FOREIGN INVESTMENT

Brigid Gavin* and Jerome Haegeli**

International Investment Rules andCapital Mobility

Considerations in Light of the Asian Financial CrisisIn the wake of the Asian financial crisis a number of questions related to free movementof capital are being reconsidered. Is it desirable to have full capital mobility for emerging

market economies? Will capital account liberalisation lead to a growing number offinancial crises which will threaten the stability of the international financial system?

The international institutional architecture, whichwas designed to deal with the post world war twoeconomic situation, has become outmoded. The legalframework governing international trade, which wasestablished under the General Agreement on Tariffsand Trade (GATT), has been revised and expandedunder the new World Trade Organisation (WTO). But ithas no comprehensive set of rules for multinationalcorporations (MNCs) which are major locomotives ofinvestment in the global economy. The foundingcharter of the International Monetary fund (IMF) didnot equip the organisation to deal with the enormousprivate capital flows which have grown in the globaleconomy since the 1980s as portfolio investmentflows and international bank lending have increaseddramatically.

The existing international investment regime is apatchwork of numerous bilateral treaties and agrowing number of regional and multilateral agree-ments. This is an unbalanced architectural structurebased on weak foundations and multiple layers ofoverlapping and inconsistent regulations. The debateabout international investment rules so far hasconcentrated on foreign direct investment (FDI). Thistype of investment is increasingly considered to be analternative mode to traditional exporting as a meansfor companies to service foreign markets. Conse-quently, the well know principles, which have beenused for the liberalisation of trade, are now beingapplied to FDI.1

But foreign investment is more complex thanforeign trade because investment requires capitalmobility as well as market access. Therefore, a com-prehensive set of rules for foreign investment mustcover both the trade and finance related aspects ofinvestment. This implies the need for joint implemen-tation of rules between the international institutionswith competence in matters of trade and finance.Furthermore, the process of establishing multilateralrules based on the codification of best existingpractices currently embodied in bilateral investmenttreaties and in regional economic agreements is anecessary but not sufficient condition for the estab-lishment of a strong and credible legal framework forglobal investment. Of equal importance is therestructuring of the competences of existing inter-national organisations to ensure consistency betweenthe two sets of rules governing international trade andfinance.

A future multilateral agreement on investment(MAI), which is expected to be negotiated in the WTO,will need, to establish a coherent set of rules for theliberalisation of 'full investment'.2 The scope of the

* Europa Institut, University of Basle, Switzerland. ** University ofBasle, Switzerland, and Harvard University, USA.

1 See the Multilateral Agreement on Investment, Consolidated Text

and Commentary, OECD, Directorate for Financial, Fiscal andEnterprise Affairs Negotiating Group on the MAI, Paris 1997.2 For the EU position on multilateral investment rules in the WTO, see

European Commission: A Level Playing Field for Direct InvestmentWorld Wide, Office for Official Publications of the European Com-munities, Luxembourg 1995. For the position of the developingcountries see A. V. G a n e s a n : Strategic Options available toDeveloping Countries with regard to a Multilateral Agreement on In-vestment, United Nations Conference on Trade and Development(UNCTAD), Discussion Paper No. 134, Geneva 1998.

INTERECONOMICS, January/February 1999 27

FOREIGN INVESTMENT

agreement should go beyond FDI to include portfolioinvestment including stocks and bonds, and debtcapital including bank lending. Such an agreement isnecessary because the different channels throughwhich capital flows internationally have now becomeintegrated to such an extent that a sectoral agreementfor FDI alone would not only be discriminatory butalso infeasible from the point of view of its adminis-tration.

A multilateral agreement which seeks to liberalise'full investment' would require complete liberalisationof the capital account of the balance of payments, inother words complete freedom of capital movement.For the industrialised countries, this has already beenlargely achieved as their financial markets have,become increasingly integrated since the 1980s. Inemerging markets the liberalisation of capital marketshas gathered momentum since the 1990s. This hasbeen accompanied by - and perhaps also motivatedby - increasing discussion in academic and policy-making forums on the need for financial liberalisationas an instrument of economic growth in thesecountries.3

But in the wake of the Asian financial crisis anumber of questions related to free movement ofcapital are being reconsidered. Is it desirable to havefull capital mobility for emerging market economies?Will capital account liberalisation lead to a growingnumber of financial crises which will threaten thestability of the international financial system? There is,therefore, need for careful consideration of howinvestment rules should deal with capital mobility.

