Nafziger Economic Development (4th ed)

526 Part Four. The Macroeconomics and International Economics of Development

BOX 15-1. THE HAWALA SYSTEM

Stateless and nomadic peoples and those living amid war often design alternative systems to those of banks, credit cards, and travelers’ checks. According to Peter Little (2003:142)

In the Somali borderlands, confidence in the local currency facilitates credit and financial transfers, critical components of commerce because of the risks associated with [traders and herders] carrying large amounts of cash. While much of the livestock trade is calculated in SoSh [the Somalia shilling issued in the 1980s] and final payments are made in SoSh or US dollars, the actual handling of cash in large transactions is minimal. Somali border traders . . . can take their earnings to Nairobi, convert them to dollars, and then “wire” them back to money houses in Somalia, where they can be picked up by associates.

This informal hawala system avoids the carrying of large amounts of cash across the border. Informal money houses and middlemen, important in long-distance trade involving livestock, mediate credit in a system that requires considerable trust to operate. The Somali shilling, because of its relative stability, facilitated border trade in livestock and other commodities in a weak state that lacked a central bank (Little 2003:142, 145).

Unfortunately for many Somalis, the largest hawala bank, al Barakat, was abruptly closed in November 2001 by a U.S.-led initiative that claimed the bank laundered funds for al-Qaida. Thus, what had evolved as a viable institution for transfers following the collapse of Somalia’s finance sector was closed to thousands of Somali families dependent on it in the region and around the world (Little 2003: 143).

The weaknesses of banks and other financial institutions impose substantial transactions costs on migrants who send remittances. The average cost of these transfers (exchange-rate commissions and transfers fees) are 12.8 percent in Cuba, 12.6 percent in Colombia, 10.7 percent in Haiti, and 9.1 percent in Mexico, an astronomical sum compared with transfers among DCs. Many U.S. banks recognize matriculas consulares, identity cards for legal or illegal residents with Mexican citizenship, as identification for opening bank accounts (World Bank 2003f:165–166).

The exorbitant transfer cost has increased the use of informal channels, such as the hawala (“transfer” in Arabic) (Little 2003:143; World Bank 2003f:173). However, in an era of concern about money laundering by terrorists, the hawala option has been increasingly cut off, as Box 15-1 indicates.

PRIVATE INVESTMENT AND MULTINATIONAL CORPORATIONS

As real aid to less-developed countries fell during the 1990s, foreign direct investment (FDI), at 74 percent in 2002, comprised an increasing portion of total resource flows to developing countries (Figure 15-1). Private FDI, a source for financing the balance

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	45
	40	1998
	35
	30
	25
	20
	15	1982
	10
	5
	0

All countries Canada Mexico China Other Asia

FIGURE 15-8. Exports of U.S. Affiliates as a Share of Total Exports (in percent).

Note: Exports from U.S. affiliates in all countries show no rise in the share of sales because of declines in the export shares in primary production. Source: World Bank 2000f:58.

on goods and services deficit, consists of portfolio investment, in which the investor has no control over operations, and direct investment, which entails managing the operations. In the 19th century, Western European investment in the young growing debtor nations, the United States and Canada, was primarily portfolio investment, such as securities. Today, DC investment in LDCs is mostly private direct investment. Multinational corporations (MNCs), business firms with a parent company in one country and subsidiary operations in other countries, are responsible for much of this direct investment.

MNC intrafirm trade is a large proportion of international trade. In 1999, 36 percent of U.S. exports were intrafirm exports, whereas in Japan 31 percent of exports were intrafirm, for both countries an increase over 1990’s percentage. Intrafirm trade in services became steadily more important during the last quarter of the 20th century.

In addition, LDCs boosted exports by participating in global production networks dominated by DCs such as the United States and Japan. Exports of U.S. affiliates as a percentage of China’s exports were 36 percent in 1998. Figure 15-8 shows U.S. affiliate percentages in other Asian countries, Mexico, Canada, and all countries with U.S. affiliates in 1982 and 1998.

