Foreign aid refers to assistance give to developing countries on favourable terms. It may be:
- Tied – i.e. with conditions attached to it, e.g. a grant of money that must be spent exclusively on products from the donor country;
- Untied – i.e. without any attached conditions;
- Bilateral – given by one country to another country;
- Multilateral – given by countries to international organisations such as the World Bank or the UN, which then redistribute to other countries.
One issue with aid is that it can increase the dependence of developing countries on developed countries who get a stronger negotiating position. Some forms of aid increase the indebtedness of developing economies. This can lead to developing economies eventually transferring more to developed economies in interest payments that they are receiving in aid.
Guidance given by the International Monetary Fund (“IMF”) may not always consider the detailed situation on the ground, and so may encourage capital intensive methods for a country with an abundance of labour but a shortage of capital, or may require cuts in spending on education to reduce a budget deficity at the expense of the country’s economic growth prospects.
International trade is often more helpful for developing countries than aid in the long run. It can improve supply conditions and reduce costs, leading to more efficient production as:
- The larger market makes economies of scale possible;
- Increased competition encourages innovation amongst domestic entrepreneurs and for them to seek out new techniques of production;
- Trade encourages a transfer of skills between developed and developing countries;
- Specialisation and trade increases incomes, providing increased savings which can then be invested.
International trade can also stimulate domestic demand, due to increased employment to cater for the export market leading to an increase in spending power.
There is strong theoretical support for the beneficial effects of trade on developing economies, however many economists are cynical as they have noticed that in reality many developing economies have tended to specialise in primary products. Those that have specialised in agricultural products have been disadvantaged as:
- Income elasticity of demand for primary primary products is low, so as world incomes have risen, increased demand for agricultural products has not been proportional, with demand shifting instead to manufactured goods and services;
- Producers of manufactured goods in developed economies have some monopoly power, which they can use to maintain high prices;
- Western countries subsidise their farming sectors, which puts downward pressure on global agricultural prices (e.g. US cotton subsidies are claimed to have given US cotton farmers an unfair international competitive advantage).
A lack of savings and financial institutions can make domestic investment difficult in developing countries, where there may also be a shortage of entrepreneurs looking to invest. Stimulating investment can lead to a virtuous cycle, as illustrated below:
China’s rapid economic growth towards the end of the last century and beginning of this century was partly due to high levels of investment. This was partly due to high domestic savings and rapid development of their financial institutions.
A multinational corporation (MNC) is defined as a firm that operates in more than one country, although its parent company is always based in a single country. Examples are McDonalds, Apple and Toyota. MNCs provide foreign direct investment (FDI) in the economies where they operate. This necessarily involves capital flow between countries. It is to be distinguished from portfolio investment, which is the purchase of shares by foreign investors in businesses located in another country.
FDI by MNCs can bring in new technology and new ideas, can add to GDP and exports and generate employment. We can see this in the Caribbean area, where US MNCs have been significantly involved in petroleum, minerals and natural gas industries. MNCs have been criticised however, as where they take over domestic firms this do not always lead to higher employment and higher incomes, they may deplete non-renewable resources and create pollution, and they may employ foreign labour, particulary in the top jobs, and may send profits back to their home countries. They are also accused of putting pressure on governments to pursue policies that are beneficial for them but may not benefit the economies in which they are producing. They may also exploit their mobility and economic power to negotiate favourable tax situations and exemptions from certain environmental laws.
Task – Foreign Direct Investment
China’s expansion into other economies
Although China’s outward FDI is growing fast, it is still less than inward FDI. China’s FDI first grew largely because of its search for energy, minerals and land in African economies. It is now moving into richer markets in a bid to get more recognition for its products and to take advantage of advanced technology.
Its investment in the Caribbean is relatively low but may increase in the future, partly because its location makes it an appropriate base to export to the USA and Canada. The region does, however, have relatively high wages and modest resources.
1.) Analyse what effect an excess of inward FDI over outward FDI will have on a country’s balance of payments;
2.) Discuss whether China is likely to invest more in the Carribean in the future.
The role of the IMF and the World Bank
Following the Bretton Woods Conference in 1945, the IMF was set up to try to support the world economy. It is headquartered in Washington DC and has 188 members (Cuba and North Korea are not members). Its purposes include:
- Promoting international monetary cooperation;
- Facilitating expansion and balanced growth of international trade;
- Providing exchange rate stability;
- Assisting to set up a multinational system of payments;
- Make resources available to members experiencing balance of payments difficulties, subject to certain safeguards.
The IMF’s three main functions are surveillance, technical assistance and lending. The first two help promote global growth and economic stability by encouraging sound economic policies. The latter helps member countries that experience difficulties in their balance of payments.
The World Bank was set up at the same time, with the function of providing financial support for internal investment payments, such as new infrastructure and health facilities. It has 5 constituent agencies:
- International Bank for Reconstruction and Development (IBRD);
- International Finance Corporation (IFC);
- International Development Association (IDA);
- Multilateral Investment Guarantee Agency (MIGA); and
- International Centre for Settlement of Investment Disputes (ICSID).
The IBRD and IDA provide low-interest or interest free loans and grants to countries that lack favourable access to international credit markets (i.e. particularly developing economies). Loans cover areas such as:
- Health and eductation;
- Agriculture and rural development;
- Environmental protection;
- Infrastructure; and
Loans typically have conditions attached regarding the economic policies of the economies receiving them.
The World Bank and the IMF have been criticised for imposing the Washington Consensus on developing economies. The Washington Consensus is a set of ten economic policy prescriptions devised in the US, including privatisation, deregulation and trade liberalisation, to increase the role of market forces. Whilst these measures may increase efficiency and thus productive potential, they may also increase income inequality and may not work if the lack of development is due not to too much government intervention, but to market failure, such as a lack of financial markets.
Task – IMF and World Bank
If a country has an undeveloped legal framework, corruption can occur and funds that could have been used for development could be diverted to the owners of firms and to government officials. Insufficient property rights can lead to firms polluting without penalties. Corrupt government officials may steal money that has been given as aid or raised as tax revenue. They might also be bribed to prefer certain firms when issuing contracts.