Across the APEC region, goods and services markets have become significantly more integrated over recent decades, as manifested in higher volumes of exports and imports as shares of members’ Gross Domestic Product. Capital markets have also become more integrated as evidenced by increased foreign capital flows which have rapidly transmitted financial shocks through the region, such as the 1997-98 Asian Crisis and 2008-10 Global Financial Crisis.

Although APEC has successfully promoted liberalised and expanded opportunities for international goods and services trade between members, considerably less attention has been paid to liberalising cross-border investment flows, especially in the form of foreign direct investment which is the focus of this paper. While there has been strong advocacy by APEC for freer international trade in goods and services there has been less enthusiasm for freer international trade in capital.

Within the APEC region, a range of restrictions apply to foreign investment in particular industries. For example, in Australia foreign investment in the financial, media, real estate and transport industries is heavily regulated, and in some sectors prohibited, on the grounds that foreign investment in these sectors can contravene the ‘national interest’, a notion that is somewhat ill-defined.

Economists since Adam Smith and David Ricardo have argued that free trade in goods and services improves economic welfare. A corollary of their arguments is that trade restrictions, especially in the form of tariffs and quotas on imports, reduce economic welfare as they impose additional direct costs on consumers, and indirect costs on exporters. Yet economic theory can also demonstrate the economic gains that stem from increased international investment, analogous to the support traditional theory provides for liberalizing trade in goods and services. As a general principle, the greater the international investment, the greater are the economic welfare gains.

Microeconomic Arguments for Foreign Investment

Direct foreign investment involving the establishment of new subsidiaries of foreign multinationals or the takeover of domestic firms by foreign interests generate most controversy. The economic impact of direct foreign investment and multinationals (MNCs) is best considered at the enterprise or industry level. Multinational corporations can directly and indirectly generate productivity benefits through the transfer of technology and through product development.

Furthermore, domestic employees of foreign-owned firms are exposed to international management practices and the presence of new entrants in domestic markets stimulates imitative behaviour and acts as a spur to greater competition. In turn, the higher labour productivity also allows domestic wages to be higher than would be possible with the smaller capital stock, resulting from reliance on domestic saving alone.

It is possible that foreign dominance of certain industries could result from foreign merger and acquisition activity which in turn could limit domestic competition in those industries. However, this then becomes a matter for the domestic competition authorities treating the foreign owned firms no differently from domestically owned firms. Similarly there could be problems with transfer pricing by multinational firms. But this too need not be an issue for foreign investment policy per se, but a matter for the domestic taxation authorities.

A commonly expressed concern about foreign direct investment is that in the form of foreign takeovers, or acquisition of real estate by non-residents, results in the loss of control of established domestic firms. Against these nationalistically inspired concerns however, there are economic benefits which accrue to the residents who choose to dispose of their assets to foreigners. It is generally not appreciated by opponents of foreign investment that whenever domestic financial or real assets are purchased by non-residents, the quantum of funds available to residents for additional spending is supplemented as a result of the asset sales.

Figure 1 below summarizes the various microeconomic mechanisms through which FDI relates to economic growth.

Figure 1: Theoretical explanation of the link between FDI and Growth

Figure 1: Theoretical explanation of the link between FDI and Growth

Macroeconomic Arguments for Foreign Investment

According to national accounting conventions an economy’s use of foreign saving or net inward foreign investment, equals its investment- saving gap. Hence, increases in the domestic real capital stock are partly financed by domestic saving and partly by foreign investment, broadly defined. By investing excess saving through equity participation, loans to resident firms and purchases of real assets from residents, foreigners finance that much more domestic investment. Moreover, the pool of funds available for investment is also supplemented when real domestic assets like property are bought by foreigners.

In other words, net capital inflow that matches the current account deficit enables economies accumulate more real capital. Another way of thinking about the significance of foreign investment is that it measures the volume of consumption spending that an economy would have to forego to lift domestic saving to the level required to fund its investment needs.

In sum, at the macroeconomic level, total foreign investment in all forms is reflected in the capital account surpluses which match the regular current account deficits of a host foreign investment nation. What is generally not appreciated is that the more foreign investment an economy attracts, the higher its current account deficit and foreign liabilities are likely to be. To the extent that, in aggregate, the productivity of the extra physical capital acquired through foreign capital inflow exceeds the servicing costs on that foreign investment, then national income can grow faster than otherwise.

Conclusion

The gains from liberalising international investment, both financial and real are less widely appreciated within APEC than the gains stemming from freer international trade in goods and services. Yet, increased foreign investment can conceivably play as important a role in economic development as increased international trade in goods and services because permitting greater capital mobility allows investment to occur in places where capital can be used more productively.

At the microeconomic level foreign direct investment in particular should be welcome because it delivers productivity gains via technology transfer, international management practices and product development and can spur greater domestic competition and imitative behaviour by existing locally-owned firms.

At the macroeconomic level, foreign capital inflow in aggregate improves economic welfare to the extent that it frees the nation from the constraint of its own saving level. As the above theory suggests, without foreign capital inflow, the level of long-term interest rates would also be higher, as the economy would then be totally reliant on domestic sources of funds to finance its investment requirements.

APEC’s development goals would therefore be well served by encouraging greater foreign investment within the region because in general, official restrictions which limit the purchase by foreigners of domestic assets impose an overall cost on the economy to the extent that they needlessly deprive the economy of much needed capital for development.

Read the entire “Prioritising Increased Foreign Investment in APEC” paper presented to the 2016 APEC Study Centre Consortium Conference (ASCCC), Arequipa, Peru, 5-6 May 2016.

Article by Tony Makin, Director, APEC Study Centre, and Professor, Griffith Business School.