Foreign inflows and economic development

Thursday, 18 November 2010 23:37 -     - {{hitsCtrl.values.hits}}

The distinct impact of Foreign Direct Investment (FDI) as opposed to Foreign Indirect Investment (FII – also referred to as foreign portfolio investment) on economic development has not largely been taken into consideration when measuring the implications of foreign inflows to Sri Lanka.

FII, as opposed to FDI, is short term investments made by foreign private investors through intermediary financial rulings or the financial market and the stock exchange. It is performed in many ways, including treasury bonds, treasury bills and short term investments in the stock exchange.

The FII, as opposed to FDIs, has no long term prospects in an economy in terms of returns made for the investment. The indirect investor is constantly alert on instant gains made possible through sudden market volatility and would also derive his investment decisions based on market speculation.

The most significant aspect of FIIs is that the effective demand FIIs enforce for real assets in its host economy is relatively negligible. Hence, FIIs are most unlikely to initiate productive investment of resources, which contribute towards economic development of a country.

However, FDI refers to long term participation involving fixed capital formation, management, transfer of technology and expertise from one country to another. It is a measure of foreign ownership of productive assets, such as factories, mines and land and therefore recognised as a measure of foreign ownership of real assets, as opposed FII which is a measure of foreign ownership of financial assets.

The analytical separation of the role of ‘finance’ from the ‘real economy’ demonstrates that economic development should be conceived as ‘real/fixed’ capital formation (FDI) which increases overall output, as opposed to the accumulation of financial assets (FII), which increases wealth claims but not output.

The nature of FDI is a case of exchanging money for commodity or effort in order to obtain more money than initially operated with. Therefore, the attitude of the Foreign Direct Investors is of parting with money for commodity with the expectation of receiving a larger amount of cash than the initial investment, hence creating demand for real assets (labour plus equipment) in the economy.

Thus, FDI has a tendency to foster economic development only if the spheres of its investment are export oriented and pregnant with scale economies and promote economic linkages. FDI bears this progressive propensity as it increases the fixed capital formation of the host country creating revenue generating activities in the latter and most importantly expanding its factor markets through linkages which have the potential to integrate the entire economy and place it on the path of economic development.

In this connection, subsequent to experiencing the highest ever FDI amounting to circa US$ 900 m in 2008, FDI in Sri Lanka continued to experience a drastic fall incessantly over the past two years. Conversely, FDI in China has been one of the major successes of the past three decades.

Starting from a baseline of less than $ 19 billion just 20 years ago, FDI in China has grown to over $ 300 billion in the first 10 years of 21st century. A recent UNCTAD survey projected India as the second most important FDI destination (after China) for transnational corporations during 2010-2012.

Further, the first nine months of 2010 saw Vietnam successfully attract US$ 12.19 billion worth of FDI, which is approximately 40 times larger on an annualised basis than the figure forecasted for Sri Lanka for 2010.

Despite the establishment of prevailing peace in Sri Lanka, it is projected that for 2010 the FDI figure would further drop by 33.3% YoY to circa US$ 400 m. Meanwhile, the FII in the form of short term funds in the Colombo bourse increased from circa US$ 315 m in 2009 to a forecasted figure of staggering circa US$ 1,110 m for 2010 (+ 254.6% YoY).

This observation indicates a fundamental shift of foreign investor patterns in Sri Lanka from direct to indirect investment. It implies that foreign ownership of financial assets is growing at a rate faster than the foreign ownership of real assets, signalling a financialisation of foreign capital accumulation in Sri Lanka.

Most importantly, this fundamental shift of foreign investor pattern from FDI to FIIs would not assist the realisation of desired outcomes of Sri Lankan Government which is currently aiming at rapid economic development.

However, in light of the post-war situation in Sri Lanka where the economy has emerged out of 30 years of ruthless bloodshed, the increase of FIIs still can be considered as a fruitful development since it underscores the prevailing positive sentiments of foreign investors towards the island nation.

In this state of affairs, it would be extremely favourable if the Government of Sri Lanka seeks large scale FDIs as opposed to FIIs and the expansion of domestic real economy in sectors which promote economies of scale and linkages directly contributing to rapid economic development.

In addition, the above mentioned policy measures would prove vital to wipe out possibilities of a sudden divestment of FIIs exposing the economy to a forex dearth and inherent calamities of such a situation.

(Source: Asia Securities Ltd.)