Speech to the 14th Global Finance Conference in Melbourne outlines the benefits of foreign investment
Ladies and gentlemen, I appreciate this opportunity to speak to you today about a subject which has generated controversy in virtually every capital-importing country since at least the time that British investors funded the construction of railways throughout the New World in the 19th century. By allowing foreigners to invest in assets in our countries, do we help ourselves in the long-term or do we mortgage our future and surrender our sovereignty?
To the sophisticated members of this audience, the question may seem a silly one, and the answer self-evident. Of course we benefit when foreigners invest in our countries, and that most governments now believe that is surely shown by the fact that most countries now have a relatively open door towards foreign investment, with many countries providing generous tax and other incentives to encourage foreign investment.
Well, not so fast. In almost all countries, there’s a significant minority of people – perhaps even a majority of people – who fear that multinationals run the world, or at very least push around the governments of small countries.
I was watching TV in the US early this year – and the channel I was watching is not normally thought of as a left-wing or radical channel – and was astounded to see the host of a talk programme whipping up hostility to a rumoured bid by an Australian-owned company to buy a freeway in the mid-West. Part of the hostility was undoubtedly to the idea of the road being sold to private investors of any description, but a significant part was hostility to the idea that the road would fall into the hands of “foreigners”, even friendly foreigners like Australians!
All over the world, there is public hostility to so-called “national champions” being taken over by foreigners. We’ve seen it in Australia when an American-backed private equity group announced they were planning to buy Qantas – and even now it looks likely that the acquisition of Qantas, if it goes ahead at all, would be conditional on its remaining majority Australian-owned and controlled.
We’ve seen it in Europe whenever a major bank or utility company has been threatened with acquisition by another European company.
We’ve seen it in the United States when an oil company was subject to a takeover bid by a Chinese company. We’ve seen it in the United States again just within the last 10 days, with strong political resistance to the idea that European airlines might be able to buy controlling stakes in US airlines – this in a country which regularly preaches about the benefits of an open-door policy towards foreign investment.
And these are examples from developed countries, where one might expect the public to be reasonably well educated about such issues, not developing countries where perhaps people may be more susceptible to the blandishments of populist politicians and media.
Most developing countries have restrictions of one kind or another on incoming foreign investment – often in the banking sector, and often restricting the percentage of shares which a foreign parent can hold.
Is this public hostility all completely irrational, or is there some basis in logic for restricting the inflow of foreign investment?
Since this isn’t a “who-done-it?”, let me declare my own position right up front. I believe that the hostility to inbound foreign investment is almost entirely irrational.
I came to this view the hard way. Indeed, I claim to be the only economist in the world who has written two books on foreign investment – one opposed to it and one in favour!
The first book, opposed to foreign investment, was my Masters thesis at the University of Canterbury where, under the influence of a Marxist economist, I came to the conclusion that countries should try to avoid using foreign capital of any kind and that, if they do need foreign capital, they should at all costs avoid foreign direct investment. Why? Because foreign-controlled companies usually earned a high rate of return on their capital (much higher than the host country could borrow at on the international market), restricted the freedom of the local subsidiary or branch to export, employed too many expatriates, and damaged the host country’s balance of payments. At the time, I was delighted when the University of Canterbury Press published the thesis.1
I then went to the Australian National University in Canberra intent on further developing that thesis by a detailed study of 100 American-controlled companies operating in the Australian manufacturing sector. At the time, there was quite widespread resentment at what was perceived as the excessive profitability of American companies operating in Australia so I found myself in a congenial environment.
Great, therefore, was my surprise when I discovered that the facts simply refused to fit into my preconceived theoretical framework. I was reluctantly forced to the conclusion that American-controlled companies operating in Australia had been of immense benefit to Australia’s development and that most of the popular hostility towards such investment was entirely misplaced.2
What are the main things which generate public hostility to foreign investment?
First, there is a vague but surprisingly pervasive sense that foreign investment implies a loss of control, a loss of sovereignty; that foreign investment will, if unchecked, make us “serfs in our own land”.
This is a very deep-seated fear. And surely it’s self-evident that if almost all the banks, most of the insurance companies, all the petrol companies, all of the large telecommunications companies, and most of the shipping companies and airlines which serve our shores are owned abroad – as is the case in New Zealand – we must have lost control of large chunks of our economy and perhaps of our identity? That New Zealand is now run from Sydney,
London, Tokyo or New York? Actually, no. All of those companies, owned abroad as they may be, are obliged to comply with New Zealand's laws and regulations, obliged to pay New Zealand's taxes and tariffs, and obliged to pay wages and salaries sufficiently generous to attract staff from New Zealand-owned companies.
Of course, foreign-owned companies will do their best from time to time to avoid paying New Zealand taxation, or to wriggle around a law or regulation. But in that they are in no way different in their behaviour from New Zealand companies, and in fact there is at least anecdotal evidence to suggest that foreign-owned companies frequently behave with greater deference to local laws and customs than do local companies in order to avoid attracting unwanted attention to themselves.
