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Inflow of capital from abroad is vital for the
growth of a developing economy, especially in
the initial stages of its economic development.

Modern economic history abounds with

examples of countries which have successfully
drawn upon the capital resources of the more
advanced industrial countries for the sake of
economic development.
The role of foreign capital can be
explained in terms of gap-filling
Three such gaps can be identified, viz.,
(a) Savings gap,
(b) Trade gap and
(c) Technology gap.

The function of foreign capital is to fill

these gaps and create conditions suitable
for fast economic growth.
Savings Gap
The key to the development problem lies in raising
the rate of capital formation. Such a raise envisages
a much higher level of investment than is
warranted by the present level of savings in a
developing economy.

The scope for a sharp rise in domestic savings is

limited by the prevailing low level of income, slow
rates of growth and rising consumption needs in
these economies.

The gap between investment requirements and

domestic savings can be filled in by foreign capital.
The fundamental proposition of national income
accounting is that
Y = C + I + (X – M)

Where Y = Gross national product (total spending), C

= Consumption, I = Investment, X = Exports of Goods
and Services plus income received from abroad, and
M = Imports of goods and services plus income paid

All this spending generates an identical flow of

income (Y); this total income equals total spending:
of all income, some is consumed (C) and some is
saved (S).
Then, since total spending equals that income,
by substitution
C + I + (X – M) = C + S
From this equation, we can, by simple
manipulation, easily discover the essential
constraints on capital formation.

Move (X – M) to the right hand, reversing its

sign; cancel C on both sides. The result is
I= S + (M – X)
The algebra is clear. A country’s investment
opportunities are determined by its potential for
domestic saving plus any net capital inflows from
abroad (M > X).

The only way for imports to exceed exports is for

the country to get capital from abroad; M > X is
thus equivalent to a capital inflow.

The availability of foreign capital increases the

availability of total resources in the economy. The
increase in total resources helps a developing
economy primarily in two ways:
One, It influences investment decisions. It
makes possible construction of many projects
which would not have been possible otherwise.
Certain programmes of development can give
optimum results if all the components of the
programme are undertaken simultaneously in a
phased manner.

The availability of foreign capital makes this

type of investment possible.
Two, establishment of bigger projects and projects
with a high investment component open up new
opportunities of investment and, thus, encourage
domestic entrepreneurs and savers to supply their
services and savings.

The addition to the total volume of resources

generated thereby exceeds the addition made by
foreign resources.
Trade Gap or Foreign Exchange Gap
A developing economy is faced with two
structural constraints:
•a minimum requirement of inputs to sustain
a given rate of growth of GNP,
•an actual or potential ceiling on export
earnings which are insufficient to finance the
required imports.
The foreign exchange gap, i.e., the difference
between the required imports and total exports is
given by
The constraint will be more severe if any of the
following two situations obtains:
One, some “Strategic Goods” like capital
equipment and technical know-how, etc. are
not available locally and could be procured
only from external sources.

Two, technical conditions of industrialisation

require a complement of foreign resources
along with domestic resources, so that the
latter would lie idle if the former are not
In either of the above two situations, the
availability of foreign exchange can save an
economy from an impasse in which it may
find otherwise, and place at her disposal high
quality factors such as improved machinery,
technical know-how and qualified foreign
technicians which may have a beneficial
effect on her development by, what Harrod
called, ‘fertilising productivity of common
Technological Gap
The role of technology in bringing about
economic growth is obvious. The level of
technology in a developing economy can be
raised through:

•the internal evolutionary process of

education, research, training and experience,
•the external process of importing from other
In respect of the import of technology,
contemporary developing countries have the added
“advantages of the latecomers”.
Since development has actually proceeded in the
rest of the world, these countries have a rather
whole range of technology to choose from and do
not have to repeat the process of evolving it.

The import of technology, however, raises two issues,

(a) the choice of technology and
(b) local adaptation.
The act of choosing a particularly technology is dependent
on the state of domestic complementary research. Only
then a country will be able to know the quantity and
quality of the know-how to be imported and the price to be
paid for it.

Adaptation of technology contemplates that the process of

import of technology should be accompanied by
indigenous research and development.

Analogous to technology gap is a gap in management,

entrepreneurship and skill. Foreign capital can supply a
“package” of needed resources that can be transferred to
their local counterparts by means of training programmes
and the process of learning by doing.
To sum up, foreign capital touches three sensitive
areas crucial in the development strategy of a
developing country.

It is almost true to say that the growth, at least in

the initial stages, in the present times cannot be a
self generating process.

Indeed, with a sole dependence on the domestic

resources, it may be difficult to breach the vicious
circle within which a developing country is usually
The inflow of capital from abroad may take place
either in the form of:
(a) foreign aid,
(b) private investment

Foreign aid includes loans and grants from foreign

governments and institutions. This source of
foreign capital, especially loans, has an important
limitation in the form of repayment obligations.

As regards private foreign capital investment, the

intense academic debate relating to its effects
remains inconclusive.
Merits and Demerits of Foreign Capital

The opponents of foreign investment have drawn attention to several

imperfections and adverse effects, such as capital intensity of such
investment, inappropriate technology, the possible adverse effects on
income distribution, transfer pricing and the negative contribution
that such investment often makes to the balance of payments.

The advocates of foreign investment, on the other hand, have

highlighted the beneficial effects in terms of encouragement to the
development of technology, managerial expertise, integration with
the world economy, exports and higher growth. It has also been
claimed that debt financing generates fixed debt servicing
obligations, while equity needs to be serviced only after profits are
There is also sufficient empirical evidence to
support both points of view. For example, in recent
years, foreign investment seems to have
contributed enormously to the growth of several
Asian countries, including China.