This paper will focus on investment rules andcapital mobility and the implications for the stability ofthe international financial system. First, we shallanalyse the growing links between the three majorcategories of private capital flows in the globaleconomy. We shall then present an analysis of themain features of the Asian financial crisis and examinethe issues concerning investment and capital flowswhich have emanated from this crisis. This will befollowed by a discussion of the existing institutionalarrangements for the liberalisation of capital move-

3 For an overview of the literature on the links between the financial

system and economic growth see M. Ge r t l e r : Financial Structureand Aggregate Economic Activity: An Overview, in: Journal of Money,Banking and Credit, 20, 1998, Part 2, pp. 559-88. For a discussion offinancial development see R. K i n g , R. Lev ine : Financial Inter-mediation and Economic Development in: C. Mayer , X. V ives(eds.): Capital Markets and Financial Intermediation, Cambridge Uni-versity Press, Cambridge 1993.4 International Monetary Fund: Balance of Payments Manual, 5th Edi-

tion, Washington D.C. 1993.

ments. Finally we shall discuss how future negotia-tions for investment liberalisation present anopportunity which should be used to strengthen thearchitecture of the international financial system.

International Investment and Capital FlowsForeign investment requires capital mobility, pri-

marily in equity and debt, across national frontiers.Capital flows in the global economy are comprised ofthree major categories, direct equity investment, port-folio equity investment and international bank lending.As will be shown below, the boundaries betweenthese three categories have become increasinglyblurred.

Foreign Direct InvestmentThe conventional distinction between foreign direct

investment (FDI) and foreign portfolio investmenthinges on whether the foreign investor can exercisecontrol over managerial decisions of the business. Inthe standard definition of FDI given by the IMF, directinvestment is made to acquire a 'lasting interest' in anenterprise operating in a foreign country and theinvestor's purpose is to have 'an effective voice in themanagement of the enterprise'.4

The investing firm acquires an effective voice orcontrol in management by owning a certain equitycapital stake. It is considered by,the IMF that a stakeof 10 per cent of the ordinary shares or voting poweris the threshold for achieving control. However, not allcountries follow IMF guidelines. There are substantialdifferences between countries' definitions of control.Some countries, such as Germany, define 20 per centof share ownership or higher as the threshold forcontrol. Therefore, the boundary between direct andportfolio investment is somewhat arbitrary. A furthergrey area is found in the measurement of FDI.

FDI flows are recorded in the IMF balance ofpayments statistics as long-term capital outflows andinflows between the parent enterprise in the homecountry and the foreign affiliates which it controls inthe host country. According to this approach FDI iscomprised of three components: foreign investor'sinitial equity capital, subsequent reinvested earningsand intra-company loans and debt transactionsbetween the parent and foreign affiliate enterprises.Only internal sources of funds for financing FDI arerecorded.

The problem with this method of accounting is thatit excludes external sources of funds for financingFDI. Foreign affiliates can finance their investment by

28 INTERECONOMICS, January/February 1999

FOREIGN INVESTMENT

borrowing from local or international lenders, or canraise funds in the domestic or international capitalmarkets. They can also raise equity capital from localand international minority shareholders if the foreignparent does not hold 100 per cent ownership.5

Multinational Corporations and Debt FinanceMultinational corporations are considered as a form

of international equity finance but they are also avehicle for international debt finance. In fact, theyhave acted as a catalyst for the unprecedentedgrowth of private bank lending since the 1960sthrough the development of interbank lending. It wasthe growth of multinational corporations which led tothe parallel growth of multinational banking in theglobal economy.

Multinational banking concerns the ownership ofbanking facilities in the economy of one country byresidents in a foreign country. The initial motivation forthe emergence of multinational banks was the'defensive' strategy of following their corporate clientsabroad for fear of losing their business to local banksin the foreign market. But the early practice ofmultinational service banking rapidly evolved intomultinational wholesale banking.6

This has created a global network for internationalcapital flows which represents the equivalent of aglobal federal funds market. It is the multinationalwholsale banking network which has become themain conduit for international capital flows through itslarge volume of interbank lending. Multinational banksmay increase the efficiency of international capitalflows and if this is so they will be welfare increasing.But if distortions exist in domestic capital markets,then international capital flows may have harmfuleffects on countries.

