University of Nairobi Foreign Direct Investment Reflection There is no upper limit for the number of words in the answer, (total words is at least 300or 35

University of Nairobi Foreign Direct Investment Reflection There is no upper limit for the number of words in the answer, (total words is at least 300or 350) but this is a graded assignment, the content is interesting, don’t be too boring in writing.

Q1 What were the most important 1-2 new things you learnt from the lecture and/or readings that you did not know before class? Describe one way in which what you learnt connects to either a different subject/topic you are interested in, or a personal experience.

Q2

What were 1-2 points discussed in lecture/readings that you are still confused/unclear about and would like some further clarification on?

Q3

What topics/questions would you like to learn more about or discuss more based on content covered in the lecture/readings? Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Closed Economy
P
S: Domestic supply
CS
P*
PS
D: Domestic demand
O
Q*
Q
Free Trade
P
S: Domestic supply
CS
Pw
PS
D: Domestic demand
O
Q2
Domestic
Production
Q1
Import
Q
Tariffs
P
A
S: Domestic supply
G
PT
Pw
E
F
I
H
B
C
O
D: Domestic demand
Q2
Domestic
Production
Q4
Q3
Import
Q1
Q
Tariffs
P
A
S: Domestic supply
CS
G
PT
F
Revenue
Pw
PS
E
I
H
B
C
O
D: Domestic demand
Q2
Domestic
Production
Q4
Q3
Imports
Q1
Q
Tariffs
• Pw: world price
• Consumer demand is Q1 and importing country’s producers produce Q2.
• So Q2Q1 is imported.
• Consumers’ surplus: ABPw, Producers’ surplus: PwEC
• If a tariff is imposed on imports and the world supply is perfectly elastic,
then the domestic price rises to Pt.
• This reduces the demand to Q3 and increases domestic production to Q4.
• Imports are reduced to Q4Q3.
• Producers’ surplus increases to PtGC since producers receive Pt that
exceeds their marginal cost of production.
• Consumers’ surplus decreases to AFPt because of higher price and reducing
consumption.
• Government revenue: rectangle GFHI
• DWL: Two triangles EGI and FBH
• EGI is a loss resulting from the distortion in production (marginal cost of
producing at home is higher than importing). FBH is the inefficiency resulting
from higher prices that reduces consumption (the utility from consuming the
foregone units would be higher than the cost of production).
Tariffs – Costs Vs. Benefits
• The figures clearly show that tariffs reduce social welfare
• Then why bother having them? [Answer in class]
Import Substitution in Practice
•
•
•
•
Did import substitution work?
In theory yes, but:
In practice – quite disappointing. Why?
Infant industry argument supports a temporary policy to
aid import-competing manufacturing
• Once learning is mostly accomplished, government help is no
longer justified
• But, in practice, the protections typically created powerful
lobbies who were able to lobby for continued protection
• Results in “crony capitalism” where policies that hurt
general welfare (like tariffs) create wealthy businessmen,
who then pay off politicians to keep the policies
Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Political Economy of Trade Policy (1)
• Why are there more likely to be lobbies in favor of trade protection
than in favor of free trade – even if free trade leads to greater
overall welfare?
• If you look at the graph – you see that the gains of free trade go to
consumers (who are many), while the costs go to producers (who
are lot fewer)
• Consider a case where:
• The benefits of no tariffs on sugar is $50/person -> total gain = $50 x 300
million (pop.) = $15 billion
• The benefits of tariffs are $1 million/producer (there are 5,000 producers), so
total gain from tariffs = $5 billion (plus say $5 billion more in tariff revenue)
• Clearly the benefits of free trade in sugar outweigh the costs of the
sugar tariffs (by $5 billion!) and so free trade would be optimal as
per any economic calculation
• But you have concentrated benefits and diffuse costs of tariffs!
Political Economy of Trade Policy (2)
• Now consider political lobbying to influence policy
• Lobbying is expensive (costs both time and money)
• Say the cost of lobbying is $100,000 (campaign contributions,
advertising, time costs, etc.)
