Foreign direct investment is mostly welcome, but large short-term flows spell trouble
Oct 1st 2016 Economist
Shannon Airport on Ireland’s west coast has been a gateway from Europe to America since the 1940s. It was built across the estuary of the river Shannon from Foynes, a small town that had served in the interwar years as a refuelling stop for seaplanes and passengers on their way across the Atlantic. A local chef, Joe Sheridan, came up with the idea of Irish coffee when he added whiskey to the hot drinks served to shivering passengers from a Pan Am flying boat. In 1947 a catering manager, Brendan O’Regan, set up the world’s first duty-free shop at Shannon, allowing transit passengers to buy tax-exempt goods.
Capital also disembarks in this part of Ireland, a country that, more than most, has been transformed by flows of capital from other places. In the 1980s Ireland seemed destined to be western Europe’s perennial laggard: “The poorest of the rich”, as a survey by The Economist put it in 1988. But within a decade Ireland had transformed itself into the Celtic tiger, Europe’s unlikely answer to the booming economies of South-East Asia.
Central to this shift were American companies seeking a foothold in the EU ahead of the creation of the single market in goods in 1992 and lured by a well-educated, English-speaking workforce. The state offered inducements, such as grants and a low corporate-tax rate. Intel, a chipmaker, started production in Dublin in 1990. Other big firms followed. Boston Scientific, a maker of medical devices, set up shop in 1994 in Galway, an hour’s drive from Shannon. A medical-technology and pharmaceutical cluster emerged in the region.
Thanks to foreign direct investment (FDI) of this kind, Ireland went from the poorest of the rich to among the richest. It was a textbook example of the benefits of capital flows. But Ireland is also an archetype of the malign side-effects of capital mobility. As it became richer, other countries took exception to its low corporate-tax rate, which they saw as simply a device to allow global companies to book profits in Ireland and save tax.
The scale of the problem was highlighted in July when Ireland’s statistical office revealed that the country’s GDP had grown by 26% in 2015. The figure said little about the health of the Irish economy. First, it was inflated by “tax inversions” in which a small Irish company acquires a bigger foreign one and the merged firm is registered in Ireland to benefit from its low corporate taxes. Last year saw a rush of transactions before a clampdown by America. Second, the GDP figures were distorted by the aircraft-leasing industry. The world’s two largest lessor fleets are managed from Shannon, though many of the 4,000 registered aircraft will never touch down there.
But it is the damage wrought by short-term capital flows in Ireland that is most striking. After the launch of the euro in 1999, would-be homeowners were seduced by irresistibly low interest rates set in Frankfurt. Irish banks borrowed heavily in the euro interbank market to fuel the property boom and to speculate on assets outside Ireland. Bank loans to the private sector grew by almost 30% a year in 2004-06, at the peak of the boom. When that boom turned to bust, the country suffered a brutal recession and had to be bailed out by the IMF. Ireland still bears the scars. Preliminary figures from this year’s census show that almost 10% of homes in Ireland are permanently empty. Some of the worst-affected areas are in the west of Ireland, up or down the coast from Shannon. Ghost estates and failed bed-and-breakfast places are the legacy of a building boom that by 2007 had drawn one in eight of all workers into the construction industry.
Short Term Capital
Unimpeded capital flows should be a boon. Like global free trade, global capital markets offer broader opportunities. More and better openings usually make people richer. Globalised capital breaks the tie between domestic saving and investment, giving poor and low-saving countries the wherewithal to speed up GDP growth. For developing economies, capital mobility is a conduit for new technology, management know-how and business networks. It also allows investors to vote with their feet, encouraging governments to follow prudent regulatory, monetary and fiscal policies.
For a long time the liberal orthodoxy was against any kind of restriction on cross-border finance. A succession of financial calamities, starting in Latin America in the 1980s and continuing with the East Asian crisis of 1997-98, prompted a rethink. Rather than imposing discipline, access to foreign capital seemed to allow countries to get into bigger messes. Whereas academics argue about the pros and cons of free movement of goods or people, they now mostly agree that liberalising capital flows can sometimes do more harm than good. Politicians may occasionally rue the fickleness of international investors, but capital mobility is not, for the most part, a target for popular anger in the way free trade and immigration often are.
There is plenty of evidence of the trouble that floods of short-term capital can cause. The IMF identified 152 “surge” episodes (periods of abnormally large capital flows) between 1980 and 2014 in 53 emerging markets. A fifth of such episodes subsequently led to a banking or currency crisis. The surges most likely to end in tears were those made up mainly of cross-border bank lending; FDI-based ones were less likely to create trouble. The euro crisis in general, and Ireland’s spectacular banking bust in particular, have shown that the syndrome is not confined to developing countries.
Markets for capital are error-prone in a way that markets for goods are not. Stocks, bonds and property are subject to wild swings in value. When capital moves across borders, these failures are amplified by distance, unfamiliarity and exchange-rate risk. There is more scope for getting things wrong, and the resulting economic crises are typically on a larger scale. It is fine for foreign companies to build or buy offices, factories and infrastructure, but the benefits of foreigners buying bonds or stocks are less obvious, and such investments tend to be volatile. Developing countries’ financial systems are not necessarily equipped to put inflows of this kind to productive use, still less to handle their sudden exit. Short-term foreign borrowing is often used to finance long-term domestic loans. The mismatch becomes even starker when the borrowing is in foreign currency. And countries subject to sustained inflows of hot money often contract “Dutch disease”, a condition that drives up their currency beyond its fair value, leaving their export businesses unable to compete in international markets.