Foreign Portfolio InvestmentThe growth of foreign portfolio investment flows

since the 1980s reflects the growing importance ofnew investors such as pension funds, insurancecompanies and investment funds on global financial

5 See E. M. G r a h a m : Foreign Direct Investment in the World

Economy, IMF Working Paper, Washington D.C. 1995.6 For the theory of multinational banks see H. G r u b e l : A Theory of

Multinational Banking, in: Banca Nazionale Del Lavoro QuarterlyReview, No. 123, 1977, pp. 349-63. See also J. M. Gray, H. P.Gray : The Multinational Bank: A Financial MNC, in: Journal ofBanking and Finance, 5, 1, 1981, pp. 33-63.7 For an analysis of the role of portfolio investment in emerging

markets, and the links between portfolio and direct investment, seeUnited Nations Conference on Trade and Development (UNCTAD):World Investment Report, Geneva 1997.

markets. Flows of portfolio investment normally takeplace through transactions involving shares ofcompanies quoted on stock markets. But they canalso take place through flows of finance to unquotedcompanies via venture capitalists. Portfolio capitalinflows contribute directly to the financing of domesticindustry in the host country when the investment ismade for primary issues on the local stock market orin international markets through equity offerings orissues of depository receipts. Portfolio capital inflowscan also be used for share purchases in the localsecondary market. The latter indirectly finances localfirms by pushing up the price of equity and therebylowering the cost of capital in the stock market andconsequently encouraging new issues. This willupgrade the domestic private sector and, thereby,also make the country more attractive to foreign directinvestors.7

Concern over portfolio investment flows ismotivated by the more short-term, speculative nature

Table 1Capital Flows and Reserves in Asia

and Latin America(in billions of US dollars, at annual rates)

TotalChina

(Other Asia1BrazilMexicoOther LatinAmerica2

TotalChinaOther Asia1BrazilMexicoOther. LatinAmerica2

TotalChinaOther Asia1BrazilMexicoOther LatinAmerica2

1980-90

12.91.9'4.73.81 . 6

0.8

13.81.2a6.81.02.1

2.7

13.32.7a

10.5-0.10.6

-0.4

1991

r52.5-1.926.2

2.520.6

5.0I

12.82.98.3

-1.42.4

0.6

55.514.125.2-0.48.2

8.4

1992 1993 1994 1995

J^et private capital inflows81.311.719.39.1

23.6

17.6

99.17.8

34.09.9

30.3

17.0

78.714.626.89.1

10.3

18.0

77.713.937.631.8

-13.2

7.6Viet official capital inflows

19.85.4

13.3-0.52.0

-0.4

13.25.65.7

-1.2-0.9

3.9

13.89.33.7

-0.70.3

1.2Net increase in reserves

71.423.225.714.7

1.2

6.6

59.21.8

37.18.76.1

5.5

48.530.523.8

7.2-18.9

5.9

33.86.91.9

-0.724.5

1.1

62.622.516.212.910.7

0.4

1996

149.823.056.835.413.5

21.1

0.97.03.8

-1.8-10.0

1.8

83.231.425.8

9.31.8

14.9

Note: Capital flows are calculated as the difference between thecurrent account and the the change in reserves; private flows arecalcualted as a residual from an estimate of official flows."1982-90.1 India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan

and Thailand.2 Argentina, Chile, Columbia, Peru, Venezuela.

S o u r c e : BIS 67th Annual Report (1997), p. 99; IMF Balance ofPayments Statistics and Institute of International Finance.

INTERECONOMICS, January/February 1999 29

FOREIGN INVESTMENT

Table 2Bank Credit Expansion and Indicators of the Banking Industry in Asian countries

Bank credit to the private sector1 Indicators of the banking industryAnnual rate of As a percentage Operating Net interest margin

expansion2 of GDP costs1981-89 1990-97" 1997 1990-94 1995-96 1990-94 1995-96

China3Hong KongTaiwanIndonesiaKoreaMalaysiaPhilippinesSingaporeThailand

Memo items:United StatesJapanG-10 Europe"

121315221311-51015

586

138

13181216

' 181218

0.51.54

971571385764955297

105

6511189

1.00.1 "1.32.31.9C

1.6"4.00.81.9

3.71.02.1

1.40.41.32.82.11.4 "3.50.71.8

3.41.11.9

1.70.2"2.13.32.2C

4.7"5.32.23.6

4.11.22.3

2.20.32.23.62.23.24.82.0