ISSN: 1391 - 0531
Sunday, August 26, 2007
Vol. 42 - No 13
Financial Times  

Being dependent on foreign capital

By Antony Motha

Foreign capital does not necessarily spur growth in non-industrialised countries and hence it ought not to be considered a panacea. Non-industrialised countries are better off focussing their energies on domestic reforms. This was the crux of the 57th Anniversary Lecture of the Central Bank of Sri Lanka, delivered by Prof. Raghuram G. Rajan, University of Chicago.

Macro-economic theory suggests that the marginal productivity of capital should be high in poor countries that are deprived of capital. Hence, the logic goes, capital should flow from rich to poor countries and - within poor countries - to the most productive of them. Over time, less capital has been flowing to poor countries even though they have improved their financial systems. Foreign capital has not even been flowing to the fastest growing economies; in recent times, the direction has been reversing. Foreign direct investment from private sources does follow the theoretical expectation, admits Prof. Rajan, but a different pattern emerges when one looks at the big picture.

A reason for this anomaly is the limited ability of domestic financial systems in non-industrial countries to effectively absorb and deploy foreign capital. Where financial infrastructure is poor, the ‘development effect’ of capital on growth is diluted or eliminated, postulated Prof. Rajan, who is an Eric J Gleacher Distinguished Professor of Finance.

Basing his findings on empirical data from 1970 to 2004, Prof. Rajan highlighted that the pace of growth in non-industrialised countries is positively correlated with savings rather than with investment. Therefore, in what was probably a message for Sri Lanka, he recommended reliance on financing through domestic savings rather than from foreign capital sources. “Be open without being excessively reliant,” he said.

In fast-growing economies, excessive domestic consumption and dependence on foreign capital leads to currency over-valuation and concomitant lowering of exports. This adversely impacts returns on investment and overall growth. Besides, as country income increases, people spend on low-supply goods, resulting in higher inflation.

Earlier, delivering the inaugural address, Ajith Nivard Cabraal, CBSL Governor, admitted that the country’s per capita income of US$ 1,355 does not reveal the actual situation. The Western Province has a per capita income of US$ 1,900, while the other eight provinces average less than US$ 800. We cannot double per capita income every six to seven years with ‘our’ own resources, he said. “We need to look at foreign direct investment and borrowings.”

Cabraal emphasised the need to make Sri Lanka more marketable. With infrastructure projects worth US$ 5 billion in the pipeline, he urged the gathering of bankers to move forward despite the challenges. W. A. Wijewardena, Deputy Governor - CBSL, spoke on ‘Central Banking: Six Decades after John Exter, the first governor of the central bank’. The Exter Report presented the case for a central bank in the country.

That was at a time when (then) Ceylon was operating under the Currency Board system and the country’s currency was backed by foreign reserves maintained with the Reserve Bank of India.


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