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Capital Flow for Developing Countries: 2 Types | Economics


After the Second World War, the developing countries are making concerted efforts to achieve rapid economic growth so as to alleviate problems of poverty and unemployment. Besides, there has been rapid growth of international trade. The developing countries like India have been facing the problem of shortage of capital. To meet this shortage, capital flows from the developed countries to the developing countries in the last two decades have substantially increased.

Immediately after the Second World War, capital flows were largely in the form of foreign aid from the governments of the developed countries and international institutions such as IMF and World Bank to the governments of the developing countries. In the last three decades the capital flows in the form of foreign aid on government to government basis have dried up, whereas aid from IMF and World Bank is based on certain conditionalities of undertaking some structural economic reforms which the developing countries often find difficult to implement to the entire satisfaction of these institutions.

Besides, the capital needs of the developing countries are so large that IMF and World Bank alone cannot meet them. Therefore, there is a great need for capital flows on private account on a large scale. Fortunately, capital flows on private account have substantially increased in the last two decades.


These capital flows on private account are of the following two types:

1. Foreign Portfolio investment.

2. Foreign Direct Investment (FDI).

1. Foreign Portfolio Investment:

This is important type of capital flow under which foreign institutions such as banks, insur­ance companies, companies managing mutual funds and pension funds purchase stocks and bonds of companies of other countries in the secondary markets (i.e., stock markets). They get returns in the form of capital gains and yearly payable dividends but do not exercise any direct control in running these companies.


Pension funds, mutual funds and insurance companies have been very active in moving portfolio capital in the last three decades because restrictions on foreign equity investment by various countries have been reduced or removed in recent years allowing pension and mutual funds and insurance companies to diversify their portfolio in order to reduce risk. Besides, the growth of portfolio foreign capital in the last three decades has also been due to the policies of liberalisation followed by the developing countries. In India following the adoption of policy of liberalisation the flow of portfolio capital was permitted in 1991. Consequently, foreign portfolio capital flows have come to India in large amounts in the last thirty years (1995-2015).

However, Mexico has been the chief beneficiary of portfolio capital flows. Portfolio capital flows now account for one-third of net capital flows to the developing countries.

Advantages and Disadvantages of Portfolio Capital Flows:

Benefits and costs of portfolio capital flows have been a subject of severe controversy. Private foreign portfolio investment in stocks, equities and bonds has been made by foreign investors in order to get higher return or higher interest on their investment and also to diversify their portfolio in order to reduce risk. Thus, Prof. Todaro rightly writes, “From the investor’s point of view, investing in the stock markets of emerging countries permits them to increase their returns while diversifying their risks.”


In the early 1990s, the return on the portfolio investment in the so called ’emerging’ developing countries was quite high, for instance, it was 39 per cent during 1988-93 in Latin America which is main recipient of portfolio capital flows. But the high returns were marred by high volatility of stock markets of these countries. Many mutual fund based US companies which were lured by high returns had to suffer heavy losses when there was collapse of Mexican stock market following 35% devaluation of Mexican currency in December 1994. The experience of these heavy losses resulted in drastic fall in portfolio capital flows in 1995 not only in Mexico but also in other developing countries. In fact, there was a net capital outflow from the developing countries for some months.

From the perspective of developing countries private portfolio capital flows are generally considered as a welcome means for raising capital for private domestic companies. However, it has been argued whether it is prudent to rely on large and volatile private capital flows as they have a destabilising influence in both the financial markets and in the overall economy. It has been pointed out that when the developing countries run into trouble, the portfolio capital flows disappear in few days as happened in case of Mexico in 1995 and recently in South East Asian countries in 1997-98.

However, it may be noted that a developing country should not cover up its structural weakness by obtaining private capital flows. If they want to ensure that these private portfolio capital flows continue occurring year after year on a sustained basis, they should manage the foreign exchange rates efficiently by controlling deficits on current account and also keeping adequate reserves of foreign exchange so that their currencies should not remain overvalued which might lead to severe long-term consequences.

From above it follows that private portfolio capital flows are welcome as they provide needed finance for developing countries and also bring in required foreign exchange. However, one should not consider them as substitutes for making structural changes in these economies such as maintaining exchange rate at the right level, controlling deficits in balance of payments, checking rate of inflation and adoption of proper monetary policy which should ensure relatively higher interest rates.

We agree with Prof. Todaro who while commenting on portfolio capital flows writes, “Like multinational corporations, portfolio investors are not in the development business. If developed country interest rates rise or expected Third World profit rates decline, foreign speculators will withdraw their ‘investments ‘as quickly as they brought them in. What LDCs need is true long-run economic investment (plants, equipment, physical and social infrastructure etc.) and not speculative equity capital.”

2. Foreign Direct Investment (FDI):

The foreign direct investment (FDI) is the investment in the construction of physical capital such as building factories and infrastructure (i.e., power, telecom, ports etc.) in the capital-importing country. It may be done in several ways. Companies or corporations may be specially set up for the purpose in the capital-exporting country to carry out trade and industry in a developing country. This is how the East India Company operated in India or railways were constructed in India.

