9
Foreign Capital and Urban Congestion in Emerging Markets Ravi Batra and Hamid Beladi* Abstract Traditional literature emphasizes the role of foreign capital, especially foreign direct investment (FDI) in explaining the high growth rates that many emerging economies have enjoyed during 1990s and 2000s. The present paper accepts this conventional wisdom but argues that the FDI has also created problems of urban sprawl and congestion that would not be so intense if economic development had primarily come from domestic sources. This is because the FDI is typically concentrated in urban areas that abound in manufac- turing and it neglects the rural areas where agriculture predominates. The paper suggests that a small tax on foreign capital tends to mitigate the side effects of foreign investment. 1. Introduction Many emerging markets such as India, Ireland, Brazil, and China have made great economic strides during 1990s and 2000s. Their growth rates have been impressive, some routinely exceeding 8% per year. Their living standards have also risen signifi- cantly, and foreign capital seems to have played a substantial role in their develop- ment. In fact, a vast literature has developed to show that foreign capital, especially foreign direct investment (FDI), has been a major force in the rapid growth of most emerging economies. Foreign capital not only fills the critical savings gap of recipient countries, it also provides new technology that makes labor very productive. Fre- quently, the FDI providers help with product marketing so that goods can be imported into developed countries. This way foreign investment brings a variety of benefits to host nations and raises their living standards. This is what the traditional literature emphasizes, especially the spillover effects of FDI, 1 yet the emerging markets have experienced problems that may be typically associated with capital inflows and the FDI. Urban congestion or sprawl is one such problem, which perhaps would not have been so intense if growth had come primarily from the use of domestic resources. Urban population growth rates have been far greater than the growth of general population, especially in India, Singapore, and Thailand among others. Take, for instance, the case of India, which has been well documented by Sivaramakrishnan and Singh (2001). The authors show that over a 100 years from 1901 to 2001, India’s urban population jumped from being 11% of the total population to as much as 28%. By 2025, this percentage is expected to rise to 42%. Furthermore, much of the urban population growth occurred in five major cities of Bombay, Calcutta, New Delhi, Madras, and Bangalore. These are also the cities that have received the bulk of FDI, suggesting that the growth in FDI parallels the growth * Beladi: University of Texas at San Antonio, San Antonio, TX 78249, USA. E-mail: hamid.beladi@ utsa.edu. Batra: Southern Methodist University, Dallas, TX 75275-0100, USA. We are grateful to anony- mous referees for constructive comments on an earlier version of this paper. The usual disclaimer applies. Review of Development Economics, 17(4), 676–684, 2013 DOI:10.1111/rode.12058 © 2013 John Wiley & Sons Ltd

Foreign Capital and Urban Congestion in Emerging Markets

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Page 1: Foreign Capital and Urban Congestion in Emerging Markets

Foreign Capital and Urban Congestion inEmerging Markets

Ravi Batra and Hamid Beladi*

AbstractTraditional literature emphasizes the role of foreign capital, especially foreign direct investment (FDI) inexplaining the high growth rates that many emerging economies have enjoyed during 1990s and 2000s. Thepresent paper accepts this conventional wisdom but argues that the FDI has also created problems of urbansprawl and congestion that would not be so intense if economic development had primarily come fromdomestic sources. This is because the FDI is typically concentrated in urban areas that abound in manufac-turing and it neglects the rural areas where agriculture predominates. The paper suggests that a small taxon foreign capital tends to mitigate the side effects of foreign investment.

1. Introduction

Many emerging markets such as India, Ireland, Brazil, and China have made greateconomic strides during 1990s and 2000s. Their growth rates have been impressive,some routinely exceeding 8% per year. Their living standards have also risen signifi-cantly, and foreign capital seems to have played a substantial role in their develop-ment. In fact, a vast literature has developed to show that foreign capital, especiallyforeign direct investment (FDI), has been a major force in the rapid growth of mostemerging economies. Foreign capital not only fills the critical savings gap of recipientcountries, it also provides new technology that makes labor very productive. Fre-quently, the FDI providers help with product marketing so that goods can beimported into developed countries. This way foreign investment brings a variety ofbenefits to host nations and raises their living standards.

This is what the traditional literature emphasizes, especially the spillover effects ofFDI,1 yet the emerging markets have experienced problems that may be typicallyassociated with capital inflows and the FDI. Urban congestion or sprawl is one suchproblem, which perhaps would not have been so intense if growth had come primarilyfrom the use of domestic resources. Urban population growth rates have been fargreater than the growth of general population, especially in India, Singapore, andThailand among others. Take, for instance, the case of India, which has been welldocumented by Sivaramakrishnan and Singh (2001). The authors show that over a 100years from 1901 to 2001, India’s urban population jumped from being 11% of thetotal population to as much as 28%. By 2025, this percentage is expected to rise to42%.

