The relative importance of direct investment in the capital flows to developing countries has been declining since the early 1970s. While direct investment continued to increase in absolute terms, bank credit has become a much more dominant factor in private capital flows. Some observers have argued that this shift in the composition of private capital flows has increased the vulnerability of the developing countries to external payments difficulties. Moreover, with relatively slow growth in bank lending to these countries in prospect for the medium term, other sources of external financing, including direct investment, will be required if the pace of development is to improve. With these considerations in mind, this article examines some of the causes and consequences of the decline in the relative importance of direct investment since the early 1970s and discusses the conditions and modifications in policies in both lending and borrowing countries that might encourage larger flows of such investment. Direct investment also involves the transfer of a package of resources, including technological and managerial expertise in addition to capital; these may have an even greater impact than capital flows on a recipient country’s production capabilities. However, this article is concerned with the macroeconomic aspects of direct investment, in particular with its role in capital transfers and adjustment.
Direct investment refers to investment made to acquire a lasting interest and an effective voice in the management of an enterprise. Many countries set a minimum proportion (generally between 10 and 25 percent) of foreign ownership of the voting stock as evidence of direct investment. In principle, all capital flows provided by direct investors, including equity capital, reinvested earnings, and net lending, are classified as direct investment.
Trends in investment
Net inflows of foreign direct investment into developing countries generally increased throughout the 1960s and 1970s. Direct investment flows from industrial to developing countries rose from an average of under $2 billion a year during the early 1960s to an average of around $13 billion a year during 1979-81. However, their share in total capital inflows declined substantially as external borrowing, particularly from commercial banks, grew rapidly.
Although the rapid expansion of commercial bank lending was already underway before the first large oil price increase of 1973-74, that event accelerated the decline in relative importance of direct investment flows, especially for the non-oil developing countries, which financed most of their larger current account deficits by external borrowing. In 1973, direct investment flows financed some 20 percent of the combined current account deficit and net accumulation of reserves of non-oil developing countries, compared with an average of only about 12 percent in later years (see chart). Nevertheless, these inflows continued to increase in real terms—at an average annual rate of about 3 percent in terms of constant prices—to an average of about $10.5 billion during 1979-81, but declined during the recession of 1982 and 1983.
As a consequence of the shift in the composition of financing, the structure of the external liabilities of these countries changed significantly. The share of direct investment in total gross external liabilities (total external debt plus stock of foreign direct investment) of non-oil developing countries declined from an estimated 26.5 percent in 1973 to 17 percent in 1983, while the share of public and publicly guaranteed debt to private financial institutions rose from 10 percent to 25 percent (see table).
Distribution of financing flows to non-oil developing countries. 1973-831
Sources: IMF. World Economic Outlook, 1984 (Occasional Paper No. 32). International Capital Markets (Occasional Paper No. 1), and External Indebtedness of Developing Countries (Occasional Paper No. 3).
1 Excluding reserve-related liabilities and errors and omissions.
These global trends mask a wide diversity of experience in individual countries, resulting from differences in both economic environment and policies toward foreign direct investment. Much of this investment is concentrated in a small number of countries that have large domestic markets, are rich in natural resources, or have significant advantages as a base for export-oriented production. Five countries (Brazil, South Africa, Mexico, Singapore, and Malaysia) accounted for almost one half of the stock of direct investment in non-oil developing countries at the end of 1983. Nevertheless, some other countries that also have large domestic markets (such as India and Turkey) or that successfully pursued an export-oriented development strategy (such as Korea) were much less reliant on direct investment.
The United States has been the principal source of private direct investment in developing countries, although it declined in relative importance in recent years along with the two other traditional sources—the United Kingdom and France—while direct investment from Germany and Japan grew rapidly. The stock of U.S. direct investment in developing countries grew at an average annual rate of less than 10 percent during 1970-82, compared with growth rates of 17 percent and 21 percent for Germany and Japan, respectively. However, in 1982 the United States still accounted for almost half of the total stock of such investment. Together, the five largest source countries have accounted for some 85 percent of direct investment flows from industrial to developing countries during recent years.
The returns on direct investment flows have fluctuated with changes in the global economy. Total net recorded dividends and net interest payments by developing countries on direct investment rose from $9.5 billion in 1973 to a peak of $26.5 billion in 1981, but then declined to less than $18 billion in 1983, when profits fell sharply as a result of the world recession. Most of the increase between 1973 and 1981 came from the major oil exporting countries; the later decline reflected lower oil prices and a weakening of the economies of some of the oil exporting countries. Payments from non-oil developing countries rose from $3.5 billion in 1973 to $9.5 billion in 1981, before declining sharply to an estimated $6.25 billion in 1983. Expressed as a percentage of exports of goods and services, non-oil developing countries’ total payments on direct investment declined gradually over the decade from 3 percent in 1973 to less than 1.5 percent in 1983. Meanwhile, interest payments on external debt rose from some 6 percent of exports of goods and services in 1973 to over 13 percent in 1983, reflecting the increased emphasis on financing of the balance of payments through debt.
