a) State what is meant by foreign direct investment (FDI) and identify the component of the

balance of payments accounts in which FDI is recorded. [2]

FDI refers to the injection of long-term capital from a foreign country into an economy,
example such as building or acquisition of production plants.

FDI is recorded under the capital and financial account of the balance of payments.

b) (i) Explain the opportunity cost of investment expenditure that uses domestic funds. [2]

Opportunity cost is the next best alternative forgone. Investment expenditure using
domestic funds would result in less funds available for consumers to borrow to purchase
big ticket items, and material standard of living can be lowered.

(ii) Using a production possibility curve diagram, show the impact of infrastructure
improvements in a country such as Singapore or Vietnam. [2]

Infrastructure improvements in a country such as Singapore will improve the quality of

capital goods and increase the productive capacity of the economy, allowing Singapore to
produce more goods and services. This can be represented by an outward shift of the entire
production possibility curve.

c) Explain how the current account of the balance of payments of Singapore or Vietnam is
likely to be affected in the long run by increased FDI. [6]

FDI that allows the transfer of skills and technology into the economy, and can allow her
export revenue to increase, in turn improving the current account of the balance of
payments.

With improved skills and technology, they can lead to the production of goods and services
with improved quality and lower unit cost of production. Improved quality of goods can
 attract greater demand for them, leading to higher export revenue. Also, with lower unit
cost of production which translate to more affordable export prices, it will lead to a more
than proportionate increase in quantity demanded, assuming close substitutability
between the home country and other competing countries, leading to higher export
revenue, and improve her current account balance.

On the other hand, with the FDI making profits at the home country in the long run, they
would repatriate the profits made back to their own home country, this repatriation of
profit will worsen the income balance at the home country, and thus worsens her current
account balance.

d) Discuss whether broad export diversify or specialization in a narrow range of exports is

more likely to be beneficial for an economy engaged in international trade. [8]

Based on Theory of Comparative Advantage, specialization and trading based on a

country’s comparative advantage can benefit economies by increasing the amount of
goods available in each country for consumption. For example, with high skilled labour,
Singapore enjoys comparative advantage in producing capital-intensive products like high-
end electronics. On the other hand, Vietnam enjoys comparative advantage in labour-
intensive goods such as textiles due to availability of huge labour base. If both countries
specialize in their area of comparative advantage where Singapore specialize in producing
capital intensive goods while Vietnam specialize in producing labour intensive goods and
then trade with each other using mutually beneficial terms of trade, they can both enjoy
consumption level beyond what they can produce on their own without trading, outside
their respective PPC curves, thus improving material standard of living. Also, the ability to
specialize allows the countries to produce on a larger scale of production and enjoy cost
savings through reaping internal economies of scale. This can lead to improved export price
competitiveness and boosting export sales, leading to higher actual growth, lower cyclical
unemployment and healthier balance of payments for their economies.

However, specialization in a narrow range of exports involves concentration risk and leave
the country more vulnerable to a downturn in one of these industries. For example, a
country exporting non-renewable energy sources such as crude oil would be especially hit
hard if other countries adopt cleaner energy sources as part of their shift towards a green
economy. The fall in export earnings results in a sharp drop in aggregate demand, which
can trigger a recession and high cyclical unemployment. Hence, economies should pursue
export diversity, such that a downturn in one industry can be buffered by continued growth
in other sectors. Also, given that workers are not perfectly suited to the production of
different goods, an economy will also encounter rising opportunity costs as it specializes in
the production of a good, hence specialization might not always lead to cost savings.

Overall, specialization in a narrow range of exports and engaging in trade is more likely to
be more beneficial for a small economy given its ability to drive growth and allow the
economy to consume outside its PPC. This is especially true for Singapore, which faces
constraints due to its small domestic market and resource scarcity. On the other hand,
while broad export diversity reduces concentration risk, it may prove challenging for
countries with limited financial resources to develop its various exporting industries.
e) Discuss whether a government should encourage domestic investment rather than
investment from external sources to improve the standard of living. [10]
Standard of living can be considered in terms of material and non-material aspects. The
choice of domestic investment or FDI to improve living standards depends largely on the
nature of the economy, as well as the nature of the investment.

In the case of small countries, FDI can have a greater impact on economic growth compared
to domestic investments. Example, Singapore has small investor base due to its population
size, thus small domestic investment relative to other components of her aggregate
demand. Furthermore, domestic investment funded locally reduces the availability of
credit for local consumption, hence the fall in consumption expenditure will partly offset
the rise in domestic investment expenditure, leading to a smaller increase in aggregate
demand. As a result, tapping on FDI to boost the aggregate demand can lead to a bigger
boost in actual and potential economic growth.

The rise in FDI raises AD and lead to an increase in real national income. It also shifts LRAS
rightwards since it can lead to a rise productive capacity, considering the increase in
quantity of capital goods in the long run. This result in an increase in real GDP, assuming
population unchanged, brings higher material standard of living. The rise in LRAS can also
help to dampens demand-pull inflation and helps maintain the population’s real
purchasing power. At the same time, the government will be able to collect more tax
revenue in the forms of higher income tax and corporate tax from foreign entities, allowing
the government to better finance spending on amenities such as healthcare and education,
which can improve the population’s non-material standard of living.

In addition, FDI which introduces higher skills and technologies into a country can boost its
export competitiveness. Training provided to local workers, such as operation of complex
machines, can also boost their productivity and income. However, this tend to favour
younger and more skilled workers, compared to the older workers. Hence, while it can
raise the material standard of living for the younger and more skilled workers, the older
workers may face structural unemployment, resulting in widening income gap and living
standards may not improved evenly for the population.

However, if FDI into a country resulted in stiffer competition for the local firms, it could
lead to decline in output and even closure of these local firms, leading to unemployment
of workers hired by them, which can lower the material standard of living. This risk is
especially pertinent for Vietnam since it is predominantly a labour-intensive economy.
Also, if labour costs are kept low to boost an economy’s attractiveness for FDI, the workers
will be earning low income and hurts their material standard of living. At the same time,
the increased in industrial activities due to increased inflow of FDI can also lead to greater
pollution in the country and lower the non-material standard of living for the people.

Overall, governments should encourage FDI since tapping on a larger pool of foreign capital
can help to stimulate economic growth to a larger extent than to rely solely on domestic
investment. However, the unintended consequences of widening income gap and
environmental issues can mean that the standard of living may be worsen in the long term.
To prevent this, countries should implement complementary policies such as training to
older and low skilled workers to reduce structural unemployment, and strict
environmental rules with relevant supply side policies on greener production method to
reduce negative environmental impact.