Foreign Direct Investments in IEA (Third Draft) Dr. Asad Zaman

Foreign Direct Investments in IEA (Third Draft) Dr. Asad Zaman Standard economic theory holds that FDI is essential for rapid economic growth and development. This is a half-truth. FDI by large US Corporations has held back the development of Latin American countries for many decades. Large foreign corporations control the economy of these states, and ensure that rules are made in their favor. In particular, local competition is destroyed. In contrast, China received a lot of FDI and has profited enormously from this. But this is because the Chinese Government managed the FDI very well, as we will show later. The purpose of this note is to clarify the distinction between good and bad FDI, and to ensure that IEA policies are put in place to encourage good FDI and discourage the bad kind. It useful to be clear that the primary goal of economic activity is to produce self-sufficiency: being dependent on others for critical sectors of our economy (primarily food, energy, and defense) allows foreigners to exploit us, to gain control of our policies. Among the best tools for achieving this goal is creating skills and capabilities for domestic production of essential goods, defense technologies, and high-value exports. FDI can help or hinder in achieving this goal. We will give examples of three types of FDI below. Harmful FDI: It has already been mentioned that many Latin American economies came under control of US corporations via FDI. Chinese FDI in Africa, Sri Lanka, and elsewhere, has been a double-edged sword – it has promoted domestic growth, but has also come at a high cost. A complete cost-benefit has not yet been done. It is worth noting that the Chinese government is conscious of its image, and is attempting to build coalitions and alliances. But the Chinese private sector is driven by profits and power alone. So, FDI by China can be entertained, but only with government-to-government guarantees and agreements. The most glaring example of harmful FDI is the East Asian Crisis. East Asian countries had strong barriers to entry for foreigners, and growth rates higher than the rest of the world. Foreign capital forced East Asian countries to open up their economies to FDI with the bait that this would create even higher growth rates. Dollars flowed into East Asia in massive amounts, inflating the stock markets and the real estate sector. However, a shock to the confidence of foreign investors (without any real causes or weaknesses in these economies) led to sudden withdrawals of huge amounts of dollars, collapsing the domestic economies. The IMF has listed over a hundred foreign exchange crises since the 1980s, so this is a common phenomenon. Adversarial Versus Cooperative Transactions: When it comes to attracting foreign investment, it is essential to distinguish between friend and foe. In 2005, world trade was around USD 50 Billion, while global capital flows were 40 times that, around USD 2 Trillion. This financial capital seeks a return, which is often created by causing deliberate crashes of currencies. No national economy is sufficiently large to defend against a financial attack. George Soros is famous for his attack on the Bank of England which won him about USD 1 Billion, while inflicting much greater costs on the population of England. An adversarial investment is one in which a foreign investor will profit from a financial crisis within the country -as happened in England vs Soros, or in the East Asian Crisis. A cooperative investment is when both the investor and the country benefit from the prosperity and stability of the country. If domestic firms borrow in USD for investments, then a domestic financial crisis makes it difficult for them to pay their loans in Dollars. As a result, the investors are able to seize domestic assets as collateral for very cheap, as occurred in the East Asian Crisis. In contrast, if payoffs to investments are denominated in domestic currency, then foreign investors cannot benefit from a crisis, and have interest in maintaining stability of the currency. It is true that they bear the foreign exchange risk in this case, and will only invest if they have faith in the stability and prosperity of the country. But this is precisely the kind of investor that we wish to attract. We do not want foreign investors who will make profits from economic crises in the country.

A CASE STUDY: How China Acquired an Aviation Industry: A country can exercise discretion and power to get favorable terms from foreign investors in special circumstances. The case of China Aviation Industry is a very instructive example. China did not have an aviation industry and wished to acquire one. But this involved acquisition of very advanced technologies, which were protected by patents, and by corporate secrecy required for private sector profits. Under normal circumstances, major aviation companies would never agree to transfer technology to China for the fear of creating a strong competitor for their own market. So, China started to look for abnormal circumstances. It got a fantastic opportunity when a consortium of European countries combined to develop the Aerobus, to break the US Monopoly on Aviation technology. The Aerobus proved extremely popular, and many pre-existing contracts for the Boeing 747 were cancelled, leaving Boeing on the verge of Bankruptcy. This created the opportunity China was looking for. China approached Boeing with a deal, which would give Boeing exclusive access to the huge market of air travel in China. But there was a catch. Boeing would have to setup its airplane manufacturing factories in China. Furthermore, they would have to gradually transfer the technology to China. The agreement was that in the first year 10% of the plane parts would be domestically manufactured, starting with seats, windows, plastics, and the simpler ones. Each year, the know-how for manufacturing an additional 10% of the plane parts would be imparted to Chinese manufacturers. By the end of the 10 years, the entire plane should be completely manufactured domestically, by Chinese personnel. Boeing stood to make huge profits from the deal, and faced bankruptcy otherwise. So, they accepted. They actually became allies of China, lobbying in Congress to allow transfer of some restricted technologies, so that they could fulfill their commitments. The bigger lesson to be learnt here is that it is domestic acquisition of productive capability – transfer of technology and development of domestic capabilities – that lies at the heart of good FDI. This needs to be kept in mind when we look for investors who will do FDI in the IEA. Another lesson is that the financial aspects of the incoming foreign currency need to be managed carefully. If foreign banks set up headquarters in Kabul, they may be able to seize control of finance in the IEA, because they are far stronger financially. After World War 2, American Banks acquired a majority share of deposits and financing in the UK, dwarfing domestic banks. Thus appropriate restrictions on banking and finance are required, to allow foreign investment, without harm to domestic finance. The Case of Pakistan: Just as China is model for good FDI, due to excellent governmental control of the FDI, so Pakistan is the model of bad FDI, due to corruption and incompetence at the highest levels. Historically, the infant industry was developed by the German Economist Friedrich List, when he saw that free trade with England was destroying domestic industries. Protecting German industry gave it the room to develop excellence at global level. In contrast, by foolish government policies aligned with the WTO, Pakistan has allowed many important industries to go extinct, and many others are suffering heavily. Pakistan used to manufacture small electronics, mobiles, silk, refrigerators, and many other products, which are no longer being domestically manufactured, because foreign competition has destroyed them. The secret to growth is to build and strengthen domestic industries, but bad governance in Pakistan has led to de-industrialization due to foreign competition.

Similarly, with encouragement of the World Bank, Pakistan set out to privatize it power sector, turning it over to IPPs (Independent Power Producers). The terms which investors (both foreign and domestic) were granted were enormously favorable, guaranteeing them a return in dollars. This FDI has been catastrophic for Pakistan, as has the sale of KESC (Karachi Electric Supply Company) to foreigners. The sale of PTCL to Etisalat has been touted as a great success story of FDI and Privatization. Detailed examination tells us a different story. PTCL was both profitable and efficient, on the verge of breaking into the international market as the first Pakistan multinational in the telecommunications industry. The sale crippled Pakistan’s domestic expertise and industry, and actually has netted less in terms of revenue than what PTCL used to earn for the government. There are no hard and fast rules here. In all of these cases, good negotiations and strict regulations could have created superior outcomes. But when government officials look for deals where they get the maximum cut, instead of deals which are best for the public, this results in huge losses to the public. In conclusion, while many think foreign investment is always good for a country's growth, the reality is more complicated. Latin American countries and the East Asian Crisis showcases disasters which can result from FDI. China shows us how smart management can make FDI work in our favor, while Pakistan's mistakes teach us what not to do. We need to be careful about who we do business with and make sure deals benefit everyone, not just a few. By careful management, countries can use foreign investment to grow stronger without losing control of their own economies. Top of Form