There are examples, particularly from Latin

America and Africa, where the contribution of
foreign investment has not been so encouraging.
Sources of Private Foreign Capital
The two important sources of foreign private capital are:
(a) Portfolio Investment and
(b) Direct Business Investment, also known as Foreign Direct
Investment (FDI).

a) Portfolio Investment
It comprises the following:
i) Equity holdings by non-residents in the recipient
country’s joint stock companies,
ii) Creditor capital from private sources abroad invested in
recipient country’s joint stock companies,
iii) Creditor capital from official sources in recipient
country’s joint stock companies.
b) Foreign Direct Investment
There are three main categories of FDI:
i) Equity Capital:
It is the value of the Multinational Corporations
(MNCs) investment in shares of an enterprise in a
foreign country.

An equity capital stake of 10 per cent or more of the

ordinary shares or voting power in an incorporated
enterprise or its equivalent in an unincorporated
enterprise is normally considered a threshold for the
control of assets. This category includes both mergers
and acquisitions, and green field investment (the
creation of new facilities).
ii) Reinvested Earnings:
These are the MNC’s share of affiliate earnings not
distributed as dividends or remitted to the MNCs.
Such retained profits by affiliates are assumed to
be reinvested in the affiliate.

iii) Other Capital:

It refers to short-term or long-term borrowing and
lending of funds between the MNCs and the
Types of FDI
Looked at from the point of view of the
investors, the FDI inflows can be classified
into three groups:

i) Market-seeking:
These are attracted by the size of the local
market which depends on the income of the
country and its growth rate.
ii) Efficiency-seeking:
In developing countries where capital is relatively scarce the
marginal efficiency of capital tends to be higher than in the
developed world where it is abundant.

Assuming that interest rates broadly reflect Marginal

Efficiency of Capital (MEC), it follows that lending rates in
Western financial centres are below MECs in developing

Hence, economic efficiency and commercial logic dictate

that capital should flow from the relatively less-profitable
developed world to the relatively more profitable
developing countries.
iii) Other Location Advantages:
These include the technological status of a country,
brand name and goodwill enjoyed by the local
firms, openness of the economy, trade and macro
policies pursued by the Government and
intellectual property protection granted by the

Whatever form of FDI, in modern times,

Multinational Corporations (MNCs) have become
the major carriers of foreign capital and technical
The major characteristics of this form of organisation.

An MNC is one which undertakes foreign direct
investment, i.e., it owns or controls income generation
assets in more than one country, and in so doing produces
goods or services outside its country of origin, i.e., engages
in international production.

As per the estimates made available by the UN Centre on

Transnational Corporations, there are more than eleven
thousand MNCs with more than eighty-two thousand
subsidiaries in operation abroad.
Characteristics of Multinational Corporations
The MNCs have certain characteristics among which the more important
are as follows:

i) Giant (Gigantic Size):

The assets and sales of MNCs run into billions of dollars and they
also make supernormal profits.
The Economist estimates that the world’s top 300 MNCs now control
over 25 per cent of the 20 trillion stock of productive assets. No size,
howsoever big, is perceived to be sufficient. Hence the MNCs keep on
growing even through the route of mergers and acquisitions.
(Wallmart $473 billion, employs 2.2 million associates)

ii) International Operations:

In such a corporation, control resides in the hands of a single institution.
But its interests and operations sprawl across national boundaries. MNCs
have become in effect “global factories” searching for opportunities
anywhere in the world.
iii) Oligopolistic Structure:
Through the process of merger and takeover, etc., in
course of time, an MNC acquires awesome power.
This coupled with its giant size makes it
oligopolistic in character.

iv) Spontaneous Evolution:

MNCs usually grow in a spontaneous and
unconscious manner. Very often they develop
through “creeping incrementalism”. Many firms have
become international by accident. At times, firms have
also established subsidiaries abroad due to wage
differentials and better opportunities prevailing in
the home country.
v) Collective Transfer of Resources:
An MNC facilitates a multilateral transfer of
resources. Usually this transfer takes place in the
form of a ‘package’ which includes technical know-
how, equipments and machinery, raw materials,
finished product, managerial services and so on.

MNCs are composed of a complex of widely varied

modern technology ranging from production and
marketing to management and finance.
Importance and Significance of MNCs
With the retreat of socialism, MNCs have
become a powerful force in the world
The Case for MNCs
The case for MNCs revolves around that
the potential benefits that a developing
economy can hope to get from MNC
operations. These benefits are summarised
in Table 1.
A recent study on the subject concludes that in today’s
world of global capitalism, foreign investment is the
only instrument that can reduce the inequalities
between nations.

The Case against MNCs

In actual operations, in the past half a-century or so,
the experience with MNCs has not been an unmixed
blessing. Main points of criticism can be summarised
as in Table 2.
In a partial response to the above propositions, it may
be stated that the modern MNCs acknowledge their
responsibility to the concerns and interests of the
host country and basically operate on the basis of
mutuality of interests.

In fact, in present times international capital has no

loyalty towards any nationality. MNCs realise they
cannot be oriented toward the state of their origin.
They have to be the citizens of the country they are
in. If they are not, they cannot succeed.
Need for Regulation of MNCs
In view of the fact that MNCs do possess a potential
that can be gainfully exploited, most of the
developing countries have chosen to regulate their
activities rather than to dispense with them
i) Threat of nationalisation is an important tool of
ii) The Government may allow or deny permission in
identified areas.
iii) MNCs may be allowed to invest for specific
periods. Thus, after a certain period of time,
restrictions may be imposed on foreign holdings, or
there may be provision for gradual disinvestments.
iv) A multi-tax system may be followed by
the Government. The MNCs may be taxed
at a higher rate.
v) The host country may lay down certain
export criteria.
vi) MNCs may be asked to carry out a
minimum fixed share of their total research
and development activities within the host