Introduction to Empirical Section



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Theory


Most theories of the determinants of capital flows focus on economic factors. My theory builds on these fundamental insights but focuses on two political factors: political institutions and investment-related economic policies. I highlight how these factors affect investment, how they interact with each other, and how they interact with economic factors .

The motivation of private investors is to maximize expected returns on capital invested. Foreign finance has a certain amount of capital available for investment, F. In addition to sending capital k to a given host country in Africa, the foreign investor has the option of utilizing its capital elsewhere, where it will receive some fixed returns = Ro. R0 is thus the opportunity cost, or the reserve value, for the foreign investor, which is external to each recipient nation. This can be termed the “push” factor. There are also factors within each recipient nation that the host country government can control, such as regime type , economic strategy s, and domestic economic factors x. These can be termed the “pull” factors. The economic strategy s determines what percentage of each economic sector j is reserved for state-owned enterprises. The balance, , is open to foreign investors in the private sectors. Foreign investors may also invest in the public sector, and the public sector has a productivity discount , since public enterprises tend to be less efficient than private enterprises (Boardman and Vining 1989).2 The share of investment k that goes into the public sector for economic sector j is j.

The utility of foreign finance is therefore





Each return function R is positive with diminishing returns, (R() > 0, R() < 0). Therefore, the optimal strategy for foreign finance, if the host country government is pursuing a capitalist strategy, is to invest k such that . If the government is pursuing a statist strategy, foreign finance will choose in sectors where  > 0. That is, in any sector where public enterprises are less efficient than private enterprises, the government will invest the minimal amount required in the public sector and the rest in the private sector. Investors will invest k such that in sectors where there is no minimum level reserved for the state, and such that where there is a minimum level reserved for the state.

This analysis yields the following propositions:



  • Foreign investors will invest less in host countries when there are attractive investment opportunities in the home country relative to those in the host country.

  • Foreign investors will invest more in countries pursuing capitalist policies than those pursuing statist policies.

  • Foreign investors will be less deterred by statist policies in economies where the public sector’s disadvantage is small relative to the private sector. In such cases, statist policies will divert investment from the private sector to the public sector.

  • To the extent that democracy increases expected returns for foreign investors, it will have a positive effect on foreign investment.

Both external push factors and domestic pull factors have been included as explanations for the rise in private capital flows to the developing world over the past 20 years or so (Calvo, Leiderman and Reinhart 1996, Fernandez-Arias and Montiel 1996), and it has been found empirically that both play a significant role (Taylor and Sarno 1997, Jeanneau and Micu 2002). According to these studies, the most significant push factors are interest rates and economic growth in developed countries. As interest rates fall in developed countries, capital seeks opportunities for higher rates of return in developing countries. Low interest rates in developed countries also encourage governments and private firms in developing countries to borrow from developed countries. Another important push factor is the rate of economic growth in developed countries; when economic growth is low in developed countries, profit opportunities in the developed world are low, and so investors are more likely to seek profit opportunities in developing countries. Other push factors that are mentioned in the literature include excess liquidity in the developed world, increased risk appetite, trends toward diversification, and improvements in communication technology which make it easier to manage international business operations. In this project, the focus is on pull factors, and so the net effect of push factors will be proxied with the total flow of each form of capital into sub-Saharan Africa.

After being motivated to send their investment dollars out of the developed world to earn a higher return, the providers of foreign finance must decide where to allocate their finance. This decision is determined by “pull” factors, some exogenous and others controlled by the government.

Foreign direct investment generally has one of three goals. Market-seeking FDI establishes productive enterprises to serve a group of customers in a foreign country. Although trade can also be used by firms to serve customers abroad, FDI is necessary or more profitable in the service and retail industries and for some types of manufacturing (e.g., when transport costs are high relative to sales price or when tariffs on the finished good is high). Efficiency-seeking FDI establishes operations in a foreign country to manufacture products at lower cost for export. Resource-seeking FDI exploits minerals, oil, or other location-specific resources. In each case, FDI generates profits by applying proprietary knowledge capital (technology, managerial practices, or business networks) to the host country’s physical or human capital. FDI, therefore, is an investment substantial enough to provide the investor with some managerial influence or control over the enterprise (10% is the common threshold between FDI and portfolio equity).

While foreign direct investors play an active role in the management of their investments, other investors are passive. Portfolio equity investors, like foreign direct investors, share in the up- or downside of profitable operations. Although they exert no managerial control over the enterprise, they can generally withdraw their investment on short notice (FDI is less liquid and therefore more long-term). Thus, such investors are motivated by both profit opportunities and short-term risks. Buyers of debt, whether commercial lenders or bondholders, receive regular repayment plus interest. They therefore lend where they are confident they will be repaid. Indicators of creditworthiness include growth, the presence of money generating resources such as oil, and low levels of debt.

