International Capital Flows: Benefits and Damages | Economics

In this article we will discuss about:- 1. Role of International Capital Movements 2. Benefits of International Capital Flows or Foreign Aid 3. Dangers.

Role of International Capital Movements:

Traditionally the capital movements were considered important as they assisted in the maintenance of BOP equilibrium. A country, having a BOP surplus, will invest or lend capital abroad and thereby offset the payments surplus. On the opposite, given a BOP deficit, it could borrow capital from abroad and remove the deficit. In other words, the capital movements had the specific role in balancing the international payments and receipts. In the context of LDC’s like India, the international capital flows or foreign aid have much vital role to play.

The international capital assistance may be in the form of private and public foreign investments, loans from foreign nationals, business and financial institutions, central banks, governments and international economic institutions such as International Monetary Fund (IMF), International Bank for Reconstruction and Development (IBRD), International Finance Corporation (IFC), International Development Association (IDA) and several other agencies. The capital transfers may also be in the form of private or inter-governmental unilateral assistance and technology transfer.

Benefits of International Capital Flows or Foreign Aid:

The major benefits or advantages of capital transfer from the advanced to the LDC’s are as follows:

(i) Increase in the Rates of Saving and Investment:

The under-development in poor country is fundamentally caused by their capital-deficiency or low rates of saving and investment. In India, for instance, the rate of saving was just about 5 percent on the eve of independence. The rate of gross investment too hovered around the same rate. With such low rates of saving and investment, the country could not expect, given a rapidly growing population and making allowance for depreciation, to grow at a rate more than 2 to 2.5 percent per annum.

Over the last four decades of planning, the rates of saving and investment could, however, be stepped up to more than 20 percent per annum and the rate of growth averaged at 3.5 percent per annum. To a large extent the credit for it must go to the substantial flow of foreign capital since the inception of planning in the country.

(ii) Technological Change:

The LDC’s are characterized by the technological backwardness manifested by low productivity of labour and capital due to abundance of unskilled labour and obsolete capital equipments. The technical barrier does not permit them to make the optimum use of all available and potential productive resources.

The inflow of capital from advanced countries, apart from removing the capital deficiencies, brings in advanced technology and skills, organizational expertise and market management, helps in training of domestic skills, establishment of infra-structure for scientific and technical research and creation of new varieties of products. The capital movements, thus, contribute in filling up the technological gaps in the developing countries.

(iii) Creation of Economic and Social Overheads:

The growth process in the LDC’s remains hindered on account of the absence of economic and social overheads that include means of transport and communications, irrigation and power, educational, training and research institutions and health services. The creation of economic overheads calls for heavy investment of capital. It is generally beyond the capacity of LDC’s to create the basic infra-structure. In case of India and several other developing countries, the foreign capital and technical assistance have played a key role in this sphere.

(iv) Development of Heavy and Basic Industries:

The industrial transformation of LDC’s requires the development of heavy and basic industries such as steel, heavy electricals, machine tools, heavy engineering, oil-refining, fertilisers, heavy chemicals, mining, transport and defence equipment industries. The creation of such an industrial base can greatly stimulate the future industrial expansion in these countries.

But all these industries have high capital-intensity and a long gestation period. It is only through a substantial inflow of foreign capital that the developing countries can hope to develop the structure of heavy and basic industries.

(v) Undertaking of Initial Risk:

In the early stages of development, the investment in LDC’s involves enormous risk on account of absence of infra-structure, skilled labour and small extent of market. The indigenous investors shy away from investment and enterprise. The foreign investors or entrepreneurs, however, venture to bear unspecified risks and set up enterprises in different sectors of the economy.

(vi) Check upon Inflationary Pressures:

The economies of the LDC’s have a very high inflationary potential. The strong inflationary pressures in these countries result from excessive demand, rigidity in the structure of production, deficit financing and priority to projects having longer gestation period.

In the conditions of severe inflationary strains, these countries can rapidly expand production of consumer goods through the import of machinery, equipment and even turn-key projects. The commodity assistance such as food grains import from the USA made by India during 1950’s and 1960’s under P.L. 480, too can contribute in a great measure in relieving the inflationary pressures.

(vii) Creation of Employment Opportunities:

As the foreign capital builds up infra-structure, assists in the setting up of heavy, basic and key industries, taps the sources of raw materials, opens up new markets, there is substantial expansion of employment opportunities in the developing countries. The modernisation of agriculture through the introduction of new farm machinery and chemical fertilisers with the help of foreign capital releases surplus manpower from that sector.

The reduced pressure of population on agriculture brings about an increase in farm productivity. The expansion of manufacturing industry through foreign capital absorbs a large part of surplus labour displaced from agriculture.

