Challenges of Globalization: Foreign Direct Investment and Trade

1. Challenges of Globalization: Foreign Direct Investment and Trade by Can Erbil 11/10/2006 prepared for HS271 – Frameworks for Development

2. Globalization • “The inexorable integration of markets, nation states, and technologies to a degree never witnessed before, in a way that is enabling individuals, corporations, and nation-states to reach round the world farther, faster, deeper and cheaper than ever before… the spread of free-market capitalism to virtually every country in the world” (Thomas Friedman, The Lexus and the Olive Tree, 1999, pp.7-8) • “A social process in which the constraints of geography on social and cultural arrangements recede and in which people become increasingly aware that they are receding” (M.Waters, Globalization, 1995, p.3) • “Globalization is defined as a process of growing interdependence between all people of this planet. People are linked together economically, and socially, by trade, investments and governance… by market liberalization, and information, communication and transportation technologies” (International Labor Organisation)

3. Globalization • “Fundamentally, it [globalization] is the closer integration of the countries and people of the world which has been brought about by the enormous reduction of costs of transportation and communication, and the breaking down of artificial barriers to the flows of goods, services, capital, knowledge, and (to a lesser extent) people across borders” Stiglitz. • “Globalisation… does not really mean anything different from an open and integrated world economy” (Samuel Brittan)

4. Globalization • Globalization is thus concerned with • increasedflowsof goods, services, capital and labour (?) • Increased flows of information, • with the increased speedof those flows, and • with increased interdependence • One can identify a number of causes or driving factors behind this process: • The liberalization of barriers to trade and mobility. • Developments in technology, and esp. information technology. This allows for both more communication / information + also increased speed of that communication. • Increased focus on “deeper integration” i.e. not just removal of barriers, but also harmonization of them. Such as, standards, legal frameworks, institutions and policies. • Changes in policy by governments and between governments.

6. FOREIGN DIRECT INVESTMENT • Over the past decade, firms based in one country have increasingly made investments to establish and run business operations in other countries. • Over the past two decades, as financial openness has increased across the world, global flows of foreign direct investment have more than doubled relative to gross domestic product. The flows increased in the 1990s, rising from US$324 billion in 1995 to $US1.5 trillion in 2000. However investment levels recently fluctuated considerably depending on the prevailing economic and political climate. The global economic slowdown has reduced financial flows in the past couple of years, against the long-term trend of increases, and political and economic instability have exacerbated problems in some regions. • Capital flows in Latin America dropped from a peak of $US126 billion in 1998 to $72 billion in 2001, reflecting regional problems and global uncertainty. • FDI flows to Argentina fell from $US24 billion in 1999 to $US3billion in 2001. • But FDI has remained strong in East Asia and the Pacific and in Europe and Central Asia. • Developing countries received around a quarter of world FDI inflows in 2001 on average, though the share fluctuated quite a bit from year to year. This is now the largest form of private capital inflow to developing countries.

7. FDI inflows, global and by group of economies, 1980–2005(Billions of dollars)

8. Concentration of FDI inflows: the share of the top 5FDI recipients in the world total, 1980-2005

11. FDI Confidence Index Survey 2005 …tracks the impact of likely political, economic and regulatory changes on the foreign direct investment intentions and preferences of the leaders of top companies around the world.

12. Private Capital Flows to Developing Countries

14. More open trade raises per capita incomes – and the incomes of the poor • There is a growing consensus in empirical studies that greater openness to international trade has a positive effect on country per-capita income. Trade openness in the figure is adjusted to remove the influence of geographical factors. A study by Frankel and Romer (1999) estimates that increasing the ratio of trade to GDP by one percentage point raises per-capita income by between one-half and two percent. Numbers of other studies reach similar conclusions, though the estimated size and statistical significance of the effects vary. (See for example, Edwards (1998) or, for a more skeptical assessment, Rodrik (1999).) A 10 percent increase in the trade to GDP ratio could ultimately raise per-capita income by five percent (cautiously taking the lower bound of the estimates by Frankel and Romer), and one would in general also expect a five percent rise in the income of the poor.

16. Payoffs from Trade Opening • Trade liberalization 'works' by encouraging a shift of labor and capital from import-competing industries to expanding, newly competitive export industries. • The unemployment caused by trade opening is, in most cases, temporary, being offset by job creation in other sectors of the economy. The loss of output due to this transitional unemployment (called the social adjustment cost of trade opening) is also usually small relative to long-run gains in national income due to opening. Or, put another way, these adjustment costs are expected to be small compared to the costs of continued economic stagnation and isolation that would accompany a failure to open up*. • Nevertheless, while adjustment costs are usually small in relative terms, they can still be a serious issue in many countries because they are often concentrated in a geographical area or in a few industries. They will also tend to be felt 'up front', while benefits will tend to be spread out over future periods. Carefully designed social-safety net and educational or retraining programs to help the most vulnerable affected groups are thus an important complement for trade reforms in many cases.