Furthermore, much of the urban population growth occurred in five major cities ofBombay, Calcutta, New Delhi, Madras, and Bangalore. These are also the cities thathave received the bulk of FDI, suggesting that the growth in FDI parallels the growth

* Beladi: University of Texas at San Antonio, San Antonio, TX 78249, USA. E-mail: [email protected]. Batra: Southern Methodist University, Dallas, TX 75275-0100, USA. We are grateful to anony-mous referees for constructive comments on an earlier version of this paper. The usual disclaimer applies.

Review of Development Economics, 17(4), 676–684, 2013DOI:10.1111/rode.12058

© 2013 John Wiley & Sons Ltd

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of urbanization. In this respect, what is true of India is also true of other emergingeconomies. According to a 2009 report on urban poverty, “The next few decades willsee unprecedented scale of urban growth in the developing world including those inAsia and Africa continents. The urban population in these two continents will doublein a period of 30 years” (UNDP, 2009).

Thus, there is plenty of evidence that FDI and urbanization have moved together,and, as mentioned above, increased urbanization creates problems of its own. Longtraffic jams in big cities of the developing world are now common; so are the problemsof water and atmospheric pollution. In fact, many articles have pointed to a direct linkbetween the FDI and growing pollution in the developing world in the form what iscommonly called “the pollution haven hypothesis.” The idea is that some foreignfirms avoid stringent pollution laws and regulations at home and relocate their opera-tions to a developing country, where such controls are either absent or go unenforced.This literature thus argues that FDI generates a negative externality.

There is also a contrary opinion suggesting that foreign companies may bring intheir higher environmental standards and pollution-efficient technology not availablein the emerging market.2 However, our focus is on a different aspect of direct foreigninvestment, which tends to be concentrated in urban areas, while neglecting the ruralsector. Such a development also has implications for urban unemployment and realwages. The present paper focuses on the role of foreign capital in creating such prob-lems, but we also analyze how the FDI raises gross national product (GNP) and eco-nomic growth. We do all this in the context of the well-known Harris–Todaro model,which is commonly utilized to explore the effects of economic policies on urbanmigration and unemployment.3

2. The Model

We assume perfect competition in product markets, linearly homogeneous productionfunctions, a small economy and inelastically supplied domestic factors. However,foreign capital has no supply constraint for a small economy and can be obtained ata cost of r*. Given these assumptions, our model starts out with the followingequations.

A A L K L g ka a a a= ( ) = ( ), (1)

M M L K B L f k bm m m m= ( ) = ( ), , , (2)

where (1) and (2) present the two production functions in agriculture A and manufac-turing M, with agriculture being the predominant occupation in rural areas and manu-facturing in the urban sector. L and K are domestically supplied resources of laborand capital, with the subscripts denoting the extent of their employment in eachsector; however, B denotes foreign capital which is used only in the urban sector.Here ki = Ki/Li (i = a,m) and b = B/Lm. The production functions are presented in theregular as well as intensive forms. Suppose Wm is the real wage in manufacturing orthe urban sector, P is the relative price of M, r* is the cost of foreign capital, rm is thereturn to capital in M, fk is the marginal product of domestic capital employed in M, fb

is the marginal product of foreign capital, and

f k f bfm k b− −( )

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is the marginal product of labor in M; similarly, gk is the marginal product of capitalemployed in agriculture or the rural sector, and (g − kagk) is its marginal product oflabor. Then assuming perfect markets,

W P f k f bfm m k b= − −( ) (3)

r Pfm k= (4)

r Pfb* = . (5)

These three equations furnish the factor-market equilibrium conditions in manufac-turing, so that the real wage in M equals the marginal value product of labor, rental ofdomestic capital equals the marginal value product of that capital, and the rental orthe cost of foreign capital equals the marginal value product of foreign capital. Simi-larly in agriculture or the rural sector, the following equations (6) and (7) describe thefactor market equilibrium.

W g k ga a k= − (6)

r ga k= . (7)

Because of domestic capital mobility,

r r ra m= = . (8)

Similarly, because of labor mobility agricultural wage equals the expected wage inmanufacturing.

Let e be the probability of finding a job in the urban sector, and Wm be its realwage, then eWm, as argued by Harris and Todaro, is the expected wage in manufactur-ing, so that

W eWa m= . (9)

The probability of finding a job in the urban sector equals

e L L Um m= +( ). (10)

Here e is also the urban rate of employment, because it is a fraction of urban employ-ment and the urban labor force, with U being the number of the urban unemployed.

We assume that domestic capital is fully employed in the two sectors and the laborused in the two sectors along with those unemployed add up to the supply of labor, sothat

K K L k L k Ka m a a m m+ = + = (11)

L L U L L L ea m a m+ + = = + . (12)

Finally, the GNP is given by

Y A PM Br= + − *. (13)

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Equation (13) argues that GNP equals the value of output in the two sectors minuspayment for the use of foreign capital.

