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International Banking International Capital Flows Session 10 --Hilla Shahpur Maneckji International Banking

Introduction (1) • The integration of the financial markets across the globe and the increase in the quantum of international trade had caused the capital to flow from one part of the globe to the other. • In a world, characterized by liberalization and globalization, firms are looking for places to invest that offer specific advantages. • Till recently, the global capital flows were determined by factors like favorable investment climate, market growth prospects, natural resources, labor markets, etc., International Banking

Introduction (2) • But now, the macroeconomic factors like good monetary policies, tax policies, exchange rate policies, etc., have taken precedence over the factors stated above. International Banking

Capital Flows International Banking

Capital Flows (1) • As many countries are moving towards globalization and liberalization, many global firms are showing great interest in investment in communications, services, marketing networks, infrastructure, etc. • The flows of capital-debt, portfolio equity, and direct and real estate investment between one country and others are recorded in the capital account of its Balance of Payments. • Outflows include residents purchases of foreign assets and repayment of foreign loans; inflows include foreigners investments in home country financial markets and property and loans to home country residents. International Banking

Capital Flows (2) • Freeing transactions like these from restrictions, that is, allowing capital to flow freely in or out of a country without controls or restrictions is known as Capital Account Liberalization. • Classic economic theory argues that international capital mobility, allows countries with limited savings to attract financing for productive domestic investment projects, enables investors to diversify their portfolios that spreads investment risk more broadly, and promotes inter-temporal trade—the trading of goods today for goods in the future. International Banking

Capital Flows (3) • More specifically: • Capital mobility means that households, firms or even countries can smoothen consumption by borrowing money from abroad when incomes are low in the home country and repaying when incomes are high. The ability to borrow abroad can thus dampen business cycles by allowing households and firms to continue buying and investing when domestic production and incomes have fallen. International Banking

Capital Flows (4) • By lending money abroad, households and firms can reduce their vulnerability to domestic economic disturbances. Companies can protect themselves against sudden cost increases in the home country, for example, by investing in branch plants in several countries. Capital mobility thus enables investors to achieve higher risk-adjusted rates of return. In turn, higher rates of return can encourage saving and investment that deliver faster economic growth. • Thus capital flows result in a free flow of capital throughout the globe from one sector to another. International Banking

Capital Flows (5) • Free flow of capital is necessary for the welfare of the society. • The international flows of capital have become everyday fact of life in the international economy, and because of their enormous size, are important. • Capital flows can affect lot of factors like exchange rates, forex rates, interest rates and monetary policy. • Various factors such as the level of human capital, political stability, and the depth of domestic financial markets, define a country’s ability to attract foreign capital. • Most of the capital flows are in the form of Foreign Direct Investments (FDIs) in different countries. International Banking

Capital Flows (6) • This happens when a domestic firm acquires ownership or control over the operations of a foreign subsidiary firm. • A firm is said to directly invest abroad if it has a direct or indirect ownership interest of 10% or more in a foreign business enterprise. • Today, FDI has become the single most important source of private development financing for the developing countries and plays an important role in the economic growth and development of the developing countries. International Banking

Foreign Direct Investments (FDIs) International Banking

Reasons for FDIs International Banking

Reasons (1) • Individual firms may not maximize profits, keeping in view the interest of the stockholders, but, instead, they maximize growth in terms of firms size. • In such cases, FDI is preferred because firms cannot depend on foreign managed firms to operate in their best interests. • Other reasons are based on the superior skills, knowledge, or information of the domestic firms as compared to the foreign firms. • Such advantages would allow the foreign subsidiary of the domestic firm to earn a higher return than is possible by a foreign-managed firm. International Banking

Reasons (2) • FDI may involve new technologies and expertise not available in the domestic economy. International Banking

FDIs In Pakistan International Banking

FDIs In Pakistan (1) • The fact that FDI helps accelerate the process of economic development in host countries made Pakistan realize the importance of new technologies for economic growth. • Of late the Government of Pakistan is also recognizing the fact that it has to overcome some past practices and adopt the emerging ones in order to make Pakistan compete globally. • In the process, it has brought about major changes in its national policies on FDI. • In the recent past, it has dramatically reduced barriers to FDI, and is wooing multinational firms. International Banking

FDIs In Pakistan (2) • The Government of Pakistan started promoting FDI through various means such as direct subsidies, extension of tax holidays, and exemptions from import duties. International Banking