• Now, it does not make sense for any individual to try and lobby for
free trade in sugar (net gains are negative : $50 – $100,000)
• But for the producers, it makes a lot of sense if the lobbying will be
successful (net gains are: $1M – $100K = $900K)
• So you are likely to have a lot more lobbying for “protection” of the
sugar market than for free trade (note that there is not much
‘learning by doing’ here and sugar is not an infant industry)
• Why don’t consumers ‘organize’ and pool their resources and also
lobby for free trade in sugar?
• There is a ‘collective action problem’ (Mancur Olson 1965)
Political Economy – Other Examples
• The idea of “concentrated costs” and “diffuse benefits” is a very
powerful one for understanding how policy can deviate from the
public interest
• When you hear stories of how “special interests” drive politics and
policy – it is highly likely to reflect the same dynamics
• Examples from the US:
– Estate taxes
– Tax code loopholes (like private-equity earnings)
– Climate change deniers
• Examples from India:
– Public sector unions
How Does Policy Get Made
• This is what you study in detail in political science classes!
• One useful framework is to think of policies as being influenced by
the 3 I’s: Ideas, interests, and institutions
• Take free trade again:
• Ideas – policy discussion takes place in the context of the ideas that
people have about trade (from academic research etc.)
• Interests – lobbying and advocacy is determined by the interests of
various groups
• Institutions – policy choices are constrained by the institutional
context (Senate ratification, fast track authority, WTO, etc)
• In the US, these factors point towards free trade (for the most part)
• But in India (and many developing countries), all three factors
pointed towards greater protection in the 50s and 60s
• And once you protected, political economy considerations made it
very difficult to open up markets to competition
Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Foreign Contact & Technology Transfer
• Recall discussion that it is easier for “laggard”
nations to copy and adopt technologies developed
in richer countries
• How exactly does technology get transferred?
•
•
•
•
Purposive imitation
Use capital goods that embody the technology
License the new technology
Reverse engineering
• But several studies on technological diffusion
conclude that many aspects of technology are
tacit and only learnt by direct practice
Foreign Direct Investment (FDI)
• What is FDI?
• Direct Investment by a foreign firm in productive
capacity in a different country
• Could be a fully-owned subsidiary or a joint venture
• Main reasons for FDI are:
• Cheaper access to domestic market (transport, duties, etc)
• Cheaper venue to produce for global market
• FDI versus FII (Foreign Institutional Investment)
• FII usually refers to pure financial investments as
opposed to investing in productive capacity
• How does FDI help in technology transfer?
History of FDI
• Many countries (including India and China) moved
from being closed to FDI in the 60s and 70s (and
chasing away foreign firms) to welcoming them in
the 80s and 90s
• Why were they closed in the beginning?
• Why did they reverse this policy?
FDI and Technology Transfer
• While it is true that foreign firms can sometimes dominate local
markets – most of the factors of production they use are local
• Labor, materials, services
• If they bring the most productive technologies with them, it
becomes an effective way to accelerate the productivity of
domestic workers
• The learning spillovers from FDI generate positive externalities
• New companies, increased returns to education, better awareness of global
standards of management practices and production, learning by doing for
joint venture partner
• May even be worth subsidizing entry!
• A good example is General Electric (GE) in India. Why?
Another Channel for Role of Exports
• Customers can be a great source of technology transfer because
they want low-cost high-quality products from their suppliers
• So they are often willing to transfer knowledge from other suppliers
and also to teach vendors how to meet standards
• Several studies show this:
• Egan and Mody (1992) look at US buyers in LDC’s
• Rhee, Ross-Larson, and Pursell (1984) look at Korean firms and find that
foreign buyers shared substantial knowledge above what was in the contract
• Korea then played a corresponding role for garment manufacturing in
Bangladesh (Korea/Taiwan continued order sourcing and fulfillment – but
outsourced production to lower wage countries)
• Learning foreign technology happens within international
production networks or “global commodity chains”
• A good example is Walmart in China. Why?
O-Ring Production Functions (Kremer 1993)
• Key idea is that complex production processes have many different
tasks, but the failure of even one of these tasks dramatically
reduces the value of output
– Y = X1 * X2 * X3
•
•
•
•
Why is it called the “O-Ring” production function?
Why is it relevant for technology adoption?
Because the risk of failure is high unless you get everything right!
