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