By Dhanusha Pathirana –

Dhanusha Pathirana

Is Foreign Investment a Source of Non-debt Foreign Savings?

We may now allude to our economists’ belief that FDIs assist to overcome the shortage of capital in the host economy (assuming for the moment that there is a shortage of domestic capital to which we shall return later) and hence tend to bridge the gap in aggregate investments and savings. The true nature of these ideas can be drawn out based on the quantitative and qualitative impact of foreign investments on the Sri Lankan economy. A look at the composition and nature of foreign investments in Sri Lanka would assist us in this pursuit. Sri Lanka’s Board of Investment data reveals that 77% of FDIs are exploiting the domestic market demand and are doing so in sectors which are unlikely to compete with imports or expand exports of the host economy. That is to say foreign direct investments are flowing into nontradables (trade, telecommunication, infrastructure, tourism, etc) which is a sector that cannot be penetrated by the overseas investors in the absence of physical presence of investments in the desired economy. (In tourism however, both tradability and nontradability exists in conjunction) Consequently, deficit in the economy’s current account of the balance of payments tends to grow when factor incomes of foreign investors are repatriated. This is so when FDIs are flowing into nontradable sector of the economy, the greater portion of incomes generated by FDIs tends to be in the form of local currency units and do not generate foreign exchange as the output of FDIs do not enter international trade nor replace the imports of the host economy with localised production.

Therefore, when incomes accrued to foreign investments are repatriated the result would be a net outflow of factor incomes from the economy of domicile. The graph below empirically illustrates this feature: repatriated factor income (refer to the standard presentation of the balance of payments – BPM 5) comprehensively exceeds the net inflow of FDIs over the years. The gap between net FDIs and the repatriated factor incomes as a share of current account deficit for the past three years averaged as much as 15.1% suggesting that the effect of specific structural attributes of foreign investment on economy’s external stability has not been ‘bridging’ the investments/savings gap as assumed by our economists but on the contrary, has been widening it. FDIs have not been offsetting the shortages of capital in the host economy but on the contrary have been intensifying it. Hence, the common view held by economists that Sri Lanka should attract FDIs to bridge the gap in the current account of balance of payments rather than debt capital needs a reality check, given that the type of FDIs received by Sri Lanka tends to bear on the current account position and the availability of capital in the economy.

Macroeconomic Determinants of the Structure of Foreign Investments

The economic phenomena that determine the technological composition of foreign investments into underdeveloped economies will be examined in the following section given that we have shown earlier in our account that FDIs into Sri Lanka have not been technology transferring type. An overview of the aggregate production process may enable us to proceed further in this path. Production in general is a process that combines technologically stagnant operations occupying relatively constant capital to labour ratio over the long run together with technologically dynamic operations that constantly raise the volume of capital invested relative to working capital and hence increase productivity and real factor incomes of both capital and labour. This is to say that the composition of production in general involves an integration of both technologically intensive and technologically neutral operations which can however, be spatially separated. For instance, the manufacturing of an automobile involves both capital and labour intensive operations which can be geographically separated. Assembly works consisting of technologically stagnant operations tend to allow a stable capital to labour ratio over the long run while production of component parts readily allows the application of modern technology and science to the production process. Integration of the two processes bearing the two antithetical forms of factor proportions manifests the general procedure of production.

However, given that the two types of operations can be geographically separated, the structural composition of direct investment flows across national boundaries tend to adhere to the existing technological organisation of the host economy and in turn concentrate labour intensive operations within developing regions and capital intensive production processes within the advanced regions of the world economy. Hence, the factor proportions of FDIs tend to adhere to the factor proportions and the particular form of factor organisation of the economy of domicile and hence do not necessarily seek to alter or transform the organisational structure of the host economy. This phenomenon is further enforced by the fact that for an economy to receive technologically intensive investments the host economy should possess an ancillary industrial structure to allow and facilitate such qualitatively advanced forms of foreign investments to take root. That is to say that a domestic network of ancillary industries (for instance iron & steel industry and a chemical industry) is required to supply the diverse requirements of capital intensive manufacturing.

