THE rich countries are still in a state of denial about the fate of the free-for-all market economy. They still believe that they can bring back the good old days of Reagan-Thatcher version of capitalism and make it run this time without ever collapsing on them as it did in 2007-08.

The G-20 meeting held last week in Washington hoped that with a little bit more effective regulation of global financial markets and continuing with the mantra of free trade, everything could be set right.

But so far there seems to be no agreement on how to make regulation of financial markets more effective. The talk that some kind of world organisation on the lines of IMF, World Bank or WTO could be set up to do the job on global basis appears to be too impractical. No country worth its salt would allow any global organisation to interfere with the domestic financial markets.

On the other hand, even the all powerful private sector of the rich countries, which actually plays the politicians of these countries like a puppet, appears in no mood to give up even an iota of its operational independence to the regulators. All that they now want from their governments is generous handouts from the tax payers’ money. They have refused so far to even pass on the reduction in the cost of money to their customers and have also refused to be dictated by the regulators on the issue of remunerations and bonuses to their top managers.

And on the issue of free trade, the G20 meeting appeared to have simply announced a wish but no clear cut policy about how to break the Doha Round ice. The unsuccessful completion of the Round has continued to frustrate the champions of the free trade. The Round has remained unsuccessful because of the adamant attitude of the rich countries which under pressure from their politically powerful agricultural lobbies find it impossible to lift their protectionist barriers made up of heavy subsidies on agriculture produce and huge tariffs against agri imports.

Meanwhile, a recently released OECD report on Foreign Direct Investment (FDIs) reflects a gloomier scenario for international finance.

As the financial crisis has evolved into a global economic crisis, the outlook for FDI is found to have likewise darkened. On current trends, international inflows are expected to be down 13 per cent and outflows by six per cent by the end of the year. These declines are expected to be much less severe than those experienced in 2001, when the FDI inflows and outflows dropped by 49 per cent and 43 per cent respectively.

Grim outlook for FDI, a publication of the OECD Investment Committee released last week, however, said it was likely that the FDI flows will fall sharply in the second half of 2008 and continue to decline into 2009, especially considering the speed with which the global economic crisis deepened during the Q3 and into the Q4 of 2008.

This is reflected in international merger and acquisition (M&A) activity (a major component of FDI), for which data are available into Q4 (22 October). On current trend, international M&A will decline by 29 per cent from the record levels reached in 2007 ($1.7 trillion). Furthermore, the bursting of the dot.com bubble in 2000 showed how sensitive international M&A activity is to economic crises, with the value of international M&A activity declining by 47 per cent in 2001.

While the aggregate FDI flows are down, inward FDI into the OECD from outside the OECD has represented a rare bright spot during the crisis to date. For example, based upon current trends for the largest 100 international M&A deals (which account for approximately 50 per cent of all international M&A activity), M&A activity in the OECD originating from non-OECD sources is set to grow by 25 per cent in 2008 over 2007 levels.

This M&A activity has already reached $71 billion in 2008, exceeding the total for 2007 and accounted for 15 per cent of the value of the largest M&A investments in the OECD area in 2008 (up from nine per cent in 2007). M&A activity in the OECD originating from non-OECD sources is the only area in which international M&A activity has been growing. In other words, the FDI has served to channel capital from places where it has been abundant to where it has become scarce during the crisis.

Barring a serious protectionist response (resulting, for example, from political pressure to stop foreign investors from “taking advantage” of the economic crisis), this positive role for international investment from developing countries will likely increase over time as both experience and available capital grow. For example, according to Deutsche Bank Research the assets under management of Sovereign Wealth Funds outside the OECD are projected to increase from their current level of around $3.6 trillion to $5 trillion by 2010 and $10 trillion by 2015.

The more severe nature of the current crisis therefore suggests that there remains considerable scope for further declines in international M&A activity.

Two forces are at play that give rise to the grim outlook for FDI. First, the freezing of credit markets, combined with sharp declines in equity markets, have forced firms to rely largely on cash reserves to finance investment. In a number of industries (such as automotive), many firms are also facing severe internal liquidity constraints.

Second, the composition of international capital flows to developing countries has changed dramatically between 1999 and 2007. During this period, FDI’ s share of total capital inflows fell from almost 90 per cent to under 50 per cent and the combination of portfolio flows and private debt increase from six per cent to 55 per cent (the net position of official creditors is actually negative at $4 billion because loan repayments have exceeded lending).

This diversification has been a positive development, and reflects a number of factors, including strong growth in developing countries, accompanied by high rates of return on investment, as well as the sound investment frameworks that developing country governments have been putting in place.

However, under the current circumstances, this increased reliance on portfolio flows and private debt could result in a sharp con-traction of international capital flows for many developing countries.

For example, according to the Institute of International Finance, private credit financing into 30 developing countries surveyed (including the BRICS) will decline by half between 2007 and 2009 (from $600 billion to $300 billion), while net portfolio inflows, which are already negative, will decline further (from –$6 billion to -$20 bill-lion). The FDI flows into these 30 developing countries, however, are only expected to decline by seven per cent (from $302 billion to $282 billion).