Foreign Domestic Investment and Contribution of Currency Flows to the Domestic Policy - Literature review Example

Running Head: FOREIGN DOMESTIC INVESTMENT Foreign Domestic Investment and contribution of currency flows to the domestic policy Name Course Instructor Date Introduction Foreign direct investment (FDI) refers to the setting whereby an organization in a certain country invests physically in another country (host). According to the international monetary fund (IMF), foreign direct investment refers to the act of an investor obtaining an investment avenue in another country, outside their own. The venture is termed direct because it is the investor or foreign organization that manages or has a major authority over the running of the enterprise. Such an avenue ensures that the host country receives an outside source of finance from the investing developed state. This has consequently seen a reduction in the levels of poverty in the host nations. Graham and Spaulding (2004) define foreign direct investment as a venture by a foreign company into the territory of another by the consent of a mutual agreement. They further claim that FDI offers businesses access to economical production facilities, markets and market guides and inexpensive manufacturing amenities. Graham and Spaulding (2004) discussed three forms of foreign direct investment which were: express attainment of overseas ventures, building of facilities and investment in shared business enterprises. In some cases, foreign companies take over the running of certain firms that have either gone under or are on receivership and put them under their management. Privatization of some business avenues also provides the overseas investors with a chance of directly acquiring them and thus making them their investment. In other cases, the construction of facilities where none exist is usually no option. When a foreign organization realizes that there is a chance for investment somewhere yet there are no laid down strategies to oversee the acquisition, they set up institutions and warehouses to develop the business enterprise. Through technological incorporation and social structures, foreign investors set up mutual ventures that are usually aimed at benefiting both the host and the foreign country. According to Simonetti (1998) mergers and joint acquisitions account for the greater part of foreign direct investments. Several foreign organizations are using mergers in order to gain access to foreign markets and new investment opportunities. Foreign direct investment has internalized commerce as well as trade guidelines and duty liberalization, slackening limitations on foreign investment and acquirement in states. The host states have been blossoming in these ventures because FDI offers them a spring of new technological and asset empowerment, up to date administrative and supervisory skills consequently a thrust for economic and technological development. Patterns of foreign direct investment At the start, foreign direct investment was in the form of equipment, machines and constructions, and was done via amalgamations and attainments. Due to the changing patterns of FDI, Graham and Spaulding (2004) claim that technology start-ups have been on the increase and with the introduction of internet practice, changes in the former patterns of FDI are being experienced. Due to governments’ intervention and funding, researches have borne new technologies that cannot be contained in huge warehouses and factories as was the case with outdated manufactures. Constant researches have led to the birth of intellectual technologies for instance software development and technology. This has greatly influenced the set patterns that FDI was running on. Given that they are intellectual technologies, software companies can be established anywhere on the worldwide market because massive expenditures on machinery and equipment are not necessary. In cases of investing in software technology, locational intention and the entry manner are not necessary factors to consider. As Simonetti (1998) notes, globalization has played a major role in the changing patterns of FDI. It has resulted to capital transfer in the global market as the world is being transformed into a global village. The only problem with software products is that they are constantly changing, and in some cases even before they reach the target market. In such cases, decision making and implementation becomes a dilemma because software technology is not complete on its own but is a product of constant evolution of technology. In addition, the cost of investing in machinery and equipment is usually known because the asset base can be calculated, but it’s tedious when it applies to software development because there is always a feature of doubt. However, its role in continued growth of global economies and the need to move with changing technology trends cannot be ignored. It, is such that has resulted to third world countries not enjoying the full benefits of changing FDI patterns. The ever growing responsibility of technology and software development has continued to modify the patterns of FDI. The government, through the licensing and funding of universities, colleges and other research institutions has