Foreign Investment and Role of MNC’s in Development

 Foreign Investment in to country can be done in two broad ways

1. Foreign Direct Investment (FDI)
2. Foreign Portfolio Investment (FPI) (Institutional investment )

FDI relates to real investment creating capital asset in a foreign country for production purpose.
It is more stable because it involves setting up a subsidiary with real assets to produce a good or
a service. The purpose of FDI is long term investment to make profit in a country over a period
of time. The country’s which allows FDI need to have specific policy support and rules to the
extent of Investment that they are willing to permit. MNC’s are setup mainly by the route of FDI

The main motive of setting up MNC is

- To earn higher profits

Higher profit become possible because developing economies tend to have higher growth
rates due to their lower base and more demand for product in MNC’s due to their larger
market
- Horizontal Integration
It is practiced to keep control on technology and process know-how to make sure that
the competition is restricted. If they set up foreign firms as their source they will have to
pass on, the technology to these firms which increase competition. Therefore, several
multinationals are setup to restrict competition by creating 100% technology for
themselves

- Vertical Integration
MNC’s are established to obtain control or raw materials directly and therefore ensure
uninterrupted supply at lowest possible cost. It is mainly observed in mineral extraction
and agro-plantation.
MNC’s can also do forward linking based investment to setup spare parts unit or
distribution network in a foreign country like automobile sector in India

- To take advantage of laws and policies in a country

Investments are made if a country abroad is providing favorable tax treatment or easier
availability of infrastructure or to break the tariff wall (e.g. Automobile)
Benefits of FDI

- It measures production capacity in both Home country (originates) and Host country (gets
the FDI)
FIG

The MNC’s can also invest in a foreign country to take advantage of higher returns due to
Production cycle behavior. It is possible that shift of capital increases production in the recipient
country because there is higher efficiency in recipient country.

“EXPLAIN THE FIGURE”

The total gain to MNC is ∆ABC which is also the gain in value of output produced. In
equilibrium the returns to capital increase in home country and returns to labor decreases in
home country while it is opposite in host country.
The home country will initially have a BOP deficit due to Investment outflow and the host
country will have a surplus. But gradually with profit earned in host country there will be
improvement in BOP of home country due to repatriation of profit. The welfare effect are
positive for both countries in long run at Macro-level.
Therefore, there should be an institutional mechanism to compensate sectors which have lost out
at a Micro-level.

Problems with MNC’s

IN HOME COUNTRY
- Job loss in the home country
- It is possible that MNC’s may compromise technological superiority of home nations
because they may have subsidiaries in foreign who get accessibility to their resources
(compromised to same extent due to R & D remains in home country)
- There can be base erosion and profit shifting by MNC’s which hurt both home and host
countries. Base erosion means reducing the base amount of profit that can be taxed in a
country by shifting it to another country which charges lesser profit tax.
- It also takes advantage of general agreement among countries on DTAA of profit in
which tax is imposed not on repatriated profit at entire rate but only on differential rate
(50%-40%)
Base erosion results in reducing capacity of revenue collection for home country. It is also
possible that MNC’s practices transfer pricing i.e. deliberately overpricing the inputs sent to
subsidiary and output produced by them. In this case they are able to reduce their tax burden in
both host and home countries and benefit even more if there is an agreement on avoidance of
double taxation.
It is possible sometime that certain firms are setup only because by round tripping of funds to
shift profit to the point of lesser taxation.

FOR HOST COUNTRIES

- Dominating the economic structure especially in a smaller country. They can dominate
economic structure such that there can be unwillingness to export to a nation which is
unfriendly to a home nation, they can borrow funds abroad and bring to host nation if
host nation is practicing tight monetary policy (roi going up) and they can influence
national taste with large scale advertisements
- Maintaining technological dependence by keeping R & D facilities in the home country.
- They may absorb large part of local finance and domestic talent due to which domestic
entrepreneurship does not grow
- They may bring in highly capital intensive technique which can create job loss for a labor
abundant nation along with exploitation of natural resources employing only skilled
workers which results in dualistic economies which are less productive

Due to these problems most of the Host nations place various restrictions on investments by
MNC’s. The restrictions can take forms of
 Limiting FDI up to a ceiling in certain sectors
 Not allowing automatic entry into country
(FIPB)(CCEA) Approved > 5000cr
 Restricting credit facilities for FDI that they can borrow from abroad
 Allowing only joint ventures i.e, FDI can enter the country only if it is in
collaboration with a domestic institution.
Regulation of multinationals is a requirement for all host nations not only to avoid the above
problems but also to assure fair trade practices like saving their domestic firms from predatory
pricing and dumping combined with unfair Trade practice of Cartelization

