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Flows of capital

Link to economic growth

Access to foreign capital allows domestic investment to exceed domestic saving. The ability to access foreign saving allows countries to run current account deficits and support their economic growth.[51] Foreign saving is, however, not a perfect substitute for domestic saving because information asymmetries between savers and investors increase with distance. These asymmetries may bias the destination of foreign saving toward funding debt and foreign direct investment rather than, for example, early stage finance. Foreign saving can also raise issues of increased risk premium (from country macroeconomic risk), taxation distortions, and ‘home bias' effects. Consequently, domestic saving and capital market development are also important.[52]

Foreign students enrolled in tertiary education - % of all tertiary enrolment, 2006
Foreign direct investment - % of GDP, 2005.
Source:  OECD

Foreign-owned firms are generally more productive than domestic firms. Studies find that, on average, foreign-owned firms have higher productivity than domestic-owned firms.[53] The management practices of foreign-owned firms are also found to be generally better.[54] Causality is difficult to determine, as there may be an element of ‘self-selection', where foreign investors select the better performing firms, though it seems plausible that there is also a transfer of knowledge from abroad.

Foreign direct investment (FDI) can have different motivations. Efficiency-seeking FDI is motivated by low cost production inputs, such as low labour costs or a low tax regime. Resource-seeking FDI looks to gain access to natural resources or high quality production inputs. Market-seeking FDI is motivated by improved access to the host economy market or third markets (e.g. to get past border barriers), perhaps to exploit economies of scale. Knowledge-seeking FDI looks to gain access to particular specialised knowledge. As discussed below, New Zealand's FDI appears to be predominantly market-seeking.

FDI provides spillovers than can improve productivity. FDI is often accompanied by financial and business expertise and skills, and through ‘demonstration effects' can allow domestic firms to imitate more advanced products or processes.[55] Multinational companies may reduce barriers to accessing international distribution networks. FDI can also stimulate domestic competition to reallocate resources to more productive firms as inefficient firms are forced out Competition in the services sector may be particularly important given that many services are not traded.

-87%
New Zealand's international investment position as a proportion of GDP (as at 31 March 2008)
Source: Statistics New Zealand

Spillovers from FDI do not fall evenly. Spillovers tend to occur vertically (forward and backward in the production chain) rather than horizontally (firms in the same industry), since multinationals have an incentive to prevent knowledge spillovers to competing firms, but have an incentive to assist upstream and downstream firms. Spillovers also vary between sectors.[56] Trade openness and FDI openness tend to be complements. Spillovers tend to be greater if the host country is closer to the technology frontier and has competitive markets.[57]

Greenfield and tradeable FDI are not necessarily better. There is no strong evidence that spillovers are greater from FDI in ‘greenfields' (new facilities) versus ‘brownfields' (mergers and acquisitions, or M&A), nor in tradeable sectors versus non-tradeable. M&A involves incremental investments and may have a more rapid effect on productivity.[58]

A wide range of policy settings influence FDI. The most important factors that influence an FDI decision depend on the motivation for the FDI. For example, market-seeking FDI may be more interested in general legal institutions, whereas resource-seeking FDI would be concerned with ease of access to particular resources. A broad scan of different policy settings that influence FDI is set out in Figure 3.

54%
Proportion of New Zealand's FDI that comes from Australia (as at 31 March 2008)
Source: Statistics New Zealand

The effectiveness of FDI incentives is probably low. The fact that FDI creates spillovers suggests a prima facie case for government intervention to boost FDI, and many countries offer some form of incentives, such as tax holidays. Incentives are more likely to be beneficial for some types of FDI, such as efficiency-seeking FDI (which is internationally mobile) rather than market-seeking FDI (where the main purpose of locating is access to the market itself). The available evidence suggests incentives probably do have an effect on increasing FDI, but it is unclear that this delivers an overall net economic benefit.[59] Difficulties exist in targeting incentives correctly and there is a risk of inciting tax competition.[60]

No strong evidence exists on spillovers from outward direct investment (ODI). Little evidence is available on spillovers from ODI, and what is available does not suggest strong spillovers. This finding does not mean ODI is unimportant - for small countries, market-seeking ODI could provide a means of achieving economies of scale, for example. The finding does suggest, however, that the benefits to ODI are largely captured by the firms themselves.

Notes

  • [51]For example, Makin et al (2008) investigated the impact on net national income and estimated that capital inflows increased income per worker by $3,000 (in 2007 dollars) cumulatively between 1988 and 2006.
  • [52]Treasury (2007) summarised the theory and evidence on saving and highlighted, among other things, the macroeconomic vulnerabilities from low domestic saving.
  • [53]For example, Figure 11 of Fabling et al (2008) shows the distribution for New Zealand firms.
  • [54]For example, see Bloom et al (2007) for international evidence and Knuckey et al (2002) for New Zealand evidence.
  • [55]For example, Görg and Greenaway (2003) summarise the literature and find that spillovers do exist, but the magnitude depends on the type of investment and the absorptive capacity of domestic firms. Keller and Yeaple (2003) found that productivity spillovers account for 14 per cent of growth in US firms between 1987 and 1996.
  • [56]For example, Lesher and Miroudot (2008) found the strongest spillovers in the services sector, especially via backward linkages.
  • [57]For example, Girma and Görg (2005) used establishment level data from the UK and found that firms need to be within 90% of the industry technology frontier to benefit from spillovers.
  • [58]For example, see Sanderson (2006), OECD (2007b).
  • [59]For example, Haskel et al (2002) found that productivity spillovers from foreign investment are often several times less than the amount paid in subsidies to attract them.
  • [60]For example, see Klemm (2009) for a recent literature survey.
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