The head office is in the investing country and the operations are in the developing country. Another method is that an already existing corporation spreads out its business in another country by establishing branches. Thus, many foreign companies producing cars, colour TVs have set up branches in India and are producing these items in India. There is another way open to the foreign entrepreneur, that is, to form companies and register them in the borrowing country without having any connection in the lending country. When India adopted protection, it became profitable and quite fashionable too, for the foreign entrepreneurs to set up so called “India Limited,” to jump over the tariff wall and to avail themselves of the various concessions which the government extended to national concerns.

These were in fact disguised branches of the foreign firms. The Indian match industry, for instance, is dominated by Swedish concerns. There is still another possibility which is now becoming common in India, viz., of joint ventures or joint participation. The foreign firms start industrial concerns in collaboration with Indian firms. This form of foreign investment has some special advantages. The standing and reputation of foreign firms inspire confidence in the domestic and foreign capital.

The long experience and efficient techniques are placed at the disposal of the domestic companies. It avoids evils of absentee ownership; it provides full opportunities for developing local skills, and also a large proportion of profits are retained in the country. It is also advantageous to the foreign investor. He is able to ward off in this manner any danger of discriminatory treatment by the government. A developing country lacks capital for development and it requires foreign capital.


Merits of Foreign Direct Investment (FDI):

Several advantages can be claimed for foreign direct investment (FDI):

i. Such investment does not burden the tax payer since no interest at fixed rate is to be paid as in the case of foreign borrowing. The foreign investor is compensated by the profit he gets.

ii. In private investment, the investor is actuated by the profit motive; hence the business operations are subjected to careful calculations. This is a guarantee that the capital resources are most efficiently employed and are not frittered away in some reckless investment as may happen in the case of borrowing.


iii. Direct investment by foreign companies introduces, in the developing country, new technology, modern skills, innovations and new ideas. This is a great gain because the developing countries are backward in technology and skills. The local entrepreneurs take a clue and start similar concerns. The Indian cotton textile industry was inspired by the Indian jute industry established by British entrepreneurs. Thus, direct foreign investment serves as an instrument for transferring modern technology to the developing countries.

iv. Another advantage is that a part of the profit is ploughed back into business and is not drained off from the country as it happens in the case of portfolio investment. The profits are invested either in modernisation and expansion of existing concerns or for establishing ancillary or subsidiary concerns in related fields. There is thus a continuing advantage for the developing country.

v. Foreign direct investments are most likely to flow into export industries. By increasing exports and reducing imports, it will improve balance of payments of the developing country. It has a specially favourable effect on balance of payments position during recession because direct investment is serviced by dividends which are related to profits and not by fixed interest charges as in the case of loans. This flexibility of pressure on the balance of payments is of great advantage.

It is worth mentioning that China in the last decades has industrially developed rapidly through foreign multinational firms to make investment in China to produce manufactured goods for exports. As a result, there has been unprecedented growth in industrial output and employment and as a result China has emerged as the fastest growing economy of the world. However, the latest trends show that in 2014-2015 and 2015-16, due to slowdown in world trade growth and protectionist policies of the developed countries, China’s overall growth has fallen to 7% y-o-y as compared to over 9 per cent in the previous several years.


vi. Even otherwise flexible return on direct investment is a great advantage as compared with rigid interest and amortization requirements associated with public foreign loans.

vii. Direct foreign investment induces domestic investment also either in the form of joint participation or in local ancillary industries. Thus, foreign capital activates otherwise inert domestic capital. The domestic capital sheds off its shyness and enters into fields opened by direct foreign investment.

viii. The direct foreign investment makes a real addition to the productive capacity of the capital- importing country. There is no question of foreign capital coming in this form being used for unproductive purposes. In the case of other types of foreign borrowings, there is nothing to prevent them from being utilised unproductively.

ix. Another important advantage of direct foreign investment is that it can be induced to be invested in infrastructure such as power, telecom, and development of ports which is an obstacle to accelerating economic growth in the developing countries. Such direct foreign investment enables the developing countries to overcome supply-side bottlenecks which will spur domestic investment. It should be mentioned that in recent times the Indian government has been wooing foreign investors to invest in the infrastructure sector. The foreign companies have the resources, technology and technical know- how to start productive ventures in the infrastructure.

x. The capital that comes through foreign direct investment has a distinct advantage over portfolio investment. While foreign institutional investors can sell their shares and take capital out of the developing countries in a very short time and thus destabilise these economies as recently happened during East Asia Crisis, it is not easy to close down foreign concerns established through direct investments. Foreign Direct Investment (FDI) enters the developing economies to build factories and these factories (i.e., physical capital) stay even if the investors decide to sell out later to domestic buyers.

