming Imperfect Markets

3. Other Theories, and

4. Theories based on other variables.

Theories of FDI can also be classified according to other criteria. For example, they can

be classified within a range between Orthodox neoclassical theories to the Marxist theory

of imperialism. They can also be classified according to whether the factor determining

FDI are macro factors, micro factors, or strategic factors. Now we can briefly introduce

these theories

2.6.1 Theories Assuming Perfect Competition: Three Hypothesis fall under this

category: (i) Differential Rate of Returns Hypothesis (ii) The diversification hypotheses

and (iii) The Output and market size hypotheses

(i) The Differential rate Hypothesis: This hypothesis represents one of the first

attempts to explain FDI flows. This hypothesis postulates that capital flows

from countries with low rates of return to countries with high rates of return

move in a process that leads eventually to the equality of ex ante real rate of

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return. The rational for this hypothesis is that firms considering FDI behave in

such a way as to the as to equate the marginal return on and the marginal cost

of capital. This hypothesis assumes risk neutrality which makes the rate of

return the only variable on which the investment decision depends. It means

that the investor consider domestic and foreign direct investments to be

perfect substitute.

(ii) The Portfolio Diversification Hypothesis: If we relax the assumption of Risk

neutrality, risk becomes another variable upon which the FDI decision is

made. Because the choice among various project is guided not only by the

expected rate of return but also by risk therefore then the decision of FDI can

be explained with the portfolio diversification hypothesis. The objective is to

reduce risk through diversification that is possible through portfolio

diversification as in the case of portfolio investment. The theoretical

foundation can be traced back to the theory of portfolio selection of Tobin

(1958) and Markowitz (1959).

(iii) Market Size Hypothesis: According to the market size hypothesis, the volume

of FDI in a host country depends on its market size, which is measured by the

sales of an MNC in that country, or by the GDP (that is, the size of the

economy). As soon as the size of the market of a particular country has grown

to a level that requires the exploitation of economies of scale, the country

becomes the potential target for FDI inflows. A sufficiently large market

allows for the specialization of factors of production, and consequently the

achievement of cost minimization, Ballassa (1966).

2.6.2 Theories Assuming Imperfect Markets: Hymer (1976) was the first economist to

point out that the structure of the market and the specific characteristics of investing firms

could explain FDI. Kindelberger (1969) refined and publicized Hymerr‘s ideas. Some of

the major hypothesis which falls under this category is as follows.

i. The Industrial Organization Hypothesis: This hypothesis was developed by

Hymer (1976) and extended by Kindelberger (1969), Caves (1982) and Dunning

(1988). According to this hypothesis, when a firm establishes a subsidiary in

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another country it faces several disadvantages in competing with local firms.

These disadvantages originate from differences in language, culture, the legal

system and other inter-country differences. But at the same time subsidiary firm

got some inherent advantages also. According to Kindelberger (1969), these

comparative advantages have to be firm-specific, it must be transferable to foreign

subsidiaries, and it should be large enough to overcome these disadvantages. Lall

and Streeten (1977) present a comprehensive list of these advantages. (Table 2.1)

Table 2.1: Advantages for Subsidiary Company in foreign country

Advantage Description

Capital Larger or cheaper cost of capital than local or smaller foreign

competition

Management

Superior management in the form of greater efficiency of operation

or greater entrepreneurial ability to take risk or to identify profitable

venture

Technology Superior technology in the form of ability to translate scientific

knowledge into commercial use.

Marketing The function of market research, advertising and promotion, and

distribution.

Access to raw

materials

Privileged access to raw materials arising from the control of final

markets, transportation of the product, processing, or the production

of the material itself.

Economies of

scale

The finance and expertise to set up and operate facilities that enjoy

these economies

Bargaining and

political power

The ability to extract concessions and favourable terms from the host

government.

Source: Lall and Streeten (1977)

Limitation: A serious limitation of the industrial organization hypothesis is that it

explains why firms invest in foreign countries but it does not explain why firms choose to

invest in country A rather than country B.

ii. The Internalization Hypothesis: According to the internalization hypothesis, FDI

arises from efforts by firms to replace market transactions with internal

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transactions. For example, if there are problems associated with buying oil

products on the market, a firm may decide to buy a foreign refinery. These

problems arises from imperfections and failure of markets for intermediate goods,

including human capital, knowledge, marketing and managerial expertise. The

internalization of markets across national boundaries leads to FDI, and this

process continues until the marginal benefits and marginal costs are equal. This

hypothesis explains why firms use FDI in preference to exporting and importing

from foreign countries. According to Dunning (1977), firms want to retain the

exclusive right of using the innovations generated by their R&D efforts.