17. Payoffs from Trade Opening • The potential costs of trade opening can also be either reduced or worsened by the overall context of policies in which reform is undertaken. • High macroeconomic instability (big fiscal deficits, high and volatile inflation, volatile real exchange rates) can aggravate the unemployment costs of trade opening by fostering uncertainty, which can prevent firms from investing in the export sectors that are supposed to create new jobs. • A premature capital account liberalization in a country with large fiscal deficits can have a similar effect, by inducing large capital inflows, causing the country's exchange rate to rise, thus making its exports uncompetitive. • The collapse of structural reforms in the 'Southern Cone' countries of Latin America at the end of the 1970s is partly attributed to this kind of inappropriate sequencing of reforms. • Extremely stringent job security regulations may prevent firms hit by import competition from laying off workers, driving them into bankruptcy, as appears to have been the case in Peru in the 1980s.

19. Why has Africa Grown So Slowly? From Xavier Sala-i Martin Notes: Column 1 displays the name of the variable. Column 2 shows the average value that the variable has for African countries. Column 3 reports the corresponding value for OECD economies. Finally, Column 4 uses the empirical estimates of Sala-i-Martin, Doppelhoffer and Miller (2003) to compute the additional annual growth rate that Africa would have enjoyed if, instead of the values reported in Column 2, it had had the OECD values reported in Column 3. For example, the average relative price of investment for Africa was 123. The corresponding price for OECD was 70. If investment in Africa had been as low as in OECD, Africa’s annual growth rate would have been 0.44 percentage points larger.

20. Short Selection of Recent Literature on • FDI • Financial Liberalization • Capital Inflows • Trade Liberalization • Globalization

21. 1) How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages • The empirical literature finds mixed evidence on the existence of positive productivity externalities in the host country generated by foreign multinational companies. The authors propose a mechanism that emphasizes the role of local financial markets in enabling foreign direct investment (FDI) to promote growth through backward linkages, shedding light on this empirical ambiguity. • In a small open economy, final goods production is carried out by foreign and domestic firms, which compete for skilled labor, unskilled labor, and intermediate products. To operate a firm in the intermediate goods sector, entrepreneurs must develop a new variety of intermediate good, a task that requires upfront capital investments. The more developed the local financial markets, the easier it is for credit constrained entrepreneurs to start their own firms. The increase in the number of varieties of intermediate goods leads to positive spillovers to the final goods sector. As a result financial markets allow the backward linkages between foreign and domestic firms to turn into FDI spillovers.

22. How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages • Calibration exercises indicate that • a) holding the extent of foreign presence constant, financially well-developed economies experience growth rates that are almost twice those of economies with poor financial markets, • b) increases in the share of FDI or the relative productivity of the foreign firm leads to higher additional growth in financially developed economies compared to those observed in financially under-developed ones, and • c) other local conditions such as market structure and human capital are also important for the effect of FDI on economic growth.

23. 2) Financial Liberalization in Latin-America in the 1990s: A Reassessment • This paper studies the experience of Latin-America with financial liberalization in the 1990s. • The rush towards financial liberalizations in the early 1990s was associated with expectations that external financing would alleviate the scarcity of saving in Latin-America, thereby increasing investment and growth. • Yet, the data and several case studies suggest that the gains from external financing are overrated. The bottleneck inhibiting economic growth is less the scarcity of saving, and more the scarcity of good governance. • A possible interpretation for these findings is that in countries where private savings and investments were taxed in an arbitrary and unpredictable way, the credibility of a new regime could not be assumed or imposed. Instead, credibility must be acquired as an outcome of a learning process. Consequently, increasing the saving and investment rates tends to be a time consuming process. This also suggests that greater political instability and polarization would induce consumers to be more cautious in increasing their saving and investment rates following a reform. • Hence, reaching a sustained take-off in Latin-America is a harder task to accomplish than in Asia.

24. 3) Why Doesn’t Capital Flow from Rich to Poor Countries?An Empirical Investigation • The authors examine the empirical role of different explanations for the lack of flows of capital from rich to poor countries the "Lucas Paradox." • The theoretical explanations include differences in fundamentals across countries and capital market imperfections. • We show that during 1970-2000 low institutional quality is the leading explanation. • For example, improving Peru's institutional quality to Australia's level, implies a quadrupling of foreign investment. Recent studies emphasize the role of institutions for achieving higher levels of income, but remain silent on the specific mechanisms. Our results indicate that foreign investment might be a channel through which institutions affect long-run development.

25. Why Doesn’t Capital Flow from Rich to Poor Countries?An Empirical Investigation

26. 4) Foreign Direct Investment and Domestic Economic Activity • How does rising foreign investment influence domestic economic activity? • Firms whose foreign operations grow rapidly exhibit coincident rapid growth of domestic operations, but this pattern alone is inconclusive, as foreign and domestic business activities are jointly determined. • This study uses foreign GDP growth rates, interacted with lagged firm-specific geographic distributions of foreign investment, to predict changes in foreign investment by a large panel of American firms. • Estimates produced using this instrument for changes in foreign activity indicate that 10% greater foreign capital investment is associated with 2.2% greater domestic investment, and that 10% greater foreign employee compensation is associated with 4.0% greater domestic employee compensation. • Changes in foreign and domestic sales, assets, and numbers of employees are likewise positively associated; the evidence also indicates that greater foreign investment is associated with additional domestic exports and R&D spending. • The data do not support the popular notion that greater foreign activity crowds out domestic activity by the same firms, instead suggesting the reverse.

