Chapter 9 FOREIGN CAPITAL

ROLE OF FOREIGN CAPITAL IN DEVELOPMENT

Foreign capital coming to the LDCs in various forms can play an important role in the context of economic development. It can be summed up as follows –

1. Raising the rate of saving- LDCs are trapped in the vicious circle of poverty. Raising the rate of saving can break this. But saving is impossible for LDCs. Under such circumstances, if foreign capital supplements domestic capital, total capital formation rises above the static level and generates economic growth.

2. Attaining a higher level of investment- Saving and investment must balance. But when a development plan is prepared and executed a higher level of investment is needed. Savings can attain this, which is not possible for LDCs. This gap can be filled up by foreign capital.

3. Providing venture capital – There are many areas, which require heavy investments. But what is ‘heavy’ for an investor in an LDC can be ‘light’ for one from an advanced country. Again ‘new’ investments are familiar in advanced countries. Therefore, such investments can be left to the foreign investors.

4. Building up of infrastructure - The LDCs require the building up of economic infrastructure in the form of social investment such as railways, bridges, etc. All these involve huge investments, which is possible with the help of foreign capital.

5. Developing basic and key industries – Basic industries such as steel, cement, etc. need heavy investment, which is a burden over an underdeveloped economy. But investment in such industry is useful in development of growth, which can be made possible with the foreign investments.

6. Creating employment opportunities – Foreign capital invested in the building up of infrastructure, directly creates employment opportunities. As a result foreign capital becomes instrument in creating employment opportunities.

7. Raising Government Revenue – Government can impose an import duty on goods being imported. This way government can get revenue. An alternative policy is to allow multinational corporations to function in the country. This would avoid imports, start the process of import substitution and thereby contribute to development. At the same time, by taxing these multinationals, the government can get a share in their profit as a source of revenue.

8. Developing human resources – When foreign capital comes into a country, especially private foreign capital, it is in the form of plant, machinery and equipment along with the technological benefits. This helps the development of human resources of the LDCs.

9. Creating industrial culture- Industrial culture is useful in the overall development of economy, which cannot be found in LDCs. The way of working of foreign firms has a demonstration effect on local firms and entrepreneurs as well as workers. These new values and attitude are the basic to economic development.

LIMITATIONS OF FOREIGN AID

Foreign investment has its limitations. They are as follows –

1. Availability of funds – There are vry few countries who can spare surplus funds required on. Many advanced countries themselves have been borrowing from the US. Sparing surplus requires containing one’s own expenses. This involves several hurdles besides motivating and persuading democratic bodies like parliaments of donor countries.

2. Absorption capacity of the LDC – The aid receiving country may demand and does need large amounts of foreign capital. But the crucial question is how much an LDC can absorb? Absorption capacity of an economy depends upon the ability to plan and execute development projects.

3. Availability of resources – Capital is an important factor of production and foreign capital is welcome on a number of counts. But for utilizing capital, a country must possess other factors of production ie. Adequately developed human and natural resources must be available.

4. Repaying capacity – The recipient LDC must possess potentialities for repayment of debt. Debt-servicing itself involves a large burden in terms of foreign exchange. The repayment capacity therefore would depend upon the capacity to generate surpluses and because these surpluses must be in the form of foreign exchange.

5. Will to develop – Foreign capital is a catalytic agent. It is the economy that develops and the society promotes such a development. The people in the LDCs must therefore possess the will to develop. They must put in their efforts and work to make the best of scarce capital resources that have become available through foreign aid.

Arguments against Foreign Capital –

Some problems related with foreign capital can be spelt out as arguments against foreign capital. They are as follows.

1. Distortion of priorities – Most of the LDCs have prepared their own plans for development according to their priorities. But the lending governments may tie their aid to some projects, which may not stand priority.

2. Inappropriate techniques – Foreign capital is said to help a transfer of technology and modern managerial skills, etc. Sometimes this is inapplicable in the recipient countries.

3. Balance of payment problems – To overcome balance of payment problems, LDCs resort to foreign borrowing. Multinational companies’ investment helps in rise in income and employment. This creates inflationary pressures. But still developing countries have to face a serious problem of deficit in their balance of payment.

4. Debt trap – Continued dependence on foreign capital and unproductive or inefficient utilization of external debt may put a country in what is known as a debt-trap. A country can be said to be caught in a debt-trap when it is required to borrow for repaying of old debts. But this situation may arise even when a country is capable of repaying because their export –earnings is much more.

5. Wasteful utilization – Borrowing is a softer option. When external debt is easily available, a government is tempted to go on borrowing. Such easy loans tend to be utilized in a wasteful manner. Where they get invested may not stand priority.

6. Gap between rural & urban sector – Foreign companies are interested to invest in urban areas where they get ready infrastructure. They help the development of urban areas. This creates a wide gap between urban and rural areas. This encourages the rural-urban migration.

7. Damaging the domestic entrepreneurship – Foreign capital accompanied by foreign managerial skills and direct investment has damaging effects on domestic entrepreneurship of the host economies.

8. Erosion of Sovereignty – The most important objection to foreign aid when it comes through official channels is that it curbs the sovereignty of the LDCs. The conditions set by the donor countries are so humiliating that if the country were not in need of aid would not have accepted them.

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TYPES OF FOREIGN INVESTMENT

Foreign investment takes different forms.

A] Private Foreign Investment –

1. Direct foreign investment – People in the investing countries may directly invest in the LDCs by starting a factory or a firm. A foreign company may set its subsidiary in a developing country. Or a corporation in some advanced country might operate various companies in different LDCs.

2. Indirect foreign investment – This type of investment is also known as portfolio investment. E.g. foreign individuals and financial institutions may hold shares of companies in India. Generally the government of India would guarantee such shares and securities. Holding of shares of companies in developing countries by private foreign investors does not involve right to control the company of which the shares or debentures are held by foreigners. They are only entitled to dividends.

B] Public Foreign Investment –

1. Bilateral loans – An LDC might enter into an agreement with an advanced country and under such an agreement, a loan may be made by the lender to the borrower country. Such agreement may or may not specify the purpose of the loan.

2. Bilateral soft loan – The lender country may grant a ‘soft’ loan, under a bilateral agreement. According to Public Law 480, the American president is empowered to give such loans to poor countries for specific reasons. The purpose of these loans is to purchase goods and commodities from specific (lender) country.

3. Multilateral loans – When developed countries contribute to ‘sow agency’ brought into existence for the purpose of giving development assistance to the LDCs and by agreement the loan made by such agency becomes a multilateral loan.

4. Intergovernmental grants – Grants given officially by one government to another government fall into this category. Such grants are usually conditional and for specific purposes only.

C] Tied and Untied Aid – Source, project and commodities can tie Aid, or it may be tied by both project and source and become double tying aid. Untied aid on the other hand is a general-purpose aid, which is also known as ‘non-project aid’ or ‘programme aid’