JC Economics Essay Foreign Direct Investments & Macroeconomic Goals Model Answers
Every country in the world desires Foreign Direct Investments (FDI for short), as it helps an economy to jump start its pursuit of economic growth. Even North Korea, the last communist state, has FDIs from Russia, as well as from China. Free Trade Agreements (FTAs) are economic treaties which make trade and investment between Singapore and the rest of the world easier. (See list of Free Trade Agreements forged by Singapore here.) usually included in FTA are flows of FDIs from and into one’s trading partner.
Question
“Foreign Direct Investments bring with it capital, technology, jobs and links to the world economy.”
(a) Account for the main reasons why some countries face difficulties in attracting investments from overseas.
(b) Discuss the view that an inflow of FDI will be equally beneficial to different economies.
JC Economics Essay – Foreign Direct Investments
Part (a)
Introduction
Countries may want to attract investment in their quest to achieve sustained economic growth.
Countries seek to attract both domestic and foreign direct investment. Investment refers to the spending by firms on capital or investment goods for use in future production • Attractiveness of investment (1) would depend on the cost of capital/investment and the returns to investment. Some countries face difficulties in attracting investment due low expected returns to investment and/or high cost of capital/investment.
One factor that makes it difficult for countries to attract investment is high rate of Interest. When interest rates are high, marginal investment project appear unprofitable as the cost of investment is high relative to the returns from the investment. Ceteris paribus, this results in countries with high interest rates facing difficulties in attracting investment. E.g. India where interest rates on loans are high, which tends to deter domestic investments unless the expected returns are even higher. However, in the case of foreign direct investment, MNCs tend to bring their own funds and are therefore not affected by domestic interest rates. Interest rate has a greater impact on local investment.
Another factor that makes it difficult for some countries to attract investment is business pessimism. When business sentiments in a country like Greece have been negative due to the poor economic performance of the country after the debt crisis there. As such, the expected returns to investment is low, making such countries face difficulties in attracting investments. Poor quality of workforce in a country may also contribute to difficulties faced by a country in attracting investments. This is because a poor quality workforce like that in African nations results in low productivity and high unit cost of production which in turn results in poor expected returns to investment, making it a less attractive investment destination. The poor quality may be due to lack of a good education system and poor training facilities available to enhance the skill level of workers.
Another factor that contributes to difficulties a country may face in attracting investment is poor infrastructure. Poor infrastructure in countries like India give rise to inefficiency in production, transportation, power, water and information are not readily available and transmitted – all these being important to potential investors. The poor infrastructure slows down production process, resulting in high unit cost of production and low returns to investment and therefore results in difficulties in attracting, investment.
Others:
Political instability → lack of long term planning by the government, possibility of changes in government policies fear among investors low expected net returns to investment difficulty in attracting investments E.g. Pakistan with regular terrorist attacks, Afghanistan which is still quite unstable, Iraq, etc. Government policies – Lack of fiscal incentives like government grants or subsidies or lower corporate taxes → poor expected net returns to investment → unattractive for investors E.g. countries like Vietnam, Cambodia, African Nations Size of market – When the country only has a small market to offer, it might deter investments, especially FDIs as the firm will have limited demand for its products due to the small market size → low returns on capital → unattractive to investment (Not a strong reason as FDIs may still be attracted by countries with small markets but good accessibility to nearby markets, e.g. Singapore)
Different countries may have their own difficulties in attracting investment due to one or more reasons. The attractiveness of a country to investors ultimately depends on the expected return to investment relative to cost. If the expected returns are greater than the high cost, countries may still be able to attract investments despite shortcomings
Mark Scheme:
L1: Can only identify the factors affecting investment without a clear link to difficulties in attracting investments
L2: Explanations of the factors are accurate but are inadequately developed with some use of examples.
L3 A good knowledge of the factors which are well explained with relevant examples.
JC Economics Essay – FDIs & Macroeconomic Consequences
Suggested Answer Part b
FDI are investments that flow into the country from external sources. These usually result in investment in production or research facilities, sales offices or even the regional offices of multi-national corporations. The inflow of FDI can affect quantity and quality of resources, benefitting a country through the achievement of its macroeconomic objectives.
Benefits the economy – if it helps the economy achieve its macroeconomic objectives – sustained economic growth, low and stable inflation, low unemployment and a favourable BOP position Different countries may be affected differently depending on the conditions prevailing in the economy
Thesis: Beneficial
Increase in National Income
Assuming that 2 countries US and Singapore receive the same inflow of FDI. In the short run, an increase in FDI increase in I→ increase in ADIAE → increase in NY through the k process. The magnitude of the impact on NY would depend on the size of the multiplier in the country. Countries with larger domestic markets with less leakages like the US are likely to experience a larger increase in NY through the multiplier process than countries with a small domestic market and significant leakages like Singapore as countries like US are likely to have a larger income multiplier than countries like Singapore. As such the same increase in FDI is likely to have a larger increase in NY in US than in Singapore.
