A debate is being conducted as to the effectiveness of sending capital abroad to low-income countries. The merits are not being discussed, but it has been flogged by Donald Trump as a waste of money to give foreign aid or a loss of opportunity for the US in the case of foreign direct investment while China has continued to expand their Belt and Road Initiative. Like any other action, there are both benefits and pitfalls, but in general it should be viewed through the same lenses as any investment: if the probability of success multiplied by the average expected payoff is greater than the probability of failure multiplied by the average expected loss, it is likely a worthwhile endeavor. Nevertheless, we need a measuring stick before we can perform any calculations.
Let’s take a step back. Evaluating success is going to be difficult because real economies are messier than capital markets and humanitarian goals are often muddled together with financial ones. Investments can come in the form of foreign aid, loans, direct investment in infrastructure, and more. They can come from the private sector or the public one. Goals range from finding a return on excess capital in a sovereign wealth fund to reducing hunger in an impoverished nation. The monetary value of a humanitarian goal must be soberly derived in order to conflate those results with more mercenary ones. This is not the space for that, so I will leave it at that.
Evaluating the efficacy of an investment will get us most of the way to determining its virtue, but potential externalities (positive and negative) and magnitude of risk involved need to be considered in finding a minimum return required for success. Every action at the scale involved will have some side effects and the receiving country must make a careful appraisal of those in the same way an investing country does, albeit with a separate set of parameters. The final outcome, though, is better than you could hope much of the time. We will look at a sampling of potential costs and benefits for each party along with some examples before concluding that it is likely an underutilized tool.
The reception of foreign money via aid or investment is almost always heralded by governments as the beginning of a new era of prosperity for their country or region. While not an unmitigated good, there are a host of reasons why it may be a reason for celebration. New projects bring in capital which reverberates throughout an economy. Entirely new markets may be created as more money brings more infrastructure and more traffic, creating a cycle of positive reinforcement. This traffic also brings in new ideas which can bump together with local perspectives and induce creative new businesses out of enterprising citizens.
Despite all that, care must be taken to avoid taking on too much. The risk is clear with taking on debt, but even grants carry risk. Injecting money into impoverished nations ruled by warlords or corrupt governments can cause long-term harm despite the short-term benefits by helping prolong bad governance. Other scenarios are more sinister still. The long term impact of China’s Belt and Road Initiative is yet unclear, but China has already leveraged the indebtedness of Sri Lanka to force the smaller country to give up an entire port. Other past endeavors have included rapaciousness on the subordinate country’s resources and forcing undesirable foreign policy positions.
Contributing parties may not mind some of those results, but less zero-sum benefits are plenty. Not all are intuitive. There is a law in economics that says current account (exports less imports) must be equal to the inverse of the capital account (capital inflows less capital outflows). An explanation deserves more thoroughness than is possible here, but basically this is because global accounts must balance, so a country saving more than it invests must export that capital somewhere and a country investing more than it saves must import that much more than it exports.* This property, then, means that by exporting capital via aid or loans, a country necessarily increases its current account. In summation, sending money abroad is a potential tool for reducing current account deficit if that is getting out of hand (for this same reason, reducing remittances is a terrible goal if you wish to reduce current account deficit and your name is Donald Trump). Additionally, exporting capital can create a new market for goods, it can help create a new trading partner, and it can be a source of labor. The rate of return on investment is often higher for infrastructure investments in a place with little existing infrastructure than a well-established one (see: law of diminishing marginal utility).
Potential gains in low-income markets are often much higher, but they come with commensurate risk. Investing in poor nations must be done cautiously, whether in the case of a government or business. Probability of default is obviously higher in the case of lending money than it would be for more established economies both because of unreliable government and currency risk. Dealing with low-income countries can also be difficult because the ruling parties have personal interests that may not coincide with national interests. Perhaps most problematic, though, is that funds may be misappropriated for arms and providing arms and training does not make a nation immune from them. A particularly relevant example is the case of the September 11th attacks being carried out by a group that we previously armed.
If proper precautions are taken, though, there are few more powerful foreign policy tools than foreign aid or investment. Beyond their stated goals, they can provide many additional benefits. China has shown its potency, but the abusiveness of their relationships with those low-income countries has soured some of them (although in the case of Sri Lanka, the pull of capital still proved irresistible and they have taken more loans). A fair and measured approach to continued foreign investment should be an essential part of any rich world country, but this is doubly true for the US because of our significant global interests and large military presence. Demagogues with orange hair should take particular interest in its effect on the current account.
*I highly recommend Michael Pettis’s The Great Rebalancing for a better understanding.