greatly affected the pattern of FDI. These research institutions have been enabled to conduct researches and in consequence produce finished products ready for the consumer market. Licensing has enabled them dig into the availability of technology and in so doing, introduce new products on the market. This has enabled numerous countries meet the monetary needs of their rising economy. This is measured through activities of the foreign affiliates and financial investment flows and stocks of a given host country. Graham and Spaulding (2004) quote the joint venture as another pattern which has been the key in starting partnering avenues. According to a Survey of Foreign Direct Investment in G-15 Countries (2010), joint ventures have helped improve and modernize the farming sector, rejuvenated the existing industries, and initiated an infrastructural revival and have generally improved service delivery. This joint investment has witnessed access to technology, availability of an expert pool in the form of human resource and the opening up of key avenues of distribution. As Freeman (2002) notes, joint ventures has been the engine that has been driving the Vietnamese economy. This has witnessed a tremendous advancement in the macro-economic development of Vietnam which had bountiful resources and unexploited markets. According to the OECD Secretariat (2002), mergers and acquisitions necessitated transatlantic commercial occupation. The numerous privatization programs taken by governments enabled FDI to expand its roots into untapped countries. South Africa was one of the beneficiaries of such a venture. Portfolio investment, being another pattern of foreign direct investment, has enabled companies with a major majority in shareholding obtain a controlling effect. The companies with the greater number of shares usually influence the decision making of the investment at all levels. According to the Joint Nature Conservation Committee (2008), UK has greatly controlled her FDI projects in monetary services, foodstuff, mineral extraction industries and farming. UK has effectively implemented these projects in India, South Africa and Mexico. According to Barcena et al (2010), patterns of foreign direct investment were interrupted by the economic crisis that had originated in the industrial nations. Growth in some up-and-coming economies, for instance the Latin America which was experiencing an upsurge in outsourcing especially in the form of far-flung business services, guaranteed that FDI did not nose dive. FDI took the advantage of setting and income advantage in Mexico and the Central American cape to invest in the region. Following the earthquakes experienced in Haiti in January 2010, there was an enormous revival in FDI to invest in telecommunication because the existing composition had been shattered. Such events affect the growth of FDI as well as a countries GDP which has been estimated to grow at a lower rate as compared to the FDI. According to Prasad et al (2006) wealth flows should be from the moneyed to the underprivileged countries. This has been the pattern, but he claims that with the changing trends there is a reverse in the FDI. This makes it impossible to detect any growth benefit on the host country because it is already in the developed nation’s bracket. Gourinchas and Jean (2006) claim that capital ought to flow in massive amounts to countries that are developing at an elevated rate because they have the most apt investment avenues. These mean patterns raise the question of whether FDI plays a key part in overseas investment flows. This could be attributed to infrastructural under development in the developing countries and lack of a conducive environment to boost business activities. For instance, Somali has been a war ground for a long time thereby limiting financial investment as foreign actors shun away from engaging in business activities. Despite such incidences, FDI growth in developing countries has been gradual an steady and this is expected to continue. How currency flows have contributed to the reduction of domestic policy influence Currency flows have contributed to the reduction of domestic policy influence to a large extent. Jones (1998) suggests that the stream of capital to developing economies have distinct and significant benefits which are more pronounced in foreign direct investment as it carries with it technological knowledge and access to markets. The currency inflow supplements domestic savings resulting to increased investment and economic growth which mostly impacts economies with low savings. She adds that a short term, large flow and reversible currency flow would impact emerging economies negatively. This is because complex policy dilemmas are posed for macro-economic management. Capital flows are of great concern to policy makers as they cause inflationary pressure on economies. In addition the exchange rate increases reducing the competitiveness of a country internationally. This is possible if correct measures are not put in place by formulating effective policies. Doojav (2008) suggests that the impact relies on the size of the currency flow, the macroeconomic policy structure and incentives in the monetary sector. According to Pruski and Szpunar, the increasing