At the turn of the 21st century, the global economy was dominated by MNCs from the United States, European Union, and Japan. DCs comprised 71 percent of foreign direct investment (FDI) inflows, 75 percent of FDI outflows, and a large share of the international trade. But emerging economies such as Taiwan, South Korea, Singapore, China, India, and Brazil are beginning to be a factor in foreign investment (D’Costa 2003:3l; Table 15-3). Moreover, as Figure 15-9 shows, in 2000, 56 percent of the FDI in LDCs is from high-income OECD countries compared to 35 percent from other LDCs, and 9 percent from high-income non-OECD countries.

High-income non-OECD/total FDI

	North-South FDI/total FDI	FIGURE 15-9. Share of South–South FDI in
		Total FDI. Source: World Bank 2003f:124.

South-South FDI/total FDI

528 Part Four. The Macroeconomics and International Economics of Development

TABLE 15-3. Outward FDI Flows,a by Geographical Destination, 1999–2001 (billions of dollars and percentage distribution)

	Value in billion dollars		Percentage distribution
	Average		Average
Region/economy	1999–2000	2001	1999–2000		2001
Developed countries	924.2	470.1	83.7		74.6
Western Europe	640.9	259.7	58.0		41.2
European Union	589.4	236.6	53.4		37.5
Other Western Europe	50.9	24.1	4.6		3.8
Unspecified Western	0.6	−1.0	0.1		−0.2
Europe
North America	256.2	197.3	23.2		31.3
Other developed countries	25.0	9.1	2.3		1.4
Unspecified developed	2.2	3.9	0.2		0.6
countries
Developing economies	129.2	115.2	11.7		18.3
Africa	6.8	8.5	0.6		1.3
North Africa	0.5	1.8	0.0		0.3
Other Africa	5.0	6.3	0.5		1.0
Unspecified Africa	1.3	0.4	0.1		0.1
Latin America and the	84.7	69.1	7.7		11.0
Caribbean
South America	39.5	20.3	3.6		3.2
Other Latin America and	36.4	38.0	3.3		6.0
Caribbean
Unspecified Latin	8.8	10.9	0.8		1.7
America and Caribbean
Asia	33.9	36.5	3.1		5.8
West Asia	0.8	2.8	0.1		0.4
Central Asia	1.0	0.1	0.1		0.0
South, East, and South-East	31.0	32.8	2.8		5.2
Asia
Unspecified Asia	1.1	0.8	0.1		0.1
The Pacific	1.5	0.8	0.1		0.1
Unspecified developing	2.4	0.3	0.2		0.1
countries
Central and Eastern Europe	18.0	18.6	1.6		3.0
Unspecified	32.7	26.3	3.0		4.2
Total world	1,104.1	630.3	100.0		100.0

May not add up to totals because of rounding.

aTotals for developed countries are based on data for the following countries: Australia, Austria, Belgium and Luxembourg, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, and United States.

Source: UNCTAD 2003:9.

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The United States accounted for 52 percent of the world’s stock of outward foreign direct investment (FDI) capital in 1971, 40 percent in 1983, 25 percent in 1993, and 16 percent in 2001. DCs comprised 97 percent of world FDI capital stock in 1983 and 93 percent in 1993, but fell to 75 percent in 2001. The United States was the leading source of outward FDI from 1971 to 2001 although the European Union, with 38 percent, had more than twice the US’s 2001 figure. The leading countries of the South with FDI stock included DCs Singapore, Taiwan, South Korea, and Hong Kong, in addition to South Africa, India, Brazil, Argentina, Colombia, Peru, the Philippines, and the OPEC countries (Bergsten, Horst, and Moran 1981:267–95; Streeten 1981:308–15; Dunning 1988:28–29; UNCTAD 1994; UNCTAD 2003:6–9).