No matter how many companies are owned abroad, ultimate authority resides with the host country government, subject of course to the right of foreign investors to take their capital to more hospitable climes if the host country government makes unreasonable demands. There is no loss of sovereignty.
There’s a strong argument that the greatest threat to the ability of a host country to control its own destiny arises not from foreign investment but rather from poor economic policy – which leads to rising public sector debt, slow growth in real incomes, inflation and all the rest.
The second thing which worries a great many people is the impact of foreign investment on the host country’s balance of payments. Yes, it’s acknowledged that while the foreign capital is coming in, the external accounts look a bit healthier, but surely down the track the foreign-owned assets generate profits which accrue to foreigners, even if not all those profits are actually remitted when earned.
This view of the impact of foreign investment on the balance of payments used to be particularly common in the Indian sub-continent. I well recall reading articles by Indian economists who would tally up the flow of dividends and profits accruing to foreigners and compare that with the original capital inflow and reach the “conclusion” that India would’ve been better off without the original investment.
Sometimes what was calculated was the so-called “net transfer of resources”, calculated by comparing in any one year the capital coming in with the debt service going out that year, with the conclusion reached that if this figure were negative the recipient country was somehow being disadvantaged.
But that this is nonsense should have been immediately obvious. The calculation makes the simplistic assumption that the original investment generates no additional output.
If this way of determining the impact of foreign investment on a host country’s balance of payments were valid, even the softest of international loans would harm the recipient’s balance of payments. A loan granted by IDA, the soft-loan window of the World Bank Group, typically has a grace period of 10 years, a subsequent repayment period of 30 years, and a service fee in lieu of interest of just 0.75% per annum. But even such a loan can be “shown” to generate more in balance of payments outgoings than it does in incomings, and if there are no further capital inflows the “net transfer of resources” is negative in every year starting with the 11th from the date of the commitment. But can anybody argue, with a straight face, that a 40 year loan granted at negligible annual cost, really involves a “negative net transfer of resources”?
It’s not at all difficult to demonstrate that the after-tax profits which foreigners earn on their investment can not exceed, and almost by definition fall well short of, the value added by the investment. In other words, the foreign investment creates additional value, some of which is captured by local employees (both those directly employed by the foreign company and those employed by other companies, as additional demand for staff pushes up wages), some of which may be captured by local consumers (through lower prices, better quality, or a wider range of choice), and some of which will be captured by the local tax authorities. Other companies may gain or lose, depending on their relationship to the newcomer, but in total locals gain a substantial part of the additional value created by the foreign investment.
But what specifically does foreign investment do to the balance of payments? Surely the huge amounts of interest and dividends due to foreigners mean that foreign investment is bad for the balance of payments? On the contrary, it means nothing of the sort. Much foreign investment adds directly to the host country’s export earnings and of course much foreign investment saves foreign exchange, by efficiently replacing imports. And even foreign investment in sectors not directly involved in earning or saving foreign exchange, such as foreign-owned companies marketing petrol, has no adverse impact on the balance of payments unless the sales of the companies involved are financed through an expansion in aggregate demand (sales by these companies will normally reduce the sales of other producers, thus freeing up resources for other companies to expand exports or replace imports). Looking only at profits accruing to foreigners is to ignore all the many positive effects of foreign investment on the host country's balance of payments.
Of course, as foreign investment flows into a country it almost by definition widens the current account deficit. It does this by increasing total investment spending. Indeed, unless the current account deficit is widened by the investment, real resources are not transferred into the recipient country. In other words, an increase in the current account deficit may simply mean that there is a strong inflow of foreign investment, and if government is not borrowing overseas that is very often precisely what it does mean. As long as the overall economic environment is sound, so that investment flows are not distorted, or diverted into unproductive areas by subsidies, protection or inflation, there is no reason to feel concern about such capital inflow, or its impact on the balance of payments.
There is one qualification to this benign assessment of the impact of foreign investment on the host country, and that’s where the foreign investor is in receipt of a substantial subsidy from the host country. I’ve argued that much of the additional value generated by foreign investment accrues to locals – employees, consumers, tax authorities, and perhaps to suppliers. But if the value added only exists because of a substantial subsidy paid to the foreign-owned company by the host country, then there may be no net benefit to the host. Indeed, there may be a net cost.
The most common form of subsidy in many capital-importing countries in the past took the form of protection from import competition, through quantitative restrictions or tariffs. If these subsidies were justified, in the sense that a temporary subsidy would eventually be repaid to the consumers paying it in the form of economic growth which wouldn’t have occurred otherwise, then it mattered not whether the recipient of the subsidy was a foreign-owned company or a domestic one. But if the subsidy was not justified, and was never repaid, there was a net loss to the capital-importing country if the subsidy was paid to a foreign resident.
I rather strongly suspect that in years gone by many capital-importing countries (New Zealand and Australia included) paid lots of these inappropriate subsidies to foreign-owned companies (one thinks, for example, of the highly protected foreign-owned motor vehicle companies in many countries), but of course the real mischief there was not foreign ownership per se but the inappropriate and wasteful subsidies.
