Foreign Capital Formation

A crucial element in the economic growth of any country lies in the enlargement of its productive capacity.  A key requirement of this process is “investment” – whether in physical capital, human capital, research and technical change, exploration of natural resources or for the up gradation of important institutions. Another investment in social overhead capital like communications and transportation systems, schools, health care systems also help facilitate economic development.

What are Investments and how do they help in Capital Formation?

  • Investments result from savings is represented by a surplus or excess of income over consumption. Low rates of savings and investment and rapid population growth are the hallmarks of underdeveloped economies. 
  • Underdeveloped economies are essentially subsistence economies. They may have good natural resources but not the capacity to develop them.  Their production of goods and services can only meet current needs of its people and the savings which represent postponement of consumption cannot support or lead to investments.
  • Investments help in developing the production capacity of the economy which in turn leads to a growth rate which is higher than population growth and consumption needs.

Plans for economic growth seek to supplement the low domestic savings rates – i.e. Savings by entities within the nation with savings of foreign nations, many of which are in a position to make investments in countries outside their own.

How does this process work?

Underdeveloped nations attract foreign capital investment by offering higher rates of return on the investment – than the amount they would get if they invested the money in their own countries.  Capital seeks high return or reward.  This is after factoring in and balancing the risks that are inherent in such investments. 

Foreign savings and investments thus add to augment the low levels of domestic savings and investment leading to a higher level of capital formation in a developing nation.  This is referred to as foreign capital formation. 

Foreign capital is attracted or can be drawn into an economy through two channels:

  • Direct investment where the foreign investor or institution sets up and helps local investors/institutions in joint ventures
  • Setting up industries, factories and also investing in social overhead capital and other types of capital. 

This is also known as Foreign Direct Investment.  It is very important for developing economies in helping them to grow at an accelerated pace.