The United States had both the largest inward (Table 15-4) and outward flows of foreign direct investment in 2001.10 When Hong Kong is included, China ranked second in 2001 in inward flows (or first in LDC inflows). Although some FDI flowing to China is recycled domestic investment (explained in Chapter 19), even if this were subtracted, China’s FDI inflows would rank first among LDCs. The world’s potentially largest market and low-cost labor-intensive production in China, which has become the world’s major industrial workshop, attracted many MNCs. Most of the world’s business community believed that no one could afford to ignore the enormous investment opportunities in China. For many an MNC, investment in China represented an effort to get its “foot in the door.” But China, a low-cost source, is a hard bargainer, frequently demanding total access to foreign technology in exchange for access to its market (Kranhold 2004:A1). Still, China’s FDI growth for the first two decades of the 21st century will depend largely on its political stability, the consistency of its economic policies, its macroeconomic management, and its integration into the world economy (UNCTAD 1994b:14–68).

Mexico and Brazil were other leading FDI hosts in developing countries. If we use UNCTAD definitions of LDCs, which include Singapore, Republic of Korea, and Taiwan, and if Hong Kong is combined with China, the top 10 FDI recipients among developing economies received 73 percent of inward FDI in 2001. UNCTAD (2002b:215) states that private capital flows have been concentrated in a few countries. Africa, where the risk premium is high, received only 19 percent. Most of the leading African recipients – Angola, Nigeria, Algeria, Chad, Tunisia, South Africa, Sudan, Egypt, Morocco, and Mozambique – received large amounts of FDI in minerals or petroleum (UNCTAD 2003:7–13, 34).

The World Bank (1997a:2) states that “participation in the global production networks established by multinational enterprises provides developing countries with new means to enhance their economic performance by accessing global know-how and expanding their integration into world markets.” Indeed, net private capital flows to LDCs were $168 billion or 2.8 percent of their GNI in 2001, a fall from

10The drop in inflows to the United States reflected large repayments of loans by foreign affiliates in the United States to their parent companies and reductions in financing mergers and acquisitions in the United States. Much of the inflow to Luxembourg, separated from Belgium for the first time in 2002, was driven by tax advantages rather than productivity (UNCTAD 2003:6–8, 31).

530 Part Four. The Macroeconomics and International Economics of Development

TABLE 15-4. FDI Inflows to Major Economies, 2001 and 2002 (billions of dollars)

Host region/economy	2001	2002
World	823.8	651.2
Developed countries	589.4	460.3
European Union	389.4	374.4
France	55.2	51.5
Germany	33.9	38.0
Luxembourg	−	125.6
United Kingdom	62.0	24.9
Other EU	238.3	134.4
United States	144.0	30.0
Other	56.0	55.9
Developing economies	209.4	162.1
Africa	18.8	11.0
Algeria	1.2	1.1
Angola	2.1	1.3
Nigeria	1.1	1.3
South Africa	6.8	0.8
Other Africa	7.6	6.5
Latin America and the Caribbean	83.7	56.0
Argentina	3.2	1.0
Brazil	22.5	16.6
Mexico	25.3	13.6
Other Latin America	32.7	24.8
Asia and the Pacific	106.9	95.1
China	46.8	52.7
Hong Kong, China	23.8	13.7
India	3.4	3.4
Korea, Republic of	3.5	2.0
Malaysia	0.6	3.2
Philippines	1.0	1.1
Singapore	10.9	7.7
Taiwan Province of China	4.1	1.4
Thailand	3.8	1.1
Other Asia and Pacific	9.0	8.8
Transitional economies	25.0	28.7
Central and Eastern Europe	25.0	28.7
Czech Republic	5.6	9.3
Poland	5.7	4.1
Russian Federation	2.5	2.4
Other C. & E. Europe	11.2	12.9

May not add up to totals because of rounding.

Categories of developed, developing, and transitional economies may vary from those in this book.

Source: UNCTAD 2003:7.

15. Balance of Payments, Aid, and Foreign Investment

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this percentage in 1990. This percentage fell even further for low-income countries, many with low credit ratings during this period, a continuation of a fall that began in the early 1980s (World Bank 2003h:16, 332; FitzGerald 2002:62–84). In addition, private capital flows are highly volatile, especially in countries that have liberalized their financial markets. After the 1997–98 Asian crisis, for example, private capital flows to LDCs fell substantially.

