Ch10 Material The Rate of Return to Investment Depends Jointly on the Capital Stock, Other Factors,

1
Ch10 Material The Rate of Return to Investment
Depends Jointly on the Capital Stock, Other
Factors, and Technology

• Case II Technological Progress
• Technological progress shifts the production
  function, as from f1(K,L1) to f2(K,L1).Note
  Change in technology only since f2gtf1 but no
  change in Labor (L)
• If technological progress causes the slope of
  f2(K,L1) at K to be steeper than the slope of
  f1(K,L1) at K, the return to investment rises
  from r2 to r3 since r3gtr2
• Reason Existing workers (L1 ) have more
  technology to work with in producing additional
  output (from YB to YC .)

YC
YB
2
Ch.10 Material International Investment and
Economic Growth

• The Schumpeterian RD model is used to explain
  how international
• investment might be expected to contribute to
  technological progress. One of
• the big issues is whether international
  investment facilitates the flow of
• technology from one country to another. There is
  some evidence that foreign
• direct investment (FDI) indeed does that,
  although the precise ways in which it
• transfers technology are still a very active area
  of research. The linkages between
• other forms of international investment and
  technology are even less
• understood.
• International investment has been linked to
  economic growth (Recall Chapter 5?).
• To understand the possible links, recall the
  Schumpeterian model of technological progress
  (q), summarized as
• q f( p, r, R, ß ).
• The variable q is the quantity of innovations
  generated in the economy, R the supply of
  resources in the economy, p is the profit from
  innovating, ß the efficiency of RD activities in
  terms of the resources necessary to generate an
  innovation, and r is the interest rate that
  reflects peoples valuation of future gains
  versus current income and at which the returns
  from investments in RD must be discounted.

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Ch.10 Material International Investment and
Economic Growth

• International investment is likely to affect
  technological progress through p, the profit from
  innovation.
• Because it contributes to globalization, which is
  essentially the integration of separate economies
  into a single world economy, international
  investment raises the potential profits from
  innovation.
• International investment can reduce the cost of
  innovation, ß, because it facilitates the flow of
  ideas.
• There is evidence that foreign direct investment
  (MNE etc) leads to the transfer of technology to
  the recipient countries, and other forms of
  investment may also facilitate information flows
  between economies, thereby reducing ß.

4
Ch.10 Material Why Is International Investment
So Small?,1

• Investment is subject to some degree of risk.
  Investment is an intertemporal transaction where
  one party agrees to accept payment(s) at some
  future date. It is impossible to foresee the
  future with certainty.
• There are also some perverse incentives that
  increase the likelihood that future payments will
  fall short of previously agreed-to levels
  (default issues.)
• Thus, international investment faces greater
  difficulties in foreseeing the future and
  countering perverse incentives.

5
Ch10 Material Why Is International Investment
So Small?,2

• Information available to lenders and borrowers is
  often asymmetric, with lenders knowing less than
  borrowers about the eventual payout of assets.
• Asymmetric information can result in adverse
  selection, which is the case where, because
  buyers have difficulty in verifying the quality
  of assets, a disproportionate amount of bad
  assets (loans by banks) are likely to be offered
  for sale to high-risk buyers
• Moral hazard refers to the likelihood that once
  borrowers have acquired a loan, sold stock, or
  sold a bond, they will behave differently than
  they would had they not gained the financing,
  thereby reducing the eventual earnings from an
  asset.

6
Chapter 11. Multi-National Enterprises (MNEs)

• MNEs are involved in over 75 of all
  international trade. either as the exporter, the
  importer, or both.
• MNEs account for a major portion of international
  investment.
• MNE investments are categorized as Foreign Direct
  Investment (FDI).
• There is extensive evidence that FDI is the
  international investment most likely to
  facilitate international technology transfers.
• MNEs do many things that could, theoretically, be
  accomplished by individual firms in different
  countries, which means that the growth of MNEs
  must be due to some special advantages that
  international business organizations have over
  individual national firms.
• MNEs have advantages in over arms length
  transactions between firms in different
  countries.
• MNEs are both admired and criticized anywhere
  unemotional discussion of why MNEs have grown
  helps to put the conflicting views into
  perspective.
• It is also important to relate MNEs to FDI in
  order to highlight the fact that international
  trade and investment are related in complex ways.

7
Vertical and Horizontal FDI

• Foreign direct investment undertaken by MNEs is
  often classified as either vertical and
  horizontal.
• Vertical FDI implies that an MNE owns facilities
  that fit into different stages of the supply
  chain. More vulnerable to disruptions.
• Horizontal FDI, on the other hand, consists of
  MNE investments that duplicate facilities and
  operation in several countries. In terms of risk
  management, this strategy impacts less on the
  firm in case of a serious disruption, such as war.

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Among the reasons for the growth of MNEs are

• It can be less costly to internalize transactions
  within a business organization than to deal with
  outside firms. Benefits from transfer pricing.
• Proprietary knowledge is often best exploited
  in-house.
• By expanding overseas, economies of scale can be
  exploited. i.e. an expanding market allows longer
  production runs, for example, FDI in China
• Reputations can be exploited in more than one
  market. It cuts both ways, Nestle products in the
  70s!
• Trade restrictions can be avoided by producing
  overseas behind tariff walls. Example, Celtic
  Tiger (Republic of Eire) Ireland

9
Among the reasons for the growth of MNEs are

• Taxes and regulations induce business to move
  activities across borders. CA firms located in
  Nevada, just across the border problem
  workmans compensation
• Exchange rate risk inherent to international
  trade and investment can be reduced by spreading
  expenses and earnings across borders.
• Example RUS RUK E(St1) - St/ St
• FDI may be possible when financial markets do not
  exist to otherwise channel funds to profitable
  projects. Equatorial Africa--- hardly any
  financial markets but lots of oil
• A local presence can help firms anticipating
  favorable local business opportunities. Example
  US companies working through 3rd parties, well
  before the US lifted sanctions against Libya!

