Foreign Capital


International Economics or international business has two parts – International trade and International Capital. International capital (or international finance) studies the flow of capital across international financial markets, and the effects of these movements on exchange rates. International capital plays a crucial role in an open economy. In this era of liberalisation and globalisation, the flows of international capital (including intellectual capital) are enormous and diverse across countries. Finance and technology (e.g. internet) have gained more mobility as factors of production especially through the multinational corporations (MNCs). Foreign investments are increasingly significant even for the emerging economies like India. This is in-keeping with the trend of international economic integration. A Peter Drucker rightly says, “Increasingly world investment rather than world trade will be driving the international economy”. Therefore, a study of international capital movements is much rewarding both theoretically and practically.

Meaning of International Capital
International capital flows are the financial side of international trade. Gross international capital flows = international credit flows + international debit flows. It is the acquisition or sale of assets, financial or real, across international borders measured in the financial account of the balance of payments.

Types of International Capital
International capital flows have through direct and indirect channels. The main types of international capital are: (1) Foreign Direct Investment (2) Foreign Portfolio Investment (3) Official Flows, and (4) Commercial Loans. These are explained below.

Foreign Direct Investment
Foreign direct investment (FDI) refers to investment made by foreigner(s) in another country where the investor retains control over the investment, i.e. the investor obtains a lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or constructing a factory in a foreign country or adding improvements to such a facility, in the form of property, plants, or equipment. Thus, FDI may take the form of a subsidiary or purchase of stocks of a foreign company or starting a joint venture abroad. The main feature of FDI is that ‘investment’ and ‘management’ go together. An investor’s earnings on FDI take the form of profits such as dividends, retained earnings, management fees and royalty payments.

According to the United Nations Conference on Trade and Development (UNCTAD), the global expansion of FDI is currently being driven by over 64,000 transnational corporations with more than 800,000 foreign affiliates, generating 53 million jobs.

Various factors determine FDI – rate of return on foreign capital, risk, market size, economies of scale, product cycle, degree of competition, exchange rate mechanism/controls (e.g. restrictions on repatriations), tax and investment policies, trade polices and barriers (if any) and so on.

The advantages of FDI are as follows.
1. It supplements the meagre domestic capital available for investment and helps set up productive enterprises.
2. It creates employment opportunities in diverse industries.
3. It boosts domestic production as it generally comes in a package – money, technology etc.
4. It increases world output.
5. It ensures rapid industrialisation and modernisation especially through R&D.
6. It paves the way for internationalisation of markets with global standards and quality assurance and performance based budgeting.
7. It pools resources productively – money, manpower, technology.
8. It creates more and new infrastructure.
9. For the home country it a good way to take advantage in a favourable foreign investment climate (e.g. low tax regime).
10. For the host country FDI is a good way of improving the BoP position.

Some of the difficulties faced in FDI flows are: problem of convertibility of domestic currency; fiscal problems and conflicts with the host government; infrastructural bottlenecks, ad hoc polices; biased growth, and political instability in the host country; investment and market biases (investments only in high profit or non-priority areas); over dependence on foreign technology; capital flight from host country; excessive outflow of factors of production; BoP problem; and adverse affect on host country’s culture and consumption.

Foreign Portfolio Investment
Foreign Portfolio Investment (FPI) or rentier investment is a category of investment instruments that does not represent a controlling stake in an enterprise. These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise which does not necessarily represent a long-term interest. FPI comes from many diverse sources such as a small company’s pension or through mutual funds (e.g. global funds) held by individuals. The returns that an investor acquires on FPI usually take the form of interest payments or dividends. FPI can even be for less than one year (short term portfolio flows).

The difference between FDI and FPI can sometimes be difficult to discern, given that they may overlap, especially in regard to investment in stock. Ordinarily, the threshold for FDI is ownership of “10 percent or more of the ordinary shares or voting power” of a business entity.

The determinants of FPI are complex and varied – national economic growth rates, exchange rate stability, general macroeconomic stability, levels of foreign exchange reserves held by the central bank, health of the foreign banking system, liquidity of the stock and bond market, interest rates, the ease of repatriating dividends and capital, taxes on capital gains, regulation of the stock and bond markets, the quality of domestic accounting and disclosure systems, the speed and reliability of dispute settlement systems, the degree of protection of investor’s rights, etc.