Although subject to substantial fluctuations, about half of private capital flows to LDCs in the 1990s were loans, which contribute to future debt service, and portfolio investments, which are subject to reverse capital flows (World Bank 2002e:354; UNCTAD 2003d:4). FDI does not generate debt servicing or capital outflows, and potentially can finance a savings or balance of payments deficit, bring about a transfer of technology and innovative methods of increasing productivity, fill part of the shortage of high-level skills, provide training for domestic managers and technicians, generate tax revenue from income and corporate profits tax, and complement local entrepreneurship by subcontracting to ancillary industries, component makers, or repair shops, or by creating forward and backward linkages.

Investment inflows as a percentage of gross fixed capital investment in Africa were 9 percent in 2002. However, although annual FDI flows to least developed countries increased by 65 percent from 1989 to 1994, and tripled from 1989 to 2001 (Figure 15-10) the least-developed countries’ share of developing-country inflows was only 0.6 per cent in 2001. Most of these flows were to African mineral and petroleum countries (UNCTAD 2002c:49, 74, 77). Moreover, low-income countries (LICs) comprised only 30 percent of the $171 billion FDI flows to developing countries of 2001, and India took a lion’s share of LIC’s FDI (World Bank 2003e:87; World Bank 2003h: 331–332).11

The share of FDI flows in 1998–2000 gross domestic capital formation was 7 percent for LLDCs and 13 percent for all other developing countries. According to UNCTAD (2002c:73–78), 17 of the 25 LLDCs for which indexes were constructed were underperformers, 1986–2001, in attracting FDI flows.

Developing countries, particularly LLDCs, need policies to increase FDI and other external resources. In 1988, the World Bank established the Multilateral Investment Guarantee Agency (MIGA) to help developing countries attract foreign investment. MIGA provides investors with marketing services, legal advise, and guarantees against noncommercial risk, such as expropriation and war (Aguilar 1997:10).

By 2001, 41 least-developed countries had concluded bilateral investment treaties (BITs) with other countries for the protection and promotion of foreign investment, and 33 had entered into double taxation treaties to avoid taxation in both LLDC and the headquarters’ country. FDI plays a role not only in finance but also in skills, technology, and knowledge needed to spur economic growth (ibid., pp. 78–79).

11Ndikumana (2001) contends that reports of a “surge” in Africa’s FDI is an illusion. Africa’s share of FDI inflows to LDCs fell from 10.5 percent in 1981–89 to 4.3 percent in 1999. Reasons for this fall were a weak macroeconomic environment, underdeveloped financial system (including weak regulation and supervision), and high country risk from high transactions cost from administrative inefficiency and psychocultural distance.

532 Part Four. The Macroeconomics and International Economics of Development

FIGURE 15-10. FDI Inflows and ODA Flows to LLDCs, 1985–2001 (billions of dollars). Source: UNCTAD 2002d:77.

Although official development assistance comprised the largest component of external resources for LLDCs, it declined relatively and absolutely, 1995 to 2000 (see Figure 15-10).

Tanzania, an LLDC, provided an enabling framework for FDI in the late 1980s and early 1990s, by making the transition to a market economy, undertaking market reforms (including enacting a mining act more favorable to FDI), and beginning a privatization program for inefficient state enterprises. During 1995–2000, Tanzania received $1 billion FDI, much in gold mining, compared to only $90 million during 1989–94. Mining served as an engine of growth, helping to increase gold exports and to modernize the banking industry. Foreign investors have helped restructure privatized enterprises, boosting technology, skills, and competitiveness. In addition, from the early to late 1990s, FDI’s contribution to the balance of payments changed from negative to positive (UNCTAD 2002c:75).

