Capital

As noted in the introduction, the problem of capital scarcity in late developers is compounded by several factors: cost, scale and uncertain pay-offs. High capital costs are a direct consequence of capital scarcity, and discourage firms from undertaking large investments. At the same time, large initial investments are necessary in most mature mass-market manufactures, because of substantial scale economies. However, because they are mature, and the competitors well established, the risk of such investments for developing country firms is augmented by uncertain pay-offs: the size of the local market typically does not justify investment on that scale, and their ability to recoup investment costs by capturing a share of the international market is limited by their lower productivity and the lack of experience and market access.

It follows that in order to stimulate the shift into new industries with higher productivity returns, a late developing country must find ways to mobilize capital on a sufficient scale, lower the costs of capital provision, and ensure satisfactory returns to motivate investment. However well regulated, local financial markets are unlikely to supply adequate

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37 solutions for these problems. Instead, most late developers found some form of solution in state intervention. The state either undertook such investments directly, through public companies, or goaded the private firms into selected activities by manipulating the costs and returns on capital: lowering interest rates on certain types of investments, offering targeted subsidies, creating a domestic market for new products, and protecting it from outside competition to ensure higher profits (Wade 1990; Amsden 1989; Stallings 2006).

This “independentist” solution rested firmly on a reciprocal relationship between the state and the local firms, but it nevertheless involved a good deal of import of foreign capital.

However, most of this capital came in via foreign borrowing, while direct foreign investment remained very limited. Foreign savings were typically channelled through government-owned development banks, which meant that governments took on part of the borrowing risk, and were able to target credit to selected activities and firms (Amsden 1989; Stallings 1990). Even in Latin America, which was more open to direct involvement of foreign companies, the arriving multinationals were hand-picked by the government and their number and behaviour strictly regulated (Shapiro 1994; Bennett & Sharpe 1979). Thus throughout the period of import-substitution industrialization, the share of FDI remained well under a quarter of the total externally sourced capital (Stallings 1990, see also Figure 2.1).

These alternatives all but dried up in the aftermath of the debt crisis in mid-1980s.

Commercial bank lending to developing countries nearly collapsed, and although private loans and portfolio investments resumed again in the following decade, the official lending continued to dwindle. On the other hand, direct foreign investment soared. Since the 1990, FDI has been the most important source of external finance for developing countries: by the middle of the following decade, it already accounted for nearly half of all net foreign capital inflows even in East Asia, while in Latin America and East Central Europe its share came closer to two thirds (Figure 2.1). At the same time, however, the reliance on foreign savings remained relatively low in East Asia, less than half of the level of East Central Europe, where net foreign capital flows account for over 6% of GDP annually. It is even lower in the older generation of “tigers” – since

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38 the late 1990s, foreign financing in Korea has fallen below 1% of GDP, and high domestic saving rates have increasingly proven a viable alternative to foreign capital (Stallings 2004; Kohli 2009).

Direct investment from abroad certainly appears to be an effective solution to most capital-related challenges outlined above. FDI is not constrained by the cost of borrowing in the local financial market, and can quickly reach the scale and productivity levels (through import of proprietary technologies and other inputs) which render host country operations competitive on the international markets. If sufficient investment is forthcoming, this can help developing countries avoid balance of payments problems often associated with import substitution strategies. Reliance on foreign investment also does away with the threat of government failure which is inherent to the developmental state’s strategy of “picking winners”

– the danger that they might make the wrong choices, or that support for development of the private sector will degenerate into cronyism.

Figure 2.1Composition of net foreign capital flows to selected regions, %GDP

However, this solution comes at the cost of novel difficulties. For one, short-term relief of balance of payment problems can turn into a long-term drain on capital account through profit repatriation, which means that the host states have to keep finding novel ways to

0.0 1.0 2.0 3.0 4.0 5.0 6.0

75-90 90-05 75-90 90-05 75-90 90-05

ECE EA LA

FDI Private Official

Note: Official flows include multilateral and bilateral loans from official sources (excluding IMF loans) and grants. Private flows include commercial international loans, bonds and portfolion investment. For the composition of regions see footnote 1.

Source: own calculations based on World Bank WDI database

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39 convince the companies to re-invest. FDI is also famously difficult to navigate: foreign firms are harder to bargain with because they have an easy exit option, and cannot be pressured to invest into less than promising activities or regions for the sake of long-term national development goals. In fact, to the extent that FDI is the embodiment of private, market-led efficient allocation of resources, it will almost by definition fail to accomplish the main task of development:

structural shift of investments towards momentarily less efficient but more promising uses. In that sense, developing country governments remain saddled with the difficult task of luring private investment to activities where it would not otherwise go, by devising various schemes to make such investments more appealing.

In the earlier generation of integrationist states, the “bait” consisted of preferential access to domestic market. Because the firms could pass on the higher costs of production to the local customers, they did not mind investing in activities which did not comply with the local comparative advantage. In the latter generation “hyper-integrationist” states, however, this is often not an option, and the incentives tend to be of a more direct kind. In order to lower investment costs, the host governments resort to manipulation of taxes to increase profitability, direct subsidies, and provision of special services and infrastructure. An interesting twist in the hyper-integrationist context, especially in smaller developing countries, is that the main prize for the foreign investors isn’t so much the local market, but the ability to serve other countries’

markets through local export platforms. This leads to a small paradox in that policies typically used to attract foreign firms and promote linkages to the local economy are also the ones which they need to abandon if the country is to become a part of an integrated trade and investment area. As we will see in more detail in Chapter 3, this conflict came into particularly sharp relief in East Central Europe once the region’s FDI-oriented development clashed with the EU’s competition regime and the interests of other member states.

This gives the alliance between states and MNCs a particularly complex character. The MNCs try to play off governments against each other in order to minimize their power over the firms’ investment decision and increase the amount of subsidies. The governments, on the other

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40 hand, have an interest to cooperate to limit the costs of FDI, but such cooperation is difficult because the pay-offs for defection are very high. A transnational regulatory regime, such as the European Union, can stabilize this cooperation to limit subsidy wars, but its interference also reinforces the interest of individual states to cooperate with the MNCs in order to outbid the competition. In the ECEs, this three-way interaction between host governments, competitor states and multinationals, under the aegis of the EU competition regime, underwrites a good deal of policy making ranging from investment policy to regional development and taxation, but its power to direct the multinationals’ investment decisions remains limited.