GCE A'Level CSQ 2021 Question 2- Suggested Answers
(a) State what is meant by foreign direct investment (FDI) and identify the component of the balance of payments account in which FDI is recorded. [2m]
Foreign direct investment occurs when a foreign firm (usually a multinational corporation) invests to acquire at least 10% equity/ownership of a local firm.
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Financial Account
(bi) Explain the opportunity cost of investment expenditure that uses domestic funds. [2m]
Opportunity cost is defined as the value of the next best alternative forgone.
Larger profits/dividends that can be earned and repatriated back to the home country from a larger foreign market sector.
(bii) Using a production possibility curve diagram, show the impact of infrastructure improvements in a country such as Singapore or Vietnam. [2m]
Infrastructure improvements in Vietnam would improve Vietnam’s trade readiness, thereby attracting more foreign investments and being able to export goods and services to other nations. This increases the real national output of Vietnam and more resources are being utilized to produce capital and finished goods. This is shown by the movement from point X to Y on the PPC diagram. The accumulation of fixed capital also increases the productive capacity of the country causing the PPC curve to shift outwards from PPC0 to PPC1.
(c) Explain how the current account of the balance of payments of Singapore or Vietnam is likely to be affected in the long run by increased FDI. [6m]
The balance of payments records all economic transactions between two countries. It can be broken down into the current account and capital and financial account. The current account comprises goods balance, services balance, primary income balance, and secondary income balance.
With reference to Extract 6, “China was the largest contributor to Vietnam’s FDI and they have been concentrated in manufacturing”. In light of the US-China trade tensions, Chinese firms have relocated their manufacturing production facilities to Vietnam in order to evade tariffs imposed on Chinese exports. Over time, Vietnam is able to export goods and services to the US resulting in the “sixth largest trade deficit with the US”. Since the trade balance is made up of export revenue minus import expenditure, a large export revenue would improve the trade balance and subsequently the current account of the balance of payments.
However, in the long run, as these Chinese manufacturers earn income from exporting goods and services to other nations, they would want to repatriate their income, profits, dividends back to their home country. There will be a net income outflow from the primary income balance of the current account. Assuming that there are no capital controls in Vietnam restricting the amount of income that can flow out of the primary income balance and also the amount of primary income outflow is greater than the value of the goods, services, and secondary income balance, the current account would be an overall deficit. It seems that foreign firms would repatriate their incomes in the fourth quarter of each financial year as shown in Figure 2 where Vietnam’s current account surplus would worsen compared to the previous quarters.
(d) Discuss whether broad export diversity or specialization in a narrow range of exports is more likely to be beneficial for an economy engaged in international trade. [8m]
Note: Common Last Topic for Year 2021
(e) Discuss whether a government should encourage domestic investment rather than investment from external sources to improve the standard of living. [10m]
Standard of living is defined as the quality of life of an average citizen in a country. It can be further broken down into two categories - the material standard of living which represents the quantity and quality of goods and services consumed by the average citizen and the non-material standard of living which represents the intangible/qualitative aspects of life such as happiness, stress levels, pollution levels and level of safety.
Thesis Statement: Governments should encourage domestic investment to improve the standard of living of their citizens. Countries like Vietnam made the list of the Trade20 Index due to improvements in infrastructure which aids in factor mobility and investment attractiveness. Since domestic investment expenditure and net exports are components of aggregate demand, it will increase, shifting the AD curve rightwards from AD0 to AD1. This would cause an unplanned fall in inventories that would spur producers to increase the production of output in the next cycle. This increases the real national income from RNY0 to RNY1 by a larger amount through the multiplier process. There would also be a fall in demand-deficient unemployment. Collectively, citizens would experience an increase in purchasing power and thus have a greater ability to afford a variety of goods and services, enhancing their material standard of living.
Investment expenditure also results in the accumulation of fixed capital and enhances the level of technology in an economy. This increases the productive capacity of the economy which causes the LRAS curve to shift rightwards from LRAS0 to LRAS1. Full employment level would increase from Yf0 to Yf1. The economy experiences potential growth. When potential growth occurs in tandem with actual growth, the economy achieves sustained economic growth. This allows the economy to produce more output without having to suffer the consequences of supply bottlenecks that would otherwise result in demand-pull inflation. If price stability is achieved, it helps to increase real wages or real purchasing power that would allow consumers to increase the quantity and quality of goods consumed, thereby enhancing their material standard of living. Investments in green technology or labor productivity may also improve the non-material standard of living. For example, with the increased use of electric vehicles made possible by technological advancements, fewer carbon emissions are released to the environment resulting in lower amounts of negative externalities to the average citizen. Labor productivity-enhancing technology can also give rise to lesser working hours and thus more leisure hours.
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Whether a government should encourage domestic investment rather than FDI depends on a few factors. Domestic investments tend to create more long-term stable jobs for its citizens as opposed to FDI which is notorious for its “foot-loose” syndrome. MNCs are mostly bent on saving costs and if wages or unfavorable factors arise, they will relocate their investments to other countries in seek of higher returns. This is seen when China’s wages are less competitive to Vietnam and the trade war with the US makes Chinese exports less price competitive. This may result in mass structural unemployment in the host country which would hurt both the material and non-material standards of living of its citizens. Furthermore, profits earned by MNC firms are not circulated within the host country which would generate even more induced consumption via the multiplier process thereby creating more employment opportunities down the line. Instead, capital is being withdrawn from the host country to benefit the citizens in their home country. Hence, the improvement in the material standard of living via FDI is less pronounced.
On the other hand, FDI does have its merits. It can help developing countries develop more rapidly through large-scale capital investments and transfers of technological know-how that will help bring about economic dynamism to the host country. Governments would also step in to improve their trade readiness to attract more FDI which would result in more infrastructural spending; increasing both AD and LRAS of the country as evidenced by Vietnam’s Trade20 Index ranking. This benefits citizens' material and non-material standards of living.
In conclusion, whether a government should encourage more domestic or foreign investment does depend on several factors. Governments should assess the risks involved where MNCs takes advantage of the host country in terms (1) resource depletion resulting in pollution and unsustainable growth, (2) exploitation of labor without strict enforcement of labor rights, (3) having the ability to repatriate unlimited amounts of profits back to home country, (4) tendency for the MNC to relocate to other countries after a short period of time (5) risk of corruption between government officials and MNCs to the demise of its citizens and much more. If all these factors are being carefully considered, then the government should encourage more FDI to rapidly improve the living standards of its citizens and enhance economic dynamism.