Economic Stability Issues - Case Study Example

Economic Stability Introduction This paper will explore the meaning of economic stability and discuss how the phenomenon affects international business, particularly foreign direct investment (FDI) in a country. To achieve this, the paper will discuss economic stability of two ASEAN countries – Vietnam and Singapore – and explore the suitability of these countries as preferred locations for FDI. Meaning of economic stability and how in affects international businesses A country’s economic stability can be thought of in terms of the country’s financial system’s capacity (a) to facilitate an efficient allocation of economic resources – both intertemporally and spatially and the effectiveness of other economic activities such as economic growth, wealth accumulation and social prosperity; (b) to evaluate, price, allocate and deal with economic risks; and (c) to maintain its capacity to perform these critical functions even when impacted by external shocks or growing imbalances –essentially through self-corrective approaches (Schinasi 2004, p. 8). Economic stability is viewed in terms of macroeconomic stability and includes price stability and sound fiscal policy, as well as budget deficit, inflation, balance of payments, and so forth (Buxheli 2011, p. 34). When there is macroeconomic stability, the situation implies that there is sustainable economic growth, a low level of inflation and exchange rate risk, and a low degree of unemployment (Neuhaus 2006, p. 147; Sheeba 2011, p. 626). Countries that have macroeconomic stability also have in place fiscal discipline and sufficient forex reserve coverage (Neuhaus 2006, p. 147). The factors that characterise macroeconomic stability have a significant impact on the level of investment, especially FDI in a country. According to Sheeba (2011, p. 626), an economy that is economically stable will attract FDI. In contradistinction, the volatility of macroeconomic factors was explored by Baniak and others (2005), who found out that it reduces FDI (cited by Buxheli 2011, p. 34). According to Neuhaus (2006, p. 147), an absence of macroeconomic stability creates a high level of uncertainty in any investment project, be it domestic or foreign. The level and predictability of the rate of growth determines the potential for future investment projects. Any risk that emerges from the probable depreciation of the host nation’s currency leads to a decline in FDI since a depreciation lowers the profits denominated in the donor country’s currency. Additionally, a low level of inflation and a steady fiscal balance improve the credibility of the government with regard to its long-term economic policy. On top of this, high deficits may necessitate governments to introduce capital controls, which may scare foreign investors. As pointed out by Banga (2008, p. 128), a large and continuous budget deficit in an economy may be a pointer to economic instability in the host country, and as such, it has a negative ramification on FDI flows. On the other hand, a stable macroeconomic environment clears the way for solid growth, which in turn increases the market potential, makes the economy stable and may propel the country into a virtuous circle (Neuhaus 2006, p. 147). Buxheli (2011, p. 34) also analysed various studies conducted by Dassagupta and Ratha (2000), Al Nasser (2007), Schenider and Frey (1985) and Venables (1997) to determine the impact of macroeconomic stability on FDI. The major finings from these studies presented by Buxheli (2011) were that stable economies enhance and sustain economic growth and thus incentivise more investments than unstable economies; per capita income and balance of payments are significant parameters that influence foreign investments; and risk more probably has a negative impact on investments. The gist of the discussion above is that countries that experience economic stability are likely to offer suitable conditions for doing business and as such they are likely to attract more FDI, and the opposite is true for countries that lack economic stability. Vietnam’s economic stability as a preferred location for FDI According to Pham (2004, p. 29), the economy of Vietnam experienced economic stability and grew rapidly at a rate of 8 per cent annually since 1986. Imports and exports have also increased significantly while inflation has remained below 10 per cent. For this reason, many foreign investors have chosen Vietnam instead of other, similarly endowed developing states in Latin America or Africa because of this stability. Much of the economic growth in Vietnam was based on the steady increase in investments between 1986 and 1996, and the relative stability in absolute investments between 1997 and 2000. FDI declined in 1997 but the state played a more important role in reviving the economy towards the end of the 1990s. Overall, Vietnam’s share of total investments increased from 38 per cent in 1995 to 62 per cent in 2000 (Luong 2003, p. 12). According to Vuong (2010, p. 365), the economic conditions in Vietnam have stabilised over time, following the shakeout departing from the previous centrally planned economic model. The growth of macroeconomic indicators in the economy suggests that the economy continues to maintain the growing pace, with the single most outstanding indicator of real GDP rate, being ranked second only to China in the entire Asian region in the wake of Asian financial crisis of 1997. In short, Vietnam has succeeded in achieving economic stability, thanks to its overwhelming transition process (Vuong 2010, p. 365). Since the 1990s, the following factors have contributed to a significant increase in the suitability of Vietnam as an FDI destination. First is the curiosity of what was behind the scenes in Vietnam’s economy, which did not collapse as would be expected with the demise of the former USSR and the collapse of the whole Eastern European Soviet bloc. The second point is that besides being a market itself, Vietnam, with a stable economy, was regarded as a gateway to another huge market – that is the People’s Republic of China (Hoang 2003, p. 12). In recent times, Vietnam has been enjoying relatively stable macroeconomic conditions but according to the World Bank (2012) the economy is slowing down due to the absence of tangible progress on the restructuring agenda. The following projections were made by the World Bank (2012) regarding the economic stability of the country: Vietnam’s economy was anticipated to grow at 5.2 per cent in 2012, this being the slowest rate in a decade. However, the economy was expected to pick up to 5.5 per cent in 2013. Year-on-year inflation dropped from 23 per cent in August 2011 to 7 per cent in November 2012. Sectors in which prices were controlled by the government experienced higher and more unpredictable inflation than those sectors that operated under market determined forces. Total export turnover was expected to increase by 18.4 per cent in 2012 compared to 2011. Imports slowed down significantly in 2012 following the economy’s sluggish growth. The country’s current account was said to have improved, from a notable deficit of 11.9 per cent of GDP in 2008 to a low level of 0.2 per cent in 2011. Further, it was projected that there would be a surplus of 2.7 per cent in 2012. Inefficiencies in state-run enterprises, public investments and banks were noted to have pulled down Vietnam’s long-term potential of growth. Even then, the government prioritised these areas and needs to put more effort in reform. From the points above, it is notable that even though Vietnam has witnessed a long period of economic stability, recent occurrences such as high inflation and slow economic growth are likely to slow down investors’ intentions to do business in the country. For instance, Sinha (2008, p. 35) argues that inflation can affect the purchasing power of consumers and therefore demand for a transnational corporation’s goods. Further, Sinha (2008, p. 35) points out that countries with lower inflation attract higher FDI. There is hope for Vietnam to attract investors since inflation was projected to drop and the government has embarked on a series of other economic reform measures. Singapore’s economic stability as a preferred location for FDI Singapore’s economic stability dates back to 1965 after the country’s separation from Malaysia. The Singaporean government aggressively sought to attract foreign capital to Singapore and hence it invested in wholly foreign-owned enterprises but also sought to bring local investors in the mix, who would then work as suppliers to multinational subsidiaries. Singapore has always had an open door policy towards foreign investment and with greater competitiveness of foreign firms in the export segment, the country has undoubtedly the most heavily dominated manufacturing sector in the world (Lim & Pang 1991, p. 52). According to Van Elkan (1995, p. 11), Singapore’s rapid growth can largely be attributed to policies that promoted macroeconomic stability such as low inflation, sound fiscal management and positive real interest rates, as well as limited price distortions in the economy (that is liberal foreign trade policies coupled with an exchange rate policy that avoided lengthy periods of real exchange rate misalignment). Additionally, Singapore has relied on market leading policies to actively promote investments in sectors that are thought to possess the greatest potential for growth such as FDI. In recent times, Singapore’s macroeconomic indicators have pointed to a stable economy that has the potential to attract even more FDI. For instance, in 2010, the country was the third fastest growing economy after Qatar and Paraguay – with a real GDP growth rate of 14.471 per cent. The economy is a mixed economy in that the government advocates for free-market practices and policies but also intervenes in macroeconomic management of factors such as labour, land and capital resources. This system where both the government and market have an equally important role to play is referred to as the Singapore Model (Economy Watch 2010). The system for instance played a role during the 1997 Asian financial crisis in that the impact of the crisis on the Singaporean economy was mild. According to Jin (2000, p.1), the key to Singapore’s resilience to the crisis was effective use of wage instruments and exchange rate. Singapore’s managed exchange rate system enabled the country to quickly devalue the Singapore dollar in response to the loss of competitiveness of its exports due to the impact of the crisis in other Asian economies. The country also liberalised the Singapore dollar to facilitate the economy. Singapore’s economy has also been pegged on openness, which can generally be measured in terms of the proportion of exports and imports to GDP. The more an emerging market attempts to open its economy to outside external trade, the more it is able to attract more FDI (Sinha 2008, p. 39), and this has been the case with Singapore. Even then, it is this openness that made the economy of Singapore more vulnerable during the global financial crisis of 2008-2009 (Embassy of Israel in Singapore 2009, p. 3). During the crisis, Singapore’s economy was harshly affected by a decline in international demand for manufacturing exports. Service sectors were also affected by the sharp reduction in regional and global finance (ASEAN, Word Bank & Australian Government 2009, p. 1). Nonetheless, the government intervened with measures to protect jobs and to protect financial institutions (Embassy of Israel in Singapore 2009, pp. 5-6). These quick response measures are a sure way to guarantee investors of a stable economic environment for business, especially FDI. The preference for Singapore as an FDI destination is also boosted by the fact that the Index of Economic Freedom (2011) rated the country as the second freest economy in the world (Economy Watch 2010). Singapore also has significant business freedom in that its takes only three days to start a business, compared to the global average of 34 days. Singapore also has a favourable tax regime (Economy Watch 2010). Conclusion Economic stability refers to stability in macroeconomic factors such as budget deficit, inflation, balance of payments, and so forth. Both Vietnam and Singapore have had long periods of economic stability that have made them attractive destinations for FDI. While Vietnam is currently experiencing a sluggish economic growth rate and recently had high inflation, the government has embarked on reform measures which promise better prospects for inward FDI. Similarly, Singapore has maintained its position as one of the fastest growing economies in the world. With an annual real GDP growth rate of 14.471 per cent and an open economy, Singapore remains open to more investors and thus remains an attractive FDI destination. 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