10
MNEs and International Technology Transfers

• MNEs use FDI to establish their methods and
  proprietary techniques in foreign countries.
• MNEs also transfer people, designs, business
  philosophies, and management techniques across
  borders.
• The evidence strongly suggests that the
  technological leaders in each industry are also
  the more active foreign investors.
• Because firms do not easily part with proprietary
  technology, FDI may be the only way to introduce
  cutting-edge technology into a country.

11
Portfolio Investment

• Portfolio investment is another of the very
  largest categories of
• international investment. This categorys recent
  rapid growth, has
• largely been due to the widespread establishment
  of stock and bond
• markets throughout the world.
• Portfolio investment consists of purchases and
  sales of securities, such as
• bonds and stocks, in amounts that do not imply
  any direct management
• control or influence on the businesses issuing
  the securities.
• Portfolio investment has, along with FDI, become
  one of the two largest categories of
  international investment.
• The prominence of international portfolio
  investment is been a very recent phenomenon,
  however.
• International portfolio investment first required
  the development of stock and bond markets in
  other countries.
• Portfolio investment is widely used by investors
  to spread risk as well as to raise overall
  returns to savings.

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International Banking

• A critical characteristic of international
  banking is the emergence of the euro-currency
  markets. Offshore banking usually elicit strong
  views for and against it. The growth of the
  euro-currency markets is an interesting example
  of how global economic activity evolves in
  response to economic incentives and the rules and
  policies established by national governments.
• Table 11.5 gives an idea of who the big players
  in international banking are. The rankings have
  been changing frequently, and indications are
  that they will continue to change as further
  mergers and acquisitions (MA) take place.
• Another issue is the recent wave of cross border
  mergers among the worlds largest commercial
  banks. Interesting issues include (a) whether
  international banking will increase or decrease
  the volatility of savings flows across borders,
  (b) whether the increased mobility of savings
  will lead to a greater concentration of flows to
  particular countries or a broader dispersal of
  savings across countries, and (c ) whether
  countries ability to regulate and direct savings
  flows within their borders will be weakened.
• NOTE The term euro-currency is misleading
  because it seems to imply that such markets are
  located in Europe! In reality, any currency
  market is so designated provided the currency is
  outside the country of origin. Thus, we have
  euro-yen, euro-pound, eurodollar, and euro-rand
  markets outside Japan, UK, US, and South Africa
  respectively.

13
Foreign Aid

• Foreign aid is not, strictly speaking,
  international investment. In the balance of
  payments it is included under transfers in the
  current account. But it is an important
  international capital flow, so it is included
  in this chapters discussion of financial flows.
  Foreign aid as a percentage of world GDP has
  declined in recent decades.
• By 2002, there appeared to be increased interest
  in foreign aid by both opponents to globalization
  and proponents of globalization, but there was no
  clear sign that the volume of international aid
  was about to increase.
• Foreign aid usually stirs strong emotions on
  either side of the debate. Are the alleged goals
  of foreign aid, namely economic growth and a
  reduction in poverty, better achieved through
  other means? The 2015 Millennium Goals How can
  donor countries prevent recipient governments
  from stealing or otherwise misusing the foreign
  aid? Should developed countries send more aid to
  developing countries? What precisely should
  foreign aid try to accomplish? Where does foreign
  aid fit in with other policies to promote
  international bank lending, FDI, and portfolio
  flows? What is the responsibility of people in
  one country vis-a-vis people in other countries?
  How does that responsibility differ from peoples
  responsibilities towards fellow citizens? Should
  it differ? That latter question brings into the
  whole issue of nationhood and globalization into
  the discussion. Philosophy and International
  Affairs types should enjoy these types of
  discussions!

14
International Investment A Historical Perspective

• When measured as a proportion of GDP, capital
  flows in the 1800s were much larger then than
  they are now.
• But, because financial markets were not as
  developed, international investment was not
  nearly as diverse as today.
• International investment flows were always
  subject to occasional defaults and renegotiation.
• Most foreign debt was serviced on schedule by
  borrowers, and, in the case of Great Britain, the
  overall returns on foreign bonds were at least as
  high as they were on domestic British assets.
• International investment came to a complete halt
  during the 1930s, only to recover toward the end
  of the 20th century.

15
International Investment A Historical Perspective

• International investment grew rapidly after World
  War II, but this growth was not uniform.
• Immediately after World War II, foreign aid
  dominated.
• During the 1950s, MNEs began to spread across
  borders and the eurocurrency market was born.
• International bank lending and FDI accounted for
  much of the international investment among
  developed economies.
• In the 1970s the eurocurrency lending to the
  developing economies grew rapidly, but the 1982
  debt crisis slowed bank lending during the 1980s.
• In the 1990s, bank lending was surpassed by FDI
  and portfolio investment as the largest
  categories of international investment.

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The rapid growth of international investment that
we are experiencing raises interesting questions

• What will be international investments role in
  the process of globalization in the future?
• Will future international investment flows be as
  volatile as they have been over the past 25
  years, or will they be more stable?