Actual Growth & Potential Economic Growth
Inflow of FDI→ Increase in AD Increase NY actual EG, ,assuming the country has unemployed resources available. (illustrate using suitable diagram). However, in economies where resources are close to or already fully employed, increase in I will have inflationary effects on the economy, with little or no increase in output (Illustrate with diagram) This may have adverse effects on the economy. FDIs by MNCs are also likely to result in a transfer of technology increase in productivity of workers fall in COP in the SR and an increase in productive capacity in the long run rightward shift of the whole AS curve. The greater the transfer of technology, the greater the impact on EG. This may differ between countries. If FDI inflow is to enjoy abundant, cheap labour, with little training opportunities for them impact on SRAS and LRAS will be small. E.g. Emerging economies like Vietnam and Cambodia. If FDI inflow is into high value added or service oriented industries → lots of training and development opportunities for local employees → more significant effect on SRAS and LRAS. E.g. Singapore
Employment
Inflow of FDI → Increase NY→ decrease in unemployment assuming the economy has unemployed resources available. The extent of job creation would depend on the type of industry FDIs flow into which is dependent on the stage of development of the economy: Emerging economies specialising in low value labour intensive production like China is likely to have FDIs into production facilities by manufacturing MNCs are likely to create a large number of low value added jobs. For countries in a more advanced stage of development like Singapore, investment is likely to be into more technology intensive, higher value added industries, there will be fewer but higher value added jobs created.
BOP
Inflow into K and financial account is recorded as a credit item in the K and financial account of the BOP. If the investment results in more goods and services produced and exported, the resultant inflow will also be recorded as a credit item in the current account of the BOP. This will result in an improvement in the current account of the BOP as well. If a country is currently facing a deficit in the current account of the BOP, the credit items, ceteris paribus, would result in an improvement in the overall BOP. This would benefit the country. E.g. Brazil, Spain
However, for another country whose BOP is already in persistent surplus → increase in FD I cause further surplus that may not be beneficial as it may have negative effects on the economy. E.g. Singapore
Anti-thesis: Not equally beneficial
Increase in FDI ceteris paribus: will increase demand for the country’s domestic currency appreciation of the currency export competitiveness adversely affected as exports become more expensive in foreign markets and imports become cheaper in the domestic market. This would result in a deterioration of net exports. The appreciation of the currency will partially offset the increase in AD/AE that arises due to increase in FDI. As such a country that is highly depended on net exports, would be more adversely affected be the appreciation of the exchange rate that arises due to FDIs. However, for countries which are highly dependent in imports like Singapore, the appreciation will reduce prices of raw materials and imported, helping to reduce COP of exports as well as reducing the domestic inflation. In addition for countries like China which tend to fix their exchange rate, export competitiveness will not be severely affected as the government would intervene into the exchange rate market to bring it down to the original level. Overdependence on FDI for economic growth country being left vulnerable to economic instability when FDIs leave when they find cheaper countries to invest in.
One way around this would be for the government to encourage domestic investment through fiscal incentive to prevent or minimise such over-dependence. Also by differentiating itself in terms of skills and expertise from other developing countries that may be abundant in low skilled cheap labour, the country will be able to attract FDIs in high value added industries. This will ensure that the FDIs do not move out in favour of low skilled cheap labour in emerging economies. In less developed country, FDI may flow is to exploit cheap unskilled labour and abundant natural resources. This will adversely affect the country’s economic growth in the long run as workers continue to remain unskilled and natural resources are depleted. In more developed countries, less exploitation if any as governments and unions pay close attention to workers’ pay and working conditions and the use of other domestic resources.
Conclusion
The inflow of FDIs into countries will never be equally beneficial to different countries as the profile of each country is different. Assuming the same inflow of FDIs, the inflow may not be equally beneficial to different countries as they may experience different effects on their economy, depending on macro factors such as the size of the multiplier, the availability of resources and initial BOP position. In addition the nature of the industry into which the FDI flows vis-a-vie the profile of the labour also may differentiate the benefits that may arise. The type of exchange rate system, the dependence on exports and imports as well as the country’s dependence on FDIs differentiate the benefits.
Marking Descriptors
L1: Only able to identify vaguely the effect of inflow of FDI on a few of macro aims without any link to why they may differ for different countries
L2; Able to adequately explain the effect of FDI on most of the internal macroeconomic objectives or 3 objectives with some reference to why they may differ for different countries
L3: Fully developed arguments with regards to both internal and external macro objectives with clear links to how the impact of an inflow of FDIs may differ for different countries.
E1 Unexplained judgment as to why the benefits may differ.
E2: Judgment based on analysis as to why the benefits may differ based on arguments presented looking closely at underlying reasons for the difference.