An important political factor to investors is the economic policies of the host country government. Specific policies are difficult to analyze since they are diverse, complicated, and include many exceptions when applied. Even obvious candidates can have surprising results; for example, the tax rate on income and profits doesn’t seem to matter to FDI (Markusen 1995, Chakrabarti 2001). However, the overall economic stance of the government should have a significant effect on the government. I simplify matters by categorizing the economic strategy into two categories: a “statist” approach, where the government is the primary investor in productive enterprises, and a “capitalist” approach, where it lets private enterprises play the primary role. A statist strategy has two components: (1) international flows of finance are restricted by the government, and (2) the government establishes and expands state-owned enterprises.

In Africa, private finance is often restricted but never banned completely. Restrictions may take the form of a requirement for approval from the Ministry of Finance for investments and divestments, exchange control requirements, restrictions on repatriation of profits, or banning foreign equity investment in “strategic” sectors such as real estate, utilities, communication, or transportation. State-owned enterprises can be fully state-owned or majority state-owned and can be established by purchasing or seizing the majority of shares (and thereby control) of private (often foreign-owned) firms, or by creating new firms (sometimes with foreign investors as minority shareholders).

Unlike the communist governments of Asia and Eastern Europe, no African government has had a pure socialist system. Instead, African states pursue a “mixed economy” strategy, in which the both the state and private (including foreign) investors have some ownership in productive enterprises. A public or state-owned enterprise is “an organization (1) whose primary function is the production and sale of goods and/or services, and (2) in which the government or other government-controlled agencies have an ownership stake that is sufficient to ensure them control over the enterprise, regardless of how actively that control is exercised” (Tanzi 1984). Thus, “nationalization” occurs when the government increases its ownership share above 50%, sufficient to achieve control.

Even governments with Communist single-party rule, such as Mattheiu Kerekou’s regime in the People’s Republic of Benin, allowed foreign direct investment. Although Kerekou’s government nationalized foreign-owned banking, oil supply, insurance, and communications companies in 1974, foreign firms continued to play an important role in other parts of the economy. In 1976, for example, Benin’s most important industrial complex opened: a textile plant majority owned by foreign firms (and 48% owned by the state) (EIU 1976). In Guinea, Sekou Toure’s government pursued a massive state enterprise program,3 but the state generally owned “just” 49%-51% of mining companies, with the balance owned by foreigners (who contributed the lion’s share of cash and know-how). In Ghana, Nkrumah nationalized five of the country’s six producing gold mines, but not the largest, Ashanti Goldfields,4 and invited the foreign firms Kaiser and Reynolds to build the aluminum smelter in his most ambitious development project, the Volta River project.

Although some foreign firms have profited to some extent under statist policies, and no African countries governments completely nationalized or banned all foreign investment, statist policies have a negative impact on foreign investment as a whole in the private sector. State-owned enterprises crowd-out and/or compete with private enterprises, and the playing field is sloped against private firms. Furthermore, when foreign firms are nationalized, investors are rarely paid full market value.5

Statist policies will thus reduce investment to the private sector, both because there are fewer private firms (i.e. firms in which private investors are majority shareholders), and because these private firms have reduced profit opportunities. On the other hand, statist policies should have a positive effect on foreign investment to the public sector. Although five-year development plans often proclaim an intention to rely heavily on domestic funding, the implementation of statist policies consistently relies on borrowing heavily from abroad to finance investments. Because the state undertakes the profit opportunities that are denied to private capital, there are an increased number of high-return lending opportunities in the public sector. For example, if the state nationalized a private mining company, foreign lenders who would have bought debt from the private firm will now buy debt from the publicly owned firm directly, or will lend money to the government that will in turn invest in or subsidize the mining concern.

The response of foreign investors in the private sector to statist versus capitalist policies by the host country government depends in large part on the industry. The value of resource-seeking FDI is largely derived from the control of the location of the natural resources, and so foreign investors are relatively unlikely to be deterred by statist policies. If the host country government is willing to give foreign firms a minority share in an enterprise to extract oil or precious minerals, many foreign investors are willing to provide the majority of the necessary capital. The value of efficiency-seeking, on the other hand, to a larger extent derives from the proprietary knowledge of the multinational firm, so investors in such industries are generally less interested in investing in public firms in which they lack managerial control. Furthermore, cheap labor is more readily available throughout the world than oil and precious minerals, and so when faced with nationalization – full, partial, or threatened – investors in such industries will withdraw and invest elsewhere. Thus, it is expected that industries where public firms are not heavily disadvantaged relative to private firms, such as natural resource extraction, it can be expected that investors will respond to statist policies by shifting some investment from the private to the public sector, while in other industries investors will respond to statist policies by withdrawing.