Source: BOISL

This is so because unlike the technologically neutral investments, the technologically progressive industries require a network of supportive industries that are capable of supplying its diverse material requirements which tends to draw supplies from many other related industries, hence providing a self expansionary effect on investments and interdependency among industries in the host economy. Therefore, a prior industrial organisation of the host economy based on domestic investments is necessary for capital intensive forms of foreign production to expand in the economy. This is further reinforced by the fact that cross border flow of technologically neutral investments being far more liquid compared to that of capital intensive investments earning the name ‘footloose industries’. This is so given that technologically dynamic foreign investments demand a whole range of production networks to be transferred geographically if a supportive industrial infrastructure is not available in the host economy, alluding to the fact that capital intensive manufacturing investments are less liquid across national boundaries. This suggests that the absence or presence of a preliminary industrial development in the host country through domestic investments determines the volume and structure of the flow of direct foreign investments into it. The structural and technological division within the pattern of world’s FDI flows pointed out in the discussion therefore, sets a barrier against the diffusion of technology across national boundaries through FDIs. This suggests that our economists’ conviction that foreign investments are the primal source of technological and organisational insights for an underdeveloped economy such as Sri Lanka demands revaluation.

The Role of the State and Foreign Investments in Economic Transformation: The East Asian Experience – Japan, Taiwan and South Korea

It should be mentioned at the outset that no foreign investments came into these three model economies during the initial stages of industrialisation which was characterised by the state led expansion of primary imports substitution industries based in rural districts transgressing towards secondary import substitution hand in hand with the utlisation of foreign exchange receipts of traditional exports to import producer goods. The export sector evolved with the advancement of industrial capabilities of the economy which were gained through producing initially to the more accessible and state protected domestic markets. This is to say that the import substitution policy paved the way for the expansion of manufactured exports later on in the process of industrial development in East Asia.

Source: CBSL

The industrialisation policy of the East Asian states enabled a shift in the structure of imports of the economies from consumer products towards producer goods, rationalising the use of scarce foreign exchange and domestic capital available in the economies to achieve a gradual industrial transformation. (see Economic Development in Historical Perspective: Japan, Korea and Taiwan, in ‘Japan and the Developing Countries’, ed K. Ohkawa and Gustav Ranis with Larry Meissner, 1985, for a discussion on the progression of stages of economic development shared by the three economies). This is quite the contrary to the practice in Sri Lanka where foreign exchange is put to waste in tremendous proportions both through the free market and government mechanisms.  If such a policy was adopted in Sri Lanka our good economists will hasten to condemn it by labeling it import substitution. This also goes without saying that Japan would have remained underdeveloped indefinitely and even worse off than Sri Lanka if it heeded to Sri Lankan economists (The inability of the market mechanism to direct resources efficiently to cause a structural transformation in the East Asian economies as well as in the Sri Lankan context will be explained later in the discussion).

The process of industrial development of the East Asian economies indicates that the impetus to economic transformation was lead not by foreign investments but by state directed domestic investments; by providing direction to the market forces through a central authority enabled a progressive economic outcome that was impossible to achieve through the free intercourse in the market mechanism. The state in these three model economies gave direction to the economy to alter the consumption and investment patterns to achieve modern industrial development which couldn’t be achieved through free market interactions (see for instance: Robert Wade, 1990, Governing the Market: Economic Theory and the Role of the Government in East Asian Industrialization). Nevertheless, the state’s intervention in the economy to provide it direction did not extend to the degree of centrally controlled Soviet economies which attempted to develop severely underdeveloped economies at breakneck speeds giving birth to authoritative political regimes. In this light the important conceptual position that springs from the development process of the East Asian NICs is that the initial impetus to industrial transformation was provided by domestic investments rather than FDI, marshaled under state’s guidance. This is in total contrast to the policy measures held in high esteem by our economists that inter alia assign great importance to foreign investments.

