The FDI importance for the economy: an injection and leakage function towards achieving economic equilibrium

Since the Washington Consensus, a more liberal economic policy orientation towards the benefits of foreign investment and privatization emerged as the new normality of economic decision-making.
Published by
Central Office
on February 16, 2024
on February 16, 2024
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Investments in industry modernization have become an important engine of economic growth for many developing countries.

Since the Washington Consensus dominated the international economic agenda at the end of the 1970s, a more liberal economic policy orientation towards the benefits of free trade, foreign investment and privatization emerged as the new normality of economic decision-making. As the benefits of free trade remain a subject that will be analyzed on another occasion, I will try to briefly explain in the following paragraphs the advantages of foreign direct investments (FDI) and privatization for a national economy, more specifically their role in stimulating the national income flow towards an equilibrium without excesses in spending or production.

Foreign direct investments (FDI) are of two types: inward and outward. While the former is represented by the sale of domestic (either public or private) assets in exchange for foreign capital, the latter is the described by the buying of foreign assets for cash. Both affect the national circular flow of income regardless of who is engaging in outward FDI, and who is in inward FDI. Imagine the national economy as a circle of four elements: output (AY), income (I), consumption (C) and spending (or demand/expenditure) noted as (AE). Since the economy works circularly, each component affects the other. Through production, output determines income; through the level of savings and taxes, income affects consumption, and depending on income, consumption can affect the aggregate spending which in turn determines the level of output. When one component is hit by upward or downward movements of the business cycle, the entire economic circular flow is to be targeted. In a recession, as the level of income goes down, there is less money to be spent on product demand. Therefore, companies decide to limit production and cut off from the labour force, increasing the already lack of income needed to demand more output. In that scenario AE<AY. Alternatively, when the economy is growing more than it needs to accommodate the national resources (AE>AY), more surplus income raises the demand for products to new highs, which in turn increases production and sets the prices upwards, eroding real wages as the national economy is switching from a recessionist cycle towards an inflationist one. Therefore, an equilibrium in the economy would occur when aggregate expenditure (AE) equals output (AY) [AE=AY]. The role of FDI (both inward and outward) is to contribute to achieving this equilibrium so that the national economy does not go through either recession or inflation. Since production generates income for households to consume, and depending on the level of income after taxation, the household decides how much to consume or save out of their total, other determinants of consumption such as private investment (Ii) and government spending (G) depend on the expected profit generated by investments in the case of the former, and the nature of public budget (deficit or surplus) for the latter. Imagine that a national economy does not generate sufficient income to determine households to spend more and save less. Additionally, the uncertainty of the national business environment determines the (Ii) to hold investment for the moment, while a deep budget deficit keeps the government on alert before increasing its investments and public consumption (G). At the end of the day AE < AY. The importance of inward FDI here is to generate the needed additional injections in the circular economy, so that the flow of income can be restored to an AE=AY equilibrium. There are many ways foreign investment could contribute to this. First, privatization is a necessary step on the part of the government to generate cash in exchange for the sale of national assets to foreign capital. Depending on the level and scale of privatization and the value of assets sold, the national budget could turn from deficit to surplus, thus increasing the G component from AE. Moreover, since FDI represents the total or partial control over the assets purchased by the investor, the production function of the asset will correspond to the business strategies of the foreign capital. This could raise production directly (AY) when the investment trust decides to raise the output capacity. Additionally, foreign capital could invest in the opening of new businesses in the country, creating employment and thus more household income (I) to be spent and contribute to AE. At the end of the day, and following the political approval of inward FDI, AE increases towards achieving the equilibrium at AE=AY. On the other hand, imagine the national economy is booming uncontrolled, there is too much income, too much household consumption (taxes and savings are low) and excessively private investment and government spending. At the end of the day AE>AY, leading the economy to an inflationary cycle. The role of outward FDI here is one of leakage function, mainly to take the national income surpluses out of the national economy and distribute them abroad as investment in other markets. Rather than investing at home, private initiative could invest in buying all or part of a business in another country. Moreover, it could invest in the foreign national infrastructure thus doing the job of the domestic government caught in a budget deficit. Lastly, government intending to proceed with outward FDI could invest its budget surpluses abroad by partially or fully purchasing a foreign public asset or business. At the end of the day, the country initiating outward FDI reaches an equilibrium at AE=AY, while the transfer of income abroad contributes to the same equilibrium for the country involved in inward FDI.

Based on the available evidence, the advantages of both inward and outward FDI for the national economy are well recognized. While in a closed economy everything that is produced and not consumed is saved and potentially used for investment, in an open economy any discrepancy in terms of output, income and public and private consumption and investment can be recalibrated by foreign investments. Taking into consideration that in a closed economy, the aggregate level of savings is available for investment, it means that the level of income (income - consumption = savings) determines the scale of investment in the economy. If income is low, consumption and savings are low, and consequently investment is insufficient to raise the aggregate spending enough for the national economy to escape from a recession. The same happens when the level of income is too high. On the other hand, in an open economy, the role of the FDI is to provide the function of injection or leakage when the domestic components of the circular flow of income cannot bring the economy towards an AE=AY equilibrium, and thus evade the constraints in terms of additional income that a closed economy faces.

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