Similar to Tanzania, there is a possibility of attracting FDI to LLDCs and lowincome countries, not just to those with potentially large markets, such as China and India; with nonresident nationals, as China or India; with resident nationals managing cross-border investments, as in Malaysia, Mozambique, South Africa, or East Africa (FitzGerald 2002:71); or with extractive industries, such as Nigeria or Angola. Vietnam introduced FDI legislation in 1987–88, which, together with the lifting of U.S. economic sanctions in 1994, increased FDI inflows from $8 million in 1988 to $150 million in 1995. Bangladesh’s FDI reforms in 1991, which facilitated the establishment of foreign-owned subsidiaries, increased inflows from just a trickle in the 1980s to $125 million in 1995. Ghana, as a result of Ashanti goldfield privatization, increased annual FDI inflows 17-fold from a $11.7 million average during 1986–92 to an average of $201 million in 1993–95 (ODI 1997:2). Even Cambodia, which created a legal framework and the necessary institutions to promote FDI after 1993, increased its FDI capital inflows from virtually nothing in 1990 to $656 million in 1996 (UNCTAD 1997a:54, 316).

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Since the mid-1980s, with falling trade, transport, and communication barriers, multinational corporations (MNCs) have increased their international outsourcing, importing components from low-cost production locations abroad and exporting to overseas assembly or processing locations. As an example, following the rise of the yen after 1985, Japan’s major electronics manufacturers outsourced assembly and other final stages of output to Asian countries (World Bank 1997i:42–43). Asian NICs and ASEAN countries were a part of Japanese companies’ borderless economic system of trade and investment. These companies used a flying-geese pattern, with Japan at the lead, and Asian emerging nations forming the “V” behind. Chapter 17 discusses both Japanese and U.S. global production networks.

Developing countries need to undertake major institutional changes (see Chapter 4), not only to facilitate foreign and domestic investment but to provide the scaffolding for other economic policies that increase a country’s attractiveness for foreign private domestic capital flows. With changes in institutions, a number of low-income countries could begin participating in the new international division of labor created by outsourcing by high-income OECD countries. But this flying-geese pattern may also apply to non-OECD leader countries. ECA (1989) estimates that, during the 1980s, Southern African Development Community (SADC) countries other than South Africa lost one-fourth of their GDP from South Africa’s destabilization. However, since 1994, a democratic and prosperous South Africa should provide the economic leadership to spur SADC’s economic development. South Africa, with its trade and FDI (including those by MNCs in the country), could serve as a “growth pole” for other SADC members of the region – Angola, Botswana, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Swaziland, Tanzania, Zambia, and Zimbabwe (UNCTAD 1997b:64–66).

Of course, participating in this global production sharing has its benefits and costs, as in the cases of Malaysia and Thailand, discussed in Chapter 17, and also discussed later when we look at the benefits and costs of MNCs.

THE BENEFITS AND COSTS OF MULTINATIONAL CORPORATIONS

Some LDC governments are ambivalent, or even hostile, toward MNCs. To be sure, these corporations bring in capital, new technology, management skills, new products, and increased efficiency and income; however, MNCs usually seek to maximize the profits of the parent company, rather than the subsidiaries’. Surely the main reason for LDCs soliciting MNC investment and other foreign direct investment is their contribution to technology transfer.12 However, it may be in the interest of the parent company to limit the transfer of technology and industrial secrets to local personnel of the subsidiary, to restrict its exports, to force it to purchase intermediate parts and capital goods from the parent, and to set intrafirm (but international) transfer prices to shift taxes from the host country. Still, during the last decade or so, some MNCs have concentrated increasing research and development in affiliates, even in LDCs.

12Javorcik (2004:605–627) finds positive productivity spillovers from FDI from foreign affiliates to their local suppliers (that is, backward linkages) but only with partially owned foreign projects.

534Part Four. The Macroeconomics and International Economics of Development

For example, in the 1990s, when U.S., Japanese, and E.U. MNC affiliates became more integrated into parent companies’ highly nuanced value added ladder, MNCs located more research and development (R&D) in their affiliates.