Moreover, the internalization process eliminates uncertainty. The Internalization

hypothesis is so powerful that it is sometime called as the general theory of FDI,

whereas other theories are subset of the general theory of internalization.

Limitations- There is two problems associated with this hypothesis. First, Rugman (1980)

argues that the hypothesis is so general that it has no empirical content. Second, Buckley

(1988) argues that the hypothesis cannot be tested directly.

iii. The Location Hypothesis: According to this hypothesis, FDI exists because of the

international immobility of some factors of production, such as labour and natural

resources. This immobility leads to location related differences in the cost of

factors of production. One form of location related differences in the costs of

factors production is the Locational advantage of low wages. Thus, the level of

wages in the host country relative to wages in the home country is an important

determinant of FDI. That is why countries such as India attract labour intensive

production from high-wage countries. Locational advantages not only take the

form of low wages; they are also applicable to other factors of production.

According to Hood and Young (1982), there are four factors which are pertinent

to location specific theory They are

1. Labour costs

2. Marketing factors (like market size, market growth, stage of development,

and local competition)

3. Trade Barriers

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4. Government policies

Limitations-The above factors have, of course, very important bearing on foreign

investment. However there are other factors like cultural factors which influences foreign

investment. Also it is the total cost not labour cost alone, which is important.

iv. The Eclectic Theory- the eclectic theory was developed by Dunning (1977.1979,

1988) by integrating the industrial organization hypothesis, the internalization

hypothesis and the location hypothesis without being too precise about how they

interrelate. The eclectic theory aims at answering following questions. First, if

there is demand for a particular commodity in a particular country, why is it not

met by a local firm producing in the same country, or by a foreign firm exporting

from another country? Second, when a firm wants to expand its scale of

operations, why does it not do so via other channels? According to this theory,

three conditions must be satisfied if a firm is to engage in FDI (Dunning 1977):

a. Firm specific advantages- A firm must have a comparative advantage over other

firms arising from the ownership of some intangible assets. These are called

ownership advantages, which includes things like right to a particular technology,

monopoly power and, size, access to raw materials, and access to cheap finance.

b. Internalization advantages- It must be more beneficial for the firm to use these

advantages rather than to sell or lease them.

c. Locational advantages- It must be more profitable to use these advantages in

combination with at least some factor inputs located abroad. If this is not the case,

then exports would do the job.

v. The Product Life Cycle Hypothesis- This hypothesis was developed by Raymond

Vernon (1966). According to this hypothesis, ‗product go through a cycle of

initiations, exponential growth, slowdown and decline- a sequence that

correspondence to the process of introduction, spread maturation, and senescence‘

(Vernon, 1971). Following are the three stages of a product under this hypothesis.

1. New product stage: The product is produced and consumed at home, close

to the customers, and because of the need of better coordination between

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R&D and production units. During this stage the demand for the new

product is price inelastic.

2. Maturing product stage: The second stage is marked by the maturity and

export of the product to countries having the next-highest level of income

as demand emerges from these developed economies. Mass-production

techniques are developed and foreign demand (in developed countries)

expands. At this stage the home country is a net exporter of the product,

while foreign countries are net importers.

3. Standardized product stage: The third stage is characterized by a complete

standardization of the product and its production process, which is no

longer an exclusive possession of the innovating firm. Price competition

from other producers forces the innovating firm to invest in developing

countries and production moves to developing countries, which then

export the product to developed countries. The home country becomes net

importer, while foreign countries net exporter.

Hence, FDI takes place as the cost of production becomes an important consideration.

FDI is, thus a defensive move to maintain the firm‘s competitive position against its

domestic and foreign rivals. This hypothesis predicts that, over time, the home country

where the innovative product first appeared switches from an exporting to an importing

country. For example, personal computers first developed by US firms (such as IBM and

Apple Computers) and exported to foreign markets. When personal computers become

standardized, the USA became a net importer from producer based in Japan, Korea and

Taiwan. Following figure shows the pattern of production, consumption, exports, and

imports over the time as the product goes through its life cycle.

Limitation- (i) The applicability of the product life cycle hypothesis is restricted to highly

innovative industries (Solomon, 1978), and (ii) it is oversimplification of the firm‘s

decision making process ( Buckley and Casson, 1976).