FPI has gathered momentum with deregulation of financial markets, increasing sops for foreign equity participation, expanded pool of liquidity and online trading etc. The merits of FPI are as follows.
1. It ensures productive use of resources by combining domestic capital and foreign capital in productive ventures
2. It avoids unnecessary discrimination between foreign enterprises and indigenous undertakings.
3. It helps reap economies of scale by putting together foreign money and local expertise.

The demerits of FPI are: flows tend to be more difficult to calculate definitively, because they comprise so many different instruments, and also because reporting is often poor; threat to ‘indigenisation’ of industries; and non-committal towards export promotion.

Official Flows
In international business the term “official flows” refers to public (government) capital. Popularly this includes foreign aid. The government of a country can get aid or assistance in the form of bilateral loans (i.e. intergovernmental flows) and multilateral loans (i.e. aids from global consortia like Aid India Club, Aid Pakistan Club etc, and loans from international organisations like the International Monetary Fund, the Word Bank etc).

Foreign aid refers to “public development assistance” or official development assistance (ODA), including official grants and concessional loans both in cash (currency) and kind (e.g. food aid, military aid etc) from the donor (e.g. a developed country) to the donee/recipient (e.g. a developing country), made on ‘developmental’ or ‘distributional’ grounds.

In the post Word War era aid became a chief form foreign capital for reconstruction and developmental activities. Emerging economies like India have benefited a lot from foreign aid utilised under economic plans.

There are mainly two types of foreign aid, namely tied aid and untied aid. Tied aid is aid which ties the donee either procurement wise, i.e. source of purchase or use wise, i.e. project-specific or both (double tied!). The untied aid is aid that is not tied at all.

The merits of foreign aid are as follows.
1. It promotes employment, investment and industrial activities in the recipient country.
2. It helps poor countries to get sufficient foreign exchange to pay for their critical imports.
3. Aid in kind helps meet food crises, scarcity of technology, sophisticated machines and tools, including defence equipment.
4. Aid helps the donor to make the best use of surplus funds: means of making political friends and military allies, fulfilling humanitarian and egalitarian goals etc.

Foreign aid has the following demerits.
1. Tied aid reduces the recipient countries’ choice of use of capital in the development process and programmes.
2. Too much aid leads to the problem of aid absorption.
3. Aid has inherent problems of ‘dependency’, ‘diversion’ ‘amortisation’ etc.
4. Politically motivated aid is not only bas politics but also bad economics.
5. Aid is always uncertain.
It is a sad fact that aid has become a (debt) trap in most cases. Aid should be more than trade. Happily ODA is diminishing in importance with each passing year.

Commercial Loans
Until the 1980s, commercial loans were the largest source of foreign investment in developing countries. However, since that time, the levels of lending through commercial loans have remained relatively constant, while the levels of global FDI and FPI have increased dramatically.

Commercial loans are also called as external commercial Borrowings (ECB). They include commercial bank loans, buyers’ credit, suppliers’ credit, securitised instruments such as Floating Rate Notes and Fixed Rate Bonds etc., credit from official export credit agencies and commercial borrowings from the private sector window of Multilateral Financial Institutions such as International Finance Corporation, (IFC), Asian Development Bank (ADB), joint venture partners etc. In India, corporate are permitted to raise ECBs according to the policy guidelines of the Govt of India/RBI, consistent with prudent debt management. RBI can approve ECBs up to $ 10 million, with a maturity period of 3-5 years. ECBs cannot be used for investment in stock market or speculation in real estate.
ECBs have enabled many units – even medium and small – in securing capital for establishment, acquisition of assets, development and modernisation.

