Sanctions and Foreign Investment in Developing Countries

Supply Chains, Foreign Direct Investment, and Multinational Corporations

• Supply chains connect companies and countries, impacting economic interests.
• Foreign Direct Investment (FDI) is crucial in international operations.
• Multinational Corporations (MNCs) play a key role in global trade.

Review Questions

• The Smoot-Hawley Tariff Act of 1930 was a response to low industrial prices and a product of Congressional logrolling. US tariffs remained high until the end of World War II, contributing to the Great Recession.
• Democracies are more trustworthy trading partners with transparency and fewer bargaining failures, relying less on state-owned corporations for revenue.
• Workers in developed democracies often support free trade.

Where Does an iPhone Come From?

• iPhones are assembled from components sourced globally.
• The most common country for manufacturing components and assembly is China.
• Components are also sourced from Germany, Japan, the USA, and Switzerland, among other countries.

Global Supply Chain

• Exporters are importers, and importers are exporters.
• Many companies invest and operate across the globe.

GAME PLAN

• Supply Chains affect economic interests globally.
• FDI is examined in terms of its advantages, economic effects, and domestic policy influences.
• The role of democracy vs. autocracy in attracting FDI is discussed.
• International efforts regarding FDI and MNC regulation are examined.

Interests, Ideas, and Institutions

• Societal/elite interests, elite interests, domestic institutions, political interests, and international institutions influence policy outcomes.
• Interpretation of interests (ideas/ideology) connect these actors together shaping policy outcomes.

How do Supply Chains Affect Economic Interests?

• Not all import-competing sectors benefit from protectionism.
• Some firms and workers depend on import inputs.
• FDI can depend on trade openness and may flow to sectors integrated in global supply chains.
• Workers embedded in global supply chains are often more supportive of free trade.

Trump's Steel Tariff

• In 2018, the Trump administration imposed a 25% tariff on steel imports from various countries.
• This policy was designed to protect the US steel industry.
• Unexpectedly, this action did not necessarily lead to record profits for US steel companies and may have had a negative impact on the US economy.
• The global nature of supply chains makes it hard to isolate the effect of tariffs on specific industries in isolation.

Trump's Steel Tariff (Continued)

• Tariffs can have negative consequences for industries dependent on global supply chains.
• International supply chains and complex interactions between markets and industries complicate the effects of tariffs.
• Tariffs often result in unintended consequences and interactions with other markets.

Foreign Direct Investment and Multinational Companies

• Foreign investment can be categorized as portfolio and direct investment.
• Portfolio investment involves holding financial assets without direct control.
• Direct investment involves owning and controlling facilities in another country.
• MNCs typically engage in direct investment.

What is an MNC?

• A multinational corporation (MNC) controls and manages production in multiple countries.
• MNCs emerged in the late 19th century, with significant historical examples like the British and Dutch East India Companies.
• Early MNCs were predominantly from the United Kingdom and subsequently the US.

FDI Flows Across Time

• FDI flows globally and to/from developed and developing countries, showing trends in investment across time periods.
• There has been a significant growth in FDI for developing countries in the last few decades.

2 Types of FDI

• Horizontal FDI maintains the same production at multiple locations.
• Vertical FDI produces different parts of the value chain in different locations.

Why Invest Abroad?

• Locational advantages determine profitability.
• Market imperfections explain why firms choose direct investment over simply hiring a foreign company.

Locational Advantages

• Companies seek natural resource reserves for production advantages.
• Locational advantages focus on efficient and lower-cost production.
• These advantages consider factor intensity in different countries.

Market Imperfections: Horizontal Integration

• Intangible assets, like a unique formula or know-how, are difficult to sell.
• Transferring intangible assets is difficult, creating an incentive for horizontal integration to maintain control of these assets.

Market Imperfections: Vertical Integration

• Specific assets dedicated to long-term relationships are vulnerable to opportunistic behaviors.
• Vertical integration eliminates such issues by controlling the entire process.

Example: Oil Producers and Pipelines

• The example shows how contracts and agreements can complicate supply-chain management and create incentives for vertical integration of industries.

Time Inconsistency in Long-Term Contracts

• Time inconsistency problems create issues with enforcing contracts and commitments across time .
• Vertical integration resolves this problem.

Oil Extraction Around the World

• Oil and gas discoveries see a 30% rise in the first half of 2018.
• Several significant discoveries take place globally.

Where and When do we get MNCs?

• MNCs form as a response to economic environments and existing conditions (locational advantages and market imperfections.)
• A company is more likely to choose FDI when locational advantages are present and market imperfections make it a more profitable decision than hiring a company in another country.