(viii) Removal of BOP Deficit:

The LDC’s are frequently faced with chronic BOP deficit. In these countries, the capacity to export is limited. The exports are either almost stagnant or declining. There is secular deterioration in terms of trade due to falling international prices of primary products. These countries, at the same time, have a strong propensity to import. They have to make large scale imports of food grains, edible oils, industrial raw materials, spares, capital goods, defence material etc.

The foreign exchange component of development programmes is invariably large. They are obliged to make provision for debt servicing. In such conditions, they are faced with mounting BOP difficulties. A large inflow of foreign aid can take care of payments for imports and servicing of external debts and BOP deficit can be removed.

(ix) Beneficial for Labour:

As the foreign capital causes industrial expansion, increased demand for labour ensures an increase in the real wages of the workers. The expanded production and creation of new varieties lower the product prices and effect a qualitative improvement in the standard of living of workers. As there is inflow of foreign capital and advanced techniques, there is creation of skills and scientific management which go a long way in not only ensuring better standards of production but also accelerating the entire process of growth.

(x) Modern Value System:

The flow of foreign capital and enterprise to the traditional societies of less developed countries starts infusing in them hard work, scientific temper, modernisation of outlook, greater innovativeness and increased self-reliance. These changes in value system pave the way for an uninterrupted process of growth.

To sum up, the foreign capital makes an immense contribution in the development process in the poor countries. It helps in the modernisation of agriculture, exploration and optimum utilisation of productive resources, in the creation of basic infra­structure, in industrialization, in the expansion of markets, in overtaking risk of pioneering, in maximization of employment, in moderating inflationary pressures, in the removal of BOP deficit, in technological development and in the creation of new skills, talents and modern outlook.

The foreign assistance is, therefore, capable of complete transformation of the socio-economic structure in the developing countries.

Dangers of Capital Flows or Foreign Aid:

Even if the benefits of international capital flows are fully acknowledged, yet it is not realistic to overlook certain dangers inherent in it or the problems that are associated with them.

These dangers or problems are as follows:

(i) Not Indispensable:

It is, of course, true that inflow of capital and transfer of foreign advanced technology are growth-stimulating factors. But it does not mean that the foreign aid is indispensable. There are instances which show that the growth process can take place even in the absence of foreign capital. That happened in the earlier stages of development of Soviet Union and China.

Bauer did not recognise the foreign capital as absolutely necessary for growth. To quote him, “Foreign aid is plainly neither a generally necessary nor a sufficient condition for emergence from poverty.”

In this connection, Bauer proceeds to say, “……….. if the mainsprings of development are present, material progress will occur even without foreign aid. It is of course true that a country receiving aid benefits in the sense of obtaining cheap or free capital……… , but this in no sense makes foreign aid indispensable for development.” Nurkse although recognised the importance of foreign aid in breaking off the vicious circles of poverty, yet pointed out that there was no substitute for action on the domestic front.

(ii) Wasteful Use of Foreign Capital:

The foreign capital, when easily available or when available free or at the concessional interest rate is likely to be misutilised in the low priority projects engaged in the production of luxury goods or other wasteful products. In the LDC’s, foreign collaborations are sometimes sought to produce non-food consumer articles such as toilet soaps, tooth pastes, cosmetics etc.

There is not only the wastage of foreign capital, when it is utilised in the production of these items, there is also the wastage of indigenous capital that supplements the foreign capital.

(iii) No Increase in Net Investment:

The LDC’s frequently resort to controls on the inflow and use of foreign capital. There are also restrictions on the remittances of profits and repatriation of capital. It results in a reduction in the inflow of capital from abroad. The regime of controls makes the indigenous and foreign enterprises to operate with excess capacity. There is some tendency among both the domestic and foreign investors to shy away from such countries.

On account of the outflow of capital due to exit policy of foreign and indigenous investors coupled with heavy annual debt servicing liabilities, the capital outflow many often exceeds the inflow of capital. This amounts to a net reduction in the inflow of capital or investment in the LDC’s. In addition, an easy availability of foreign capital tends to reduce the domestic tax effort for stepping up investment. Thus the foreign capital may not promote investment. It may rather lead to a net reduction in investment.

(iv) Increase in External Debt Burden:

If the foreign capital is employed for unproductive purposes or for financing consumption, the burden of external debt tends to increase. Except for only a few among the developing countries, there has been a general failure in raising the income-earning capacity through external capital.