Conversely, the conditions required to attract qualitatively beneficial type of foreign investments needs to be examined. The view of our economists regarding the matter was stated in the SLEA 2013 Annual Summit and is as follows:

“But for Sri Lanka to attract FDIs, says Indraratna that just peace and law and order are not sufficient. In addition, the country should have good governance, rule of law, right to information, efficient, honest and independent public sector institutions, enlightened free media and simple rules and procedures in customs and immigration. Without these essential requirements in place, the country will have to forget about the attainment of the sustainable growth in the long run.”

“But Sri Lanka’s track record of attracting FDIs has not been that encouraging contrary to, in Usvattearatchi’s words, “widely publicised expectations”. He attributes three most important reasons to this: The poor law and order situation, faulty dispute settlement mechanisms and lack of quality manpower at middle levels.” – SLEA 2013 Annual Sessions

The conditions of attracting FDIs in general let alone the qualitatively advanced type of foreign investments are reduced to noneconomic nuances on law and order, enlightened media, etc, further reflecting the futility of the level of economic thinking. The development of an industrial infrastructure rather than flyovers and highways (productive as opposed to unproductive infrastructure) remains the initial precondition that should be met through domestic investments for progressive foreign investments to expand in an economy, which was an observable empirical phenomenon in the three model economies under review. The initial technological and organisational gap in “latecomer” economies such as Taiwan, South Korea, Japan and China was narrowed not by relying on technology transfers through FDIs but by locals acquiring the required knowledge with the assistance of foreign technologists with direct state involvement and adapting the said technologies to suit the factor proportions and factor endowments of the domestic economy (see for instance Gustav Ranis, Factor Proportions in Japanese Economic Development, Sep 1957, The American Economic Review) which is quite the contrary to the practice in Sri Lanka.  This is to say that key agents of development for the Sri Lankan economy and as for any underdeveloped economy remains to be the industrial orientation of the state’s economic policy and the corresponding character of domestic investments rather than foreign investments. Hence, a structural transformation in the general pattern of domestic investments is critical not only in enhancing the qualitative aspects of the economy but also to attract foreign investments into manufacturing as explained earlier in our discussion.

Structure of the East Asian Labour Supply and the Expansion of Domestic Industry over Foreign Investments

Let us now turn to the common structural aspects shared by Sri Lanka and the three model economies, Japan, South Korea and Taiwan with the aim of understanding the barriers to the inflow of foreign as well as domestic investments into labour intensive manufacturing. It can be pointed out that Sri Lanka is hardly receiving the labour intensive type industries through foreign investments or not to mention the domestic investments. The FDIs into the economy as well as the domestic capital formation are dominated by infrastructure, hotels, casinos, restaurants, trade etc of which capital to labour ratio is notably high preventing us from chategorising the latter as labour intensive despite their technological backwardness. This is to say that the foreign and domestic investments expanding in the economy are not that of labour absorbing type despite the production operations of investments being grounded on stagnant technique. This is a critical feature that has gone unnoticed and the current structure of investments in the economy can hence be categorised as nonindustrial capital intensive type rather than labour intensive.