Most foreign investment is from large corporations. The largest MNCs, with hundreds of branches and affiliates throughout the world, have an output comparable to the LDC with which they bargain. ExxonMobile, Shell, BP, General Motors, Ford, Toyota, Hitachi, Matsushita, Siemens, and General Electric each have an annual value added exceeding that of most third-world countries (Table 15-5). Thus, for instance, General Motors would not negotiate investment in Bangladesh or ExxonMobile in Nigeria as an inferior party but as roughly an equal in economic power and size.13 Furthermore, MNCs are increasingly footloose, shifting investments from country to another as tax rates, wages, and other costs change (Barnet and Cavanagh 1994).

MNCs are important actors on the international scene. UNCTAD estimates that the value added of the world’s top 100 firms accounted for 4.3 percent of world GDP in 2000 (UNCTAD 2002:91) and that MNC intrafirm trade was one-third of international trade (UNCTAD 1994b). Four-fifths of Africa’s 1983 commodity trade was handled by MNCs. Thirty-eight percent of total U.S. imports in 1977 consisted of intrafirm transactions by MNCs based in the United States. Over one-third of these transactions were from LDCs. Moreover, MNCs play an important role in LDC manufacturing exports, responsible for 20 percent of Latin America’s manufactured exports. Indeed, U.S. affiliates alone accounted for 7.2 percent of 1977 LDC manufacturing exports, 35.7 percent of Mexico’s, and 15.2 percent in Brazil, but only 1.5 percent in South Korea (UNCTAD Seminar Program 1978; Streeten 1981:308–315; Economic Commission for Africa 1983a; UNCTAD 1985:3–8; Blomstrom, Kraus, and Lipsey 1988).

The markets MNCs operate in are often international oligopolies with competition among few sellers whose pricing decisions are interdependent. International economists contend that large corporations invest overseas because of international imperfections in the market for goods, resources, or technology. The MNCs benefit from monopoly advantages, such as patents, technical knowledge, superior managerial and marketing skills, better access to capital markets, economies of large-scale production, and economies of vertical integration (that is, cost savings from decision coordination between a producing unit and its upstream suppliers and its downstream buyers). An example of vertical integration is from crude petroleum marketing backward to its drilling and forward to consumer markets for its refined products. UNCTAD (1993:5) argues, however, that in the 1990s, with substantial improvements in communication and information technologies, MNCs have moved to even more complex integration, coordinating “a growing number of activities in a wider array of locations.” Multinationals are increasingly establishing stand-alone affiliates, linked by ownership to the parent but otherwise operating largely as independent

13Table 15-5 subtracts purchases of inputs from other firms from, for example, General Motor’s production to get value added, to avoid double-counting the production of inputs supplied by one firm to another. This makes the figure for GM comparable to Bangladesh’s GDP. The table’s notes indicate the adjustment made to sales to obtain value added, an adjustment that, at best, indicates a rough comparability between MNCs and nation-states.

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TABLE 15-5. Ranking of Developing (Lowand Middle-Income)

Countries and Multinational Corporations According to

Value Added in 2000a ($ billions)

1.	China	1,080
2.	Brazil	595
3.	Mexico	575
4.	India	457
5.	Argentina	285
6.	Russian Federation	251
7.	Turkey	200
8.	Saudi Arabia	173
9.	Poland	158
10.	Indonesia	153
11.	South Africa	126
12.	Thailand	122
13.	Venezuela	120
14.	Iran, Islamic Rep. of	105
15.	Egypt	99
16.	Malaysia	90
17.	Colombia	81
18.	Philippines	75
19.	Chile	71
20.	Exxon Mobileb	63
21.	Pakistan	62
22.	General Motorsb	56
23.	Peru	53
24.	Algeria	53
25.	Bangladesh	47
26.	Hungary	46
27.	Ford Motor	44
28.	Daimler Chrysler	42
29.	Nigeria	41
30.	General Electricb	39
31.	Toyota Motorb	38
32.	Kuwait	38
33.	Romania	37
34.	Royal Dutch/Shell	36
35.	Morocco	33
36.	Ukraine	32
37.	Siemens	32
38.	Viet Nam	31
39.	Libyan Arab Jamahiriya	31
40.	BP	30
41.	Wal-Mart Storesc	30
42. IBMb		27
43.	Volkswagen	24
44.	Cuba	24

(continued)