DEVELOPMENT ECONOMICS:

PROBLEMS AND POLICIES

(Econ 3394 - Winter 2025)

TOPIC 4: FINANCING ECONOMIC DEVELOPMENT

LECTURE 2: Financing Economic Development From

External Sources

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 Topics
1. The Role of External Finance in Development
2. Foreign Direct Investment Flows
3. Portfolio Investment Flows
4. Worker’s Remittances
5. Official Development Assistance/AID

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 1. The Role of External Finance -The Two-Gap Model
■ Investment cannot exceed available
■ savings (foreign plus domestic)
■ If available savings (foreign and
domestic) exceed desired investment,
the country does not face a savings
gap
■ The constraint is not binding
■ If the rate of investment is
constrained by available saving, the
country faces a savings gap
■ Investment is equal to saving but below
the desired level
■ The constraint is binding
■ The savings gap (or savings
constraint) can be released by:
■ Increasing the domestic savings rate
(sY)
■ Increasing foreign capital inflows (F)
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 The Role of External Finance -The Two-Gap Model
■ Any excess of imports over exports must be
■ financed by foreign capital inflows (or foreign
savings)
■ If available foreign capital inflows is sufficient
to finance the excess of imports over exports,
the country does not face a foreign exchange
gap
■ The foreign exchange constraint is not binding
■ If the excess of imports over exports is limited
by the availability of foreign savings, the
country faces a foreign exchange gap
■ There may be sufficient savings for desired
investment but not enough foreign exchange to
purchase necessary imported inputs
■ The foreign exchange constraint is binding
■ The foreign exchange gap (or constraint) can be
released only by:
■ Increasing foreign capital inflows (F)
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 The Role of External Finance – Types of Flows
■ Net Foreign Saving is, ■ Foreign Direct Investment
by accounting ■ Direct participation in domestic
definitions, the enterprises by foreign
difference between (multinational) enterprises
domestic investment ■ > 10% of voting stock (when
and domestic saving equity is purchased)
(public and private)
■ Portfolio Investment
■ In its strictest ■ Purchase of domestic financial
definition, it generally
instruments by foreigners
takes four forms
■ Can take the form of equity or

bond purchases
■ <10% of voting stock (when

equity is purchased)
The Nature of Foreign Capital Inflows
■ Direct Foreign Borrowing ■ Personal Remittances
■ Public Borrowing
■ Personal transfers from
■ Bilateral, Multilateral, Private migrants abroad and
■ Private Borrowing wages (compensation) of
■ Bank loans and (rarely) bond employees working
issues abroad
■ We looked at these in the last ■ Not all personal
lecture remittances can be
■ Official Development Assistance classified as foreign
(Loans) saving, but it does help to
■ Concessional financing from
release the foreign
foreign bilateral and multilateral exchange constraint
agencies
■ Concessional loans (≤ 75% of
market equivalent)
■ Grants
2. Foreign Direct Investment
■ Most foreign direct investment (FDI) is undertaken by
multinational (or transnational) corporations (MNCs/TNCs)
■ A corporation or enterprise that conducts and controls
productive activities in more than one country.
■ Most multinationals are confined to developed countries
(North America, Europe and Japan) but increasingly
multinationals include operations in developing countries
■ Some developing country multinationals operate only in
developing countries or in both developed and developing
countries
■ Petrobras, Tata Steel, Cemex, Huawei, etc.
■ These firms may be public or private sector firms
 Foreign Direct Investment (FDI)
■ FDI to developing countries has increased since the 1990s
and especially since the early 2000s
■ It now represents the largest flow of capital to developing
countries
■ However, it has been quite volatile, especially since 2008
■ Though developed countries continue to be the main
recipients of FDI, middle-income countries are claiming an
increasing share of global FDI
■ Low-income countries, however, receive very little FDI
■ Most of what they receive is related to resource extraction
■ Most of the profits generated by MNCs is repatriated to
investor countries (mostly developed)

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 Foreign Direct Investment (FDI)
■ The effect of FDI on long-term growth in developing
countries depends on how the differing objectives of MNCs
and developing country governments are reconciled
■ Multinational corporations are:
■ Motivated by profit maximization
■ Large and often with larger incomes than the GDI of most
developing countries
■ That means both market and non-market power
■ Willing to use available leverage to advance their interests
■ Developing country governments are motivated by:
■ A desire to fill the savings and/or foreign exchange gap
■ A desire to obtain technology and other advantages from
MNCs
■ Would prefer extensive domestic linkages and the reinvestment
of profits by MNCs
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Foreign Direct Investments
■ The case for MNCs
■ Import of Capital (filling the savings gap)
■ Filling the foreign exchange gap
■ However, that could be reversed over the
long term
■ Source of tax revenue
■ Access to management experience,
entrepreneurial abilities, and technological
skills
■ The hope is that this is transferred to local
enterprises
■ Access to new technologies
 Foreign Direct Investments
■ The case against MNCs - ■ The detrimental effects of
economic the use of market power to
■ They may crowd out domestic dominate local markets may
investment and stifle domestic negate any benefits from the
entrepreneurship transfer of managerial and
■ Their relative size and greater other skills
experience gives them a major
advantage
■ MNCs may reduce net foreign
exchange earnings in the long
run
■ Repatriated profits and a high
import content of production
■ They often pay less tax than
they should
■ They negotiate tax concessions
■ Transfer pricing is used to
understate profits
 Foreign Direct Investments
■ The case against MNCs – structural ■ MNCs may use their power to
and political exercise political influence
■ MNCs reinforce dualistic economic ■ Success depends on the degree to
structures and exacerbate inequalities
■ Divert resources from food to luxury which the objectives of MNCs
goods and from rural to urban coincide (or are made to
■ Stimulate inappropriate consumption coincide) with the development
patterns objectives of developing country
■ Niche market production and a high governments
import content of production
■ Domestic resources are allocated to ■ Singapore/China/ASEAN
socially undesirable projects
■ MNCs use their power to direct
government policies in ways that
enhance their profits but are
unfavourable to development
■ The suppression of local
entrepreneurship may have long-term
developmental impacts
3. Portfolio Investment
■ Purchase, by foreigners, of domestic equity securities (stocks) and
debt securities (bonds, certificates of deposit, commercial paper
etc.)
■ The liberalization efforts encouraged by the Washington
Consensus, the growth of domestic financial sectors in
middle-income countries, and the creation of bond and equity
markets by the Brady Plan generated new avenues for portfolio
investment in the 1990s
■ Before this, portfolio investment was largely confined to developed
countries
■ It is, however, by far the most volatile of foreign capital flows
 Portfolio Investment Flows