Probability of success is higher when you are taught and trained in
all components of the technologically advanced manufacturing
process
• Again think of Walmart in China and GE in India
• Keep in mind for technology adoption in agriculture
• In general, adopting a new technology can increase productivity but is also
risky because you don’t know how to do it well (at least in the beginning)
Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Three Views of Trade & Growth (for
developing countries)
•
•
•
•
Trade as an enemy of growth
Trade as an enabler of growth
Trade as engine of growth
These 3 views are not inconsistent or mutually exclusive
– Validity depends on initial conditions and how they influence
trade patterns
– Fundamentally an empirical question
Trade as Enemy of Growth
• Trade takes place according to comparative advantage, but has
long-term dynamic costs for developing countries
• Developing countries start exporting primary products (PP – crops,
minerals) because they have a comparative advantage there
• But, learning by doing is much faster in manufacturing
• Workers move from manufacturing to PP industries in the SR, but in
the LR, their output is lower since fewer workers in manufacturing
• Similar conclusion in related literature in sociology that
development of the countries on the “periphery” is hindered by
their export of primary products to the developed countries at the
“core”
• Also, known as “dependency” theory
Trade as an Enabler of Growth
• In this view, trade is neither essential nor inimical to growth, but
provides useful discipline to domestic industry
• The need to export serves as a check on the appropriateness of
new industries and costs
• Being open to foreign competition also discourages local
monopolists from producing sub-standard goods at higher cost
• Trade also allows economies of scale and make efficient
investments that require a larger market size to be profitable
• Useful analogy with financial development
Trade as Engine of Growth
• In this view, the most important source of long-term growth is
technological progress as opposed to mere capital investment
• Thus, trade with more technologically advanced countries acts
as a vehicle for the flow of knowledge (sometimes embedded
in capital) from them and drives growth over time
• Foreign Direct Investment (FDI) plays a similar role
• These 3 views are not inconsistent or mutually exclusive
• Validity depends on initial conditions and how they influence
trade patterns: Fundamentally an empirical question
Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Globalization and Growth
• Go back to the
Solow model?
• Will countries
converge or
diverge?
• The current view is
that globalization
and openness to
trade promote
convergence
• Why?
Jones & Romer, 2009
Globalization & Convergence (1)
• Remember that convergence requires two critical pieces:
• More capital investment in low-income countries (LIC’s)
• More technology adoption in LIC’s
• Globalization helps with both of these channels:
• Increases in global capital mobility (and information flows) allows for more
investments in LIC’S
• Weakens the “home-bias” noted by Feldstein-Horioka (1980)
• “Home-bias” paradox is that people’s assets are disproportionately
invested in their home country though expected returns would be
higher from investing overseas (including LIC’s)
• Why might this “home bias” get weakened with globalization?
• Easier to learn about investment opportunities in LIC’s and invest
• Improved institutions/investor protection in LIC’s as they seek FDI and FII
• Increases in global goods mobility (fall in shipping/transport costs) allows more
“investment for export” in LIC’s (along with improved technology adoption)
• Thus, overall we expect that globalization should promote convergence
Evidence on Trade & Growth
• Several studies have found a strong positive relationship
between increased trade and growth
• Sachs & Warner (1995); Frankel & Romer (1999)
• Cline (2004) – also studies effects on poverty
• Rodrik (2013) – finds convergence in manufacturing (which is
highly globalized)
• Some studies warn that trade may increase growth, but also
increase inequality in developing countries (Topalova 2007)
Globalization & Convergence (2)
•
Economic historians identify the ~50-year period before World War I (1860-1915) as
the “First Wave of Globalization”
•
This is also when the first wave of “convergence” took place (remember Baumol’s
“convergence club”)
•
Then global trading system collapsed for ~30 years (2 world wars)
• Poor countries stay closed to trade post independence (for historical and
ideological reasons)
• This is a period of divergence (remember the slide showing no evidence of
convergence) when OECD countries (that are open to each other for trade) grow
faster than poor countries (contradicting the Solow model)
• Why? Most likely because of trade barriers
•
Current wave of globalization after 1980 (and especially 1989) – much greater global
movements of goods & ideas
• Seems to have ushered in a new wave of convergence
• More people lifted out of absolute poverty in last 35 years than in all recorded
human history (driven mainly by China and India)
• But globalization may be in retreat (Brexit; US elections; trade wars; COVID-19)
Economic History of the World in
One Picture!
