V Developments and Policies in Industrial Countries and Foreign Investment
- International Monetary Fund
- Published Date:
- January 1985
At present, most industrial countries maintain relatively few restrictions on capital outflows and provide some encouragement for direct investment in developing countries, through guarantee and insurance schemes and various forms of official financial support. The decline in the relative importance of direct investment in total capital flows to developing countries since the early 1970s is not due to any major change in such policies. It reflects changes in the structure of the international financial system over the last 15 years and, in particular, the greatly increased role of commercial banks in international financial intermediation. Nevertheless, an examination of policies of industrial countries toward direct investment in developing countries may suggest ways of encouraging higher levels of such investment.
Developments in Financial Markets
Structural changes in the financial system were already underway by the late 1960s as major banks increased their international operations and, attracted by promising growth prospects, greatly increased their lending to some of the more rapidly industrializing developing countries. For instance, the long-term debt of the 25 principal borrowing countries to financial institutions increased at an average annual rate of over 30 percent between 1967 and 1973. This trend was continued after 1973, as the asset preferences of the relatively risk-averse oil exporting countries led them to hold many of their assets in the form of liquid bank deposits. Together with greatly increased demand for medium-and longer-term financing by developing countries, this provided banks with the opportunity to expand their role as international financial intermediaries. As a result, the share of claims on non-oil developing countries in banks” total net international claims increased from under 23 percent in 1970 to around 30 percent by the early 1980s.22
Much of the new lending was either to, or guaranteed by, governments and was encouraged by a view that the risks associated with such sovereign lending were relatively low in comparison to normal commercial lending. In contrast, there was much less scope for large immediate increases in direct investment, which depended on the identification of individual opportunities for profitable investment and was influenced by a wide range of institutional restraints that could not be altered quickly. Also, the prevalence of low or negative real rates of interest between 1974 and 1978, together with expectations that such rates would continue, probably encouraged developing countries to rely on external borrowing for their financing requirements.
This increased role of commercial bank lending was probably unavoidable, especially in the years just after the large increases in oil prices, and it certainly helped cushion non-oil developing countries from the immediate effects of adverse external influences. The question whether, over the longer term, direct investment could have substituted for at least a part of the increased bank lending has already been discussed in Section III. In addition, some observers have argued that the international capital markets may not have been able to cope with a substantial increase in the share of direct investment in total capital flows to developing countries. The preference of the oil exporting countries for relatively liquid assets meant that banks were inevitably heavily involved in international financial intermediation, and transnational corporations faced limits on debt/equity ratios and foreign exchange exposures. It has been argued that this could have affected their willingness to raise the necessary finance for a large-scale increase in direct investment, even if suitable projects and regulatory environments had been present in host developing countries.
The degree to which bank lending to non-oil developing countries reflected a recycling of the deposits of oil exporting countries fluctuated substantially. The latter were major contributors of funds to the international banking system in the periods shortly after the two oil price increases, but were much less important in the mid-1970s, and their deposits declined after 1982 (Table 3). Consequently, the influence of their asset preferences on the composition of capital flows declined as the world economy adjusted to the new oil prices, while portfolio preferences in the capital markets of the industrial countries became predominant once again. As a result, the possibilities for substitution between bank lending and direct investment in capital flows to non-oil developing countries may have been greater once the initial impact of the higher oil prices had been absorbed.
|Average annual flows||Cumulative flows|
|Net borrowing from banks||15||19||33||21||216|
|Net long-term borrowing from official creditors||7||12||20||24||165|
|Net inflow of direct investment||5||6||10||11||82|
|Current account balance of non-oil developing countries||-37||-38||-87||-69||-588|
|Net increase of oil exporting countries bank deposits in industrial countries||30||11||28||-15||127|
Negative numbers imply deficits.
Negative numbers imply deficits.
Moreover, the increase in direct investment that might have resulted from any substitution was not likely to have been large enough to have encountered significant capital market constraints, at least on a global basis. The net cumulative flows of direct investment and bank lending into non-oil developing countries during 1974–83 are estimated at $82 billion and $216 billion, respectively (Table 3). By contrast, the total assets of the parent companies of U.S. transnationals alone (excluding the assets of overseas affiliates) amounted to over $1,500 billion at the end of 1977.23 Even a major increase in direct investment financed solely by increased borrowing would have had only a modest effect on the debt/equity ratios of transnational companies. Moreover, if additional investment opportunities had been available, these companies could also have raised additional equity financing.
One other set of influences on the composition of capital flows to developing countries has been the financing decisions of the foreign-owned affiliates. Although little concrete information on these is available, there are some indications that the share of affiliates’ capital expenditures financed by overseas borrowing from third parties (in particular, bank lending and suppliers’ credits), rather than by transfers from the parent company, may have increased during the last decade. This appears to have been especially true immediately after the first large oil price increase.24 In addition to reflecting a number of general influences (such as low real interest rates) in world financial markets that tended to encourage a substitution of debt for equity, this trend may also have been influenced by a desire by some parent companies to reduce their risk exposure in some developing countries and by host-country tax and foreign exchange regulations that often favored overseas payments in the form of interest rather than dividends.