Determinants of FDIs In Pakistan International Banking

Determinants of FDI (1) • In a developing country like Pakistan, certain factors like regulations and effective administration, infrastructure, labor costs and taxes playa vital role in determining the quality and quantity of FDI. • For promoting FDI in a country, the investment community always calls for a transparent system and efficient practices in business, administration, and prospects for profits in the country. Therefore the Government of Pakistan is taking relevant steps to create a favorable climate for FDI in the country. International Banking

Determinants of FDI (2) • Another area of strategic significance is the infrastructure. It is well known that infrastructure is crucial for aiding growth and in turn development of economy. Reliability on power, transport, and communication is vital as they are the engines of economic growth. Many nations give due importance to FDI involvement in the infrastructure owing to its role in the economy. In the absence of FDI in infrastructural development, it is very difficult for a large developing country like Pakistan to finance solely. Apart from the above social sector, investment in education and wealth will take an active role in increasing the per capita and quality of life, which the government has to finance on its own. International Banking

Determinants of FDI (3) • Location is strategic not only for attaining profits, and lower costs but can also make sense in exporting those goods back to investing nation. Reducing tariffs and barriers are often done to boost trade. Export Processing Zones (EPZs) are created by the Government of Pakistan to promote exports and facilitate the exporters to become globally competitive. • Labor costs, and tax rates also influence FDI investment. Per unit labor cost of the final output is vital in a developing country like Pakistan. The labor laws in Pakistan are being made flexible and are tuned in accordance with the developed economies. International Banking

Issues Relating to FDIs In Pakistan International Banking

Issues Relating to FDIs (1) • Some of major issues, which make Pakistan less attractive for FDI compared to other countries, are its poor infrastructure, and productivity of labor. • Apart from the above two issues, some of the major obstacles are: • Lack of Transparency in FDI Policy: This is evident from actual investment being made into sectors compared to committed FDI. Red-tapism has often curtailed the interest of some of the companies and they have eventually cancelled or dropped out of the projects due to delays caused in approvals. International Banking

Issues Relating to FDIs (2) • FDI Regime: No doubt, there has been an improvement regarding policies, clearances but still there are restrictions on foreign ownership in certain sectors like defense and railways. It also takes a lot of time for government approval. Deregulation in infrastructure sector would be welcome sign. • High Tariff Rates: Despite reduction of the tariffs, they are still high compared to global economy standards. Though the post-WTO regime is still on its course, the high tariff rates is one of deterrents for major MNCs to invest in Pakistan. International Banking

Issues Relating to FDIs (3) • Financial Sector: In spite of an improvement in terms of opening insurance sector, and banking sector, the ownership issue still needs clarification in terms of 100% FDI into these sectors. The Pakistani financial sector had its own share of debacles in terms of crisis and scams from 1991. Accordingly, transparency has become a crucial issue now. • Labor Laws: The labor laws in Pakistan give companies reasonable hedge in terms of hiring and firing employees without seeking the permission of the state government, unlike in India. International Banking

Issues Relating to FDIs (4) • Decisions from the State Government: The state governments were passive to the reform process as most of reform process was concentrated in substantial initiative in attracting FDI, and they still have to depend on central government in terms of freedom, with respect to certain infrastructure areas. • Export Processing Zones (EPZs): We need more EPZs in terms of scale, government initiative in terms of incentives, labor reforms, regulations so as become real export houses for the nation. International Banking

Issues Relating to FDIs (5) • So considering all these issues, the major areas that require improvement are: • Bureaucracy: Bureaucracy has been a bugbear for the clearance of FDI. The delays due to multiple agencies at both center and state governments hinder processes. This is where Pakistan lags behind China despite being a democratic country where decisions are expected to be taken on time. Systems have to be fine tuned so as minimize delays in getting necessary clearances. A lot of improvement needs to be done with respect to consolidation of various regulatory agencies, and single window clearances procedures. International Banking

Issues Relating to FDIs (6) • Tax and Tariffs: The complex tax & tariff structure has been a major issue not only for the foreign businessmen but also domestic businessman. Though central taxes are in right direction, other areas call for a major overhaul. Tax & tariff structure is very perplexing, and the amount of time taken to clear issues is enormous. International Banking

Issues Relating to FDIs (7) • Leveraging the Labor Force: Though there is no dearth for skilled labor in Pakistan, educated and English speaking sections forms a small part of economy. Owing to this factor, we have seen the reasonable growth in the IT and Pharmaceutical sectors. The thrust on export based and knowledge intensive products along with traditional products can provide the extra growth. Recently automobile industry is one of the sectors reaching global standards. The thrust on domestic market and also reliance of the MNCs on Pakistan as an export base is enabling us to place ourselves on the global map, as well as provide jobs and investments needed for development of ancillary industries. International Banking