Limiting Capital Flow
Limits on capital flows other than FDI thus seem like a good idea. In 2012 the IMF conceded that capital controls of a temporary and targeted nature were warranted, as a last resort, where the scale of capital inflows put financial stability at risk and conventional monetary or fiscal policy was unable to respond effectively. But what can be done to stop bad capital flows while letting through the good ones?
One approach is an entry (or Tobin) tax, proportionate to the size of the capital inflow and levied at the time when currencies are exchanged. Such a tax would bear more heavily on short-term inflows. Until recently controls of this kind were believed to have little effect on capital inflows. But they may be more effective than previously thought.
Brazil, which in October 2009 imposed a 2% entry tax on portfolio investments. This was meant to stop the country’s currency, the real, from appreciating further. It was soon raised to 4% and then to 6% in short order. At first the measures did not seem to work, but that changed when in mid-2011 they were supplemented with a tax on the notional value of derivatives. It is estimated that up to 10% of the subsequent fall in the real was due to the intervention.
Once the real had fallen, in 2012, Brazil started to dismantle its capital controls. But if hot-money flows are an ever-present threat, would it not make more sense to have controls permanently in place? There is a distinction between “gates”, episodic controls in response to sudden inflows of a certain kind, and “walls”, long-standing controls on a broader range of assets. In a study of 44 countries between 1995 and 2010, gates do not curb exchange-rate appreciation, raise GDP growth or stop the build-up of financial risks. But long-standing capital controls (walls) might.
The ten countries with capital “walls”, including China, on average saw a slower rate of growth in private debt relative to GDP and weaker growth in bank lending than the 34 other countries. They were also less likely to experience abnormal capital surges. That suggests walls are effective. But countries with walls are generally poorer than countries with gates. And when controlled for GDP per head, the statistical distinction between gated and walled countries mostly disappeared. Neither type of capital control had much effect.
This is an awkward finding. In principle, the flexibility of gates should make them a better instrument of control than walls, which can deter even the right sort of capital. Ideally capital controls should be tightened as inflows intensify. But gates may be ineffective for practical reasons. The tax rate required to stem a flood of inflows might be unfeasibly high. And gates are likely to be more permeable than walls, because countries with long-standing controls will have learned how to police capital inflows effectively. China, for instance, has been able to control its nominal exchange rate from behind its imposing capital walls.
The best policy might be a mixture of both. Not everyone is convinced by Brazil’s experiment. It showed that a tax has to be fairly high and broadly applied before it has much effect. That makes it difficult to levy it only on “bad” capital flows. And just as heavier policing in one area may simply shift crime to a neighbouring area, Tobin taxes may simply divert capital flows rather than deter them altogether. Brazil’s Tobin tax encouraged emerging-market bond and equity funds to flood into other commodity-rich countries instead.
Observers with longer memories recall that before Brazil’s experiment, Chile was held up as an exemplar of the wise use of capital controls. In the 1990s capital imports into Chile were subject to an interest-free deposit of 30% of the investment. Chile’s central bank has since eschewed controls in favour of direct intervention in currency markets (selling pesos to build reserves when inflows are strong), a policy that has the virtue of being hard to circumvent. This helps guard against incipient Dutch disease, but it does little to deter inflows. If the main worry is too much lending on property, then macroprudential policy is probably a better bet. One useful measure is to limit the amount banks can lend as a proportion of the value of the property.
Economists in Ireland once made a distinction between the Celtic Tiger phase of the country’s economic boom, which was powered by FDI, and a second, “bubble”, phase, inflated by low interest rates and short-term capital. But these days FDI does not always result in a new factory, research facility or office building, with new jobs to match it. Often it amounts to a transfer of intangible assets for the purpose of lowering corporate tax.
Ireland is among the world’s top countries for foreign direct investment relative to GDP. Most of the others on the list are also small countries with low rates of corporation tax. Luxembourg, for instance, accounts for 10% of the stock of global FDI but only 0.07% of world GDP. Competition is generally a good thing, but in matters of taxation that is not always true.
Multinational companies are able to avoid tax because there are so few generally agreed principles of cross-border taxation. One approach, taken in America, is to tax a company’s global income on the basis of where it is “resident” (where its headquarters are), regardless of where its profits are made. A second method, widely adopted in Europe, is to tax profits where they are generated. In practice the two are often used in combination. You can play one country off against another so you’re not resident anywhere.
Globalisation and the growing importance of intangible assets, such as patents, have made concepts such as residence and sources of income much less useful. Supply chains are now so complex that it is hard to know where a source-based tax on profits should be applied. If the value of a drugs company lies mostly in its patents, for example, it can move to a tax haven and enjoy low taxes without uprooting any of its physical operations.
Purists argue that, since all taxes are ultimately borne by individuals, there is little point in chasing elusive companies all over the globe; better to abolish corporation tax and increase sales taxes instead. There are two objections to this. First, for reasons of equity it may be preferable to tax shareholders rather than consumers. Second, corporate taxes make up a large share of revenues in resource-rich poorer countries, where few workers are on formal payrolls and sales taxes are easy to evade.
One way of dealing with that might be a special regime of royalties or land taxes levied on mining companies. Michael Devereux, a tax expert at Oxford’s Said Business School, predicts that in the long run tax competition and avoidance will erode rich countries’ corporate-tax base. He proposes a value-added tax with deductions for labour costs and other inputs. That would approximate to a tax on excess profits, or “rents”.
True FDI is an unalloyed benefit. But the growing practice of using offshore investment to avoid corporate tax might make capital mobility the target of popular anger, alongside trade and immigration. The EU’s case against Apple may be just the beginning. Many people see footloose global companies and deregulation as the handmaidens of the worst kind of corporate practice. Yet economic ills such as weak real incomes, inequality and immobile workers may be partly due to a failure to liberalise product markets further.