Foreign investment to blame in currency crisis

By Bharat Jhunjhunwala

NEW DELHI (JP): Malaysian Prime Minister Mahathir Mohammad has been blaming currency speculators for the collapse of his country's economic miracle. Nothing could be farther from the truth.

The fact is, it is developing countries who invite such travails when they seek heavy foreign investments as a shortcut to prosperity. These heavy inflows disturb the natural path of growth and lay bare developing economies to "operation smother" by the industrial countries.

This is what happened in Mexico and Thailand alike. Mahathir has reasons to be worried because with Malaysia being the highest per capita in foreign investments, it may well be the next to fall from grace.

Small amounts of foreign capital can serve as a catalytic agent and be beneficial to an economy. Gradual and small doses of import liberalization push domestic businesses to modernize to international standards and are equally good.

These amounts, being small, hardly have a visible impact on the exchange rates or the returns to domestic capital. They dissolve into economies like salt in water.

When, however, developing countries seek foreign capital in large amounts, it no longer dissolves. It creates its own trajectory like oil in water.

Hence starts step one of "operation smother" by the industrial countries. These inflows of foreign capital begin to tell on exchange rates. Heavy foreign investment increases the availability of dollars in the market.

The price of the dollar declines and proportionately the domestic currency, say the ringgit for example, appreciates. This appreciation of the ringgit discourages exports and encourages imports.

Yet, it does not lead to a balance of payment crisis because the foreign investment inflows provide an adequate supply of dollars to meet the increasing imports' bills.

The inflows on capital accounts (foreign investment) are used to finance the imports on current accounts (for consumer items such as washing machines). The capital that comes in has to be serviced later but the money that goes out is consumed right away and is depleted. This process leaves a net external liability of servicing foreign capital.

The second effect is that the law of diminishing returns sets in. Increased availability of capital leads to a reduction in the rate of return on both foreign and domestic capital.

This decline does not really affect foreign investors who are accustomed to much lower rates of return in their home economies. However, it reduces the profits of domestic companies and affects their ability to invest and upgrade to meet the global economic challenge.

Large amounts of foreign investment, therefore, lead to two results. First, they lead to an appreciation of the ringgit and adversely affect exports while encouraging imports. Second, they reduce the capability of domestic industries to invest. Therefore, the capacity of domestic industries to meet global economic challenges is impaired.

Then follows step two of "operation smother". The situation is allowed to drift while foreign investments continue briskly and consumers get accustomed to buying imported goods. Meanwhile, domestic companies lose their courage to compete with multinational companies and foreign investment continues to provide the needed dollars for imports.

These investments also create enough demand to keep economic growth rates nudging along. On the surface, everything is comfortable. Balance of payments are stable. Growth rates are reasonable. Yet, the character of the economy gradually changes from domestic investment, and an export-led economy, to foreign direct investment, and an import-led economy.

The rate of return on investment continues to decline. At a certain point it becomes uneconomic for multinational companies to invest further. Then comes the crash. Step three hits as if from nowhere. Fresh investment is held back and the focus shifts to profit repatriations.

The real drama starts at this point. Foreign direct investment dollars are no longer available to finance the imports of consumer items. Instead, the demand for dollars increases in Malaysia as the multinational companies buy them to repatriate their profits. This leads to a pressure on the ringgit.

In the meantime, foreign exchange reserves have already been used to finance imports. The external account comes under pressure. The currency has to be heavily devalued. It is this devaluation that currency speculators bring about. But the ground for them is prepared by ourselves. They are merely the ones who recognize the symptoms of an unhealthy economy and strike at the most vulnerable spot.

Theoretically, such a devaluation can once again lead to export-led growth. But the domestic capital has been smothered in the intervening period. Domestic entrepreneurs have become mere selling agents for multinational corporations. They cannot find their bearing.

Step four is any one's guess. The currency has depreciated. Export earnings go to meet profit repatriations. Domestic industry has been stifled -- rates of return are too low for them to be able to make significant investments. Thus, the transition to globalization is completed. A vibrant domestic capital and export-led economy is turned into a placid foreign capital and import-led economy. This is the story of Mexico and Thailand.

The beginning of "operation smother" starts from a developing country seeking heavy foreign investments. It is followed by the use of foreign exchange reserves to finance imports. Without the host economy (1) seeking heavy foreign investments and (2) using the reserves for imports, the operation fails. Thus we find the industrial countries continually harping on the beneficial effects of foreign capital and open trade.

It is time for all developing countries to realize that Mother Nature has built into this world a natural speed. If we try to give birth to a child before nine months, what we get is an abortion. This is also the case in economics. Impatience is what leads us to seek heavy foreign investments and cheap imports. Slow and steady wins the race.

The writer is a free-lance journalist based in New Delhi.