■ Advantages of Portfolio Investment ■ Portfolio flows are

■ A means of raising capital for local complicit in all of the
firms major financial crises of
■ Financing without the surrender of the last few decades
domestic ownership rights
■ From Mexico in 1994 to the
■ Disadvantages Global Financial Crisis of
■ Most investment is short-term and 2008
highly volatile
■ It is highly unequally distributed
across countries
■ As a result, the movement of portfolio
flows can be very destabilizing
■ These flows may disappear quickly if
local profit opportunities are seen to be
declining (or at risk) or if more attractive
options exist elsewhere
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 4. Personal Remittances
■ Personal remittances comprise personal
transfers (transfers account) and
compensation of employees (income
account)
■ It is the most stable of the capital inflows
■ In fact, it tends to be anticyclical
■ It has been increasing steadily since the
1990s
■ Some of that increase comes from better
measurement
■ However, its distribution favours
middle-income countries
■ The benefit of these flows must be
balanced against the brain drain that it
might represent
■ This is less of a concern when the labour
is unskilled
■ A significant amount of remittances come
from developing countries
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 5. Official Development Assistance
■ Inflows that are non-commercial in intent and concessional in
nature
■ There are four main types of Official Development Assistance
■ Concessional Loans
■ Grants
■ Technical Assistance (Provision of skill or technology)
■ Emergency Aid (food, medical and other assistance)
■ Concessional Loans
■ Loans provided on better-than-market terms
■ With respect to interest rate and/or repayment period
■ 25% or more grant element qualifies as ODA
■ The main sources are international financial institutions
(multilateral) and other governments (bilateral)
■ Multilateral - World Bank, Regional Banks, IMF
■ Bilateral - USAID (USA), DFID (UK), MOFCOM (China) etc.
■ Such aid is often tied in terms of:
■ Purchase of inputs (typically from donor country firms)
■ Spending – designated for a specific project or program
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 Official Development Assistance
■ Grants
■ These are financial resources provided to
countries with no repayment requirement
■ The main sources are also multilateral and
bilateral
■ Technical Assistance
■ Aid in kind
■ Provision of human expertise and other
kinds of technical capacity
■ Emergency Aid
■ In kind, like technical assistance, but
dominated by food aid and other kinds of
assistance needed to deal with
emergencies, conflicts etc.
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 Official Development Assistance - History
■ It is the only foreign capital
■ 1969 UN (Pearson inflow that low-income
Commission) recommendation countries receive a
that donor countries (developed substantial share of
countries) should aim to give ■ In 2019 low-income countries
0.7% of GNP in aid. received 30% of ODA
■ That would translate roughly to ■ In 2019 least developed
2% of government revenue for countries received 33% of
most countries ODA
■ Only a few countries meet that
criteria on a regular basis
■ The flow of ODA has varied
over time
■ Increased through the 1980s, fell
in the 1990s and increased after
2000

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 Official Development Assistance
■ Why do donors give aid?
■ It is in their political, economic and
strategic self-interest to do so
■ Purchasing political cooperation
■ Assisting in generating economic
development, particularly of countries in
which donors have an economic interest
■ A complement to trade, FDI and other
financial flows
■ Market creation
■ Tied aid that generates demand for donor
goods and services
■ Absorptive capacity may limit the impact

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 Official Development Assistance
■ Why do developing countries accept
aid?
■ It supplements scarce domestic
resources
■ That is particularly true for the
low-income countries starved of other
form of capital inflows
■ A means of support for incumbent
governments favoured by donors
■ Particularly those that are unpopular at
home
■ Needed assistance in emergencies
■ Implicit reparations for past exploitation
(?)
■ Compensation for the assigned status in
the global division of labour (?)
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 Foreign Capital Inflows to Developing Countries

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 Allocation of Foreign Direct Investment

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 Portfolio investment Flows

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 Personal Remittances Received

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ODA AS A PROPORTION OF (%) OF GNI IN 2023
 Official development Assistance

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