Between 1991 and 2000, the external debt burden rose from 116.5 billion U.S. dollars to 238.0 billion dollars in the case of Brazil, from 101.7 billion dollars to 150.3 billion dollars in case of Mexico and from 71.6 billion dollars to 100.4 billion dollars in case of India. India’s external debt stood at US $ 262.3 billion in 2010. It increased sharply upto US $ 442.3 billion in 2014.

(v) Inflationary Conditions:

Foreign aid has moderating effect on inflation. However, the foreign capital and investment may reinforce the inflationary pressures in the LDC’s. It is generally found that foreign capital is used in the developing countries for setting up ambitious capital-intensive projects which have a prolonged gestation period. The increased investment spending and consequent increase in factor incomes, given the less elastic supply function of output, is bound to strengthen the inflationary conditions.

(vi) Balance of Payments Problem:

The LDC’s have low capacity to export which is eroded further because of increasing domestic price trends. A larger flow of aid in the form of commodities, services and capital, at the same time, tends to increase the BOP deficit.

(vii) Alien Growth Models:

Along with the inflow of foreign capital, the foreign economists, financial experts and planners start tendering advice to the LDC’s. They try to apply Western growth models to the conditions of the developing countries. As the conditions in these countries are altogether different from those in Western countries, it is not pragmatic to apply these alien models in the LDC’s. The adoption of inappropriate growth models causes wastage not only of foreign capital but also of indigenous capital and skills.

(viii) Financing of Uneconomic Activities:

It is believed that the foreign assistance can contribute in relieving the shortages of food and raw materials and in promoting the production of exportable goods and import substitutes. But the experience has shown otherwise. The foreign aid, in the form of loans, is frequently used in the financing of uneconomic activities or projects.

(ix) Tied Foreign Capital:

The aid-giving countries impose generally arbitrary and unacceptable conditions upon the recipient countries. For instance, they tie aid to the purchase of capital goods and raw materials from the specified suppliers belonging to these countries. Generally these inputs are supplied at the prices higher than the competitive prices.

The aid-seeking countries have no option other than acceding to unfair conditionality including low real rates of interest, over-valued exchange rate, reduction in export subsidies, reduction in tariffs etc. The conditions that are thrust upon the LDC’s are invariably detrimental to their long-term interests.

(x) Unsuited Technology:

It is true that the foreign capital can bring new technology into the LDC’s. But it has been the experience of these countries that technology offered to them is either obsolete from the standards of the advanced countries or it is not in conformity with their resource endowments. The introduction of capital-intensive and labour-saving technology in the capital-deficient and labour-surplus poor countries causes the serious problems like inflation, unemployment and BOP deficit.

(xi) Adverse Effect on Domestic Saving:

The increased import of consumer goods by way of foreign assistance and greater priority to the production of luxury and semi-luxury goods causes an increase in consumption and consequent decline in domestic saving. A large inflow of foreign capital makes the people and State in LDC’s to make less effort to step up domestic savings. Many often foreign capitals do not supplement but supplants the domestic capital.

A study made by K.B. Griffin and J.L. Enos related to 32 LDC’s showed that 25 percent of the foreign aid only resulted in an increase in investment and imports and 75 percent was used for consumption. It suggested that the foreign aid discouraged domestic saving. Some other empirical studies, however, disputed this contention.

According to them, in certain countries each dollar of aid inflow resulted in more than one dollar worth of saving and investment. In case of other countries, aid inflow had adverse effect on domestic saving and each dollar of aid led to a less than one dollar of investment.

(xii) Political Domination:

The aid-receiving countries have often to face the political pressure from the donor countries. The latter start dictating the economic and political policies for the former. Such policies are invariably against the interests of the LDC’s and serve the vested interests of the donor countries. The LDC’s have the painful experience of foreign subjugation by the Western imperialism. The world has been a witness to arm- twisting by the United States forcing Russia to suspend Cryogenic rocket engine deal with India.

The United States and some other advanced countries imposed sanctions, including denial of loans from multilateral institutions like World Bank and ADB and denial of credit guarantees by U.S. government bodies against India after nuclear explosion by her in May 1998. Similarly pressure has been exerted upon China, Iran, Iraq and several other countries. This has created serious misgivings among the politicians, economists and general masses in poor countries about the desirability of securing foreign aid.

It is true that the reliance on foreign capital has its grave risks and dangers. But at the same time, its benefits to the development process in LDC’s cannot be over-looked. The policies should be made in such a way that foreign capital does not have adverse repercussions upon the developing countries.

The LDC’s should take precaution that the unnecessary economic and political strings to the inflow of aid are not accepted. The care should also be taken that the aid is used according to the accepted plan priority and dissipation of aid in non-priority areas is scrupulously avoided.