Policy Implications
• One of the best things that developed countries can do to promote
welfare in developing countries is to provide increased market access
for products that developing countries specialize in
• Developed countries will ALSO benefit (principles of comparative
advantage)
• But there are often adverse distributional consequences in developed
countries (standard trade dislocation)
• Autor, Hanson, and Dorn (2013)
• Hence, political costs in developed countries for more trade access
and it’s often easier to support “aid”, though the evidence suggests
that “trade” would be much more effective
• For developing countries, being open to trade and foreign
investments (FDI in particular) would in general be a good thing
Agenda for the day
1. Import Substitution
2. Political Economy of Trade Policy
3. Foreign Contact, Technology Transfer, and FDI
• O-Ring Production Functions (Kremer 1993)
4. Three Views on Trade & Development
5. Empirical Evidence on Trade & Growth
6. Reviewing the Indian Experience
Key Historical Points in Trade Policy
•
1950-51: Begin with a liberal import licensing regime, low tariffs, comfortable stock of pound
sterling balances
•
1957-58: BoP crisis and the introduction of foreign exchange budgeting and tightening of the
import regime
•
1965-67: Crisis, devaluation, the failed liberalization giving way to further tightening of the
regime
•
1977-78: The P. C. Alexander Committee and the introduction of the Open General Licensing
(OGL)
•
Second half of the 1980s: Devaluation and export incentives
•
1991-92: End to import licensing except for consumer goods
•
2001: End to licensing on Consumer goods imports
•
2017: Some creeping return of tariffs (again – connect back to ideas, interests, institutions)
35
Compression of the Top Tariff Rate
•
•
•
•
•
•
•
•
•
1991-92: 150%
1992-93: 110%
1993-94: 85%
1994-95: 65%
1995-96: 50%
1996-97: No change
1997-98: 40%
1998-99: No change
1999-2000: No change but
rates unified from seven to
five (5, 15, 25, 35 and 40)
• 2000-01: 35% (four rates with
40% dropped)
• 2001-02: No change
• 2002-03: 30%
• 2003-04: 25%
• 2004-05: 20%
• 2005-06: 15%
• 2006-07: 12.5%
• 2007-08: 10% (current top rate on
industrial goods with some peaks
on auto and textiles & clothing)
• Agriculture remains highly
protected, however
36
60
1991
2001
50
40
30
20
1969: 4.1%
10
0
1960
1970
1980
1990
2000
Import of goods and services (% of GDP)
2010
2020
Trade (% of GDP)
37
Export of goods and services (% of GDP)
30
25
20
15
10
5
0
1960
1970
1980
1990
2000
2010
2020
38
Service exports (BoP, current billion US$)
250
200
150
100
50
0
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
39
Foreign Direct Investment and Portfolio Equity
Inflows
70
60
50
40
30
20
10
-10
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
0
-20
Portfolio equity, net inflows (BoP, current billion US$)
FDI net inflows (current billion USD)
40
Foreign Exchange Reserves (million USD)
41
Summary
•
Understanding trade and trade policy, and the extent of integration between India and
the world economy is key to understanding the performance of the Indian Economy
•
Policy choices in the 50s to 70s reflected the widespread post-WW2 view that “trade is
an enemy of growth”
•
However, the “import substitution” policies (combined with various restrictions on
domestic business) really did not work:
• Political economy & lobbying to protect inefficiency
• Lack of exposure to global ideas and knowledge
•
Reducing trade barriers and integrating more with the global economy starting in the
1980s and especially after 1990 was a key driver of Indian growth (same for China)
• Key components include FDI & FII
• Increased export of goods and services (leveraging lower labor costs)
• Learning to meet global standards (being embedded in global value chains)
•
However, growth cannot be taken for granted, and economists (including me) are
worried about the creeping return of tariffs and protectionism in Indian policy
• Reflects a combination of lack of competitiveness in many areas (due to lack of
public investments and more restrictive laws), corresponding lobbying for
protection from firms, and a …
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