Our analysis uses the following standard properties of the production functions, sothat

g f fkk kk kb< < >0 0 0, , (14)

N k f bf bf k f Nm kk kb bb m kb1 20 0= +[ ] < +[ ] = <,

and

H f f fkk bb kb= −[ ] >2 0.

In addition, we assume that Wm is the fixed minimum wage and that manufacturing iscapital-intensive relative to agriculture in both the physical sense and the value sense,that is,

k km a>

and

rKW L

rKW L

m

m m

a

a a

> (15)

or

k k em a> . (16)

Equation (16) is the well-known Neary condition for dynamic stability of the Harris–Todaro model.

3. Foreign Capital and Urban Congestion

Let us first explore how direct foreign investment affects urban congestion, whichincreases when workers from rural areas move to cities in search of employment at ahigher wage. There are three parameters in our model, Wm, p, and r*, and we firstseek to analyze the effect of a fall in r* or the cost of foreign capital, which tends toincrease the use of direct foreign investment. Thus increased foreign capital inflow isrepresented in our model by a fall in the cost of foreign capital, which is our param-eter. To solve for our variables, we start with equations (3) and (5), which contain twovariables, km and b, in two equations. Differentiating them totally with respect to r*gives us:

dkdr

ND

m

*= − >2 0 (17)

dbdr

ND*

= <1 0 (18)

where

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D k Hm= > 0.

Similarly, from (4) and (8), we obtain

drdr

bk

drdr

m

m

a

* *= − = < 0. (19)

Since N1 < 0, the right-hand side of (18) confirms that a fall in the cost of foreigncapital, r*, increases b or the capital-intensity of foreign capital in M. This in turnraises the demand for domestic capital and labor employed in M, which means thatthe return to capital in M must rise, as is clear from (19). However, Wm remainsunchanged, as it is constant by assumption. As a result, the demand for labor in Mrises faster than the demand for domestic capital, so that the capital–labor ratio in Mfalls, as is clear from (17). Since rm rises, capital moves from agriculture to manufac-turing, so ra also rises.

Let us see what else is happening in agriculture. For this we turn to (7) and solvefor ka, because once ra is solved, ka can be solved from that equation. This gives us:

dkdr

bg

ka

kkm

*= ⎛

⎝⎜⎞⎠⎟ . (20)

In other words, as r* falls, capital-intensity in agriculture falls as well. This is consist-ent with the rise in ra mentioned above.

In order to see how all this affects employment in the two sectors, we differentiateequations (9)–(12) with respect to r*, and obtain the following solutions.

dedr

bkw k

a

m m*= (21)

k k e dL L dk L dk k L e dem a m a a m m a m−( ) = − − − ( )2 (22)

dLdr k k e

L gk

L NHk

K e bk

w km

m a

a KK

m

m

m

m a

m m*=

−( )+ − ( )⎡

⎣⎢⎤⎦⎥

1 22

(23)

dUdr

bkw K

k ek k e

UK k k e

L gL N

Ha

m m

m

m a m m aa KK

m

*= +

−⎛⎝⎜

⎞⎠⎟ −

−( )+⎡

⎣⎢⎤1

22

⎦⎦⎥. (24)

Equation (23) furnishes the effect of how a fall in r* affects labor movement in manu-facturing. It is clear that dLm/dr* is negative. In other words, as r* declines, demandfor labor and its use increase in manufacturing. The conclusion is unmistakable.Increased FDI augments urban congestion, and makes life more difficult in emergingeconomies. This clearly happens because the agricultural wage declines, as is evidentfrom the fact that DWa = −kadra. We get this from (6) and (7).

As capital moves out from A, labor’s marginal product declines in agriculture, andso does its real wage. This induces labor to move out to manufacturing, and whilelabor’s employment rises in M, the urban rate of employment, e, actually falls. This isapparent from (21). At the same time, urban unemployment goes up, as the right-hand side of (24) is positive, which means that as r* falls, urban unemployment rises.

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dYdr

bk

kkem

ma

*= − −⎡

⎣⎢⎤⎦⎥. (25)

Now let us see how the increased capital inflow affects GNP, which is described in(25).

Since dY/dr* < 0, it is clear that a rise in direct foreign investment resulting from afall in the cost of foreign capital raises GNP, and hence the growth of the economy.

By now it should be clear that the model we have developed is consistent withmany of the facts observed regarding emerging market economies, some of whichhave enjoyed superb growth rates with the help of vast inflows of foreign capital butalso suffered extraordinary urban congestion along with rising urban unemployment.Our model shows that foreign capital indeed contributes to growth improvement, butby concentrating itself in manufacturing it also adds to negative externalities or side-effects of urban sprawl and reduced wages in agriculture.