Let us reflect on the organisational structure of the economy’s labour market which promotes such a typology of foreign and domestic investments. The organisation of the agricultural sector mainly influences the organisational structure of the labour force of an economy in general. The degree of mechanisation of agriculture determines the availability of labour to nonagricultural pursuits and its inter-sectoral mobility. In this light it can be stated that the inability to mechanise certain cultivation processes involved with paddy cultivation, such as water management and land preparation practices, gives birth to sharp irregularity in labour demand during the cultivation period. This creates what Marx pointed out in his Grunrisse, unevenness in labour time over production time in agriculture or in other words production time being significantly higher than the corresponding labour time in cultivation process, a condition which is alien to industry. However, in total contrast, wheat farming in Europe and U.S. and in other parts of the world allows for full scale mechanisation of all the separate cultivation processes involved, releasing the labour from the agricultural sector to be freely deployed in non-agriculture. On the other hand mechanisation of agriculture renders the demand for labour a more even function over the cultivation period. Industrialisation of agriculture eliminates the gap between production and labour time involved in cultivation and therefore underemployment of agricultural workers. This in turn, unchains the rural labour surplus from the domains of agriculture entirely, to be redeployed in nonagricultural pursuits at a regionally competitive wage rate while simultaneously reducing the labour input in agriculture reducing the unit supply price of agricultural sector. However, in contrast, the asymmetrical and incomplete mechanisation of the separate processes involved with paddy cultivation tends to enclose a large reservoir of rural labour within the limits of the rural economy, who remain underemployed due to the sporadic nature of labour demand in paddy cultivation. This is indicated by Sri Lanka’s rural population being as high as 84% of the total and lower labour force participation rate compared to the region. The general level of underemployment is also characteristic of the lower dexterity of rural workers as they are unaccustomed to regulated regiment of work ethic found in the nonagricultural sector.

This is to say that the purpose of industrialisation of agriculture is not only to increase productivity of agricultural labour but also to make the demand for labour an even function throughout the cultivation period and hence avoiding long spells of idle labour time during the cultivation period. This entrapment of economy’s reservoir of labour within the rural confines due to reasons discussed above renders it impractical to be freely deployed in nonagricultural pursuits; hence, a large section of the labour force remains nonresponsive to the demands of the free market mechanism. Hence, despite the fact that a significant degree of idle labour time does exist within the rural economy, given that rural labour is not continuously employed nor unemployed throughout the year and hence locked up within the bounds of agriculture, labour is not freely available to be deployed in other sectors of the economy. This is so because non-agricultural investments unlike agriculture in general require a continuous deployment of labour, access to which is prevented by the unevenness of labour absorption pattern in the paddy economy, triggering labour shortages in industry and services sectors of the economy while the rural labour surplus is largely underutilised. The key factor to be noted in this formulation is the irregularity in the availability of labour surplus prevalent in the rural economy which renders it unemployable in industry (see Professor S. B. D. De Silva, unpublished thesis on the theory of surplus labour, 1972).

This phenomenon on the other hand tends to raise the level of domestic nominal wages beyond that of the region even before the entire volume of labour surplus in the economy is fully exhausted while productivity of labour remains stagnant hence producing uneven real wage/productivity ratios across economies. This is indicated by relatively higher nominal wages in Sri Lanka than those in the region hand in hand with the existence of rural underemployment while economy’s labour productivity remains below that of the region. The inflow of foreign investments as well as domestic investments into manufacturing is restricted by this peculiar and irrational organisational structure of labour. As a result the development of an indigenous industrial class in the economy is obstructed whilst the combined financial strength and economic dominance of merchant, finance, construction and other unproductive classes strengthen. This is to say the structure of labour organisation in the economy promotes the growth of nonindustrial capital intensive type foreign and domestic investments as opposed to manufacturing industry. This is further reflected by the structural similarity of foreign and domestic investments which are both largely concentrating on nonindustrial capital intensive processes.

The current literature on the theory of foreign investments (The Production Cycle Theory of Vernon (1966), The Theory of Exchange Rates on Imperfect Capital Markets (1981), The Internalisation Theory (1983) and The Eclectic Paradigm of Dunning (1988)) with its MNC centric disposition do not capture the central attribute which determines the cross-border flow of manufacturing investments. This can be attributed to the fact that theorizing on FDI has been grounded on the approach of the multinational companies’ (MNCs) decision making process rather than on the world division of labour between advanced and underdeveloped economies and the factors causing a concentration of advanced production processes in first world economies and the technologically neutral forms of production in underdeveloped regions.

To be continued..