Changes in financial markets
Structural changes in the financial system were already underway by the late 1960s as major banks increased their international operations and, attracted by promising growth prospects, greatly increased their lending to some of the more rapidly industrializing developing countries. This trend was continued after 1973, as the relatively risk-averse asset preferences of oil exporting countries led them to hold many of their assets in the form of liquid bank deposits. Together with the greatly increased demand for medium- and longer-term financing by developing countries, this provided banks with the opportunity to expand their role as international financial intermediaries. To indicate the magnitudes involved, the cumulative current account deficits of non-oil developing countries over 1974-83 amounted to $588 billion, while net borrowing from banks by these countries was $216 billion and the net inflow of direct investment $82 billion (also see chart). Much of the new bank lending was either to, or guaranteed by, governments and was encouraged by the view that the risks associated with such lending were relatively low in comparison to normal commercial lending.
In contrast, there was much less scope for large immediate increases in direct investment, which depended on the identification of individual opportunities for profitable investment and was influenced by a wide range of institutional restraints that could not be altered quickly. A considerable part of the external borrowing was undertaken by governments to finance balance of payments or fiscal deficits and it might have been difficult for foreign equity capital, which is more directly associated with private enterprise investment, to substitute for a substantial proportion of such borrowing, at least in the short term. This is because most developing countries have limited and fragmented capital markets, which means that the particular causes of a macroeconomic imbalance have a strong influence on the composition of capital inflows. Even so, longer-term possibilities for substitution between direct investment and borrowing from commercial banks as sources of capital inflows can still be significant, especially for countries with substantial domestic markets or natural resource endowments; these countries were often among the larger borrowers from commercial banks. In this regard, restrictive policies adopted by many developing countries toward foreign direct investment also seem to have contributed to a greater reliance on bank credit.
Host country policies
Most developing countries combine some degree of regulation and control of direct investment, aimed at improving net benefits to the host country, with various incentives designed to attract such investment. In general, during the 1960s and much of the 1970s there was a trend toward greater restrictions. Increased availability of alternative external financing, disappointment with some of the results of direct investment, and growing nationalist sentiment in many countries all contributed to this trend.
Although the combination of policies chosen depends to a large extent on a country’s development strategy and market philosophy, the underlying attractiveness of a country as an investment location is also important since this affects its relative bargaining strength vis-à-vis potential direct investors. A number of countries (particularly in Africa and the Caribbean) were unable to attract significant inflows of direct investment despite offering substantial incentives, because of their small domestic markets and limited natural resources. However, a few territories and countries with relatively small domestic markets (including Hong Kong, Singapore, and, to some extent, Malaysia) that pursued open economic policies and maintained few restrictions on foreign investment were able to attract substantial export-oriented direct investment, while generally offering only moderate incentives. Many other countries imposed a number of restrictions or specific performance requirements on such investment, as they sought to extract greater benefits.
Restrictions and regulations often acted as a barrier to the entry of new investment, but they were sometimes offset by a country’s attractive location, especially if they were not too complex or subject to sudden and frequent changes. The provision of a stable economic environment and the adoption of appropriate financial and exchange rate policies are probably at least as important for encouraging foreign investment and for increasing the flow of new benefits to the host country as are policies related specifically to such investment.
Recent trends in a number of countries indicate a liberalization of policies in order to attract more foreign investment. Some countries (including Egypt, Jamaica, the Philippines, and Turkey) shifted from policies that emphasized detailed control of direct investment to much more flexible arrangements, while more gradual policy changes took place in other countries (including Korea, Mexico, Morocco, and Pakistan). The policies of some centrally planned economies toward foreign direct investment were also modified in recent years. One of the greatest changes took place in China, which now encourages investment through either joint ventures or wholly foreign-owned enterprises, and has liberalized regulations governing the purchase of inputs and the sale of a proportion of output on the domestic market (see the article by Luc De Wulf in this issue).
Industrial country policies
At present, most industrial countries maintain relatively few restrictions on capital outflows and provide some encouragement for direct investment in developing countries, through guarantee and insurance schemes and various forms of official financial support. The decline in the relative importance of direct investment in total capital flows to developing countries during the 1970s was not due to any major change in such policies. Nevertheless, the protectionist trade measures adopted in recent years could have discouraged direct investment since they reduced opportunities for profitable investment in export sectors where developing countries have demonstrated a comparative advantage.