What about foreign investment in the banking sector? A great many countries have some form of restriction on foreign investment in the banking sector, and that is true in reality even in some high income developed countries.
In New Zealand, by contrast, virtually the entire banking sector is owned abroad, much of it by Australian banks. We have banks from the Netherlands, from Germany, from the UK, from the US, from Japan, from Korea, and of course from Australia. New Zealand-owned banks constitute just 2% of the assets of the banking sector.
When I was Governor of New Zealand’s central bank, I was often asked whether that heavy predominance of foreign ownership in the banking sector was a major headache. My answer was always “not at all.”
What does a central banker want of a banking sector? That it’s prudentially sound, that it’s technically sophisticated, and that it’s highly competitive. The New Zealand banking sector is all of those things. Of course it would be nice if there were a strong New Zealand-owned bank – I was managing director of a New Zealand-owned bank at one stage and I had high hopes that it would develop into a fully viable bank able to take on the large international banks in the domestic market – but that was about national pride, about emotion, not about a rational calculation of what was in New Zealand’s best economic interests.
What about the pressure which many governments place on foreign-controlled companies to share ownership with local investors? Well, there may be small benefit in doing that in terms of encouraging the development of local equity markets, but it’s a very small benefit in relation to the cost. Most foreign-owned companies do not want to share ownership with locals – it brings all kinds of complications in terms of pricing technology, deciding which external markets the subsidiary can serve, and so on – and shared ownership may therefore be bought at quite a high price. That high price might be selling the shares to locals at a high
price-earnings ratio (which is often pretty easy to do, given the reputation that many foreign corporations have in developing countries), or it might be in some other form, perhaps the promise of a substantial subsidy by means of ongoing protection from imports. Indeed, foreign companies which feel they need a subsidy to prosper actively seek local ownership as a way of making the subsidy more politically palatable in the host country.
The reality is that when a foreign corporation talks to a host country government a bargain is struck: the important thing to ensure is that the host country maximises the benefit it gains in that bargain and minimises the cost. Demanding a local shareholding is rarely worth expending precious bargaining chips to acquire.
But what if a foreign-owned company squeezes out a local company which, given time and space, might have developed into a major company itself, thus providing much greater benefits to the host economy? This is often a concern expressed by those who see foreigners buying up successful local companies.
Let me concede that this is a reasonably respectable argument for restricting foreign investment. It’s what might be called the “infant firm” argument, analogous to the infant industry argument for tariff protection. The argument runs that, if foreigners are prevented from acquiring, or competing with, a budding domestically-owned company for a time, the growth of the locally-owned company will, in due course, more than repay other local citizens for their sacrifice in the short-term, through enhanced employment opportunities, better or more appropriate technologies, and other “externalities”.
But while conceding this as a theoretical possibility, it’s very difficult to give operational content to such a policy because the conditions which must be met before the country is better off by preventing the entry of the foreign investment are very demanding. What’s at issue is not the benefits to the host country of the development of a locally-owned company compared to the benefits which accrue to the host country if the company is owned abroad instead. Rather, what is relevant is the benefits which accrue to the host country if the company remains locally-owned compared to the situation where the company is foreign-owned and where the original owners have sold out of their first firm and invested in something additional. In other words, the host country’s total capital stock, and probably stock of technology and management experience as well, is greater when the foreign company is allowed access than when it is not. It is very difficult indeed to see how a host country could in practice be better off by refusing entry to the foreign company.
But surely there should be some conditions on foreign companies wishing to invest? I am reminded of an incident, which I believe to be true, which occurred shortly after Singapore became an independent country in the early sixties. It announced a policy to encourage foreign investment in Singapore, and a leading Indian industrialist flew to discuss with Singapore's Minister of Finance the establishment of a large plant in Singapore. After he had outlined the scale and nature of the proposed investment, he asked the Minister what conditions the new company would have to meet, expecting to be read a list of demands relating to the maximum number of expatriates that could be employed, the minimum share of ownership which must be reserved for local investors, the amount of the plant's output which had to be exported, and all the rest. The Minister replied that Singapore's only condition was that the investment should operate profitably. The Indian industrialist assumed that the Minister had not understood his question, and repeated it.
Again the Minister said that the Singapore Government was only concerned that the new venture operated at a profit. A third time the industrialist, by this time getting a little irritated, asked what conditions he would have to meet to be allowed to invest in Singapore. And for the third time the Minister advised him that the Singapore Government hoped that the company would operate profitably. Because, he explained, if you operate profitably you will employ more Singaporeans and pay more taxes; you will in due course invest more, employ still more people and pay still more taxes. What else should we want of a foreign investor in Singapore?
I’m right with the Singaporean Minister.
1 D.T. Brash, New Zealand’s Debt Servicing Capacity: A Study of Changes in New Zealand’s Ability to Service her External Debt, University of Canterbury, 1964.
2 D.T. Brash, American Investment in Australian Industry, Harvard University Press, 1966.
2 April 2007.
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