Infrastructure and core sectors such as Power, Oil Exploration, Road & Bridges, Industrial Parks, Urban Infrastructure and Telecom have been the main beneficiaries (about 50% of the funding allowed). The other benefits are: (i) it provides the foreign currency funds which may not be available in India; (ii) the cost of funds at times works out to be cheaper as compared to the cost of rupee funds; and iii) the availability of the funds from the international market is huge as compared to domestic market and corporate can raise large amount of funds depending on the risk perception of the International market; (iv) financial leverage or multiplier effect of investment; (v) a more easily hedged form of raising capital, as swaps and futures can be used to manage interest rate risk; and (vi) it is a way of raising capital without giving away any control, as debt holders don’t have voting rights, etc.

The limitations of ECBs are: (i) default risk, bankruptcy risk, and market risks, (ii) a plethora of interest rate increasing the actual cost of borrowing, and debt burden and possibly lowering the company’s rating, which automatically boosts borrowing costs, further leading to liquidity crunch and risk of bankruptcy, (iii) the effect on earnings due to interest expense payments. Public companies are run to maximise earnings.

Private companies are run to minimise taxes, so the debt tax shield is less important to public companies because earnings still go down.

Factors Influencing International Capital Flows
A number of factors influence or determine the flow of international capital. They are explained below.

1. Rate of Interest
Those who save income are generally interest-induced. As Keynes rightly said, “interest is the reward for parting with liquidity”. Other things remaining the same, capital moves from a country where the interest rate is low to a country where the interest rate is high.

2. Speculation
Speculation is one of the motives to hold cash or liquidity, particularly in the short period. Speculation includes expectations regarding changes in interest and exchange rates. If in a country rate of interest is expected to fall in the future, the present inflow of capital will rise. On the hand, if its rate of interest is expected to rise in the future, the present inflow of capital will fall.

3. Production Cost
If the cost of production is lower in the host country, compared to the cost in the home country, foreign investment in the host country will increase. For example, lower wages in a foreign country tends to shift production and factors (including capital) to low cost sources and regions.

4. Profitability
Profitability refers to the rate of return on investment. It depends on the marginal efficiency of capital, cost of capital and risks involved. Higher profitability attracts more capital, particularly in the long run. Therefore, international capital will flow faster to high-profit areas

5. Bank Rate
Bank rate is the rate charged by the central bank to the financial accommodation given to the member banks in the banking system, as a whole. When the central bank raises the bank rate in the economy, domestic credit will get squeezed. Domestic capital and investment will get reduced. So to meet the demand for capital, foreign capital will enter quickly.

6. Business Conditions
Conditions of business viz. the phases of a business cycle influence the flow of international capital. Business ups (e.g. revival and boom) will attract more foreign capital, whereas business downs (e.g. recession and depression) will discourage or drive out foreign capital.

7. Commercial and Economic Polices
Commercial or trade policy refers to the policy regarding import and export of commodities, services and capital in a country. A country may either have a free trade policy or a restricted (protection) policy. In the case of the former, trade barriers such as tariffs, quotas, licensing etc are dismantled. In the case of the latter the trade barriers are raised or retained. A free or liberal trade policy – as in today’s era – makes way for free flow of capital, globally. A restricted trade policy prohibits or restricts the flow of capital, by time/source/purpose.

Economic polices regarding production (e.g. MNCs and joint ventures), industrialisation (e.g. SEZ Policy), banking (e.g. new generation/foreign banks) and finance, investment (e.g. FDI Policy), taxation (e.g. tax holiday for EOUs) etc., also influence the international capital transfers. For example, liberalisation and privatisation boosts industrial and investment activities.

8. General Economic and Political Conditions
Besides all commercial and industrial polices, the economic and political environment in a country also influences the flow of international capital. The country’s economic environment refers to the internal factors like size of the market, demographic dividend, growth and accessibility of infrastructure, the level of human resources and technology, rate of economic growth, sustainable development etc., and political stability with good governance. A healthy politico-economic environment favours a smooth flow of international capital.

Role of Foreign Capital
1. Internationalisation of world economy
2. Facelift to backward economies – labour, markets
3. Hi-tech transfers
4. Quick transits
5. High earnings to companies/governments
6. New meaning to consumer sovereignty – choices and standardisation (superioirites)
7. Faster economic growth in developing countries
8. Problems of recession, non-prioritised production, cultural dilemmas etc

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