Centralized planning is a technique in which government in the centre will have control over the
resources such that it performs production of and distribution activities in such a manner
consumption needs of people are decided by government control of resources
In centralized planning the advantage is that government can predict consumption
needs, plan investment accordingly and produce exactly sufficient to exactly meet the need of the
market. There is low wastage of resource and better distribution efficiency. The initial success of
planning in Soviet Union and similar success in countries like India encouraged the theory that
centralized planning can bring economic development with equitable distribution.
The problem with centralized planning mechanism is possible lack of co-ordination
among people and authorities. This results in inability of the Government in centre to accurately
predict the requirement of all the people and it is not possible similarly for the people to adjust to
requirement set by the government. Under centralized planning another problem observed is
continuous shortage combined with possibilities of Black marketing in the absence of
coordination.
Economists like Oskar Lange suggested that decentralized planning using computer simulators to
predict market requirements is a better technique than centralized planning. Under decentralized
planning there is horizontal devolution of power, where provincial government and local bodies
can plan utilization of resource and it can be coordinated by central planning authority. It is
suggested that even individual industries can make their plan and send it for approval. The
advantage of decentralized planning is, increase in coordination, better prediction of future
demand and easier distribution of commodities. However, decentralized planning does not work
if power in the centre is not informed well in advance. It also does not work if a change takes
place locally but does not affect other regions. A computer simulation will require extremely
advanced level of software and detailed information on all sets of price and quantity
After 1991, when centralized planning was less favored many countries adopted indicative
planning. In this case the government’s do not set rigid targets and their is no centralized control
or instruction to achieve these targets. Instead, the government provides broad directives by
choosing indicators representing development possibilities. They are outlined to both public and
private sector with inherent message to the entire economy regarding the focus area and
direction. Government wants the economy to move under indicative planning, the benefit is it
doesn’t needs nationalization of enterprises and it can be implemented without rigid control of
government on resources . The government can use tools of taxes and subsidies along with other
fiscal expenditures and credit policy to indicate to the market about the direction in which it
wants development. This will help in achieving the broad targets of development without
committing too much of government resource

Public Private Partnership as a tool to implement Indicative planning

PPP can be conducted in various ways. The initiation under National Highway development
programme was through the method of Build Operate and Transfer (BOT) , under this the private
sector company was expected to build the project by incurring all the expenditure ranging from
the development of the project to its completion, while designing of the project and arrangement
of the land was done by the government . The entire risk of project w.r.t construction and
profitability is born by private sector, and it gets land at a concessional rate from government.
After completion of the project it can transfer it to the government and get annuities or it can
charge toll either by owning the project (BOOT) or by getting the project on lease (BOLT) and
recovers its investment along with profit at a pre-determined rate at a contracted rate . In this
case the risk of toll collection and responsibility of toll revision is on private sector. The project
has to be transferred to the government after the contractual period is over
 Another method (used in Airport development in Delhi, Mumbai, Hyderabad) is
Design, Build, Finance, Operate and Transfer. In this case project designing and financing is also
done by private sector and govt. has no role to play in project development. The private sector
can collect toll charges entry fee to recover its investment and then transfer it to the govt. There
is more flexibility for private sector in this case.
These methods were expected to meet the benefit of Public and Private sector expertise
like provisioning of law and order, making land available and other infrastructural support
(communication facilities) to be given by government, project efficiency, timely completion and
improved quality to be provided by private sector. In reality there were several projects which
did not deliver as promised by the above vision. lack of proper financing, cost over run (10cr to
20cr) lack of timely clearance, large number of litigations against projects and developers and
slow down in Indian economy resulted in sudden disruption in many projects due to which they
become unviable and also a source of nonperforming assets to several commercial banks ..
In the last two years, the government has issued fresh contracts with Hybrid Annuity Model
(HAM) and Engineering, Procurement and Construction (EPC) model to assure private sector
regarding completion of project and minimizing its risk of recovering its investment from
running the project.
Under EPC (like DMRC) projects, the private sector has to engineer i.e. to design and
build, procure all materials, arrange its finances, construct the project and give it to the
government . It has no risk of running the project as the government compensates it for project
cost at a predetermined level
The benefit for the government is that it does not have to involve in development of its
project and it can use finances saved for other developmental requirements
In the recent years (Highway development, Railway project and Port development)
HAM has been preferred over other methods because of being more transparent and minimizing
the loss of private sector. The government pays 40% of the project cost to the developer
implying that even project risk is shared by the government and developer has to complete the
project to receive the rest 60% on annuity basis. The benefit for the developer is the absence of
any risk w.r.t running of the project. The government retains the ownership of project throughout
development. Therefore, HAM combines the benefit of transparent and efficient delivery
mechanism along with satisfactory completion of project.
In case of any PPP project, It is always an agreement b/w govt. and concessioner
which determines the quality that will be reached in the market. There should be little control to
protect the interest of the people
- Contract should be well defined with complete transparency in project cost and its
recovery.
- The plan of the project should be shared with all local bodies in project zone and their
suggestions should be sought to get cooperation from local population
- In case of Toll based projects cost over runs should be absorbed by the government and
not always passes on to people
 - Quality checks should always be monitored and in case of highways alternative route
should be planned which are toll free.
If proper checks and balances are kept in place the Private participation can
bridge the gap of Rs 2 trillion Investment that the govt. visualizes as the requirement to develop
essential infrastructure projects.
  Utilitarian approach
 Resource based approach
 Sen’s criticism of both
 Development as freedom approach – sen’s concept of 5 freedoms (Basic needs approach)
 HDI, MDPI
The concept of development as making choice with complete independence was covered by
Dr, Amartya sen in “Development as Freedom”. Before this approach, the economics
followed utilitarian approach and resource based approach. Acc, to Utilitarian approach,
development is more individualistic; i.e. if an economic system can optimize utility of
individuals through higher provision of commodity demanded then it represents higher level of
economic development. This was criticized in Sen’s approach because it assumed that simple
provisioning of goods for consumption will increase the utility and it did not consider role of
externalities in individual utility optimization. This means that it did not have complete vision of
macro economic development
Resource approach was based on the concept that if an economy saves more, invests
more and generates more resources then it is better placed to provide higher standard of living to
its people. The criticism of this approach is that it is not necessary that higher availability of
resource will transpire into higher level of distribution. The examples of several planned
economics in 1970 showed high level of investment in capital goods along with low availability
of consumer good which reduced over all standard of living.
Sen’s criticism in both the approaches is mainly centered on one concept i.e. The
approach did not take qualitative aspect and only considered quantitative aspect and only
considered quantitative aspect as development. In ‘Development of freedom‘Dr. Sen provides
for five basic tenants of freedom , they are

