Forex: Forex and Domestic Investment
It is similar to domestic investment in that it increases income and employment in the process of capital formation and ultimately enlarges capacity for higher income after the capital has been formed.
On the first score, loans lead to increased employment and income when the proceeds are spent on exports to obtain command over real resources either by the borrower himself, or by the party who bought the foreign exchange from the borrower. Second, foreign capital investments do, although one needs to make a distinction between 'national income' and 'geographic product'.
The foreign lending alters factor proportions in the two countries from what they would have been without foreign investment. This leaves domestic factor proportions unchanged and forestalls an increase in the capital labor ratio, which would have raised the marginal product of labor and lowered that of capital--- had it been invested domestically.
One old distinction made turned on the location of the physical assets. The private investor runs risks whether he invests at home or abroad. If he makes a mistake in judgment and his investment proves worthless in the case of domestic investment, the physical assets at least are within the national boundaries, but if the unsuccessful investment is foreign, the physical assets accrue to foreigners.
This is an appropriate one if the risk the investor judges incorrectly is that of confiscation by government authority without adequate compensation. But, this distinction cannot be made for economic risks. A worthless factory or railroad is worthless, whether at home or overseas; and an asset with some value can be sold for that value, again in such case.
But of course, such perfect capital markets are far from achieved. There are risks of default and confiscation, which require a subjective risk premium, different for each country, before capital will flow from a safe home market to countries abroad. What is more, most investors and borrowers are myopic in that their horizons are restricted to the home territory, both for investments and for loans.
This is not necessarily irrational, as there is a cost to obtaining information on investments and opportunities for loans in a foreign country.
Economists would like to play with the idea that it would pay a country to limit the movement of the investment overseas, if the unrestricted movement of investment lowered its interest rate. The domestic price of capital under optimum lending should be equal to the marginal rate of return on foreign investment, not the average rate, if the two differed, as would be the case if the lending should be equal to the marginal rate of return on foreign investment, if the lending country were a price maker in the world capital market.