27. 5) Trade Liberalization, Poverty andinequality: Evidence from the Indian Districts • Although it is commonly believed that trade liberalization results in higher GDP, little is known about its effects on poverty and inequality. • This paper uses the sharp trade liberalization in India in 1991, spurred to a large extent by external factors, to measure the causal impact of trade liberalization on poverty and inequality in districts in India. • Variation in pre-liberalization industrial composition across districts in India and the variation in the degree of liberalization across industries allow for a difference-in-difference approach, establishing whether certain areas benefited more from, or bore a disproportionate share of the burden of liberalization. • In rural districts where industries more exposed to liberalization were concentrated, poverty incidence and depth decreased by less as a result of trade liberalization, a setback of about 15 percent of India's progress in poverty reduction over the 1990s. The results are robust to pre-reform trends, convergence and time-varying effects of initial district-specific characteristics. Inequality was unaffected in the sample of all Indian states in both urban and rural areas. The findings are related to the extremely limited mobility of factors across regions and industries in India. • The findings, consistent with a specific factors model of trade, suggest that to minimize the social costs of inequality, additional policies may be needed to redistribute some of the gains of liberalization from winners to those who do not benefit as much.

28. 6) Globalization and Poverty • This essay surveys the evidence on the linkages between globalization and poverty. I focus on two measures of globalization: trade and international capital flows. Past researchers have argued that global economic integration should help the poor since poor countries have a comparative advantage in producing goods that use unskilled labor. • The first conclusion of this essay is that such a simple interpretation of general equilibrium trade models is likely to be misleading. • Second, the evidence suggests that the poor are more likely to share in the gains from globalization when there are complementary policies in place. Such complementary policies include investments in human capital and infrastructure, as well as policies to promote credit and technical assistance to farmers, and policies to promote macroeconomic stability. • Third, trade and foreign investment reforms have produced benefits for the poor in exporting sectors and sectors that receive foreign investment. • Fourth, financial crises are very costly to the poor. • Finally, the collected evidence suggests that globalization produces both winners and losers among the poor. The fact that some poor individuals are made worse off by trade or financial integration underscores the need for carefully targeted safety nets.

29. Capital Flows and Financial Markets: Case of Turkey

30. After 2001 Financial Crisis • After 2001 financial crisis structural change became inevitable in Turkey. The rehabilitation of institutions and policy change were placed in the agenda and in this respect: • Central Bank Independence • Shift to Floating Exchange Rate Regime • The establishment of the Banking supervision and auditing institution. Following this period: • One party political majority in the assembly • The end of the war in Iraq • The start of EU negotiations • Contributed to the economic stability.

31. Consumer Price Inflation and (Implicit) Inflation Targets

32. Maturity on Public Debt (months)

33. Falling inflation and easing fiscal dominance brought high and sustainable growth.

34. Capital Flows and Business Cycle

35. Capital Inflows in Turkey Non-bank private sector began to use long term credits which constitutes 48.9 percent of total capital inflows. 96.5 percent of these credits were long term.

36. Foreign Direct Investment / GDP The share of FDI and long–term capital inflows in total capital inflows is increasing. FDI share: % 41.3 Long–term inflows as a share of total credit: % 84.2

37. Short – term capital inflows after/before EU negotiations For those countries in which the ratio is below “one” short – term capital inflows decreased (except Poland) after the start of EU negotiations.

38. Long – term capital inflows after/before EU negotiations For those countries in which the ratio is above “one” long – term capital inflows increased after the start of EU negotiations.

39. International risks are also falling Chicago Board of Exchange Volatility Index (VIX) The fall in international investment risks, motivated the investment motivation in high return emerging markets.

40. We observe a fall in the risk premium for Turkey EMBI presents the risk premium that Turkey pays in terms of foireng currency borrowing.

41. Current account deficits of developing countries doubled in the 2003 – 2005 period. Long – term capital inflows was the main instrument to finance the deficit.

42. Current account deficits in new and prospective EU members Current account deficits and questions regarding its sustainability is not unique for Turkey.

43. Current Account Deficits

44. FDI/GDP A comparison among countries (2003)

45. Financial Deepening and Capital InflowsCredit to Private Sector / GDP

46. The change in credit compositons

47. Real Interest Rates (Ex-post, CPI)

48. Short – term interest rates Volatility in interest rates declined.Given inflation figures, real interest rates preserve their high levels.

49. Real Exchange Rate Index (1995=100) Capital inflows in floating exchange rate regime appreciates Turkish Lira.

50. Productivity and Unit Labor Costs