4. A Tax on Foreign Capital

So what can be done to mitigate some of these side-effects. We suggest that a tax beimposed on the use of foreign capital in manufacturing. In fact, some nations such asBrazil, Indonesia, and Taiwan among others have already done so. In order to analyzethis case, equation (5) has to be rewritten as

1+( ) =t r Pfb* (26)

and equation (13) becomes

Y A PM t Br= + − −( )1 * (27)

where t is the tax on foreign capital. Other equations of the model remain the same.The tax, of course, reverses the negative effects of foreign capital, as is clear from thefollowing three equations, where the effects of differentiating with respect to t arepresented.

dedt

bk rW k

a

m m

=*

(28)

kke

dL L dk L dkk L

edem

am a a m m

a m−( ) = − − − ( )2(29)

dYdt

bk

kke

rm

ma= − −( ) *. (30)

Equation (28) shows that as the tax goes up, the urban employment rate rises asde/dt > 0. Similarly, dLm/dt < 0, so that the tax reduces urban migration and henceurban congestion. Finally, the tax also reduces GNP, as is clear from (30), asdY/dt < 0. Thus the tax policy suggests that the nation has to choose between highgrowth and the side effects caused by the FDI. Clearly, a few nations have chosen torestrain capital inflows because of their negative consequences. These nations felt thatthe negative consequences were only in the form of the rapid appreciation of their

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currencies4 so they imposed capital controls to bring a balance to their exchange ratesand thus improve their trade balance. However, our model suggests that there areother positive effects as well, such as the reduction of urban congestion, increased rateof urban employment and the fall in urban unemployment.

5. A Pollution Tax

An interesting question presents itself at this point. Can a tax on traffic congestion oron polluting firms, foreign as well as domestic, achieve the same results as a tax onFDI? The answer is “no.” While such a tax, which is often suggested to fight a nega-tive externality, is likely to reduce pollution and traffic congestion, it will not lowerurban unemployment or raise the agricultural wage. However, a tax on FDI willachieve this desirable objective. Any levy that affects producers in both sectorsequally, has no impact on resource allocation in the economy.

Similarly, a tax on domestic capital will have no effect on the real wage andemployment in the two sectors, again because employers in both areas will be affectedequally. However, a pollution tax can be combined with a tax on FDI to generate themaximum beneficial results of pollution restraint, urban jobless reduction and a rise inthe agricultural wage.

Eventually, the policy choice may depend on what is feasible. From a politicaleconomy perspective, the government may have a variety of tax instruments at its dis-posal to address the various big city externalities but may be afraid to use them forfear of being voted out of office by the people. However, a tax on FDI has been triedby some governments, such as Taiwan and Brazil, and this may be more feasible thanother types of levies.

6. Conclusions

There is a vast literature that shows that FDI has contributed significantly to the eco-nomic performance of many emerging market economies, including China, India,Brazil, Taiwan, Ireland, among others. This fact is undeniable, and this paper agrees.However, we argue that FDI has also resulted in several negative side effects such ashigher urban congestion and unemployment along with lower wages in agriculture.Accordingly, a nation may be better off by following a balanced growth policy,whereby slightly lower growth becomes desirable so long as the negative effects ofFDI are mitigated. Such an objective can be achieved by imposing a tax on the use offoreign capital in manufacturing that is located primarily in urban areas.

The paper offers a simple model of FDI and economic development. Because of itssimplicity, it can be extended in a number of ways. First, FDI is normally associatedwith an inflow of superior technology; how does this impact resource allocation, urbanemployment and agricultural wage? Similarly, the host nation may encourage foreigncompanies to bring in environmental friendly techniques not in vogue at home. Thismay then have only positive effects and no side effects at all. Another line of researchmay be to explore how FDI could help the rural sector, with the host country offeringincentives to foreign companies to open factories in rural areas. All these will makethe model more complex but at the same offer new insights into how developingcountries could harness foreign technology and investment for the good of theirpeople.

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Notes

1. See, for instance, Aitken and Harrison (1999), Barrios and Strobl (2002), Barrios et al.(2004), Chuang and Hsu (2004), Chuang and Lin (1999). Blomstrom and Kokko (1998),Braconier et al. (2001), and Girma et al. (2001).2. Jie He (2006) gives good account of both sides of the pollution haven debate.3. See Beladi and Marjit (1992a,b), Beladi and Oladi (2011), Bhagwati and Srinivasan (1974),Corden and Findlay (1975), Gilbert and Oladi (2009), Grinols (1991), Harris and Todaro(1970), Maiti and Mukherjee (2013), Neary (1981), Oladi (2004), Oladi et al. (2011) and Sarkaret al. (2008).4. This linkage is analyzed by Chakrabarti and Scholnick (2002), Cushman (1985), Escalerasand Thomakos (2008), and Goldberg and Klein (1998).

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