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The kind of investment that matters

  • Published at 11:48 pm January 5th, 2019
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How poor countries really get richer

Foreigners are taking their money out of the Bangladesh stock market, the DSE. This isn’t much of a problem as an actual thing, outside money coming into the stock market isn’t an important determinant of how the economy is doing. We might use it as a guide to what else we might think is going wrong or could be made better in the economy but that’s all.

Not that this is very different from the concept of foreigners investing in Bangladesh -- that is important and we’d be very worried indeed if more was going out than it coming in. It’s the distinction between “investment” and “investment in the stock market” that matters here. 

Investments into the stock market -- and bonds and the like -- are what we call “portfolio” investment. It’s really not all that important an issue in the grander view of the economy. In fact, the usual warning is that we don’t want too much of it, for if things start to go bad it can all rush for the door at the same time. The underlying point here is that foreigners, when they do this portfolio investment, are almost always investing in old share or bonds, those that already exist. No new money flows through into the real economy, that is, we just see the prices of stocks and bonds rising.

This has its effect, it most assuredly does, for if companies are more valuable, then it is easier to raise money for a new one -- and the incentive to start is greater, as the rewards from success are greater. But this is an indirect effect and as such it’s obviously more attenuated than the same money arriving through other routes.

The most obvious other route is when foreigners invest not in shares, but directly into land, factories, buildings and the rest. This is called “direct foreign investment” and it’s a very important part of a country’s development. A poor country is poor because it has little capital, so, more capital coming in from elsewhere is going to make it richer.

How it makes a place richer is that it makes those new factories, buildings and so on which people can then make a living in. Or buys the machinery -- is, often enough, the machinery -- which makes labour more productive and as we all know more productive labour gets paid more. 

We’re really very interested indeed in there being more direct investment, even as we think that portfolio as such is only mildly so, and comes with the associated risks of greater volatility.

There is one other little wrinkle to this though. This is the truism that the balance of payments always balances. This is an identity, it’s something we specify before we start, so it’s not something we can argue about. That balance is made up of the current and capital accounts – it’s a little more complex in detail than this, but not much.

The current account is the trade balance -- again, skate over the precise details -- and this is the thing people perennially complain about for Bangladesh. That the country imports more goods and services than it exports. We call this the trade deficit and my, doesn’t everyone complain about the existence of that?    

The capital account is the net investment position. Portfolio and direct added together, looking at whether there’s more capital flowing out of Bangladesh than into it. And here’s where that balance part comes in. If there’s a trade or current account deficit then there must be a capital account surplus. 

Also vice versa, a trade surplus must mean capital slowing out of the country. It continues to work in other ways too -- if we’ve got more capital coming in than going out, then we must be running a trade deficit. As above, this is an identity, it’s in our original definition, we can’t argue about this.

So, we think that capital coming in is a great idea for a poor place, this means that poor place should be, must be, running a trade deficit. Which rather puts that concern in its place. We can take this further too in our analysis of the Bangladeshi economy. 

We’ve not really noticed the trade deficit falling all that much recently -- to put it mildly. Thus about the same amount of capital must be flowing in. But we can also see that the portfolio capital amount is negative. 

Our capital coming in is being invested into factories and machinery and productive things like that instead of just buying second-hand financial assets and doing little other than changing their price.

Yes, obviously, it’s vaguely disappointing that foreigners aren’t realizing the economic success story that is the development of the Bangladeshi economy. But a proper analysis of the inflows and accounts shows that the overall change is almost certainly beneficial.

Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.