Developing countries, also known as the emerging markets, have attracted tremendous interest of foreign capitals from their richer counterparts. The reason is simple, there is more room for growth. This huge inflow of capital, usually in the form of foreign direct investment or international bank lending, is subjected to a number of systematic risks that the investors would be aware of. The risks include economic and political ones, such as the fluctuation of currency exchange rate, protectionism-driven trade policies, and local tax codes. Developing countries courting the global capitals nowadays are willing to stabilize their exchange rates, lower their tariffs for imports and reduce the corporate tax that foreign companies. Some ex-developing countries have successfully leveraged these policies to attract foreign investment, and simultaneously build their own economies using the technical and managerial expertise that come along. Ireland, the celtic tiger in the 90s, is a case in point. The low corporate and export tax combined with the highly educated workforce of the country have attracted numerous multinational companies to put regional headquarters and manufacturing divisions in there, and ireland gradually becomes the export platform for these firms. Many cities in China, such as Shanghai, Dalian, Tianjin, now all have the so-called high-tech zones, which are trying to do what exactly ireland, south korea, taiwan, or singapore were doing 10-20 years ago.
There are other risk factors that foreign capitals might face in developing countries that are not as easy to manage. The top three risks are social-political instability, corruption and lack of transparency. Social-political instability affects the security of the capital investment and the market demand (which might be highly manipulated by the governments). The poorest countries in the world have always been those with constant domestic unrest, albeit they might have the lowest wages. Corruption puts the foreign investment in an unfair competition. Foreign companies are restrained to bribe local officials to be favored over a government bid, for example, will lose to another firm which is willing to do so. The winner of the bid might not necessarily have the most cost-effective solution. The bidders who on the other hand have the expertise are discouraged from participating again. At the end, everybody loses except the corrupted officials, who usually are not accountable for how they are spending the tax-payer's money. Furthermore, accurate and updated financial information, macro-economic data, and information about government policies are usually not easily available to foreign investors. As a fund manager deciding which chinese companies to put your clients money into, for instance, you bear a lot of risks: does the company you are researching published trustworthy financial statement? Is the unemployment rate reported by the government accurate enough so that I can use that to plan my factory capability? Will my investment on a certain project be at risk if suddenly the government change its policies to favor another project?
These questions are exactly what a developing country should tailor its economic reform to address to make the country more attractive to a continuous flow of foreign investments. Feasible economic measures to reduce corruption, include reducing relation-based bank lending, better accounting standards and allowing more foreign competitors to enter the local market. If banks are operating on their own instead of being guaranteed by the government, they would only lend loans to the most profitable projects. If more foreign players are let in, with their more sophisticated operations and managements, weaker local companies who used to rely on bribery will be forced out of the competition. Fast and more accurate disclosure of information too is desirable for governments as well as for banks and private companies. In U.S., macro-econ data is published everyday, both by public and private agencies. Investors learn these data and make decisions. Such efficiency can quickly direct resources to the most needed areas away from those non-profitable ones. In developing countries, herding among investors (investors following not their data-driven decisions but the crowd) is a common phenomenon. The root cause is the lack of accurate information that they can study. Such herding tends to amplify the economic cycle and driving output and asset prices higher in booms and lower in slumps. The economic stability will therefore be seriously damaged due to the lack of information.
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