Why Attract FDI?

• Governments actively attract FDI through various agencies and programs.
• Offering incentives like tax breaks, easing regulations and providing support for companies looking to invest in their regions.

FDI's Potential Economic Benefits

• FDI creates economic growth by transferring capital between states.
• Companies can also transmit managerial and technological expertise, leading to spillover effects.
• Firms gain access to global markets for their commodities or services.

FDI's Potential Economic Costs

• FDI can divert capital away from domestic firms.
• Firms can engage in practices like higher licensing fees and royalties to transfer pricing for their foreign affiliates.
• FDI objectives may conflict with a host country's domestic policy objectives.

MNCs in the Developing World

• Following independence from colonial states, states attempted to gain autonomy through nationalization or expropriation of existing and future FDI.
• Modern developing nations open their doors to FDI while seeking to ensure their rights are protected under a global system with a more balanced regulatory regime.
• National economic benefit and interest needs drive some policies.

MNCs in the Developing World (Continued)

• States often seek to manage FDI to ensure a beneficial outcome, through policies requiring local ownership, setting performance standards, or prohibiting ownership of key industries and sectors.
• Competition to attract FDI ensues among countries under a largely unregulated system.

FDI and Domestic Politics

• Developed states typically have more capital than developing states.
• FDI is not often driven by these kinds of factors alone, rather other factors may play equally important influences.

A Puzzle

• Theoretical arguments on FDI suggest flow from capital-rich to capital-scarce states.
• However, the data shows that large flows often occur between countries with equal or similar levels of capital and/or industry.
• This discrepancy is due to additional factors beyond capital and industry alone.

Where does FDI go?

• Advanced industrial countries are the providers and recipients of FDI in global markets.
• FDI is concentrated mostly in the wealthiest developing or prominent markets.
• Despite the theoretical expectations on FDI's direction, the data shows a degree of imbalance.

Bargaining for FDI

• States and MNCs engage in bargaining for FDI.
• The benefits for states often outweigh the possible costs.
• When trying to attract FDI, states may give up some policy control or make concessions to gain advantages.

Foreign Direct Investment and the Commitment Problem (Again)

• The example illustrates how commitments can be broken if both sides are not satisfied by terms and/or outcomes.

Democracy and FDI

• Democracies are often better at preventing expropriation and other abuses of power by the host state when attracting FDI.
• This is because democracies often have more "veto players" – individuals or groups with the ability to block policies.
• This makes it more difficult for one actor to enact policies that disadvantage investors compared to other political systems.

Other Types of Risk

• Companies fear policy volatility as it can make conducting business difficult.
• Concerns may include unstable exchange rates and political risks that may add to transaction costs and losses, especially in unstable political/economic systems.
• Such risks can impact profitability and may be important considerations for firms making international investments.

Back to the Puzzle

• A country's economic policies or political stability can be an important determining factor in a foreign company deciding to invest or not.
• Some countries, even those that are not as economically developed, may have better political climates and easier regulatory systems than more established countries.

Attracting FDI through a "Race to the Bottom"?

• States may compete by lowering taxes and regulations to attract investment.
• This can create a negative environment of minimal protections, or even a reduction of protections within a country.

Do FDI and Supply Chains Enhance Welfare of Citizens?

• Whether poor regulation attracts FDI is a complex issue, with potential benefits and costs.

The "Race to the Bottom"

• The "race to the bottom" describes a competitive dynamic among countries.
• It is driven by the desire to attract FDI by lowering taxes and regulations.
• Lowering regulation can lead to sub-optimal outcomes and/or negative consequences that are not as apparent upon first glance.

The "Climb to the Top"

• Beyond just lower taxes and regulation, companies also want public goods like infrastructure and educated workforces.
• Attractive markets can create indirect pressure for improving public goods and governance, beneficial for a country's long-term development.

What Does the Evidence Say?

• Studies regarding policy regulation and its effectiveness in attracting FDI provide mixed findings.
• Some studies show a positive correlation between FDI and improved labor rights and reduced child labor, but findings in specific sectors still show complex influences on the ground.

"Race to the Bottom" in Taxes through Transfer Pricing

• Companies may use transfer pricing to shift profits to low-tax jurisdictions, thus reducing taxes owed within their home country.

International Regulation of FDI

• No multilateral rules or institutions govern international FDI and MNCs.
• International regulators often struggle to enforce their rules in regions or countries with significant economic power.

Bilateral Investment Treaties (BITs)

• Bilateral investment treaties are used to govern international investment relations to fill gaps in multilateral frameworks and global institutions.
• BITs may be useful depending on both countries' relative power and the overall structure of the global system.