Another political factor that will affect foreign investment is political institution, or regime type. The response of foreign private investors to regime type also depends upon the endowments of the host country and whether the FDI is market-, efficiency-, or resource-seeking. A stable democracy should carry a number of benefits for investors. The long time horizons resulting from orderly succession via elections should encourage the protection of property rights (Olson 1993). Free elections and a free press imply transparency and the free flow of information, which enables investors to make efficient decisions (Przeworski et al 2001, p. 144). The accountability of the government to voters should reduce corruption and increase investment in public services favorable to investors such as human capital (Lake and Baum 2001, Boix 2003, Stasavage 2005). However, the presence of oil and mineral wealth can undermine many of the investment-enhancing features of democracy. Resource wealth encourages vote-buying and other corrupt practices, which undermine the rule of law and support for democratic regime, thus making democracies in such environments short-lived.6 Most resource-abundant countries spend most of their history as dictatorships. The presence of natural resources such as oil encourages autocracy by providing the government with the means to buy support and repress opposition without needing to invest in its citizens (Ross 2001). The flow of FDI into such countries multiplies this dynamic because it doesn’t require human capital and provides the government with foreign capital to supplement export revenues for political purposes. Resource-seeking FDI is motivated by the presence of oil or mineral reserves and so is relatively indifferent to the level of human capital or transparency. Furthermore, some argue that FDI prefers authoritarian rule because of increased stability and the ability to suppress demands among the populace (or a large support coalition) for benefits such as higher wages, the creation of additional jobs, investment in schools or healthcare, or compensation to residents for displacement or environmental degradation.

Governments in countries without heavy endowments of resource wealth rely more heavily on their populace to generate income to tax, or to attract foreign investment. Whereas resource-seeking FDI is location specific and thus relatively indifferent to any potential benefits of democracy, market- and efficiency-seeking can be located anywhere there are customers or workers. These types of investors are therefore more likely to be influenced by the advantages of democracy, including rule of law and transparency.

Although results vary, studies covering earlier years (Olson 1994, Li and Resnick 2004, Resnick 2001) are less likely to find a positive relationship between democracy and FDI than those covering later years (Li and Reuveny 2004, Jensen 2004, Leblang and Eichengreen 2006). When periods of time are looked at separately, it appears that democracy begins to attract FDI in the 1990s (Busse 2004), lending support to the argument (Spar 1999) that the shift from resource-seeking FDI in the primary sector to efficiency- and market-seeking FDI in manufacturing and services has created a positive relationship between democracy and FDI in regions such as Latin America and Asia, where the share primary sector FDI declined in the late 1980s. In Africa, however, where the share of primary sector FDI was highest, this share actually increased (UNCTAD 1999).

Statist policies from popularly elected governments might be expected to be particularly threatening to foreign-owned firms. While governments led by small coalitions might be bought off with some bribes or other favors, a government that relies on a broad coalition will need more to be more satisfied, ranging from jobs to high taxes to nationalization. For example, in 1974 the foreign-owned phosphate mining company in Togo, COTOMIB, allegedly offered President Eyadema a bribe of 1.5 million francs CFA to maintain the tax and investment privileges (EIU 1974). Although Eyadema was an autocratic ruler throughout his reign, in the early 1970s he was pursuing a large coalition strategy in which state jobs and other benefits were distributed throughout the population.7 By nationalizing the phosphate mining company, he was able to increase state revenues to finance a large share of 400 billion francs CFA worth of state enterprise investments (the country also ran up debts of 5.6 billion francs CFA) (Decalo 1990, pp. 229-30).

To summarize, I have the following expectations with regard to political institutions, economic policies, and private capital flows in Africa:


  • Countries with high natural resource endowments will receive high levels of capital inflows, including those with authoritarian regimes, to exploit location-specific resources.

  • In countries with high natural resource endowments, investors will respond to capitalist policies by investing heavily in the private sector, and to statist policies by shifting investment to the public sector.

  • In countries lacking natural resource endowments, investors will respond to statist policies by withholding investment.

  • In countries lacking high natural resource endowments (and therefore striving to attract market-seeking and efficiency-seeking FDI), there will be a positive relationship between democracy and capital inflows, while investors in natural resource-rich countries will be indifferent or prefer authoritarianism.




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