Chapter 14: Foreign Finance

7. Why does multinational corporation investment not necessarily offer the advantage of domestic employment expansion? Hint: Capital-intensive production coupled with crowding out of local borrowers when capital is raised locally.

Along with encouraging inappropriate consumption, MNCs use capital-intensive technologies that create little employment. Studies show that investment from other developing countries may be more conducive to employment expansion.

5. Why does investment by multinational corporations not necessarily help to close the foreign exchange gap. Hint: Investment funds may be raised locally, and the subsidiary may not export its output.

Although MNCs provide capital, they may lower domestic savings and investment rates by substituting for private savings, stifling competition through exclusive production agreements with host countries, failing to reinvest much of their profits, etc. They also raise a large fraction of their capital locally and this may lead to crowding out of investment of local firms.

6. Explain what is meant by investment by MNCs encouraging inappropriate consumption.

MNCs typically produce products only demanded by a small, rich minority of the local population, which stimulates inappropriate consumption patterns (for the rest of the country because they do not have the money to buy such expensive products) through advertising and their monopolistic market power.

11. Discuss how remittances can help reduce poverty and meet other development objectives in recipient nations?

People migrate from developing countries to high-income developed countries because wages are approximately 5 times higher for similar occupations in developed countries. Higher wages mean more money for migrants that they otherwise wouldn't receive if they stayed in their country. - Migrants often build houses for their families and send money that is vital for keeping children in school and better fed. Thus, remittances now provide a significant pathway out of poverty. - World Bank reports remittances have substantially reduced poverty in such countries

10. (Case Study) What role have remittances and direct foreign investment played in Guatemala, Costa Rica, and Honduras.

Remittances makeup 1.2%, 15.7%, and 10% of GDP for Costa Rica, Honduras, Guatemala (respectively). Remittances play a bigger role in Honduras and Guatemala due to the amount of people emigrating because of the lack of opportunities in those countries. Direct foreign investment is (out of U.S. million dollars) 18,713, 9,024, 8,914 for Costa Rica, Honduras, and Guatemala (respectively). Due to such high foreign direct investment, Costa Rica has access to high-tech technology, better roads, and other infrastructure.

4. Explain the motives of developed countries in providing foreign aid.

The motives of developed countries when allocating resources and giving foreign aid to developing countries is based on strategic, political and economic interests. The strategic interest can be in the form of multilateral ties, trade relations and overall strategic relations with an ally. A clear example of this can be seen with the US and Taiwan, as USA makes for a strategic ally in the region with the rising threat of China. Another motive is through political motivation, in which the aid can help governments prosper and gain local support. We saw this through the H. W. Bush administration, which politically supported Argentina under Menem because they supported similar ideologies and strategic initiatives. Finally, economic motives include the Two-Gap Models, in which external finance can play a major role in helping and aiding domestic resources in order to relax savings/ foreign exchange bottlenecks. There are two potential gaps from the Two-Gap Model, a savings gap or a trade gap, in which international transfers can fill both gaps to achieve desired investment.

1. Suppose an MNC subsidiary buys 100 input units from its parent at a price of $2 each. It has $300 in additional production costs, and sells its 100 units of output for $6 to the MNC. It pays a 25% local profit tax. The MNC sells the output at home for $8, and its cost of producing inputs is $1. It pays a profit tax of 20% at home on repatriated profits. What is the subsidiary net profit? Assume no selling costs at home. What is the MNC's total profit from the operation?

The net profit for the subsidiary is (6*100 - 300 - 2*100) * (1 - 25%) = $75. The calculation of the total profit for the MNC is a little complicated. It should be the sum of foreign profit after the repatriated tax (75 * 80% = $60) and the domestic profit. The MNC only produces inputs at $1 but sells to the MNC subsidiary for $2 per unit, so the profit here is $100. The MNC buys output from the sub for $6 per unit but sells at $8 per unit, making a profit of $200. Therefore, the total profit for the MNC should be 100 + 200 + 60 = $360.

3. State three major potential advantages of foreign direct investment for a developing country. State three major potential disadvantages.

Three major potential advantages of foreign direct investment (FDI) for developing countries including promoting stable long-term lending, providing financing to differing industries, and providing technology to various industries. Three potential disadvantages of FDI include ownership of strategic industries by foreign companies, investors may have less moral attachments to the citizens and land of recipient country, and foreign companies may gain access to local markets through unethical methods.

2. It has been argued that tied aid leads to inefficiencies in the recipient country's economy. Explain how this could occur.

Tied aid can be tie by a source (loans or grants that have a specified purchased of donor-country goods and services) or by project (funds can be used for a specific project). In both cases, the value of aid is reduced because the specified source is likely to be an expensive supplier or the project is not of highest priority.

9. Critically evaluate the following statement: "If no other assistance is available, tied aid should be accepted anyway, on the grounds that developing countries should accept any help they can get." Hint: Calls for a discussion of the costs and benefits of tied aid, which can lead to net positive or negative benefits.

Tied aid does have advantages for the developing country in that, with no other option, the aid is generally adequate, timely, and can be assured for a long-term basis. The country that's giving the aid is typically in a better position than the aided country to take decisions regarding the aided projects and details. However, tied aid does come with costs, especially for the aided-country. The economic cost of tied aid will always increase for the recipient country. The value or quality of the aid is less likely to be negotiated and the aided-country doesn't have much say. Tied aid restricts the choice of where the money goes to; the choice typically stay with that of the aid-giver and where they would prefer the money to go. The aid-receiver may also be subject to "returning the favor" with some matching reciprocating deal that sings away capital and land.

8. State at least two major benefits of promoting non-governmental organizations in developing countries as sources and conduits of foreign assistance. Hint: Benefits: less constrained by political motivations, and able to avoid cynicism and suspicion by working directly with and for local people.

Two major benefits of promoting non-governmental organizations (NGOs) in developing countries as sources and conduits of foreign assistance include their knowledge of the situation on the ground (knowing the needs of the people) and they can be a reliable source if the government is known to be corrupt.