Issues Relating to FDIs (8) • On the flipside, FDIs also do not come free of cost. • They are definitely required but excessive use may lead to turmoil as happened in East-Asia, Mexico and Chile. International Banking

Costs Associated With FDIs International Banking

Costs Associated With FDIs (1) • Foreign capital inflows can work both ways for a country. • We have seen that from many economies like Mexico, South-East Asian countries which had economic crisis. • Thus certain economies are small and have structural deficiencies, which are not conducive for FDI. • Entry of MNCs in capital-intensive sector would reduce the demand for labor, thereby intensifying the unemployment. • In other case, reduction in tariffs can reduce the revenue for the government. International Banking

Costs Associated With FDIs (2) • Without proper competition policy, MNCs over time can reduce competitors through their power, which can affect domestic economy in terms of job losses, reduction in consumer welfare society at large. • The domination of MNCs in global market is a huge concern for the developing countries which have sizable population. • These countries have own reasons to develop economy due to huge population, backwardness, for want of capital and technology. • The MNC can drive out domestic players once they get a foothold in a market, monopolizing the market in future. International Banking

Costs Associated With FDIs (3) • FDI affects the domestic entrepreneurship adversely as competition and cost structure can become huge barriers for the infant industries. • The larger social issues pertaining to culture and values are taken care of. • So, given the distractions in most of the developing countries in terms of economic, infrastructure, and government policies, attracting FDI can worsen the overall development due to further disparity between rich and poor in the society. International Banking

The East-Asian Crisis International Banking

The East-Asian Crisis (1) • The East-Asian miracle economies became a major attraction for foreign investors during the 1990s. • These economies were well managed, had been growing rapidly, their exports were internationally competitive, governments were well disposed to foreign investment, and labor was hardworking, well-trained, and motivated. • With stock markets expanding, and privatization of several public enterprises underway, these were ideal emerging markets, promising high returns with relatively low perceived risk. • The East-Asia region as a whole received almost US$ 500 billion (or a little under 40% of the world total) in net capital inflows during the five-year period 1993-97. International Banking

The East-Asian Crisis (2) • About 60% of the inflows consisted of FDI and portfolio investment. • The macroeconomic fundamentals of the East-Asian economies remained strong on the whole right up to the outbreak of the crisis with the devaluation of the Thai baht. • For instance, Indonesia, Korea, Malaysia and Thailand had all enjoyed strong economic growth for many years and their inflation rates were in single figures. • Their domestic savings rates were among the highest in the world and their levels of investment were very high. • Government fiscal balances were either in surplus or showed only small sustainable deficits. International Banking

The East-Asian Crisis (3) • All had the ability to service their debts in the long-term. • GDP growth for Indonesia, Malaysia and Thailand during the 1990s averaged at rates higher than those prevailing in the previous two decades, though in Korea’s case it was a little lower, but still an impressive 7.5% a year. • But the other side of the coin was that each of these countries started to run high current account deficits, though at least in the case of Korea and Indonesia not quite as large as those witnessed in the earlier Latin American crises. • With government accounts more or less in balance, it was the private sector in each of these countries that was rapidly accumulating foreign liabilities. International Banking

The East-Asian Crisis (4) • A number of observers have explained the East-Asian crisis in terms of misguided investments in real estate, “crony capitalism” in which governments and private enterprise engage in reciprocal favors, lack of prudential regulation of domestic financial institutions, and various other failures. • While each of these explanations had some factual basis, and cannot be dismissed offhand, they give rise to awkward questions. • Why were these weaknesses not evident to foreign investors before it was too late? • Or, if they were evident, why were they not taken into account in their investment decisions? International Banking

The East-Asian Crisis (5) • The close government/business relationship in East-Asia, though widely denoted in the press as corruption, had been applauded as an example of successful partnership in economic management, which other countries needed to follow. • The soft prudential regulation and other weaknesses of the financial sector were also well known, and noted by the World Bank in its country reports. • But granting that these weaknesses already existed points only to one conclusion, that the opening up of the capital account and financial deregulation in the East-Asian economies was premature and should have been undertaken only after the correction of the weaknesses that are now held to explain the crisis. International Banking