Most industrial countries provide insurance for new direct investment in developing countries, generally with coverage of noncommercial risks such as expropriation, losses due to war, and inconvertibility of dividend and capital transfers. However, with the exception of Japanese and Austrian direct investment, more than half of which is covered by such insurance, existing official arrangements cover only a small fraction—generally less than 10 percent—of industrial countries’ total direct investment in developing countries. The World Bank is exploring a multilateral investment insurance scheme that would build upon and complement existing national and private schemes (see “Increasing private capital flows to LDCs” by Ibrahim Shihata in the December 1984 issue).
|Stock of foreign|
(In billions of dollars)
|Share of foreign|
in total gross
|Seven major borrowers||20.0||59.6||350.1||14.5|
|Non-oil developing countries||47.0||140.9||685.5||17.0|
Effects on external adjustment
The shift in the composition of capital inflows into developing countries, toward more bank credit and less direct investment, is likely to have increased these countries’ vulnerability to various economic disturbances. This is because, unlike debt, an equity investment requires no service payments unless it earns a positive return. In this sense, the greater the share of direct investment in a country’s portfolio of external liabilities, the greater is the share of risk associated with economic disturbances that is borne by foreign investors. In addition, since direct investment can be sensitive to changes in a host country’s relative competitiveness, as well as to its interest rate and credit policies, a higher proportion of such investment in total capital flows can increase the responsiveness of such flows to a country’s adjustment policies.
Because of the greater risk associated with equity investment generally, returns on such investments usually need to be higher than those on external debt. The combination of risk and return that a country is willing to accept is determined not only by individual preferences within the country but also by the costs associated with maintaining service payments on foreign liabilities when economic conditions deteriorate. These costs generally result from the need to restore a sustainable current account position either by reducing aggregate expenditures or by switching resources from nontraded to traded sectors.
There is some evidence that total returns on equity investment are more correlated with a country’s ability to service its external liabilities than are interest payments on external debt. For a group of non-oil developing countries for which sufficiently long time series are available on reinvested earnings, the estimated annual rate of return on direct investment was positively associated with the annual rate of growth of GDP; there was a similar, although much weaker, association with the rate of growth of exports. By contrast, there was little association between these countries’ rates of growth of GDP or exports and the average interest rate paid on their outstanding external debt. The contrast in movements in rates of return and interest rates was particularly marked during the recent recession.
In light of the relationships described above, the process of adjustment to economic disturbances should be easier in a country with a large proportion of direct investment in total external liabilities. For 28 developing countries that rescheduled part of their external debt during 1983, the stock of direct investment accounted for an average of only 14 percent of their total external liabilities (i.e., direct investment plus external debt) at end-1983, compared with an average of 24 percent for those 49 developing countries with available data that did not reschedule debt.
However, the way in which variations in profits affect current account adjustment also depends on their distribution between remitted dividends and reinvested earnings, since this influences the immediate foreign exchange outflow. The share of earnings that are reinvested fluctuates substantially with changes in economic conditions. For example, there are indications that—at least during the recent recession—remitted dividends declined much less than did reinvested earnings, particularly for direct investment in the manufacturing sectors of developing countries.
Prospects and policies
The financing pattern that supported the upsurge in current account deficits of developing countries through 1981 is unlikely to be repeated. In particular, new net lending through the international banking system is likely to be much more constrained in the future, so that foreign direct investment will probably be needed to contribute a greater share of future capital inflows. New net bank lending to countries with heavy principal payments on rescheduled debt is likely to be particularly constrained. These countries could find it advantageous to encourage a greater inflow of direct investment so as to maintain resource inflows sufficient to support an adequate growth rate, as well as to reduce vulnerability to any future deterioration in economic conditions. There are, of course, many other factors which will affect these countries’ overall growth prospects; for example, higher domestic savings rates could help achieve higher growth rates without increased reliance on foreign financing.
The scope and need for an increased role for such investment can be illustrated in the context of the medium-term scenario for developing countries prepared for the Fund’s 1984 World Economic Outlook. Over the period of the scenario, 1986-90, foreign direct investment flows to non-oil developing countries are assumed to increase by around 5 percent per annum in real terms. However, the volume of direct investment inflows would only reach the peak level achieved in 1981 by around 1988 because much of the growth would simply represent a recovery from the downturn in direct investment that occurred in 1982 and 1983.
Such growth in direct investment flows appears achievable for the group of non-oil developing countries as a whole—though not necessarily for each country—provided that the generally more encouraging policies of recent years toward direct investment are maintained and that the improvements in the world economic environment assumed in the medium-term scenario are achieved. If the exposure of international commercial banks evolves as assumed in the “base” scenario (i.e., with total exposure unchanged in real terms, except for trade-related credits, which increase in line with imports), the share of direct investment in total financing of the combined current account deficit and reserve accumulation of non-oil developing countries would rise moderately, to around 15 percent in 1988-90 compared with some 11 percent during 1979-81. A more substantial liberalization of policies toward foreign private investment could lead to much greater inflows.
Many of the more heavily indebted countries will need to make more substantial changes in policies toward direct investment if they are to achieve the level of inflows consistent with the growth prospects of the “base” scenario. This will be especially so if, as seems likely, new bank lending to countries with a large volume of rescheduled debt expands less rapidly than lending to countries with a lesser debt burden.
A longer paper on this topic by the author is available as IMF Occasional Paper No. 33, entitled Foreign Private Investment in Developing Countries (forthcoming). Copies are $7.50 ($4.50 to university libraries, faculty, and students) and can be ordered from the Publications Unit, International Monterary Fund, Box A-851, Washington, DC 20431, USA.