The Financial, Policy and Development Costs of Commercial Flows
However, there are a number of serious doubts about over-reliance on these types of investments as mechanisms for North-South financial flows, especially in low-income countries.
They are extremely expensive in foreign exchange terms, especially for poorer countries. As a result, maintaining a positive net resource transfer requires a continual and increasing flow of new capital, which entails a very rapid build-up of foreign exchange liabilities.
They are strongly skewed away from poorer countries, whose efforts to compete for the available flows reduce the potential benefits to the host country.
They are volatile, procyclical and (in the case of equity investment) subject to serious problems of contagion, increasing vulnerability to external shocks.
They seriously limit a government’s economic policy options, and over the longer term, they may seriously weaken the political system by increasing the role of TNCs.
A universal opening to all forms of capital flows for all purposes should be avoided. This suggests a need to retain some degree of control over commercial capital flows. This is incompatible with the proposed extension of the IMF’s mandate to include capital account liberalisation. What is needed is a selective approach, to ensure that flows are limited to those which confer net benefits from a long-term developmental perspective. Simply seeking to sustain the volume of North-South financial flows could be seriously counterproductive if the liabilities created by commercial flows prove unsustainable; or if the wider effects of the flows themselves, or of the processes of opening the economy to them and attracting them, have negative effects on economic or human development.
This suggests that:
portfolio investment should generally be avoided by low income countries, as being too expensive and too volatile;
direct investment should be limited as far as possible to the creation of new capacity for the production of exports which will not have an adverse effect on other developing countries (eg., by depressing commodity prices), and other sectors where the benefits of foreign investment to the rest of the economy outweigh the potential costs of the investment (eg., telecommunications); and
competition for FDI flows which reduces their benefits to host countries (eg., tax breaks, direct or indirect subsidies and preferential treatment) should be avoided.
For middle-income countries, the balance between the costs and benefits of commercial financing tends to be more favourable: the cost is lower; the build-up of the stock of investment is slower; economies are less subject to other external shocks (eg., due to the greater diversification of their export bases); and political systems are generally more robust. Nonetheless, caution is required; and the volatility of portfolio investment is likely to be a particular problem, as demonstrated by the East Asian crisis.
Apart from their limited access to commercial flows, their high cost and volatility will seriously limit the extent to which most low-income countries can rely on this source of finance. Commercial capital flows cannot simply substitute for official sources of finance. Therefore, if financial flows to low-income countries are to be increased significantly in such a way as to enhance rather than damage long-term economic and human development, this will require an increase in net official flows; more grants or loans on concessional terms; and/or a substantially greater degree of debt reduction than is currently envisaged (without an off-setting reduction in new flows).