The East-Asian Crisis (6) • It was the rapid opening up of the capital accounts and deregulation of the financial sectors that attracted the massive capital inflow (especially short-term loans) into the region’s economies, and should be considered as the major cause of the crisis. • In any case, the purveyors of foreign capital once again demonstrated their inability, or unwillingness, to see the financial strains and avoid another financial collapse. • Perhaps the problem of “moral hazard”, which had been noted in the context of the Mexico crisis, is real: private lenders from the north shared the expectation born out of past experience that they would be bailed out by governments or international public agencies in time of trouble. International Banking

The East-Asian Crisis (7) • The IMF responded with policy prescriptions that it had applied in other countries with altogether different conditions and circumstances. • It also insisted on a broad range of socio-political institutional measures, to deal with labor market reforms, corporate governance, government/business relations and corruption, among other things, and to further open up to foreign investors. • In prescribing a regime of sharp demand compression, accompanied by steep increases in interest rates, the IMF may have deepened instead of alleviating the East-Asian crisis. International Banking

The East-Asian Crisis (8) • In the event, the steep rise in interest rates failed to prevent the currency collapse, but the two together raised the burden of external and internal debt to unsustainable levels, resulting in the technical bankruptcy of major segments of the domestic private sector. • Industrial disruption has been widespread, with declining domestic output and sharply rising unemployment. • The resolution of a serious financial crisis is bound to inflict the pain of adjustment; on an economy. • But a situation where adjustment reduces, rather than enhances, the economy’s ability to cope with the crisis can hardly be regarded as a remedy. International Banking

The East-Asian Crisis (9) • The IMF has therefore come under considerable criticism, and not only from the quarters generally hostile to the institution. • Recently, certain well-known mainstream economists, including some in the World Bank, have questioned the soundness of the IMF’s diagnosis and the standard remedies prescribed for the countries in deep trouble. • These comments are a welcome addition to the more long-standing critiques of the Washington consensus, which so far has been unshakable. International Banking

Chile & Mexican Crisis International Banking

Chile’s Experience in Regulating Capital Flows (1) • Chile should be studied for lessons in tackling Asia’s present problems. • Unlike other Latin American countries in the 1980s, its crisis was created in the private sector, and it took action to stem short-term capital inflows. • The fixed exchange rate had encouraged heavy borrowing in US$. • With peso devaluation, debt repayments faltered and the government bailed out the banks by taking over loans to foreign creditors. • Assistance totaled about 20% of GDP, setting off a major recession. International Banking

Chile’s Experience in Regulating Capital Flows (2) • Several steps were taken by Chile. • A 1986 banking law, set strict operational guidelines, applied by an independent supervisor, that prohibit banks from holding shares in companies or other banks, prevent build-up of currency mismatches in borrowing and lending, and establish firm provisioning requirements for loans. • In addition, since 1991 foreign lenders must deposit 30% of the loan amount with the Central Bank, which holds it for one year without interest. • To reduce volatility this measure was extended to stock-market inflows; under another regulation, FDI requires Central Bank approval. International Banking

Chile’s Experience in Regulating Capital Flows (3) • Chile also adopted a strong macroeconomic framework that led to surpluses of 1% - 3% of GDP. • Monetary policy, under an independent Central Bank, responded quickly to signs of overheating. • A flexible exchange rate policy has kept the current account deficit in check. • The system may have flaws and be hard to replicate elsewhere, but one exportable lesson is that well-regulated banks are absolutely essential for financial stability. • The regulations also encourage long-term rather than short-term capital. International Banking

Chile’s Experience in Regulating Capital Flows (4) • Statistics of outflows (not controlled) indicate that speculative inflows could still occur: high interest rates make loopholes profitable, and export advances or FDI can be used for short-term inflows. • In addition, large companies with access to foreign capital have issued new shares or borrowed abroad. • Policymakers do not appear to be concerned about this because the banking system is not exposed, depositors funds are safe, and the broad objective of dampening the volatility of short-term flows has been achieved. International Banking

Mexican Crisis & Comparison With Thailand (1) • Private capital inflows financed a boom in private consumption in Mexico, but private investment in Thailand. • Both countries experienced a pre-crisis surge in private capital flows, a sharp increase in credit to the private sector, and concerns about sustainability of rising current account deficits and loss of competitiveness (exchange rates and inflation). • The banking systems were weak, especially in Thailand (higher private sector external debt). • Thailand’s investment rate rose steadily after 1983 (28% of GDP 1983-89, 40% in 1990 and onward). International Banking

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