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Inflows can turn out to be outflows
May, 03rd 2007

Many developing countries actively woo foreign investment into domestic enterprises. A serious risk, though, is that unfettered inflows can turn out to be outflows, as Kavaljit Singh cautions in Why Investment Matters, from the Forests and the European Union Resource Network ( "The foreign company can finance the equity buyout of a domestic company through domestic banks and lenders," explains the author, who is director of Public Interest Research Centre, New Delhi. He cites, as example, the Dabhol power plant, which got the bulk of its debt funds from Indian banks.

FDI (foreign direct investment) involves substantial foreign exchange costs, says Singh. "Capital can move out of a country through remittance of profits, dividends, royalty payments, and technical fees." In the case of Brazil, for instance, foreign exchange outflows `rose steeply from $37 million in 1993 to $7 billion in 1998'.

A paper on the Brazilian economy by Fernando Seabra and Lisandra Flach, on http://economicsbulletin., says, "Unregulated FDI flows can bring about serious difficulties to balance of payments owing to high import content and profit outflows related to multinational capital." Using the Granger causality test procedure developed by Toda and Yamamoto, the paper forecasts that Brazil will be facing `a remarkable increase in profits remittance considering the vast capital inflows registered during the late 1990s.' In many African economies such as Botswana, Democratic Republic of Congo, Gabon, Mali and Nigeria, profit remittances are higher than FDI inflows during 1995-2003, notes Singh, on the strength of UNCTAD data.

The author, therefore, calls for cost-benefit analysis of foreign investment, especially in the service sector, considering the fact that FDI has a growing share in telecom, energy, construction, retailing, financial services and so on. Worryingly, `capital can also move out of the country via illegal means such as transfer pricing and creative accounting practices'.

Transactions can be so structured as to undervalue profits and reduce tax burden in the host countries, cautions Singh. "For instance, oil giant Exxon never paid any taxes in Chile as it had never declared any profits during its 20 years of operating in the country."

Another example reads thus: "A Korean firm manufactures an MP3 player for $100, but its US subsidiary buys it for $199, and then sells it for $200. By doing this, the firm's bottom line does not change but the taxable profit in the US is drastically reduced. At a 30 per cent tax rate, the firm's tax liability in the US would be just 30 cents instead of $30."

The US is estimated to be losing $30 billion in tax revenues, despite its elaborate regulatory regime governing transfer pricing. Curbing transfer pricing misuse is not easy, concedes Singh. "It requires international coordination to build standardised invoicing and customs procedures besides harmonising tax and arbitration systems."

He emphasises the need for enlargement of the rights of governments over transnational capital through policy measures such as tough competition laws, increased corporate taxes, capital controls, taxes on speculative investments, and stricter labour and environmental regulations.

"Growth must emanate primarily from domestic savings and investments," insists Singh. "Rather than focussing on export-led growth, domestic markets should act as the prime engines of growth."

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