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Figure 2.3: Production and Consumption during the Product Life Cycle

Source: Moosa. Imad A. (2002)

2.6.3 The Oligopolistic Reactions Hypothesis- In an oligopolistic environment, FDI by

one firm triggers a similar reaction by other leading firms in the industry in an attempt to

maintain their market shares (Knickerbocker, 1973). Lall and Streeten (1977) argued that

the very structure of oligopolistic competition and equilibrium is such that none of the

participant can afford ignore what the others are doing. Knickerbocker (1973) suggested

that oligopolistic reactions increase with the level of concentration, and decrease with the

diversity of the product. But this hypothesis fails to identify the factors that triggers the

initial investment

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2.6.4 Other Theories of Foreign Direct Investment-: Four hypotheses which fall under

this category are:

(i) The Internal financing hypothesis

(ii) The Currency area hypothesis

(iii) The hypothesis of diversification with barriers to international capital flows and

(iv) The Kojima Hypothesis

(i) The Internal financing hypothesis- Internal financing refers to the utilization of

profit generated by a subsidiary to finance the expansion of FDI by an MNC in

the country where the subsidiary operates. This hypothesis postulates that MNCs

commit a modest amount of their resources to their initial direct investment, while

subsequent expansions are finance by reinvesting profits obtained from operations

in the host country. It is therefore implies the existence of a positive relationship

between internal cash flows and investment outlays, which is plausible because

the cost of internal financing is lower. This hypothesis is more appropriate for

explaining FDI in developing countries for two reasons: (i) the presence of

restrictions on the movement of funds; and (ii) the rudimentary state and

inefficiency of the financial market.

(ii) The currency areas hypothesis and the effect of exchange rate- This hypothesis

was put forward by Aliber (1970, 1971). In this hypothesis, he tries to explain

FDI in terms of the relative strength of various currencies. He postulates that the

firm belonging to a country with a strong currency tend to invest abroad, while

firm belonging to a country with a weak currency do not have these tendencies. In

other words, countries with strong currencies tend to be source of FDI, while

countries with weak currencies tend to be host countries. The important

assumption is that there is a bias in capital markets, which arises because an

income stream located in a country weak country is associated with foreign

exchange risk. Hence a strong currency firm may be more efficient in hedging

foreign exchange risk.

Limitation- This hypothesis cannot account for cross-investment between

currency area, and for direct investment belonging to same currency area, and for

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concentration of FDI in certain industries (Lizondo, 1991). Dunning (1973)

suggest that the currency area hypothesis adds to the industrial organisation

hypothesis, because country risk affects the relationship between the investing

firms and their competitors.

(iii)The Hypothesis of Diversification with Barriers to International Capital flows:

According to this hypothesis if international diversification needs to be carried by

two firms then two conditions must hold- (i) There must exist barriers or cost to

portfolio flows that are greater than those associated with direct investment; (ii)

investors must recognize that multinational firms provide diversification

opportunities that are otherwise unavailable (Agmon & Lessard, 1977).

(iv) The Kojima Hypothesis: Kojima (1973, 1975 and 1985) views direct investment

as providing a means of transferring capital, technology and managerial skills

from the source to the host country. This approach is also known as

‗macroeconomic approach‘ or a factor endowment approach‘, as opposed to the

‗international business approach‘ to FDI. Kojima classifies FDI into two kinds.

The first is trade-oriented, which generates an excess demand for imports and

excess supply of exports at the original terms of trade. This kind of FDI leads to

welfare improvement in both countries. This would promote trade and beneficial

industrial restructuring. The second kind is the anti-trade oriented FDI, which has

exactly opposite, affects to those of the first kind. Thus, anti-trade-oriented FDI

has an adverse effect on trade, and it also promotes unfavorable restructuring in

both countries. Kojima argues that Japanese FDI has been trade-orientated, but

FDI from US is not so much trade oriented.

Limitation- Petrochilos (1989, p.21) suggested that Kojima hypothesis not so

much a theory explaining FDI, but more like a prerequisite for establishing

foreign trade. He also argued that some element of Kojima Hypothesis can be

found in other theories such as the product life cycle hypothesis.

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2.6.5 Theories based on Other Factors There are three other factors that have been used

to explain FDI. These factors are (i) Political risk and country risk (ii) Tax policy, trade

barriers and government regulations (iii) Strategic and long term factors.

(i) Political Risk and Country Risk- Lack of political stability discourages inflows of FDI.