global markets have considerably impacted the advancement of monetary and fiscal policies. Domestic policies that have been affected by the exchange rate policy, monetary policy and fiscal policy. Increasing capital flow has led to increased market volatility increasing the real interest rates in the long run. This makes it difficult to maintain a fixed exchange rate policy. As a result, the exchange rate for any country is dependant on the prevailing global rates as impacted on by capital flow. Spiegel (2007), suggests that the probability of a country applying fixed exchange rate to last eight years has been computed to be below 0.3. Some economies have tried to limit currency flows by use of capital controls and their efforts have proven to be inadequate as they distort the normal operation of monetary systems and markets. Since no country can exist in isolation and without being impacted on by the global market economy, any efforts to develop controls are frustrated. So long as a country is a player in the global market, such impacts are unavoidable. Such economies have no choice but to adopt a monetary policy with a steady and low inflation in order to stabilize the exchange rate. Long term growth is dependent on financial development. Studies have shown that foreign investment on domestic economy led to establishment of economic institutions that formulate new policies to keep the inflation and current account deficits as low as they can and also stabilise the inflation. Pruski and Szpunar claim that external financiers have played a vital role in the development of Polish financial systems regarding both financial institutions and markets. They attribute this to liberalisation of financial and capital flows carried out during the 1990s. Currency flow has also facilitated the development of financial markets and institutions. This has led economies to change their initial monetary policy to a reliable one to reduce adverse macro-economic effects and result to financial stability. Banks that previously relied on domestic capital ended up in financial crisis, and the solution to stabilize the banking sector was to increase currency flow by encouraging foreign investors. Increased currency flow led to establishment of a market for risk hedging instruments, amplified market liquidity and broadening of investors’ base. The broadening and increase of the investors’ base has promoted stability by getting rid of undesirable outcome of investment limiting large local institutional investors. Domestic policies cannot now being developed without a consideration of the international markets. This has caused governments to loosen or do away with some policies that were previously a hindrance to international investors. Though such policies were aimed at protecting the local producers, it has become necessary for countries to embrace the role of global market in influencing local markets and policy development and implementation processes. As such, a country is left with no option but adjust local policies to suit the international markets even when such decisions impact on domestic industries. This has been evident in import and export policies for agricultural products in different countries (Hsiao, 2001). Increased capital flow has led to establishment of a new macroeconomic environment resulting to economic independence. To achieve this, countries had to relinquish various controls, restrictions and entry barriers. Many countries opened up their economies in order to compete for international capital and transformed their economies to be able to draw external investment. This resulted to enormous flow of currency and fluxes in exchange rates. These processes were hand in hand with the switch from central planning to market economy. Inflation is a major result of increased currency flow in a country. It affects different economic activities on both micro and macro levels resulting to the reduction of domestic policies. During inflation, money loses its value. This implies that in the lending-borrowing process, lenders will be losing and borrowers will be gaining, at least to the extent of the time value of money. To solve such problems, lenders increase the interest rates to cover for lost value. Cost of capital/credit will increase and the demand for funds is discouraged in the economy, limiting the availability of funds to be invested as capital. Other things constant, during inflation more disposable incomes will be allocated to consumption since prices will be high and real incomes very low. In this way, marginal propensity to save will decline culminating in inadequate saved funds. This hinders the process of capital formation and thus the economic prosperity to the country. As such, economic growth as well as FDI growth is negatively impacted on resulting to low growth rates or economic stagnation. In addition, inflation leads to an expansion in economic growth while others associate inflation to economic stagnation. Such kind of inflation if mild, will act as an incentive to producers to expand output and if the reverse happened, there will be a fall in production resulting into stagflation i.e. a situation where there is inflation and stagnation in production activities. This results to huge