The direct foreign investment (DFI) is opposed on the ground that it seeks to establish ‘financial imperialism’. It leads to political domination and economic exploitation. That is why foreign capital was so unpopular in India. The strength of this objection really rests on the nature of political set-up. A free democratic country of the continental size such as India need not entertain such fears.


In order to promote private foreign direct investment, it is necessary both for the lending and borrowing countries to remove the impediments to free flow of capital and to grant the necessary facilities. The borrowing country should guarantee immunity from nationalisation and repatriation of profits. The crux of the problem is to assure higher returns and minimum risk.

At present investment is deterred by political and social instability, uncertainty about the jurisdiction of courts, exchange controls and currency inconvertibility, controls on capital issues, fear of discriminatory legislation and fear of nationalisation, the practice of shutting out some industrial fields for foreign investors, employment of nationals in superior posts etc.

Among the measures to minimise risks and allay fears may be mentioned investment treaties, government guarantees, tax incentives, joint ventures, relaxation of restrictions and granting of concessions.

The investment climate must be made most favourable by ensuring the following:

(i) Political stability and freedom from external aggression.

(ii) Security of life and property.


(iii) Availability of opportunities for earning profits.

(iv) Prompt payment for fair compensation and its remittance to the country of origin in the event of compulsory acquisition of a foreign enterprise.

(v) Facilities for the remittance of profits, dividends, interest, etc.

(vi) Facilities for the immigration and employment of foreign technical and administrative personnel.

(vii) A system of taxation that does not impose an excess burden on private foreign enter­prise.

(viii) Freedom from double taxation.


(ix) A general spirit of friendliness for foreign investors.

The Department of Commerce of the United States mentions certain factors which stand in the way of private investment of American capital. These are uncertainty created by the present political situation, the policies and practices with respect to foreign investment, the relatively low level of economic infrastructure and the lack of trained labour, and the limited knowledge of the developing countries on the part of American businessmen. The particular impediments mentioned in the case of India are the nature of India’s screening policy shutting out foreign investment in certain spheres and controls on imports, exports and foreign exchange and the absence of a double taxation agreement, obligation to employ and train Indian labour.

India also offers some special inducements, e.g., special tax exemptions, increased depreciation allowance and other benefits available to domestic industry, guarantee of exchange facilities for profit remittances, capital repatriation and import of essential requirements, government assistance in the acquisition of land, transport facilities, etc., the right to hold controlling interest. This compares quite favourably with many other countries. But there are still some countries with more attraction in the form of higher returns and better guarantees and they can absorb a substantial supply of foreign U.S. capital.

However, in the opinion of the present author direct foreign investment in the field of infrastructure in India may not be as much as expected because infrastructure projects relating to power, telecom, ports are of the nature of public utilities and, therefore, the price of their end-product (for example, electricity charges) has to be controlled which may not yield sufficient profits to attract foreign investment.

NDA’s ‘Make in India’ Policy:

As part of structural economic reforms initiated in India from 1991 under the former Prime Minister, Dr. Manmohan Singh, there was liberalisation of foreign investment policy. To attract foreign investment, it was decided to grant automatic permission to private foreign investors to hold equity up to 51 per cent of total equity shares in high priority industries. The priority sector included power generation and petroleum refining. The government also gave a guarantee of 16 per cent return on foreign investment in priority sectors.


As a result, foreign direct investment started coming into India and after 2003, it picked up but foreign direct investment into India was much less than that in China and some other developing countries. Now, after coming into power in 2014, NDA Government headed Mr. Modi has proposed a new scheme called ‘Make in India’. For this scheme, foreign investors have been invited to make large-scale investment in India for producing manufacturing goods in India and mainly export them abroad, just like China did three decades before. In this way, it is thought industrial growth of output and employment will rise rapidly and overall growth of the economy will greatly pick up. Modi Government intends to solve the problem of unemployment in this way.

To ‘make in India’ scheme success, foreign investment norms in India have been greatly liberalised, land acquisition bill is being passed so that land for setting up industrial projects by foreigners be procured. In the budget for 2015-16, corporate income tax has been reduced from 30 per cent to 25 per cent in a phased manner in the five-year period. This will raise the return on foreign capital invested. No retrospective taxation has been promised to woo foreign investor. Minimum Alternative Tax (MAT) on the earnings of FIIs has been abolished with effect from 2015- 16 so as to prevent them flowing out.

In the view of the present author the timing of ‘Make for India’ is wrong as at present expansion in world trade has slowed down. The recovery in the US from 2008 crisis is fragile; Europe too is not yet developing and facing the problem of burden of external debt. It is due to these reasons that China’s industrial growth has slowed down. India’s exports are also falling. How then in the present context under ‘Make in India’ by foreigners to export them would succeed.

In our view, what is important is to launch a scheme of ‘Make for India, India’s domestic product is quite large. What needed is well-designed development strategies which use labour-intensive technologies to produce mass consumer goods and essential capital goods needed for them. Scarce resources should be discouraged to be used for manufacturing big luxury cars, colour TVs, Smart Mobiles etc. if growth with social justice in India is to be achieved.

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