Political risk arises because of unexpected modifications of the legal and fiscal

frameworks in the host country may change the economic outcome of a given investment

in a big manner. Although the results produced by this studies are mixed for this factor.

According to Schneider and Frey (1985) the models encompassing economic and

political factors perform better than other models that do not contain political variables.

(ii) Tax Policy: Tax policy of the government plays a very important role. If the tax

policies of the host countries are favourable then there will be more inflow of FDI

whereas if it is not very welcoming for the foreign investors then there could be decline

in FDI inflows. But it has been observed that even if the tax policy are not very

conducive still FDI may come as there could be other factors which may have greater

significance for the investor. Jun (1989) identifies three channels through which tax

policies affect the decisions taken by MNCs. First, the tax treatment of income generated

abroad has a direct effect on net return on FDI. Second, the tax treatment of income

generated at home affects the relative cost capital of domestic and foreign investment.

Third, tax policies affect the relative cost of capital of domestic and foreign investment.

A study done by Slemrod (1989) indicates a negative impact of US tax rate on FDI.

Whereas, Hartman (1985) concludes that the domestic tax rate on foreign income and the

presence or otherwise of tax credit should be irrelevant to a mature foreign subsidiary.

This is because domestic taxes are unavoidable cost. Graham and Krugman (1991) also

suggested the same that tax policy has no effect or a trivial effect on FDI.

(iii) Strategic and long term factors: If the investors has some strategic reason behind the

investment which usually is the case in oligopoly competition than also the FDI will

come to the host country. Similarly it is also assumed that FDI are long lasting in nature.

They are not there to earn quick money. Reuber et al. (1973) list the following factors

that may have bearing on firm‘s investment decision to invest abroad:

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1. The desire on the part of the investor to defend existing foreign markets and

foreign investment against foreign competitors.

2. The desire to gain and maintain a foothold in a protected market or to gain and

maintain a source of supply that in the long run may prove useful

3. The need to develop and sustain a parent-subsidiary relationship.

4. The desire to induce the host country into a long commitment to a particular type

of technology.

5. The advantage of complementing another type of investment.

6. The economic of new product development.

7. Competition of market shares among oligopolists and the concern for

strengthening of bargaining positions.

(iv)Trade Barriers: Sometime FDI may be undertaken to circumvent trade barriers such

as tariffs as FDI can be viewed as alternative to trade. This means that open economies

should receive fewer FDI flows. But the results of various studies are mix. Moore (1993)

and Wang and Swain (1995) found trade barriers as insignificant determinant of FDI.

However, Bajo-Rubio and Sosvilla-Rivero (1994) found the relationship significant.

Lipsey (2000) concludes that countries that are more open to trade tend to provide and

receive more FDI.

(v) Government regulations: The governments‘ world over adopt policies that are either

encouraging9 or discouraging to inward FDI. Government can encourage FDI by

providing incentives or it can be discourage FDI through restriction or by putting other

kind of restriction on it. The incentive offered by host government to investing firms

includes the following (Moosa, 2002):

9 In order to attract foreign investment, the Philippines government gave an advertisement in Fortune, an

international magazine. In this advertisement, the government of Philippines declared that, to attract foreign

companies, the government had ‗felled (sic) mountains, razed jungles, filled swamps, moved rivers,

relocated towns… all to make it easier for you and your business to do business here‘.

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1. Fiscal incentives such as tax reductions, accelerated depreciation, investment and

reinvestment allowances, and exemption from custom duties.

2. Financial incentives such as subsidies, grants and loan guarantees.

3. Market preferences, including monopoly rights, protection from competition arising

from imports and preferential government contracts.

4. Low cost infrastructure, fuel, energy.

5. A framework for clear, efficiently implemented stable policies with respect to FDI.

6. Flexible conditions with respect to local equity participation.

On the other hand disincentives include a number of impediments that may range from

the slow processing of the required authorization to the complete ban on foreign

investment in specific regions or sectors. According to Agarwal (1980), incentive has a

limited effect on the level of FDI, as investors base decision on risk and return

considerations. But disincentives seem to have more definite impact on the inflow of

FDI.

2.7 Summary: In this chapter those concepts that are relevant for the present study has

been discussed in detail. This includes the concept of Dual-Gap analysis, savings,

investment, transfer of technology and external debt. In the second part of the chapter

summary of various theories and determinants of FDI has been discussed. With help of

this information, we can now move on to our next chapter.

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