losses on the part of the producers as the cost of production increases and the demand falls. During inflation domestic commodity prices are higher than the world market prices, a country’s exports fall while the import bill expands. This is basically due to the increased domestic demand for imports much more than the foreign demand for domestic produced goods (exports). The effect is a deficit in international trade account causing balance of payment problems for the country that suffers inflation. Inflation also causes income distribution in a country to worsen. The low income strata get more affected especially where the basic line sustaining commodities’ prices rise persistently. In fact, such persistence accelerates the loss of purchasing power and the vicious cycle of poverty despite the domestic policy of increased living standards. Governments should adopt measures in order to control inflation. Fiscal Policy based on demand management in terms of either raising or lowering the level of aggregate demand. The government could attempt to influence one of the components of the aggregate demand by reducing government expenditure and raising taxes. This policy is effective only against demand-pull inflation. Neo-Keynesians contend that monetary policy works through the rate of interest while monetarists’ viewpoint is to control money supply through setting targets for monetary growth. This could be achieved through what is known as medium term financial strategy (MTFs) which aims to gradually reducing the growth of money in line with the growth of real economy – the use of monetary policy instruments such as the bank rate, open market operations (OMO) and variable reserve requirement (cash & liquidity ratios). Doojav (2008) recommends the following strategies to elude the adverse effect of surge in currency inflow: fiscal soberness, tightened monetary policy, improved bank supervision and institutional enhancements. He adds that well established and deeper stock market could stimulate financial constancy and aid in decreasing the economy’s vulnerability from volatile currency flows. Conclusion Foreign Direct Investment has seen an inflow of capital all over the globe. There has also been the transfer of skills, technology and job creation. All these have led to the growth of economies all over the globe. Foreign Direct Investment through its expansion has seen globalization expand to encompass the entire world. Currency flow has highly contributed to the reduction of domestic policy influence. This is mainly because capital inflow is vital especially for developing countries and an increase in the flow often affects domestic policies. Despite the negative impacts FDI may have had on countries, its benefits outweigh the cost incurred. It has remained a major driver in a country’s economic growth. The tremendous change in FDI patterns mainly attributed to globalization are a major booster to global economies. It is as a result of such that domestic policies have been impacted on as countries seek to reap maximum benefits that come with foreign direct investment. Reference Graham, P. and Spaulding, R. (2004). Understanding Foreign Direct investment. Modified June A Survey of foreign Direct Investment in G-15 Countries (2010). Working paper series, Volume 7. summit Level Group of Developing Countries: Group of Fifteen. Retrieved http://www.g15.org/workingpaper7.pdf Freeman, N. (2002). Foreign Direct Investment in Vietnam: An Overview. Paper prepared for the DFID workshop on Globalization and Poverty in Vietnam. Hanoi. 23-24th September, 2002. Joint Nature Conservation Committee, (2008). Tracking UK Foreign Direct Investment (FDI) into selected overseas economies. Phase 1 report. Simonetti, R. (1998). Cross-Border Mergers and Acquisitions: Patterns in the EU and Effects. London: South Bank University. Barcena, A. et al (2010). Foreign Direct Investment in Latin America and the Caribbean. Briefing Paper. ECLAC OECD Secretariat, (2002). Foreign Direct Investment for development: Maximizing Benefits and Minimizing Costs. Paris: OECD Publication. Prasad, E. (2006). Patterns of Internal Capital Flows and their Implications for Economic Development. Research Department IMF. Retrieved http://prasad.dyson.cornel.edu/doc/book_chapters/PatternsofInternationalCapitalFlowsan dtheirImplementationsforEconomicDevelopment Gourinchas, P. and Jean, O. (2006). Capital Flows to Developing Countries: the Allocation Puzzle. IMF Working Paper, Forthcoming. Jones, S. (1998). Stabilizing Capital Flows to Developing Countries. Retrieved http://www.eldisa.org/vfile/upload/1/document/0708/doc5796.pdf Pruski, J. and Szpunar, P. Capital flows and their Implication for monetary and Financial Stability: the experience of Poland. Retrieved bispap44u.pdf(application/pdf object) Spiegel, M. (2007). Financial globalization and monetary policy. Presentation at the Bank of Korea 15th annual central banking seminar, 18th-21st September. Doojav, O. (2008). Capital flows and their implementation for Central Bank Policies: The case of Mongolia. Retrieved http://www.mongolbank.mn/documents/tovhimo/group5/06.pdf Hsiao, C, (2001), Analysis of Panel Data, Cambridge, Mass.: Cambridge University Press. 18, 2005. Retrieved on 10th April, 2012. Read More