Policies of Industrial Countries
Virtually all industrial countries have relatively open policies regarding equity capital outflows.25 A few impose exchange controls, generally as part of broader restrictions on capital flows designed to support the balance of payments. For instance, some countries (including France) require most outward investment to be financed by borrowing in foreign currencies or have arrangements whereby total purchases of foreign securities by residents must be matched by proceeds from the sales of such securities. A few countries (such as Australia and Sweden) require individual authorization of direct investment proposals, although such authorization is generally granted, especially if the proposed investment would boost home-country exports. Few such restrictions discriminate in favor of investment flows to developing countries.
Capital market regulations in developed countries may also hamper portfolio equity investment in developing countries. The costs of meeting registration requirements, and the comprehensive disclosure of information required, mean that direct equity issues in industrial countries are not a viable alternative for most companies from developing countries. Moreover, regulations governing the composition of investment institutions’ portfolios in some industrial countries limit these institutions’ ability to purchase foreign securities, including those of developing countries.
There has been concern in many industrial countries about the effects of outward direct investment on domestic employment opportunities and real wage levels. Most studies have concluded that foreign investment does not lead to a net loss of employment in the capital-exporting country, once such indirect effects on employment as the increased exports generated by direct investment packages are included. Nevertheless, while such concerns have not generally resulted in greater controls over outward direct investment, they have contributed to a reluctance by some industrial countries to grant greater incentives for investment in developing countries. Even more important is the spread of protectionist trade measures during the recent period of high unemployment. Although these new measures are not directly aimed at reducing direct investment flows, they often have this result, since they discourage new export-oriented investment in those sectors where developing countries have the greatest comparative advantage.
The systems of corporate taxation in developed countries can have various and significant effects on direct investment in developing countries. They affect relative after-tax rates of return to domestic and foreign investment; influence net benefits to developing countries through the apportionment of tax revenues between home and host countries; and have a major impact on the way direct investment is financed. A number of industrial countries have concluded tax treaties with various developing countries, often with some provisions that were more favorable than in similar agreements with other developed countries. Some authorities from developing countries have argued, however, that the conventional pattern of such treaties tends to favor capital-exporting countries and consequently have been reluctant to conclude them. The 1979 UN Model Double Taxation Convention Between Developed and Developing Countries provided a framework in which greater taxing rights were granted to developing countries and a number of treaties have been concluded along these lines.26
In this context, two key aspects of the tax policies of industrial countries are whether they are neutral between domestic and foreign investment and whether any tax incentives granted by a host developing country will be offset by increased taxes in the capital-exporting country. Most industrial countries avoid double taxation of income generated abroad, either by exempting it or by granting a credit for foreign taxes paid.27 Under the former system, the tax-related attractiveness of foreign as opposed to domestic investment depends on the relative size of taxes in the home and host countries; the home country cannot easily grant incentives to foreign investment, but host-country incentives are not nullified by offsetting changes in home-country taxes. Under the latter system, which is used by many industrial countries (including Japan, the Federal Republic of Germany, the United Kingdom, and the United States) firms are allowed a credit for foreign taxes paid against the domestic tax liability established on the basis of worldwide income. Consequently, any tax incentives granted by the host country are liable to be offset by higher home-country taxes. To allow developing countries to offer such incentives, a number of industrial countries (but not including the United States) allow notional tax credits for foreign taxes that would have been paid in the absence of incentives. In fact, a few developing countries (including Singapore) grant some kinds of tax incentives only to firms from countries that have such provisions. In practice, however, the effectiveness of host-country tax incentives can also be maintained, to a considerable extent, when home countries (such as the United States and most other industrial countries) defer taxing the profits of overseas subsidiaries until they are remitted as dividends. Such tax deferral can also reduce the effective tax rate on income from abroad (if the host-country tax rate is lower than that of the home country), and thereby provides some inducement to investment overseas; it also creates a strong incentive to finance additional direct investment out of reinvested earnings.28
Most industrial countries make available insurance for new direct investment in developing countries, generally with coverage of noncommercial risks such as expropriation, losses due to war, and inconvertibility of dividend and capital transfers.29 Such insurance can help promote investment by reducing risks, particularly for small and medium-sized firms. However, with the exception of Japanese and Austrian direct investment, more than half of which is covered by such insurance, existing official arrangements cover only a small fraction—generally less than 10 percent—of industrial countries” total direct investment in developing countries. This is because of restrictions in coverage, self-insurance by large multinational firms, and the availability of some private insurance against political risk. In this regard, the World Bank is exploring a multilateral investment insurance scheme that would build upon and complement existing national and private schemes.30
Some financial support for direct investment in developing countries is provided by most industrial countries. Much of this is through public investment corporations, including the IFC and similar national organizations, that usually invest directly in projects in partnership with domestic and foreign investors. They play an important role in generating total investments much larger than their own contributions, since their participation can increase private investors” confidence in the security and financial viability of projects, as well as assure host governments of their development contribution. The IFC has also played a major role in promoting increased foreign portfolio investment in developing countries and has encouraged the establishment of a number of private investment funds for the purchase of equity in particular developing countries. Some industrial countries also offer loans and loan guarantees for direct investment, usually in a form similar to the various export credit schemes. By far the largest volume of such loans has been extended by Japan, where the outstanding stock of official loans in support of private direct investment in developing countries amounted to over $6 billion at the end of 1982.