ECONOMICS

ECONOMICS

ECONOMICS

The gap between the world's rich and poor countries largely comes down to the financial and physical assets that create wealth. Developed economies possess more of this capital than developing ones, and what they have usually incorporates more advanced technologies. The implication is clear: A key aspect of economic advancement lies in poorer nations' capacity to acquire more capital and scale the technological ladder. Emerging economies undertake some capital formation on their own, but in this era of globalization, they increasingly rely on foreign capital.

Indeed, total capital flows to developing economies have skyrocketed from $104 billion in 1980 to $472 billion in 2005.[1] The foreign capital has the potential to deliver enormous benefits to developing nations. Besides helping bridge the gap between savings and investment in capital-scarce economies, capital often brings with it modern technology and encourages development of more mature financial sectors. Capital flows have proven effective in promoting growth and productivity in countries that have enough skilled workers and infrastructure. Some economists believe capital flows also help discipline governments' macroeconomic policies (see box titled “Does Financial Globalization Shape Fiscal Policy?”).

Capital flows come in three primary forms:

Portfolio equity investment, which involves buying company shares, usually through stock markets, without gaining effective control.

Portfolio debt investment, which typically covers bonds and short- and long-term borrowing from banks and multilateral institutions, such as the World Bank.

Foreign direct investment (FDI), which involves forging long-term relationships with enterprises in foreign countries.

FDI can be made in several ways. First, and most likely, it may involve parent enterprises injecting equity capital by purchasing shares in foreign affiliates. Second, it may take the form of reinvesting the affiliate's earnings. Third, it may entail short- or long-term lending between parents and affiliates. To be categorized as a multinational enterprise for inclusion in FDI data, the parent must hold a minimum equity stake of 10 percent in the affiliate.

Establishing foreign affiliates usually entails starting new production facilities—so-called greenfield investments—or acquiring control of existing entities through cross-border mergers and acquisitions. Recent years have seen a marked shift toward international mergers and acquisitions.

In developing nations, equity investments as a percentage of gross national income have been flat in recent years. Debt flows, however, have picked up since 2002 after plunging to zero in the previous two years. Meanwhile, FDI as a share of GDP has grown rapidly, becoming the largest source of capital moving from developed nations to developing ones (Chart 1).

From 1990 to 2005, developing economies' share of total FDI inflows rose from 18 percent to 36 percent. In addition, the geographical composition of FDI flows has changed dramatically over the past four decades. Within developing economies, Latin America's share of FDI has fallen from 52 percent in the 1970s to 33 percent since the 1990s. Asia's share of inflows has risen from 25 percent to 60 percent during the same period.

Within Asia, China and India have gained FDI share relative to Southeast Asia. Today, these two emerging economic giants are the most attractive markets for ...