 Political freedom to make choice

Acc. to Sen, it is related to democratic institutions and level of empowerment w.r.t
franchise right. He also promoted concept of Universal democracy in which people have
right to make their own choice of even local government

 Freedom to make social choice w.r.t Individual benefits

Acc. to Sen’s theory, Individuals should be free to take personal decision even while
living in a commune. Acc to the theory, it means that social choice should not impinge on
private right. He advocates private property as one manifestation of individual rights in
social system

 Economic freedom to take opportunities and use resources

Without any restriction on the basis of ability of resource. Equitable distribution of
opportunity by giving everyone the right to pursue their economic activities is centered to
this approach. Gender equity at work is an example given to explain economic freedom
  Transparency
The fourth freedom is transparency i.e. creating institutions in the society with the given
economic system to keep decision making transparent such that the economic system is
better understood by all participants. This can be done by choosing rule over discretion.
Therefore, Sen suggested that institutionalization of decision making should be promoted
for transparency in the system.

 Protection of life
In his theory, Dr Sen gives two typical examples to explain protection of life

 First, protecting people and giving them freedom in a conflict zone.

 Second, example is a micro system of protectecting the girl child from female
infanticide

The theory was expanded to include not only freedom to be capable, but also empowered to use
the capability. This is called “Theory of Capability Enhancement” . This completed basic
needs approach given by Dr Sen. Where he asserted that development is about creating
availability of basic needs for all and practicing “Inclusive Growth”

HDI
- HDI uses a cutoff of 20yrs for minimum age because it is considered that any society
with LE less than 20yrs will become extinct .It is an improvement on previous methods
because the rank of country does not get affected by change in lowest achieving country’s
position

- Education Index has been changed to include GE and Dropout rate by considering
expected years of schooling for a child and qualitative valuation of adult literacy by
giving weight to average years of schooling for adults. This dimension also helps in
incentivizing country’s with 100% literacy to strive for better educational achievement. It
also incentivizes Govt. to not only introduce the child to school, but also to restrict
dropout rates.

- Standard of living uses $100 as the lowest margin to assure that it is easier to calculate
and also because the poorest countries over the years have per capita GNP above $ 100
Log values are taken

 To reduce variation
 To reflect diminishing
 Importance of income with increase in it on provision of Income

Log values increase at a decreasing rate this means that an increment in income will add
to the index value but comparatively lesser than increment in other indicators

It was suggested that Log values should be used even for other indications but no
empirical evidence was found of their declining importance with increment in their value

- The data for LE is provided by UN dept on economic and social administration

Data on education is provided by UNESCO instituted of statistics. Date on GNP is taken

by evaluation from W.B and IMF.

In case of missing data, two possible method are used

 Taking data of two neighboring countries as substitute

 Taking a long term average of 25-30 years

If both of these are missing , then data is collected by using Substitution technique from any
relevant study in the past

MDPI

Multi Dimensional Poverty Index, published by oxford education on poverty and Human
Development is a good corollary to HDI. It measures development on same three standards as
used by HDI, but the parameters chosen to measure the standard are different.

Health is measured in terms of

 Child Mortality
 Nutrition

Both these parameters are given 1/6 (0.166) as weight.

Education is measured in terms of Adult literacy and years in school for children . Both measures
have a weight of 1/6 each.

Standard of living is measured on the basis of availability of

 toilet,
 drinking water,
  electricity,
 land,
 other assets and
 income level.

All these have a weight of 1/18(0.055)

This index does not measures relative value (as HDI). It measures development
considering absolute values and considers a population under deprivation if it does not meet the
basic requirement on ¼ (0.25) of total terms and severely deprived, if it does not meet basic
requirement for 1/3rd of all elements. It includes 102 countries and data set is provided by
individual countries and participation is voluntary