Foreign Exchange Costs of FDI and Equity Investment

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Foreign Exchange Costs of FDI and Equity Investment

An important feature of FDI and equity investment is their rates of return. Because investors bear the risk that their investments might fail to make a profit, they set higher target levels for profits to compensate them for the greater risks. As a result, rates of return to direct and equity investments are much higher overall than on loans. As well as increasing the rate of return on these investments generally, this also means that the rate of return is highest where the risk is seen as greatest - that is, primarily in the poorest and least developed countries. According to a recent World Bank publication on private capital flows,

"rates of return on FDI have generally been much higher in Sub-Saharan Africa than in other developing regions. During 1990-94, rates of return on FDI in the region averaged 24 to 30 percent, compared to 16 to 18 percent for all developing countries." (World Bank, 1997a, p34)
For equity investment, rates of return may be still higher. Based on World Bank (1995a) data,
"The average rate of return on equity investments in 1976-92 in 15 emerging markets which had attracted foreign equity inflows by 1993 was 29 per cent per annum. In only two cases (Indonesia at -12 per cent and Malaysia at +14 per cent) was the rate of return less than 20 per cent; and in the former case the data covered only three years (1990-92). In three cases (Argentina at 68 per cent, the Philippines at 45 per cent and Colombia at 43 per cent) it was above 40 per cent." (Woodward, 1996a, p46)

Even 16-18% per year is far above the cost of commercial loans to the private sector, which in turn is greater than that of loans to governments (again because of the higher level of risk). The average interest rate on new loans by private creditors to developing countries as a whole was 7.3% per year in 1996 (World Bank, 1998). For Sub-Saharan Africa, it was 6.1% per year, one-quarter to one-fifth of the rate of return on direct investment.
Private foreign investors generally return at least part of the profits they earn in the host country to their own countries in the form of dividend payments (for equity investments) or profit remittances (for direct investment). In the case of the poorest countries the proportion of FDI profits which is remitted rather than retained and reinvested in the on-going venture or a new investment project may be large compared with other countries. This may be because:

 the investment climate is riskier so that investors adopt a more short-term view - “The basic rule for black Africa [sic] is: get your money back in 12 to 18 months, or don’t do it - who knows what’s going to happen next?”8 or;

 it is perceived that there are fewer investment opportunities - “parent companies want to remit a much higher proportion of their profits from SSA [Sub-Saharan Africa] than from other regions, as they see fewer new manufacturing opportunities.”9
To repatriate their profits, foreign investors must convert them into their own currencies, which means that the country concerned must be able to provide enough extra foreign currency to allow the conversion to take place. This foreign exchange must come from earnings on additional exports (or savings from reducing imports), or from more financial inflows.
The significance of the high rates of return noted above is generally played down by the proponents of FDI on the grounds that only profits which are made can be remitted. In practice, this does not always appear to be the case: in Botswana, for example, profit remittances on FDI exceeded total declared profits in every year from 1990 to 199410.
More importantly, even where profits are made, they will not necessarily represent an increase in the country’s net foreign exchange earnings. In particular, the generation of foreign exchange will be limited for investments which take the form of the purchase of existing productive capacity rather than the creation of new capacity, and where investment is in production for the domestic market (particularly of non-tradeable goods) rather than for export (Woodward, 1997).
The former condition applies in particular to privatisation, and the latter to most investment in services, as well as to many other investments in each case. Privatisation alone accounted for nearly half of all FDI in transition economies in 1991-3, and around one-eighth in developing countries as a whole (Sader, 1995, Table 1). Investment in services (for example, public utilities, fast-food restaurants, etc.) accounts for more than half of the total global stock of FDI; and this proportion has been increasing steadily (UNCTAD, 1997, p71; World Bank, 1998, p21)11. Most equity investment also takes the form of purchases of shares in existing capacity (rather than new issues for the creation of new productive capacity), so that the net foreign exchange effect is almost certain to be negative, because output is not increased.

Where FDI and equity investment fail to generate sufficient extra foreign exchange earnings (or savings) to cover profit remittances, this will worsen the balance of payments. In poorer countries, where the rate of profit is higher, the amount of extra foreign exchange needed will be greater, and a negative overall effect is therefore more likely for any particular investment. In view of the need these countries have for foreign exchange to import essential goods, this is potentially a major drain on the economy.
Over the medium-term, any negative balance of payments effect may be off-set by continued inflows, reinvestment of profits on FDI, and the fact that most of the return on equity investment is in the form of capital gains rather than dividend payments. However, all of these effects serve to increase the value of investment on which future profit remittances will be made, which in turn increases the new flows required to keep the net transfer favourable; and the rate of increase may be very considerable.
In this context, the 24-30% annual rate of return estimated by the World Bank for Sub-Saharan Africa is exceptionally onerous. This is illustrated in figures 3-6. These are based on three scenarios over a 20-year period:
(A) a one-time inflow of $100m in year 0, with one-third of profits reinvested in each subsequent year (roughly in line with the average for developing countries);
(B) a one-time inflow of $100m in year 0, with new investment in each subsequent year equal to profits (ie., just enough to avoid an outward net transfer); and
© an inflow sufficient to achieve an inward net transfer of $100m in every year.
In scenario (A), profit remittances lead to a continuing and increasing outward net transfer of foreign currency, as reinvestment increases the value of the investment. The total outward net transfer in the first 6 years exceeds the initial inflow; and by year 20 as much as is transferred out every 18 months as was originally invested. In scenario (B), by definition, net transfers are zero. However, this is achieved only by rapidly increasing new investment, adding to the capital stock. By year 20, the total value of inward investment is nearly $7½bn, and the country needs to attract $1.4bn every year to avoid an outward net transfer, compared with an total inward transfer of $100m in year 0.
In scenario (C), the new investment needed to off-set profit remittances escalates still more rapidly. By year 20, the total value of inward investment is nearly $40bn, and inflows of $7.4bn are required each year to achieve an inward net transfer of just $100m.
At a rate of return of 0% per year, the picture is considerably worse. In Scenario A, more foreign exchange is transferred out of the economy in 10 months in year 20 than was originally invested. In Scenario B, the stock of investment reaches $19bn in year 20 (2½-times the figure at 24% per year), and the new inflows needed are tripled to $4.3bn. In Scenario C, the stock of investment in year 20 is more than doubled to $82bn, and the new investment needed increases by 150% to $19bn.
In view of these results, it is not surprising that the stock of inward FDI in Sub-Saharan Africa increased from about 7% of GDP in 1980 to 20% in 1994, while net transfers remained substantially negative throughout this period (UNCTAD, 1997).

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