Investor-State Dispute Settlement (ISDS)

• Investor-state dispute settlement processes allow investors to sue governments if their investments are harmed or if the government changes investment conditions.

Tobacco Company Lawsuits

• Lawsuits relating to tobacco companies highlight the intricacies and complexities of international and domestic regulation.
• Tobacco is a regulated product in many countries, which adds another dimension to the issue.

Progress on taxes: the OECD Minimum Tax

• The OECD Minimum Tax aims to prevent multinational corporations from avoiding taxes in low-tax jurisdictions.

Countries Now Implementing the Minimum OECD Tax

• Various countries have implemented policies aligning with the OECD Minimum Tax.
• The implementation of global tax systems can show different paces and/or varying degrees of compliance across the world. A variety of factors may make or break a country's compliance with the new rules and/or regulations.

Take Aways

• Supply chains make it harder to determine the impacts and outcomes or trade policies.
• Multiple factors, not just economic ones, affect international investment and policy outcomes.
• Various incentives and constraints can impact policy choices regarding regulating the international movement of capital.

Why ISI?

• While there are many good arguments for importing substitution industrialization, there are some challenges that lead to difficulty in policy success and sustainable development.

The Economic Ideas Behind ISI: Structuralism

• Structuralism, a dominant philosophy in early development economics, argues that under certain circumstances, trade policies that support domestic or homegrown industries are beneficial for developing countries.
• Research suggests that free trade is not beneficial for all countries, especially those with fewer economic resources.

Interest-Based Explanations for ISI

• Interest groups and different stakeholders often have differing views on trade policies.
• The presence, or absence, of political incentives may influence decisions.

Who benefits/loses from ISI?

• Different stakeholders, such as land owners and owners of capital, have conflicting interests regarding trade policies or openness.

Who Held Political Power?

• Power structures and incentives may change over time, leading to changes in policies or rules.
• The political power holders and their interests are often a significant factor in economic policy choices.

How did ISI perform?

• Historical data on growth in per capita GNP, manufacturing, and exports across different regions provides varying outcomes depending on how trade policies are structured.

East Asian Model: Export Oriented Industrialization

• Export-oriented industrialization in East Asia relied on different strategies compared to ISI in countries like South America.

Why did the Asian "Tigers" Reform and not the States of Latin America?

• Political climate differences and historical events can influence a country's path to economic development.
• For instance, WWII provided a clean slate for economic change in Asia compared to Latin America, where existing power structures persisted.

Why didn't states move away from ISI quicker?

• Political incentives can lead to sustained policy even when they would not be considered beneficial in the longer term or under better circumstances.

How did states move away from ISI?

• The need for financial bailouts, or interventions, in many countries in the 1980s and 1990s is an example of the challenges and/or failures that can arise from certain trade policies or trade imbalances.

Core Takeaways

• Trade and industry policies can have significant impacts on an economy.
• Outcomes and benefits depend on the strategies and trade policies implemented.

Economic Sanctions

• Economic sanctions are used to coerce policy changes in other countries.
• The implementation of policies to enforce sanctions can create a complex web of relationships with countries and their citizens alike .

Sanctions Usually Require (Inter)dependence

• Countries' reliance on each other makes sanctions effective; however, this also means that the countries imposing sanctions may be hurt at home through lost trade or investment.

Domestic Economic Costs

Do Sanctions Work?

• Scholarly evidence regarding the effectiveness of sanctions is often mixed or disputed.

There is a Problem in This Research Design

To Sanction or Not to Sanction...

Imposition is the Failure of a Threat

Why Do We See Impositions Then?

• Targets may miscalculate the costs of sanctions.
• Senders may miscalculate the target's resolve or capabilities.

Why do we see impositions then?

The Costs of Sanctions (For Target State)

• Sanctions create burdens or hardships for citizens.
• Elites or certain groups may benefit from sanctions while the average citizen suffers.

Comprehensive vs. Targeted Sanctions

• Comprehensive and targeted sanctions differ in their scope and economic impact.
• Targeted sanctions are designed to minimize the impact on innocent civilians while still influencing the target state.

Do Targeted Sanctions Work Better?

• The effectiveness of targeted sanctions is still debated, with mixed evidence.
• There is limited consensus on the effectiveness under varying conditions.

Limits of Economic Coercion

• Interdependence can limit the effectiveness of sanctions.
• Political problems, including regime survival, may overshadow or reduce the impact of economic sanctions.

Core Takeaways

Next: Monetary Policy