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James Hines
  James Hines

Restricting Foreign Direct Investment Dampens Multinationals' Profits

12/27/2004 --

Profits may fall short of expectations when U.S. multinational firms invest in countries with capital controls.

ANN ARBOR, Mich. – Investing overseas in countries that impose restrictions on direct foreign investment may not produce the high returns U.S. companies expect.

A recent study at the University of Michigan's Stephen M. Ross School of Business reveals that multinational firms making new investments in countries with capital controls face higher costs of local borrowing and significant costs associated with the actions needed to mitigate the impact of those controls.

As a result, multinational firms end up investing significantly less than they would have if the targeted countries did not impose capital-account restrictions. In terms of profitability, foreign affiliates subject to capital controls report lower profit rates than comparable affiliates operating without restrictions.

"Countries that fear the economic disruptions that may accompany capital flows are often tempted to impose control on international capital movements," said James Hines, professor of business economics at the Ross School. "Yet, these same countries typically are eager to attract foreign direct investment, which presumably can have beneficial effects.

"Given the overall importance of foreign direct investment to economic growth, understanding the effect of capital controls on the behavior of multinational firms is valuable in assessing the economic impact of capital-account policies."

In their study, Hines and colleagues C. Fritz Foley and Mirhir Desai of Harvard University examine the activities of all U.S. multinational firms from 1982 to 1997 and analyze how the foreign affiliates of these companies respond to capital controls and the removal of foreign-investment restrictions. Their results reveal that foreign affiliates operating in countries with capital controls face 5.4 percent higher interest rates on local borrowing than affiliates of the same parent company located in countries without such controls.

The researchers also find evidence that American multinational firms circumvent capital controls by adjusting their reported intrafirm trade, affiliate profitability and dividend reparations. The distortions to reported profitability are comparable to those incurred in response to a 24 percent higher corporate tax rate.

Dividend repatriations by foreign affiliates in countries that control remittances are regularized, or smoothed, to enable multinational companies to extract profits. On average, these affiliates are 9.8 percent more likely than other affiliates in unregulated countries to remit dividends to parent firms.

Evading capital controls in these ways is costly, however, given the associated tax, resource-allocation and other business considerations that otherwise would guide dividend repatriations and trade between related parties, according to Hines, Foley and Desai.

"The costliness of avoidance and higher interest rates serves to raise the overall cost of capital, thereby significantly reducing the level of foreign direct investment and discouraging many potential investors from establishing affiliates in the first place," Desai said. "Our findings indicate the initial capitalization of foreign affiliates in countries with capital-account restrictions is 13 percent to 16 percent smaller than the initial capitalization of affiliates elsewhere."

This weaker start, however, is not offset by higher growth through increased profit retentions, the researchers say. Foreign affiliates in countries with capital controls not only begin with fewer assets, but also accumulate retained earnings at slower rates. The bottom line is that these affiliates have 4.7 percent lower reported profit rates than comparable affiliates in countries without capital controls.

Firms without access to internal capital markets are hardest hit by capital-account restrictions, according to Hines, Foley and Desai.

"Capital controls not only raise the costs of capital faced by smaller domestic firms but also put them at a disadvantage relative to larger multinational competitors," Foley said.

The study results show, however, that the effects of capital controls are reversed when limitations on foreign investment are removed.

For more information, contact:
Bernie DeGroat
Phone: (734) 936-1015 or 647-1847